© 2015 OnCourse Learning California Real Estate Finance Fesler & Brady 10th Edition Chapter 15 Financing Small Investment Properties

Objectives After completing this chapter, you should be able to: – Describe financing alternatives for residential income, commercial and industrial properties. – List and briefly explain advantages and disadvantages to investing in each of the categories of investment property. – Calculate and apply “break even analysis” to income producing properties. – Discuss how financing conditions affect prices of income producing properties. – Compute debt-coverage ratios.

Outline The Single-Family House as Income Property The Two- to Four-Unit Residential Property The Five-Plus Unit Residential Income Property Break-Even Analysis Financing Starts with the Listing Introduction to Commercial and Industrial Properties Debt Coverage Ratio

The Single-Family House as Income Property (Slide 1 of 4) Key Characteristics – Large supply – Management is easier – Active resale market – High degree of liquidity – Sold outright or tax deferred exchange

The Single-Family House as Income Property (Slide 2 of 4) Non owner occupied 75% loan to value Fannie Mae and Freddie Mac use 80% loan to value But require one year experience as landlord Or six months PITI in reserve ¼ to ½% higher interest Higher loan fee Fixed rate Prepayment penalties only within first three years – For owner occupied – But rental properties can differ

The Single-Family House as Income Property (Slide 3 of 4) Flipping – Buy a house with long escrow – Value appreciates – Sell before closing first escrow – Works well with appreciating values – With depreciating values, buyers “walk away” – Lenders become reluctant to offer non-owner occupied loans

The Single-Family House as Income Property (Slide 4 of 4) Advantages – Larger selection of properties – Management is easier – Investment is more liquid – Tenants pay for utilities, gardening, and minor repairs – Depreciation tax shelter – Tenants remain longer – Passive loss rules apply up to $25,000 – Low vacancy factor – Hedge against inflation – Leverage during inflation – “Walk away” during decline – 1031 Exchange available Disadvantages – Could be negative cash flow – Rent/ft 2 lower – 100% vacancy – You are the manager – But could get professional management (10% of rent) – Owner pays for repairs – If owner has many houses, no economy of scale – Tax deductions can be changed by Congress

The Two- and Four-Unit Residential Property (Slide 1 of 2) 75% loan to value 15% down Many sellers will carry second ½ to 1% higher interest Higher loan fees If owner lives in one unit – Get owner-occupied financing Prepayment penalties – Six months unearned interest – 20% payoff allowable in any one calendar year

The Two- and Four-Unit Residential Property (Slide 2 of 2) Advantages – Many available – Owner can be manager – Tenants pay utilities, etc. – Rent unfurnished – Tenant may be manager – More privacy for renter – Good LTVs – Depreciation tax shelter Disadvantages – Expensive – Negative cash flow – Higher qualification requirements – Repairs and replacements – Reserves needed – Owner pays water, outside lights and laundry room utilities – Reluctance to raise rents

The Five-Plus Unit Residential Income Property (Slide 1 of 3) Characteristics – Better buy than 2-4 units – Larger down payments required – Demand is lower – Keeps prices down – Sell at prices relative to income – Not much vacant land for building – Need parking and open space for new construction – Environmental factors make apartments more difficult to build

The Five-Plus Unit Residential Income Property (Slide 2 of 3) 60 – 75% loan to value 30% down ½ - 2% higher interest Higher loan fees Amortized for 30 years, but due in 1-10 years Lenders use appraisal and capitalized income stream to determine loan value Need better than good credit

The Five-Plus Unit Residential Income Property (Slide 3 of 3) Advantages – Constant demand for housing – Concentrated management – Resident manager possible >16 units requires one – Cost/unit is less – Fewer being built – Tax shelter – Equity appreciation Disadvantages – Lots of expenses – Need reserves – Changing neighborhoods – Owner-tenant laws – Rent control – Need patience – No tenant pride of ownership

Break-Even Analysis (Figure 15.1) Sales = Fixed Costs + Variable Costs

Financing Starts with the Listing (Slide 1 of 2) Reasons for selling? – Improvements – Neighborhood change – Rent control – Exchange up – Wants more/less units – No depreciation left Existing financing information – Lender, balance due, interest rate – Assumable – If more than one loan, same info – Minimum credit score – Short Sale?

Financing Starts with the Listing (Slide 2 of 2) New financing – Will lender allow assumption – Minimum credit score – Prepayment penalty negotiations – Down payment – Interest, term, prepayment penalty, acceleration clause, loan fees, down payment, impounds – Second loan Capitalization Rate – Cap rate = Net Operating Income/Sales Price – Compare to interest rate If rising, cap rate decreases Does it make good sense without tax shelter?

Introduction to Commercial and Industrial Properties (Slide 1 of 3) Strip malls Free standing commercial buildings Convenience centers Supermarkets surrounded by other stores Department stores Service stations Garage buildings Franchise outlets Quick service restaurants Motels, hotels, mobile home parks Office buildings Rest homes and convalescent hospitals Other special purpose (drive in banks)

Introduction to Commercial and Industrial Properties (Slide 2 of 3) Industrial – Small 10,000 – 100,000 ft 2 – Larger One tenant/long term lease – Industrial parks Developer buys land and develops individual building to specs of master plan Office Parks – Could include restaurants, shops and hotels

Introduction to Commercial and Industrial Properties (Slide 3 of 3) Advantages – Steady income – Low vacancy – Lessee makes major improvements – COLA clauses or percentage lease – No rent control – Business tenants are easier to deal with – Lease insurance available Disadvantages – Higher prices – Vacancies during down times – “Main Street” vs. newer centers – Fixed rents – City codes

Debt Coverage Ratio Debt coverage ratio = Annual Net Operating Income Annual Debt Service Should be >1.1

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