Income Property Survival Guide Joe Lumbley, President JP Lumbley & Associates, LLC

Get Rich Quick (GRQ)  Main purpose is to sell seminars and books  How else can they afford 30 minute infomercials?  Sell the dream, not the reality  So, why not sell the truth?  Can’t give the truth away in most cases, much less sell it  It’s not what people want to hear. It’s not the easy way.

The Rare GRQ Deal: Make Haste Slowly  Sometimes lightning strikes.  But only those who’ve managed to place a lightning-catcher in just the right place will benefit  How to catch lightning  Think ultra long-term. Befriend lots of property owners. Treat them right. Stay in touch. Be very low-key. Don’t try to convince or to sell. Learn from these owners. Let them know you appreciate it. Ask their advice on other deals.  Let them know that you’d like to become an owner yourself someday.  Wait for them to decide to sell and make them an offer then.  Happens most often with property managers, relatives

Get Rich Quick: Fallacies  Most sellers are intelligent people. Many are also active buyers themselves, and they’ve seen it all.  GRQ (get rich quick) deals, if they’re even for real, are the extraordinary deals. You cannot base a long-term business plan on just finding extraordinary deals. Remember the bell curve

The Bell Curve

What they didn’t cover in the get-rich-quick books  Classic pyramid. Only those at the top make any real money.  Professionals will just flat-out ignore you.  Sellers are seldom desperate enough to accept such flaky deals.

Advantages of Real Estate Investing  Everybody’s got to live somewhere  Not making any more of it—finite supply  History of year-to-year appreciation  Tax benefits  You control it more than stocks & bonds  You already understand most of the mechanics of the process  Ability to negotiate price & terms

Disadvantages of Real Estate Investing  Time-consuming. Plumbing calls in the middle of the night  24 x 7 job  Stressful. Lots of money involved  Antagonistic. Much of real estate is a zero sum game.  Not liquid  Lots of commissions & fees  No guarantees. No FDIC/FSLIC. No safety net.

Leverage What is leverage? What can you leverage?  Money—OPM, Other Peoples Money  Rents  Net Worth  Reputation  Time  Your network  Information

Rent Leverage  Income property is valued based on revenue, not just real estate  Typical apartment deal valued at 6X gross rents  20 units at $416/month ~ $100,000 revenue. Value is $600,000.  10% rent raise to $458/mo. ~ $110,000  New value is $660,000.

Net Worth Leverage  Higher net worth = more business respect, better business terms, more opportunities  Net worth for most part is STATED. Very seldom do you need to get appraisals to back it up.

Reputation Leverage  Do more deals = become more of a known factor.  See Net Worth Leverage. Same concepts.  Works both ways. Negative reputation can kill you. It’s still a small community.

Time Leverage  What is the only thing that is 100% finite and always in limited supply? Time.  Get other people working for you. Referrals, leads, employees, tenants, brokers, loan brokers, lenders.  Develop systems to do deals efficiently and quickly  Don’t waste your own time  Don’t let others waste your time for you  Deal with professionals. Don’t try to do everything.

Seller-Centric Buying  Deal doesn’t come down without both a Buyer AND a Seller.  Both parties have to be satisfied  Seller has inertia on his side  Find out what the Seller wants  Give him the minimum you can to make him happy.

Typical, real world deals  Leverage  20% down at local banks, good local credit, local history  25% down at more conservative lenders or on more borderline deals  30% down at some lenders, who may allow a seller-financed second lien.

Seller Financing  Sellers almost always want the cash. Cash talks. Sellers listen.  Most of the time, sellers know the real values of their buildings. They’ll be real happy to show you how the rents will increase 50% but they’re not stupid enough to base the values of their second-lien note on those projections.  When money’s easy, seller financing is very hard.  When money’s tight, seller financing is more likely

If I can’t start with zero cash, how do I start?  If you don’t have good credit or you don’t have money or assets for a down payment, you need to work on those problems first.  Build up your credit rating  Save up a war chest  Own your own home first  Start making contacts  Keep watching for the rare but sometimes attainable zero/low down deal but don’t build your future plans on being able to find it.

Other Peoples Money--OPM  Purchase money  Improvement money  Grants  Hard money  Tax incentives  Credit cards  Construction money

Money Sources Whose money?  Lenders  Sellers  Partners  Government  Tenants  Buyers  Family & Friends  Retirement money  Credit Cards  Home equity

Taxation  Understanding real estate taxation is key to the entire process  Ad Valorem taxes are property taxes. They’re NEGOTIABLE. Don’t take tax increases lying down  Income taxes are partially sheltered by interest and depreciation deductions  Capital gains taxes are due on sales profits  Recapture taxes are due in year of sale and are high at 25%  Understand 1031 exchanges

Locating Income Property  Do your homework  Pre-qualify with lenders  Have your down payment lined up  Quantify what an acceptable deal looks like.  Build your network  Identify and concentrate on your market  Use brokers  Watch the ads and the online listing services  Walk the area. Find properties you like. Talk to the owners.  Track financial news and trends

