real estate investing study guide

ABOUT YOUR INSTRUCTOR Tom Lundstedt, CCIM, is known as the funniest investment and tax guy in America! His programs for residential and investment real estate have entertained and enlightened more than 2,500 audiences from sea to shining sea. He’s a former Major League baseball player whose striking combination of humor and real-world examples makes his subjects spring to life.

Students of a Lundstedt workshop invariably rave about how much they learned- and how much fun they had doing it! As one person recently said, “Every time I attend one of Tom’s seminars, I know I’ll leave with solid information I can use immediately!”

Tom holds a bachelor’s degree in business administration from the University of Minnesota as well as the prestigious CCIM designation from the National Association of REALTORS®.

To learn more about Tom Lundstedt, please visit www.TomLundstedt.com. You may also email Tom at [email protected].

http://www.tomlundstedt.com/

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Keynote Professional Development Series Course

Real Estate Investing Made Clear

Student Manual

Instructor: Tom Lundstedt

Presented by:

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© Keynote Professional Development Series P a g e | 1

Module 1: Money Machine Learning Objectives

• You will be able to explain why it’s important to analyze an investment property before the purchase or before the listing.

• You will be able to recognize that investment real estate requires a different set of skills than residential real estate.

• You will be able to list the three parts of a real estate "money machine."

I. Investment Real Estate • Clients seeking to purchase investment property need an agent who understands

investment property. Having a real estate license does not necessarily confer expertise in investment real estate. Investment real estate requires a different set of skills than residential real estate.

• It is important to analyze an investment property before the purchase or listing to determine how much money it will produce and how quickly it will produce it. This can be done by analyzing the three parts of the “money machine.”

II. Three Parts of the Money Machine

Investment real estate can be compared to a “money machine” with three parts. The three parts of the machine are: 1. Income – The income is money received from the tenants. The most obvious type of income

is rent but income can also come from garages, washer and dryer, pop machines, etc.

2. Expenses - There are a number costs involved in owning investment property, such as property tax, repairs, insurance, utilities, management, etc. Operating expenses do not include principal and interest payments if there’s a loan.

3. Financing - The interest rate, the term, and payments are all important factors in financing.



Module 2: Four Financial Benefits Learning Objectives

• You will be able to list the four financial benefits of owning investment real estate. • You will be able to define cash flow before tax. • You will be able to explain that appreciation is a long-term benefit. • You will be able to explain the role of depreciation in creating income tax savings. • You will be able to identify principal reduction as a subtle, but valuable financial benefit.

I. Four Financial Benefits

The four financial benefits of owning investment real estate include: 1. Cash Flow Before Tax. Once you collect rent, then pay your operating expenses and loan

payments, there ought to be some cash flow left over. 2. Principal Reduction. With investment property, any loans on the property are paid down

with rent collected by tenants. The tenants are essentially buying the property for the owner.

3. Income Tax Savings. The first two benefits, cash flow and principal reduction are taxable.

But both can be sheltered from income tax by depreciation.

4. Appreciation. Appreciation means “increase in value.” It doesn’t happen overnight; it happens over the years.

Module 3: Investment Property Worksheet Learning Objectives

• You will be able to describe the four major areas of the Investment Property Worksheet. • You will be able to explain the limitation of doing long-term projections. • You will be able to demonstrate that the financial concepts apply to large and small

properties. • You will be able to explain the importance of financing in determining the success of a real

estate investment.



I. Real Estate Investment Projections Projections are only as good as the assumptions you make. When making projections for real estate investments, the first year’s numbers are the most meaningful. The further out you go out into the future, the less reliable the projections will be.

II. Investment Property Worksheet

The Investment Property Worksheet is a great tool, based on solid fundamentals, to help you analyze a property before the purchase or listing. The worksheet has four major areas: 1. Property Information Deals with the property itself (purchase cost, cash invested, financing

and depreciation). 2. Income & Expenses Used to calculate Gross Operating Income and Operating Expenses. 3. Four Financial Benefits Used to calculate cash flow before tax, principal reduction, tax

savings, and appreciation. 4. Rates of Return Various measurements used by investors.

