Generally I don't like to post in continuous days but after reading a recent blog post on "Bigger Pockets" I felt obligated to share the article / blog post with everyone.
http://www.biggerpockets.com/renewsblog/2010/09/15/analyzing-a-real-life-rent-flip-deal/?utm_source=BiggerPockets+Newsletter&utm_campaign=1e08f4e1dd-September_19_2010_Newsletter9_19_2010&utm_medium=email
When it comes to real estate investing unless you have formal education, training, real world experience or a mentor then generally you would not have been exposed to the financial tools and theory's that lead to quality decision making. The blog posted at Bigger Pockets allows readers to see a real-world real estate investment in action.
There are a few criticisms I have of the financial aspects of this deal:
1. His split for land value to building value is subjective and a better way to determine it would to look at a tax assessment to gain a more detailed understanding of land value to improvement.
2. In today's market, the vacancy rate used on pro forma's is rising, 8.3% may be a good number for his property in his market but his number should be heavily dependent on the market you're investing in. (Same with the rental rate but that should be more obvious).
3. Revenue and expenses are estimated at 2% increases annually. This is a fair assumption for the sake of a pro forma but one needs to understand that rental rates can decrease if market fundamentals demand it. Also, operating expenses can rise faster as insurance, taxes, etc. can be increased at a faster rate then rental rates.
4. There are a few before tax cash flow ingredients missing like annual depreciation which can reduce taxable income (and possibly exploiting a deprecation analysis technique called cost segregation which depreciates improvements at individual schedules per the IRS leading to extra depreciation expenses). NOTE: depreciation expenses are good, not bad, don't let the term "expense" fool you. This expenses is a non-cash deduction to your taxable income which decreases your tax obligation.
5. This investor is using a 3 year balloon interest only loan. This is a risky mortgage product as at the end of year 3 a lump sum mortgage pay off (known as the balloon payment) is due. The assumption is that he would have the property sold at that time. The market may dictate otherwise. (this is the type of product that gave momentum to the housing industry collapse). These products can be great but knowledge is power here...be careful.
6. For the disposition (the sale of the property after year 3) I don't see reference to capital gains taxes. Of course using a 1031 exchange can defer capital gains tax but I don't see reference to that.
It's a great mental exercise to read and analyze articles like this as I think they are a great way to see a professional investors thought process in practice. Just be careful and be critical of data, assumptions and missing components that make situations less rosy then they appear to be.
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