Purchasing Income Property  Be ready to move quickly  Understand the seller’s  Motivation  Cash needs  Timeframe  Special needs  Offer with a respectable earnest money deposit. Offer reasonable option fees.  Don’t waste your time or the seller’s.  Give yourself a short-term inspection clause that allows you full access to property and records

The Purchase Process  Make an offer  Negotiate price and terms of an offer contingent upon financing and inspections  Inspect the property and books  Re-negotiate price and terms to release the inspection contingency  Negotiate and obtain any loans or financing  Close the deal

Important Terms  Net Operating Income = NOI = Scheduled revenue – vacancy – expenses  Capitalization Rate = CAP Rate  GRM = Gross Rent Multiple  Cash Flow = NOI minus debt service  After-tax Cash Flow = Cash Flow – income taxes on the revenue  Cash-on-cash return = cash flow / cash investment.  Internal Rate of Return = IRR = current value of the entire stream of income. Includes final sale of property so includes appreciation

Evaluating the Income Stream  You’re not just buying real estate. You’re buying a stream of income to be received in the future.  Actual rents or street rents?  Street rents through rent surveys in the area.  Actual rents (collected rents) are AFTER vacancy, so don’t try to apply a vacancy rate if you’re looking at actual receipts.

Vacancies  Apply a vacancy rate to street rents or pro- forma rents  View over a year’s time  Your mileage may vary. Management can play a part here  Vacancies also affect other income, such as laundry and vending income  Vacancies also affect expenses such as utilities and unit cleaning and make-ready  Also include collection losses due to nonpayment of rent

Quality of the Income Stream  Is it real? It’s very simple to fake up rent rolls.  Is it steady or seasonal?  How long have the tenants been there?  What’s the turnover?  Are the tenants all related or all working for the same employer?  How many tenants are behind on their rent right now?  How many evictions have they had in the last year? Affects legal costs and fees May indicate poor tenant screening  How many units are non-revenue?

How much is it worth? Multiple ways of approaching value. All contribute to overall pricing  View it like a bond CAP rate = NOI/price. Lower CAP=Higher Price. CAP rate ~ interest or yield on a bond  View it like a stock GRM = Gross Rent Multiple = Price/Annual Income Lower is better GRM ~ earnings multiple  View it like a house Price per unit Price per square foot  View it like a business Cash-on-cash return After-tax cash-on-cash return

View it like a bond  This is an “intrinsic” method of valuation  Does not consider financing. Looks at value as though there were no financing at all on the property.  Not affected by leverage  Doesn’t consider taxation  Doesn’t consider appreciation in value  Adaptable to any type of income property  Conservative approach. Bankers use it, as do big all-cash buyers like pension funds

View it like a Stock  Stock is really a pretty weak analogy, but bear with us  GRM is like an earnings multiple based on gross earnings  Doesn’t consider financing or leverage or taxes  Considers appreciation to a small degree. As gross rents go up, value goes up.

View it like a House  Comparable sales  Limited MLS information available  Some specialized registries like Roddy Report  Price per unit  Price per square foot  Comparable GRMs  Comparable CAP rates  Comparable cash-on-cash

View it like a Business  Before- and After-Tax Cash flows  Considers financing  Affected by leverage. More leverage = more money financed = more debt service = less cash flow  After-tax cash flows take into account income taxes

View it as Income Property  Melding of all the methods above  Internal rate of return (IRR) considers everything  Cash flow  Allows you to assume % increases in revenues and expenses  Appreciation  Allows you to assume net cash in a sale down the road  Taxes  Income tax  Capital Gains  Recapture  Alternative investments. IRR allows you to assume a reinvestment rate of return on cash flows

The Process of Valuation  Use house-like valuation to eliminate obvious clunkers  Evaluate the income stream  Use GRM and CAP rates to further refine whether you even want to spend more time on the deal and to get closer on price  Use business-like methods to refine further and to decide whether the investment meets your criteria.  Use IRR to determine property’s value to you and to prepare presentation materials for your lenders.

What next? Expanding your holdings.  Can use IRR methods to calculate your current IRR on existing investments  Look at the rate of return curve  Sell, trade, or refinance when the IRR drops below what you can get on new deals  This method can work to help convince sellers that it’s OK to sell.  Refinance and pull cash out of the deals— this is the only place where GRQ concepts really apply.  Consider 1031 exchanges rather than sales

Summary  Do it NOW. How long do you plan to live?  Forget everything you learned in television seminars  Develop a method that works for you and then stick with it. This is business, not emotion.  You’re not looking to LIVE here. You’re looking to cash the checks from others who live here.  Remember, not every at-bat is a home run. If you only swing at home run balls, you’ll miss a lot of singles, doubles, and triples.

For more information  Joe Lumbley  Monte Self  Thanks for your time. Hope you gained something from this presentation!