Chapter 28: Types of Investment Properties

Flipping Property (Situations to Avoid)

- Floor plans that don't have wide appeal. - Outdated architectural styles. - Poor basic construction. - Obvious or likely code violations. - Work that appears to have been performed without the proper building permits. - Properties in neighborhoods that are on the decline.

Reasons some Invest in Residential Property

1) Some investors purchase property to keep, meaning that they will buy the property and hold it for the long term. An investor purchases property to get income, to see the property appreciate in value, and sometimes to gain tax benefits. 2) The other reason investors purchase property is to flip it. A property purchased to flip is one that is intended to be resold as soon as possible. Investors that intend to flip properties feel that they can make a profit either with or without renovation, repairs, or improvements.

Real Estate Investment

A basic goal in investing is to generate more income and create wealth. Real estate is typically illiquid. - Real estate investments are different from stock market investments because the control remains in the hands of the investor. The investor makes his or her own decisions that affect the future of the investment and can also structure purchases and sales according to his or her particular needs. An investor can realize profits from real estate in several ways: - Positive cash flow: Any cash received from rents that is in excess of the expenses. - Tax benefits: Real estate can both avoid and shelter income from taxation. - Appreciation: Property can increase in value and be realized at the time of sale or can be realized by borrowing on the equity.

Fee Simple

A commercial property can be owned outright by the business or an individual. - This is the highest interest in real estate recognized by the law; the holder is entitled to all rights to the property.

Time Value of Money (TVM)

A core principle of finance based on the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity (provided money can earn interest, any amount of money is worth more the sooner it is received). - For example, if $1,000 is invested today at a 5 percent interest rate, it will be worth $1,050 in one year ($1,000 x 1.05). On the other hand, that $1,000 received one year from now would only be worth $952.38 today ($1,000 divided by 1.05), assuming the 5 percent interest rate. - The present value of an investment is the principal invested. In our example above, that's $1,000. The future value is the principal plus the interest - $1,050.

Capital Gains Tax

A federal tax paid by businesses and investors when they sell stocks or real estate.

Anchor Tenant

A major tenant in a shopping mall, such as a department store, that in theory serves to attract shoppers to the mall to the benefit of other, smaller stores.

Section 1031 (Internal Revenue Code)

A property that is held for investment purposes can be exchanged for like-kind property. In such an exchange, the capital gains tax is deferred until the investor disposes of the property in a taxable transaction. - called a "1031 exchange" - a rented single home is eligible.

Single-Family Homes

A structure that houses one family and is characterized as detached units found in subdivisions, neighborhoods or in cluster home developments, where the owners share outdoor and common areas. - Single-family homes are the most liquid of all real estate investments and are the most easily rentable.

Like-Kind Property

A tax term used in exchanges; real property must be exchanged for other real property; it cannot be exchanged for personal property. In addition, personal residences are not eligible for exchange treatment. Under the like-kind definition, a rental home can be exchanged for another rental home, multiple units, an apartment complex, commercial property, or land.

Liquidity

A term that refers to an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value. Cash is the most liquid asset. A liquid asset can be sold rapidly, with minimal loss of value, anytime within market hours. The essential characteristic of a liquid market is that there are ready and willing buyers and sellers at all times. An illiquid asset is an asset which is not readily saleable due to uncertainty about its value or a lull in the market in which it is regularly traded. Property is considered an illiquid asset which cannot be transferred as easily as other assets, such as stocks or bonds. Given the illiquid characteristic of real estate, investors should carefully examine their goals before making an investment in property. Is this a short-term or long-term investment? Does the investor want to hold the property permanently or does he or she hope to sell quickly at an opportune time and move on to another investment? Real estate investments can fluctuate due to trends in the market, so investors should be certain that they have enough reserves to wait out a low period in the economy.

Investing in a Condominium

A unit in a planned unit development. The advantage is that it is relatively easy to rent, while providing less direct owner involvement. In a condominium complex, the grounds and exterior maintenance are handled by an association, so the investor doesn't have to provide those services. On the other hand, a disadvantage is that condominiums have generally appreciated at a much slower rate than other units. When the economy is experiencing a recession, the value of a condo tends to be less than that of a single-family home. T Before an investor considers purchasing a condominium, it's important that he or she check the restrictive covenants carefully. Sometimes condominiums and cooperatives have rental restrictions that might clash with the investor's future plans. It's also important to find out if the condominium has any special assessments for unusual expenses. Because the condominium is governed by an association, the owner has less control over the costs.

Loft Building

An industrial building of several floors with large areas of unobstructed space, originally rented out for light industrial purposes and now frequently converted to residential occupancy.

Fixer-Uppers as Investments

An investor in a fixer upper can get an important tax benefit if he or she chooses to occupy the home for two years. If the investor does this, then the profit on the sale of the home is not taxed as income. This exemption of $250,000 for an individual and $500,000 for a couple is not just a one-time exemption. It can be used every two years.

