Investment in Real Estate Residential and Commercial

mohammad.tehrani@houstonvolunteer.org

tehrani@tehraniandassociates.com

Meeting by Appointment:

713-487-6565

Office Hours: By Appointment

Location: Gessner

SCORE - Houston 1

Investment in Real Estate Residential and Commercial

Part OneWhy Investing in Real EstateTypes of Real EstateEconomic Cycle and Real EstateSpeculation in Real Estate and ConsequencesPotential Profits from Real Estate Investment and Role of Leverage

Part TwoFinancing Real Estate investment – TermsReal Estate Loan OriginationTypes of Real Estate LoansRisk and Commercial Real EstateRequired information for a Real Estate Loan

SCORE - Houston 2

Why Real Estate Investment?

There are a twofold approach to accumulating wealth:

• Saving as much as possible • Could loose value on the long term (reduced purchasing power)

• Embarking on a long-term Investment• Investment in Stocks, Bonds, Collectable, Real Estate, etc.

• Real estate is superior to other investments and has both advantages and disadvantages:

Advantages -

1. It is not subject to daily price fluctuations, as stocks are

2. The relative difficulty of buying and selling encourages investors to hold on for a long-term (capital intensive)

3. An investment in real estate provides a return of 5-10% per year

4. It provides tax benefits through depreciation

5. It provides liquidity through refinancing (appreciated property and payoff of mortgage) and rental income

SCORE - Houston 3

Why Real Estate Investment? – Con.

6. It is an excellent hedge against inflation, its value tends to rise more than inflation.

7. Leverage – Can be financed up to 80-90% of purchase price.

Disadvantages -

1. Real estate value, like stocks are subject to ups and downs of economy

2. It is not a liquid assets and should be done with surplus asset

3. Real estate requires more hands on management than stocks

Investment in real estate is different from Fixer Uppers. The purpose of Fixer Uppers is to buy, remodel as quickly as possible with the lowest cost and then selling it as soon as possible.

Investment in real estate is a long-term goal (3-5 years) investment, which bring regular cash flow (through rent and refinancing) and building equity.

SCORE - Houston 4

Types of Real EstateReal estate investment can be classified into several categories:

1. Personal Homes and other small residence

2. Other residential properties

3. Land

4. Net leases

5. Build-to-suite

6. Shopping Centers

7. Office Buildings

8. Industrial/Office Warehouses and Storage Facilities

The goal is direct investment in real estate. Investment in real estate securities such REIT or share in real estate development corporations are indirect investment.

SCORE - Houston 5

Personal Homes and other small residencePersonal homes

The first real estate investment should be personal home. It is called starter home.

It is the soundest investment in real estate because the investor can get up to 90% financing.

It should be a modest home and should not go beyond the means of investor.

Starter home can be used to purchase a second house down the road. Here is an example of how:

SCORE - Houston 6

Yr. One Yr. Four

Cost 100K Selling Price 120K

Down Payment 10K Less mortgage Balance 85K

Loan 90K Cash Received 35K

New Home Cost 150K

Down Payment 15K

Cash on hand for second home 20K

Personal Homes and other small residenceSmall Apartment Complexes

• Relatively inexpensive with profit potential

• It comes in the form of Duplex, Triplex, Quadruplex or six- family Dwelling

• The owner can live in one and lease the others

• Income from leased apartment can be used to cover total operating costs as well as to some extent mortgage and use cash flow proceeds to purchase additional properties. Here is an example (15 years mortgage at 8 ½%)

SCORE - Houston 7

Quadplex Four Units

Three Units

Four Unites

Three Units

1. Cost 100K 100K 9. Payment of principle 2,656 2,656

2. Down Payment 20K 20K 10. Total Return 3,202 -2,800

3. Mortgage 80K 80K 11. Annual % return 16% -14%

4. Rental Income 24K 18K 12. Appreciation 5,000 5,000

5. Operating Exp. 14K 14K 13. Return + Appreciation. 8,202 2,200

6. Operating Cash Flow 10K 4K 14. Net Return 41% 11%

7. Mortgage Payment 9,454 9,454 15. Depreciation 2,909 2,182

8. Net Cash Flow 546 -5,456 16. Amount Subject to Tax -2,363 -7,638

Personal Homes and other small residence

Advantages:

1. You have opportunity to live in one unit and save on rent

2. Often Owner financing is available

3. The price of multifamily dwelling, regardless of size is a function of income

4. Multifamily dwelling provide a way to learn how to manage a property

5. Provide you with capital to buy “up”

Disadvantages:

1. If you live in one of the units, then you have to handle tenets complaints 24 hrs. per day

2. As the owner you will be responsible for collection of rents, filling vacancies, and doing repairs

SCORE - Houston 8

Other Residential Properties

Residential properties come in a variety of sizes, price range and diverse tenants.

