Real estate investing: Mind financial and tax issues
Investing in commercial real estate has its complexities and certainly isn’t for the faint of heart. Investors must perform financial analysis on various potential investment opportunities to determine the best possible performers and, hopefully, pick a winner. Here’s a brief overview of the financial analysis and key tax aspects involved in such investments.
One of the first steps in analyzing any real estate investment is the determination of the projected net operating income (NOI). NOI is calculated by subtracting operating expenses from the gross rental income from the property. Operating expenses include real estate taxes, maintenance, insurance, janitorial, accounting, management fees, etc. Many investors like to use projected NOI to calculate a “cap rate” on the prospective property. A cap rate is simply the NOI divided by the total purchase price of the property. For example, if a potential real estate investment with a purchase price of $500,000 was projected to generate an NOI of $40,000, then the cap rate would be
8 percent. Some investors prefer to calculate a “cash-on-cash” return. The cash-on-cash return takes a pure cash flow view of the investment and considers the financing aspects of the deal. Using the previous example, let’s say the $500,000 in real estate is going to be purchased by making a $150,000 down payment with the balance of $350,000 financed with a long-term bank loan. Let’s assume the bank loan requires an annual debt service of $24,000 (principal and interest). The annual cash-on-cash return is 10.6 percent ($40,000 NOI less $24,000 debt service divided by the $150,000 down payment).
While the cap rate and cash-on-cash return are convenient, back-of-the-envelope calculations, they merely reflect a snapshot in time. More sophisticated investors will most likely want to calculate an internal rate of return (IRR) on their potential real estate investments. An IRR is a motion picture allowing the investor to see into the future. The IRR will consider changes in future rental rates, operating expenses and vacancy rates as well as consider capital appreciation of the real estate investment. Furthermore, the IRR takes the time value of money into account as well as adjusts the net future cash flows for the tax savings from depreciation deductions. The IRR is certainly a more interesting and informative calculation of potential investment performance. While an IRR can be calculated with the use of a spreadsheet, more complicated investments could require the use of specialized software.
The income tax effects of a potential real estate investment should always be part of the analysis. The depreciation deductions generated could result in additional positive cash flow in the form of tax savings over the life of the project. Consequently, it’s usually in the best interest of the real estate investor to maximize depreciation deductions, especially in the earlier years of the project.
The remainder of this column discusses a couple of common strategies used to maximize the tax benefits of depreciation and increase the IRR of the project:
- Separating improvements from land. Not all of the cost of acquiring real estate is depreciable. Specifically, the cost of improvements to land is depreciable, but the cost of the land itself is not. Clearly, then, it’s desirable to identify and document at the time real estate is acquired the part of the overall acquisition cost allocable to improvements. Thus, when property is purchased, a qualified real estate appraiser should be retained to make an allocation between land and improvements. Or, if the investor has enough valuation expertise and knowledge of the locality, the investor could determine and document his or her own detailed analysis and allocation. In either case, it would be important to have an accountant review the analysis to determine whether it’s in accordance with valuation techniques respected by tax laws. Regarding the allocation, the investor also should be aware the cost of improvements includes not only the cost of buildings, but also the cost of such items as landscaping and roads and even some costs of grading and clearing.
- Separating personal property from buildings. Most commercial buildings must be depreciated over a period of 39 years, with exceptions for residential rental real estate (27.5 years) and for restaurants and certain leasehold improvements (15 years). On the other hand, land improvements are depreciated over 15 years and most personal property (furniture, equipment, etc.) is depreciable over five years or seven years. As you can see, if a specific item is classified as personal property rather than part of a building, the depreciation deductions for that item will be available sooner and, in economic terms, have a greater “present value” to the property owner and increase the IRR of the project. In the same way it’s desirable to properly allocate between improvements and land, it’s important to take steps to identify and document at the time real estate is acquired the items that are personal property and the items that are building parts. For some items, the distinction follows “common sense” — an ordinary chair is personal property, a weight-bearing brick wall is part of a building.
However, for many items — lighting fixtures, signs, floor coverings, wall coverings, plumbing, electrical systems and heating and cooling systems — the distinctions are governed by tax rules that can be complex, involve projections as to the future use of the items and could even necessitate consultation with engineers or other construction experts. After the personal property and building items are separately identified, they must be separately valued, either by an appraisal, a breakdown of construction costs or both.