Property Investments

Are generally considered to be long-term and low-risk, as compared to some other types of investments and can also serve as a hedge against an inflationary economic trend. Property investments must offer the promise of higher returns in order for an investor to choose property over other, safer investments. For example, if an investor knows that he or she can get a 6 percent return on a treasury bond, he or she will expect more from a property investment because of the risks involved. Ways to lose money on property: 1) Negative cash flow - When income does not exceed expenses, although often the tax benefits will minimize the effect. 2) Loss realized at the time the property is sold.

Retail Centers

Are of differing sizes and fall into categories with distinct functions. Each center usually has a main tenant called an anchor tenant. It is often essential to have a lease commitment from an anchor tenant before a lender will agree to the financing for the shopping center. - Strip Centers: Also called convenience centers, strip centers provide for the sale of personal services and convenience goods. These centers typically have a total leasable area of up to 30,000 square feet and are usually anchored by a convenience store, such as a minimarket. Tenants in a strip center can include a dentist office, beauty salon, dry cleaner, or small restaurant. - Neighborhood Centers: These centers provide for the day-to-day living needs of the immediate neighborhood. They are usually anchored by a supermarket and have a total leasable space of about 60,000 square feet - although they could have up to 100,000 square feet of space. Tenants in the neighborhood center are similar to the strip center and could include a drugstore, laundry, barbershop, shoe repair shop, shipping store, and small restaurants. - Malls: By definition, a shopping mall is a public area with a complex of shops with associated walkways and parking areas. Many shopping malls are enclosed or covered to allow for the same climatic conditions year-round. - Regional Centers: These centers provide general merchandise, clothing, furniture, and home furnishings as well as other services and recreational facilities. They are anchored by one or two full-line department stores of at least 50,000 square feet each and have a total leasable space of about 500,000 square feet. These centers provide services that are typical of a business district. - Mega Malls: Also called super regional centers, these malls offer extensive variety in general merchandise, clothing, furniture, and home furnishings as well as a variety of other services and recreational facilities. They are usually anchored by three or more full-line department stores of at least 75,000 square feet each. One of these centers usually has about one million square feet of leasable space, but can have up to 1.5 million square feet. - Outlet Centers: An outlet center is a type of specialty center in that it does not fit into any of the categories described above. It has its own focus, which is typically to sell the merchandise of particular manufacturers at a discount. An outlet center is usually anchored by at least two large discount stores and has a total leasable space of 100,000 to 300,000 square feet.

Investment Risks (other than financial)

Business risk Inflation risk Management risk

Interest Rate Risk

Changes in interest rates can affect the rate of return equity investors earn.

Legislative Risk

Changes in regulations such as tax laws, rent control, zoning and other government restrictions can negatively affect an investment's profitability.

Environmental Risk

Changes in the environment or the sudden knowledge that an existing situation could pose health hazards can have an effect on the value of real estate.

Financial Leverage

Created by mixing borrowed funds with equity (the cash contributed by the investor).

Low-Rise Building

Describing a building having one, two , or three stories and usually no elevator.

Investing in Two-to-Four Unit Properties

Duplexes, triplexes and fourplexes are sought after investment vehicles, even though in certain areas they may be hard to find. - These units are relatively easy for investors who are new or inexperienced. - These small properties are very popular among investors and usually have good resale value. - There are many laws that protect those who invest in one-to-four family buildings that don't apply to buildings that are larger. These laws include prepayment privileges and penalties, provision for late charges and other consumer protection laws. - One of the reasons that these types of properties are so popular is that an investor can choose to live in one of the units, while renting out the remaining units. This helps the investor with the purchase of the property. - While the initial rents may not be enough to make the mortgage payment, the additional cash needed for the payment will often be less than what the investor would pay for a comparable single-family home. Although the investor cannot take depreciation on the apartment that he or she lives in, the investor can depreciate the other units in the building. This will help in securing a net positive cash flow for the investor.

Warehouse Property

Focuses on storage and distribution of goods.

Multifamily Housing

Housing that features two or more family dwellings within the same building (and is usually distinguished by its location).

Residential Properties

Include single-family homes and multiple-family properties such as apartments, condominiums, and co-ops. - By definition, residential properties provide dwelling places for individuals or families. - Although, in fact, hotels and motels sometimes provide residences for people, they are considered to be only temporary, so they are not classified as residential property.

Income-Producing Property

Investment in income-producing properties can result in several benefits to the owner. Expenses can be deducted, taxes can be sheltered, and allowances for depreciation can be taken. Investment properties can fall into any one of a number of categories: - Unimproved land - Office buildings - Residential properties - Mixed-use buildings - Retail centers - Manufacturing properties

Real Property

Land and everything permanently attached to it. Physical property.

Manufacturing Buildings

Large facilities designed to accommodate the equipment for various manufacturing processes. - Light manufacturing buildings can be up to 300,000 square feet. - Heavy manufacturing can utilize up to one million square feet or more. These buildings usually need large bay doors with at-grade or dock-high parking for the truck to maneuver.

Scarcity

Limited quantities of resources to meet unlimited wants

Loan-to-Value Ratio (LTV)

Loan Amount (borrowed funds) ÷ Market Value In the real estate market, the ratio between borrowed funds and the market value of the property being financed is more commonly used.