Location of property determine the type of tenants and demands (e.g., students are tenants of an apartment complex near university).

Residential properties includes:

- Apartment complexes

- Attached rows of townhouses

- Low and high rise apartment buildings

- Boarding and rooming houses

The value of investing in one over the other is relative.

If an attached row of townhouses reflects a higher rate of return on cash than a high rise apartment building, then you might decided on the former.

SCORE - Houston 9

Garden Apartment ComplexesGarden apartment complexes consist of groups of two-to-three story walk-up

with up to 12 apartments per building or rows of apartments similar to townhouses

AdvantagesThey are more management intensive, so sold for lower price and giving a higher

rate of returnThey are built on larger areas of land and often its value goes up over the yearsIt normally requires lower percentage of down payment

DisadvantagesMaintenance and management cost are higherInsurance costs are higherDue to size it has a higher security riskIt is very much subject to local economyIn purchasing a garden apartment complex, rent revenue is not the only main factor. Location, land, building conditions and operating expenses must be analyzed.

SCORE - Houston 10

High Rise BuildingsHigh rise buildings are defined as an elevator building compromising many

floors with many apartments

They are built in strategic locations where land is limited and expensive

Advantages It offers economy of scale (everything is in the building)

Easier and cheaper to operate

Offer a higher rate of appreciation (difficult to duplicate)

It is easier to get financing

Disadvantages It is sold for a higher price and not suitable for small investors

In certain areas like NY, there might be rent control and other protection regulations

It is not easy to demolish and use the land for other purposes.

SCORE - Houston 11

Shopping CentersThe term shopping centers refers to a variety of commercial spaces, ranging

from small group of stores on a parking area to megamall shopping centers.

Shopping centers can be classified differently, but the most common classification is:

Anchored shopping centersThe anchor is a major store. The anchor is the main draw which indirectly generate

business for other tenets. Examples of anchor stores are:1. Supermarkets2. Drug chains3. Department stores4. Movie theaters

AdvantagesEasy to manage – responsibility include ground and structural upkeep, management,

insurance and real estate tax paymentAs community around shopping center increases, the value of land increases and the land

can be used for other purposes in the future.The presence of an anchor store make it easier to get financing.

SCORE - Houston 12

Shopping CentersDisadvantages

Most of the income comes from anchor stores, so if one or more anchor store move out or go out of business, the shopping center need retrofitting

Unless there is a cost of living adjustment (COLA) or other escalations, a long-term fixed lease can results in slow increase in the value of property (no income increase)

Anchor tenants are very much tough negotiators and often impose certain requirements such as who should other tenants be.

Anchor shopping centers are excellent investment for new small investors as part of a group (partnership).

SCORE - Houston 13

Shopping CentersStrip Centers or Strip Malls

They are made up a series of retail stores with average size of 1,000 square feet

They have good visibility and are located in a densely populated neighborhood

They normally have access to freeway

Advantages They are an income producing real estate investment and income increases as community develops

There is no major risk of loosing a draw tenant

They represent a smaller investment

Leases tend to be shorter term (re-adjustment of rent for inflation)

Easy to manage

Disadvantages Tenants may not come if it is not well located

Tenants tend to leave if their business is not doing well, the rate of vacancy is higher

Strip centers are good investment in commercial real estate with lower down payment requirement. They are normally sold below the replacement cost.

SCORE - Houston 14

Office BuildingsOffice buildings are similar to apartment complexes in terms of investing, but

also are more service intensive

The owner of office building provide electricity, heating and cooling, cleaning services and internal repairs

The rental income and related value of office buildings fluctuates with economic conditions

Advantages1. They are located in strategic locations2. Their replacement cost keeps going up3. Can be purchased during down economic and sold during economic boom

Disadvantages1. They requires a large cash investment2. They are management and labor intensive3. Their income and value depends on economic conditions

They are too large for small and novice investors specially because of intensive management complexity and demands.

SCORE - Houston 15

Economic Cycles and Real EstateWhat is an economic cycle?

It is the natural fluctuation of the economy between periods of expansion (growth) and contraction (recession). Average cycle is 4-8 years.

During growth period purchases create demand which pushes prices higher. It is reverse during recession.

As the growth continues, investor forget the real value of what they are investing in and believe they are buying future profits.

When the expectation of future profits are not materialized, then they panic and start dumping their investment which results in recession.

