In last month's Wealth Chronicle newsletter one of the articles was titled Distressed Properties 101 which providedthe details and differences from Foreclosures, Short Sales, and Bank REO properties. This month's article is the second part in that series; we will explore what to look for when buying a distressed property in order to decide whether it to be a successful investment.
When it comes to investing in distressed properties (or any type of property) there are four ways to make money
- Cash Flow
- Appreciation
- Loan Amortization
- Tax Shelter
Each property you invest in is unique and will blend the four benefits above differently. This article will detail each of these four topics
Cash Flow
Cash flow is simply money coming in and money going out. If you look at a particular period of time (usually 12 months) you will want to know if more cash comes in than goes out. (positive cash flow) If a property has a negative cash flow it means you, as the investor, will have to ante up your own personal money to make up the deficiency. Having an occasional negative cash flow does not automatically make it a flawed investment; you may make up your returns in the other three areas.
Example
You own a six-unit building. Two units rent for $800 a month, two for $900 a month, and two for $1,000. Each month you make a mortgage payment of $2,800. You pay $14,100 in real estate taxes, $3,800 in insurance, $4,200 for maintenance and repairs, $800 for water, and $75 for miscellaneous supplies
Cash In
(2 x 800) + (2 x 900) + (2 x 1000) = $5,400 per month
5,400 x 12 months = $64,800 per year
Cash Out
Mortgage (2,800 x 12 months $33,600
Real Estate Taxes $14,100
Property Insurance $3,800
Maintenance $4,200
Water $800
Supplies $75
Total $56,575
Cash Flow $8,225
Appreciation
Next to Cash Flow to most meaningful return is appreciation which is defined as growth in value of a property over time
The amount of appreciation is the difference between the selling price and your original purchase price.
Loan Amortization
When you use a mortgage loan to help you purchase an income property someone else (the tenants) are paying your bills. Each mortgage payment you make includes both interest and principal. Amortization is the liquidation of this debt by the application of installment payments over time
Example:
You make monthly mortgage payments of $1,500. At the end of the year, your bank reports that you have paid $15,00 in interest for the year your amortization for the year is
Annual Debt Service ($1,500 x 12) $18,000
less interest paid for the year $15,000
= Amortization for the year $3,000
Tax Shelter
As owner of an investment property, you take in taxable rental income, and pay out tax-deductible operating expenses like insurance and repairs, leaving you with a "net operating income" (NOI) on which you would expect to pay taxes. However, the tax code permits further deductions. The first of these deductions is for mortgage interest. The second source is through depreciation (cost recovery).
Example
Income $64,000
less Operating Expenses $22,975
= Net Operating Income $41,825
less Mortgage Interest $32,000
less Depreciation $8,000
= Taxable Income $1,825
Successful investors focus on the property's income stream. Don't make a decision to buy, hold, or sell based on emotional factors. To achieve a successful return you have to focus on the numbers carefully: the current financial data and at reasonable projections of how the investment will perform in the future.