Vacation Home Investments

Many investors purchase a vacation home for enjoyment, as well as investment. The fact that interest and property taxes are tax deductible helps to offset the cost of the second home. - If the investor lives in the vacation home for 14 days a year or less, he or she can take depreciation on it. - However, if the investor lives in the home for longer than 14 days, no depreciation is allowed. Therefore, many investors use a vacation home a few weekends a year and then rent it out at all other times in order to be able to take depreciation. Most Desirable Locations: - Homes in warmer locations like Florida, California or Arizona - Homes at ski resorts - Homes near bodies of water - lakes, ocean, etc. If there is a popular recreational interest nearby, most any residence could provide a good second-home investment.

Unimproved Land / Undeveloped Property

Probably the riskiest of all property investments. It can be the most illiquid of all property types. - This is a long-term investment with a negative cash flow. Even if the investor pays for the property in full, he or she must still pay the yearly taxes, which could increase substantially over time. - Since there are no improvements on the property, there are no depreciation benefits with unimproved ground. - the zoning of the land can change. A change in zoning could mean a change in the property's value. A change from residential to commercial could result in a substantial increase in value. Conversely, a change from commercial to residential could have serious adverse effects on the property's value. - governments can impose building restrictions that could limit or even prohibit development until utilities are brought to the site - utilities that could be charged to the property owner. - Investments in land are not depreciable.

Risk

The chance of experiencing a loss. The loss can be either monetary or non-monetary. A loss can be real even if it is only considered a loss by one individual. Often, the greater the risk of loss, the greater the potential rate of return on the investment.

Future Value (of an investment)

The future value is the principal PLUS the interest gained/earned.

Principle of Substitution

The maximum value of a property tends to be set by the cost of purchasing an equally desirable substitute property.

Business Risk

The possibility of loss (failure) or gain (success) inherent in conducting business. Changes in economic conditions can have an effect on some properties more than others depending on the property type, its location and any existing leases.

Mixed Use Developments (MXDs)

The practice of allowing more than one type of use in a building or set of buildings. - Combine several different uses into one complex including retail, office, residential, hotel, recreation, or other functions.

Present Value (of an investment)

The present value of an investment is the principal invested.

Depreciation

The process used to deduct the costs of buying and improving a rental property. Rather than taking one large deduction in the year you buy (or improve) the property, depreciation distributes the deduction across the useful life of the property.

Rate of Return

The recovery of the invested monies - and a return on the funds in the form of a profit. Often, the greater the risk of loss, the greater the potential rate of return on the investment.

Leverage

The use of borrowed funds to increase the potential return of an investment. In other words, the concept of using other people's money for investing. - Financial leverage is created by mixing borrowed funds with equity (the cash contributed by the investor). The higher the ratio of borrowed funds to equity, the greater the degree of leverage. - Leverage magnifies both gains and losses. When the rate of return exceeds the costs of borrowing, the leverage is said to be favorable or positive. If the cost of borrowing is greater than the return, then the leverage is unfavorable or negative.

Mid-Rise Building

These are moderately tall buildings, averaging 4 to 15 stories, and typically have one elevator.

Garden Office

These are one to five story buildings with extensive landscaping.

Research and Development

These are typically one or two stories with up to 50 percent office or dry laboratory space and the rest workshops, storage; and possibly light manufacturing.

High-Rise Building

These buildings are normally over 15 stories tall and have multiple elevators. High-rise buildings are not as tall as skyscrapers. - They tend to have multi-tenant floors near the base of the building and single-tenant floors near the top. This helps use the building space in the most efficient manner possible.

Flex Space

These buildings are usually one or two stories that can accommodate warehouse and light industrial activities in addition to offices.

Management Risk

This risk is based on the capacity of the manager and his or her ability to innovate, respond to competitive situations, and operate the business activity competently.

Liquidity Risk

This risk occurs when the real estate market is slow with not many buyers, sellers, or transactions. Inflation risk - Unexpected inflation can diminish an investor's rate of return if the income from the investment does not increase enough to make up for the effect of the inflation.

Investing in a Single-Family Home

Three Advantages: 1) There is usually a large selection of properties available from which to choose. 2) Management of a single residence can be easier than with other types of income properties. 3) The investment is more liquid than other kinds of property.

Debt to Equity Ratio

Total Debt/Total Equity - Total liabilities divided by shareholders' equity. - Can be used to measure financial leverage.

Flex Property

Typically defined as anything between offices and warehouses, usually combining the uses of both. Flex buildings are often one- or two-story buildings ranging from 20,000 to 100,000 square feet. The use pattern is typically 25 percent office space to 75 percent warehouse space, although recently the proportion in new buildings seems to be shifting in favor of more office space.

Industrial Property

Typically divided into three primary categories: - Warehouse/distribution - Manufacturing - Flex

Passive Loss Rules

Under certain conditions, an investor could deduct up to $25,000 of losses against his or her other taxable income, such as wages, salary, interest and dividends. - This applies to rental homes.