What factors affect economic cycles?

Gross domestic product (GDP), interest rates, levels of employment and consumer spending can help to determine the current stage of the economic cycle.

What an investor should do to avoid loses?1. Plans a long-term prospective (3-5 years)2. Avoid getting involved in speculative investment in good times 3. View bad times as an opportunity for investment

SCORE - Houston 16

Economic Cycles and Real EstateHow the economic cycle affect real estate?

Growth -- People would speculate and price of properties increases unreasonably

1. Investor must evaluate economic indicators and their effect on the real estate (low interest rate increase demand for real estate, and later increase in construction)

2. During the late boom or growth period when the prices are reached to an unreasonable level, the investor in real estate should do nothing or sell all or part of his/her properties

3. Low interest rate, ease of monetary policy by Fed, and lower price of energy increases growth in real estate

Recession – People panic and try to sell their property to protect their assets1. Increases in interest rate and over construction reduce demand for real estate and price of real estate

properties would start to fall

2. The sign of real estate recession include – Increase in vacancy, foreclosure, and abandoned properties by speculators

3. High interest rate, tightening of monetary policy by Fed, and higher price of energy reduces activities in real estate

The best sign for determining over priced value of real estate is when speculators participate in real estate activities and real users can not afford prices.

SCORE - Houston 17

An example of wrong speculation

Boom Recession

Purchase Price 100K 100K In planning an investment in real estate you need to identify:

Bank Mortgage 90K 90K 1. The stage of economic cycle

Investor Equity 10K 10K 2. National economic status

Market 115K 82K 3. Local market economy status

Bank Mortgage 90K 90K 4. Level of speculation in the market

New Equity 25K -8K 5. Return on investment during boom and recession periods

Original Equity 10K 10K 6. Financial status of investor

Profit/-Loss 15K -18K

Return on Investment 150%

SCORE - Houston 18

Calculating long term potential profits from investment in real estate

Ideally one should invest in real estate when real estate is out of favor (recession) and sell it during the late stage of boom

There are two guidelines to buy property1. Buy property in a good area that has been overbuilt

2. Buy in deteriorated, but well located areas on the brink of recovery

Before you purchase a property, no matter what potentials are offered by the investment, you must calculate the return on the investment.

If the cash flow is not positive after payment of operating expenses, do not buy it

Real estate profit have three sources1. Positive cash flow – should generate 8-10% cash flow after operating expense and loan payment on a cash

investment

2. Appreciation – Property appreciate an average of 5-10% per year

3. Leverage – Debt remain constant (Interest Payment Only)

SCORE - Houston 19

Potential Profits – Positive Cash FlowAssume: Property selling price - $200K - Down Payment – 50K

Loan - 150K – Interest -8% - Loan Term – 15 years –

Expected Rate Return 10%

SCORE - Houston 20

Item InterestOnly

Interest + Principle

Comment

1. Income 32K 32K When an investment has positive

2. Operating Expense 12K 12K Cash flow, the actual rate of

3. Profit before debt (expected) 20K (10%) 20K (10%) Return can exceed expected rate

4. Interest Expense 12K 12K of return. Thus an investor should

5. Net cash flow before interest 8K 8K Calculate return on investment

6. Principle Payment 0K 4.5K under normal, good and bad conditions

7. Net cash flow after principle Payment 8K 3.5K

8. Return on Original Investment 16% 7%

Potential Profits – Cash Flow + AppreciationThe second source of profit is appreciation which is not included in the prior example

Purchase price 200K – Loan 150K and cash payment 50K

We assume an annual appreciation of 5% over original purchase price

We calculate the value of investment after 5 years

SCORE - Houston 21

Interest only

1. Original purchase price 200K

2. 5 years later value 250K 200K + 200 (5yrs*5%)

3. Original Cash flow (after paying Oper. Exp) 20K 200k + 200(10%*5yrs)

4. Cash flow (yr. 5) 100K

5. Cash flow + Appreciation over five years 150K

5. Total = Value + Cash flow 350K 250K + 100K

6. Property value/original Investment 5.00X 250K/50K

7. Total return = Cash flow +Appreciation 150K 50K (appreciation) + 100 (Cash flow)

8. Total return over 5 year before interest 300% 150K/50K

Part Two

Financing

SCORE - Houston 22

Financing Real Estate Investment - TermsInvestment in real estate can be (1) cash purchased only or (2) cash purchased plus

financing

Financing real estate purchase means borrowing money or getting a loan. There are two types of loans

1. Secured loans – where collateral is used to secure the loan2. Unsecured loans – where there is no collateral and the loan is awarded on the credit

worthiness of borrower. An example of unsecured loan is Line of Credit (LOC) awarded by banks to their best customers with good history and sound assets.