III. Importance of Financing

Financing is extremely important. • If the financing changes, the investment value of the rental property changes. • If the financing involves an adjustable rate loan, be extra careful. The property's rate of

return might look good measured against the initial interest rate on the loan. But what if interest rates rise in the future and the loan adjusts to a higher interest rate? That could send the rate of return on the property right down the tubes. If you’re going to buy with an adjustable rate loan, it’s a good idea to analyze the property using the upper limit interest rate on the loan, not the initial interest rate.

Module 4: Income and Expenses Learning Objectives

• You will be able to define investment real estate terminology, including: annual rent, vacancy rate, gross operating income, operating expenses.

• You will be able to calculate and explain the significance of the operating expense ratio. • You will be able to explain the shortcomings of the gross multiplier method of valuation. • You will be able to avoid "garbage in – garbage out" by utilizing IRS form Schedule E.



I. Types of Income in Investment Real Estate Rental property produces four different types of income. These are: 1. Annual Rent 2. Gross Operating Income 3. Net Operating Income 4. Cash Flow Before Tax

II. Income and Expenses Defined

• Annual Rent is the total possible income. This can include items such as apartment rents, garage rents, washer/dryer income, vending machines, etc.

• Vacancy Rate is calculated as the percentage of Annual Rent that is not collected as a result of having no tenants or of experiencing credit losses. The vacancy rate will vary depending on several things including type of property, location, management, etc.

• Gross Operating Income is what you actually collect. Gross operating income is calculated by subtracting Vacancy Amount from Annual Rent.

• Total Operating Expenses includes all expenses with exception of debt service. Generally, the biggest operating expenses include property tax and utilities.

III. Schedule E

When analyzing investment property, it’s very important to use accurate numbers!

• One way to verify the numbers is to make the transaction contingent upon seeing the seller’s Schedule E.

• Schedule E is the tax form where the income and expenses are reported to the Internal Revenue Service (IRS).

IV. Operating Expense Ratio

The operating expense ratio is another way to measure the accuracy of the numbers.

Operating Expense Ratio = Operating Expenses ÷ Gross Operating Income



Module 5: Cash Flow Before Tax Learning Objectives

• You will be able to calculate the property's net operating income. • You will be able to determine the cash flow before tax. • You will be able to explain why dollars from cash flow are better than dollars from a job. • You will be able to explain that dollars from cash flow can be sheltered by depreciation.

I. Net Operating Income

Net operating income is the amount of income left after vacancy and operating expenses are subtracted. • It’s the amount of cash flow an investor would have if there were no loans on the property. • Often referred to as NOI.

Net Operating Income = Gross Operating Income – Operating Expenses

II. 1st Financial Benefit: Cash Flow Before Tax

The first financial benefit is cash flow before tax. Once you collect the rent and pay your operating expenses and loan payments, there ought to be some income left. Cash flow before tax is:

• taxable but can be sheltered by depreciation; • exempt from Social Security tax and self-employment tax.

Cash Flow Before Tax = Net Operating Income – Annual Debt Service

Module 6: Principal Reduction and Tax Savings Learning Objectives

• You will be able to calculate principal reduction. • You will be able to explain how principal reduction is taxable. • You will be able to explain the difference between gain and equity. • You will be able to describe key points about depreciation deductions.

I. 2nd Financial Benefit: Principal Reduction

The second financial benefit is principal reduction. Any loans on the property are paid down with rent collected from the tenants.



• Principal reduction is not a current benefit; you don’t get the money until you sell or refinance.

• It is taxable every year but it can be sheltered by depreciation. • Principal reduction is not taxed when you sell.

Principal Reduction = Annual Debt Service – Interest

II. Gain vs. Equity

Gain and equity are two different, unrelated items. When you sell, you pay tax on your gain, not your equity.

III. 3rd Financial Benefit: Tax Savings

The third financial benefit is tax savings. Both cash flow and principal reduction are taxable every year, but both can be sheltered by depreciation.

Taxable Income = Net Operating Income – Interest – Depreciation

IV. Depreciation Key Points • Depreciation is a “non-cash” deduction, which means it’s merely an accounting entry, not

an actual “out-of-pocket” expense. • Depreciation is also known as “cost recovery.” • The IRS tax rules allow the owner of investment property to depreciate their cost over a

specified number of years.