Real estate loans are secured by a first, second and even third mortgage on residential or commercial property

In real estate one often talk about property. So, we need to define property first. Property is divided into two categories

1. Personal property – which is anything that is movable. Personal property can be attached to a land or building and then become real property.

2. Real property – which are not movable. There are three types of real property 1. Land which is always real property2. Buildings are real property . Trees and shrubs are also real property because they are attached to land.3. Fixtures which is a hybrid between personal property and real property (AC – initially was a personal

property and then become real property).

SCORE - Houston 23

Financing Real Estate Investment - TermsEstate refers to the degree or extent of ownership in property. They are:

• Free simple estate – also called sole tenancy is the greatest and highest degree of ownership in real property

• Tenancy in entirety – It is an estate held by husband and wife with the right of survivorship• Tenancy in common - is an estate held by two or more persons without the right of survivorship• Joint tenancy - is an estate held by two or more persons with the right of survivorship

Deeds refers to an instrument that conveys title from the grantor (owner of title) to the grantee (recipient of title). There are different types of deed and they are:• General warranty deed – In addition to conveying title to real property it also contains certain warranties

such as: (1) the grantor is the owner of the property, (2) the right to convey the title and (3) the grantors defend the title against the whole world.

• Bargain and sales deed – Conveys title to real property without any warranties what so ever. It is used by the county or state to convey title to individuals since the agencies do not want to warrant title.

Check the estate law where the property is located for any variation and special requirements regarding deeds.

SCORE - Houston 24

Real Estate Loan OriginationOrigination is the process of creating a real state loan or mortgage. In order to

process loan, the following information is required by underwriter or loan broker:• Credit Guidelines – The underwriter should ask the following questions when processing a

loan applications1. What is the borrower’s ability and willingness to pay2. Is the property acceptable security for the proposed loan

• Income and Employment – The FHA, VA and most lending institutions require written verification of the loan applicant’s employment for at lease the past 24-month. This indicates job stability and loan repayment. In addition to income, age, bonus income, other sources of income are also considered

• Assets – Assets are reviewed from two prospective1. The applicant can demonstrate an ability to accumulate cash and other liquid assets2. The applicant has enough liquate asset to fulfill his/her obligation

• Liabilities – All lenders consider debt, both short and long terms when reviewing loan application. Liability include credit card debts, child support, other loans and most importantly filling for bankruptcy

So, a loan applicant, whether applying for residential or commercial real estate must ensure that he/she has all the requirements before submitting application for a loan.

SCORE - Houston 25

Residential Real Estate (RRE) LoanBrokers have to follow underwriters’ rules

Conventional Loans- It is a loan secured by real estate without the benefit of government insurance or guarantee

Eligibility – best offers are given to single-family detached owner-occupied dwellings less than ten years old1. Town houses/apartments are also eligible 2. Term – The maximum loan term is 30 years

Interest rate and discount points – Current federal law pre-empties state usury celling's. As long as this law exits, lenders can charge rate, discount points and fees on first mortgage loans without limitations.

Conventional loan income ratio – Depends on the lender but the convention is a person should not spend more than 25% of gross income on housing.

1. Monthly interest $800, taxes and insurance $3002. Ratio – 25%3. Annual income = $52,800

Veterans Administration Loans – It is a real estate loan that is made to veterans and secured by Veteran Administration

Federal Housing Administration Loan(FHA) – Loan is guaranteed by FHA. Borrower must comply with FHA rules not the lender.

1. FHA loan is based on applicant income2. 35-50 rule is used to determine income eligibility (House expense should not exceed 35% of effective

income or combine housing expenses plus other recurring charges should not exceed 50% of effective income)

SCORE - Houston 26

FICO (Fair, Isaac & Company)Nearly all the lenders base their lending decisions and terms on the applicant

FICO score

It is a numerical computer generated score that predicts a lender’s risk of doing a business with a borrow

There are three companies (Experian, Equifax and Trans Union) that determine FICO score for individuals:

Scoring is based on things like:1. Job history2. Time applicant have lived in his/her current address3. Payment history4. Outstanding debt5. Credit history6. Type of credit used (banks credit or debt card, personal installment loans)7. Negative information (bankruptcies, late payments, late fees)

Income and assets are not considered

SCORE - Houston 27

Commercial Real Estate FinancingCommercial real estate (CRE) are defined as those that are built and operated for

the purpose of producing income

As long as the property has a steady, assured and adequate income, then it has marketability and can be financed

The lender primary underwriting considerations in order of their importance are:1. Credit (good tenants)2. Location3. Type of real estate

The only time a CRE loan is foreclosed is when the property ceases to produce income.