Module 7: Income Tax Savings: Depreciation Learning Objectives

• You will be able to identify the four depreciable categories. • You will be able to determine how to allocate the total cost into the four depreciable

categories. • You will be able to demonstrate the depreciation percentages for each category. • You will be able to calculate the dollar amount of depreciation.

I. Four Categories of Cost for Depreciation

The IRS tax rules allow owners of investment property to depreciate their cost over a number of years. The specific number of years depends on how the cost is allocated. There are four distinct categories of depreciation.



The four categories of cost are: 1. Land -It is not depreciable. 2. Personal Property – Is depreciated over 5 years in a residential investment property. 3. Building

• A residential rental building is depreciated over 27.5 years. • A non-residential rental building is depreciated over 39 years.

4. Land Improvements • Depreciated over 15 years • Land improvements include items like parking lots, landscaping, fence, etc.

II. Depreciation Rates

• You can obtain a chart from the IRS that states depreciation percentages for the number of years the property has been owned.

• The depreciation percentage will give you the depreciation rate for each category.

III. Calculating Depreciation

There are several possible ways to allocate costs between the 4 categories. They include:

1. Use the property tax assessor’s ratio for land and building. 2. Make an itemized list of the personal property and land improvements and estimate their

value. 3. Have an appraisal done. 4. Have a cost segregation study done by an engineering firm. This can be very costly and

usually done for large properties. 5. Negotiate each of these items in the purchase contract. This is known as “bifurcating” which

means to divide and is what many experienced investors do.

To calculate the dollar amount of depreciation for each category, you use percentages provided by the IRS which will change depending on the number of years the property has been owned.

Depreciation = Cost x Depreciation Percentage



Module 8: Income Tax Savings: Calculation Learning Objectives

• You will be able to calculate an investment property's taxable income. • You will be able to explain how a property's negative taxable income results in income tax

savings. • You will be able to state that the passive loss rules govern when a real estate tax loss can be

used. • You will be able to calculate the actual dollar amount of income tax savings.

I. Calculating a Property’s Taxable Income

Taxable Income = Net Operating Income – Interest Paid – Depreciation

II. Calculating Income Tax Savings

Income Taxes = Taxable Income x Tax Bracket Percentage

• Income tax can be saved when taxable income is negative! • Negative taxable income produces a “loss” for tax purposes and can be used to shelter

income from other sources such as wages, salary, etc.

III. Passive Loss Rules • When a “loss” occurs, it is subject to passive loss rules that govern when and how a real

estate tax loss can be applied. • The passive loss rules are complicated so be sure to ask your good tax manager how they

impact your unique situation. • Be extra sure to ask about the special exception for real estate professionals!

Module 9: Appreciation and Rates of Return Learning Objectives

• You will be able to explain that appreciation should be considered an added benefit. • You will be able to calculate rate of return without appreciation. • You will be able to Illustrate to sellers how to arrive at a realistic value.

I. 4th Financial Benefit: Appreciation

The fourth financial benefit of owning investment real estate is appreciation (or increase in value.



• When you’re analyzing a rental property, it would be best to assume ZERO appreciation. • Investment property should make financial sense without any appreciation.

II. Calculating Rates of Return without Appreciation

Rate of Return without Appreciation = Cash Flow Before Tax + Principal Reduction + Tax Saved

Cash Invested

Module 10: Case Study 1

Learning Objectives

• You will be able to use the Investment Property Worksheet to analyze an investment property before the purchase or listing.

• You will be able to assemble raw data (income, expenses and financing) and enter it on the Investment Property Worksheet.

• You will be able to use the Worksheet to calculate the four financial benefits: cash flow before tax, principal reduction, tax savings and appreciation.

• You will be able to combine the financial benefits to determine rate of return.

I. Investment Property Worksheet • The Investment Property Worksheet is a powerful tool that enables you to analyze a

property before the purchase or listing. • By using the worksheet, you are able to calculate an investment property’s four financial

benefits and rate of return. • Once you know how the Worksheet operates, you can apply it to virtually any market, under

any conditions.

real estate investing study guide

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