The market value of all CRE is directly related to the amount of income it produces (basis for value), the reliability or quality of the income stream (basis for loan-to-value ratio), and duration of income stream (basis for loan term)

CRE are generally divided into two categories:1. General use – Apartment buildings, office buildings, shopping centers, retail outlets2. Special use properties – Hotels and motels, banks, mobile home parks, restaurants

SCORE - Houston 28

Analyzing the Income Property Loan

Every income property loan are analyzed for:1. Feasibility – Does the property is a viable property and produces enough income 2. Location – Property to be financed should be analyzed for population growth,

income level, stability of employment, accessibility by automobile and public transportation, and competing properties

3. Timing – Assuming that 1 and 2 above exist, but is the timing of financing a real estate construction project correct? (A similar project is in progress and in 3-6 months the project is completed)

4. Borrower – Does the borrower has skill and desire to create value (borrower background is checked)

5. Real Estate – For years the value of real estate used to serve as the basis for a CRE loan (75/25 loan to equity ratio). Although valid approach, lender later learn that the value of a real estate directly related to the general economic climate and borrowers personality. This resulted in lenders consider not only the real estate, economic conditions, but also the credit worthiness of the borrower.

The stage through which an income property loan progresses are not in the same order of residential real estate. It normally start with feasibility and followed by other steps(complex process and out of scope of this workshop)

SCORE - Houston 29

Risks Related to Commercial Real EstateThere are many risks that are associated with CRE investment that must be

considered by both lender and borrower. They are:1. Business Risk – It is a risk that fluctuate with economic cycles, such as interest rate

risk2. Financial Risk – This is the risk of debt or leverage3. Liquidity Risk – It is not only the risk of investment not being a liquid asset but

also it is the risk that business will have inadequate cash flow or working capital. 4. Management Risk – This risk relate to poor management and development of

commercial real estate such as delay in construction or tenant dissatisfaction. 5. Risk Management – It relates to not be able to identify material sources of risk,

measuring and monitoring those risks and devising approaches that reduces those risks (e.g., purchasing liability insurance, hazard insurance, building security)

Commercial loan evaluation first focuses on the properties and risks associated with and then on the borrower who expects to own and manage property

SCORE - Houston 30

Information Required for a CRE LoanThere are few standards and little regulation directing a prospective

borrower how financial information should be presentedRegulations that apply to what type of information are required are

exclusively directed by the lendersSpecific information that most likely required by most lenders are:

1. Operating statement of property – If property is operating, the operating statement for last 2-3 years is required. The underwriter often asked these statements to be prepared by a CPA. The operating statement include:• Balance Sheet – lists company's assets, liabilities and owner equity. The most important

information in BS is the original cost and how it is compared with current value• Profit and loss Statement – It an statement of income and expenses. The P&L statement

describes the nature of expenses and their costs• Operating statement – It is similar to P&L statement but include debt services, and

depreciation2. Pro Forma Cash Flow Statement – It is a projection of both income and expenses.

It is mostly used for new property development3. Personal Financial Statements – For Principals involved in project and must be

updated within the past 60 days

SCORE - Houston 31

Information Required for a CRE Loan – Con.4. Business and Personal Tax Returns – For the last 2-3 years5. Current Rent Roll – It is a list of space available for rent, vacancies, current rent

(gross and effective rate per square foot per year), escalation clause and maturity of rent contracts

6. Accounts Receivables and Accounts Payable – To help analyze the overall health of the business (can be found in BS)

7. Purchase Contract (PC) or Warranty Deed (WD) – PC and all the addendum if the property is to be purchased and copy of WD the property is owned

8. Insurance – hazard and general liability insurance9. Current Real Estate Appraisal – Should include cost, market, and income 10. Survey – A current survey of land made by a registered surveyor11. Property Tax Bill – Often used to verify legal description of property, owner and

tax assessment12. Resumes of Principles – Should contain a history of experience13. Articles of Incorporation14. Authorization of Release Information – For checking credit score and filling tax 15. Environmental Audit – All commercial loans require an environmental site

assessment

SCORE - Houston 32

SCORE - Houston 33

mohammad.tehrani@houstonvolunteer.orgtehrani@tehraniandassociates.comMeeting by Appointment:713-487-6565Office Hours: By AppointmentLocation: Gessner