I.D.E.A.L. Math on Pretty Properties & The Speed Wealth Method

What you’ll learn in this episode:

*One of the first things Lance learned when he started small apartment investing in 2002 was the notion of an “IDEAL” investment. It’s an acronym where words associated with each of the letters in the word “ideal” define it.

*An ideal investment has INCOME, which means cash flow that is generated or increased on apartments by raising the revenue, raising the rents, lowering or raising other income or lowering expenses. 

*The second element of an ideal investment is DEPRECIATION, referring to a tax depreciation benefit. The IRA gives us a paper loss which we can claim on our tax return, thereby paying less taxes.

*The third attribute is EQUITY, which we gain by the mortgage being paid down on our properties that we buy using third party financing, whether it’s with a bank mortgage or seller financed mortgage. Whatever the vehicle is, we’re buying it with a mortgage in place. Every month, the rent paid by tenants goes to paying down the mortgage. 

*The fourth attribute is APPRECIATION, meaning we increase the value of our properties so that it builds equity for us. There are two types of appreciation. The first is market appreciation which means the value of things goes up even if we don’t do anything. Right now, we’re pretty much in a market appreciation type market. The second type is one we have control over, forced appreciation. Whenever we raise the net income of a property, we raise the net income by raising the revenue and lowering expenses. That also boots the value.

*The fifth attribute is LEVERAGE. We buy the investment using other people’s money. With small apartments you typically buy these with 65 to 100% leverage. You can actually buy with more than 100 percent leverage, most likely in the ugly property realm where you can raise more money than you need to purchase the property and walk away from the closing with cash. With pretty properties, we can get 100% financing through seller financing, where the owner just takes back monthly installment payments.  

*The more attributes of an ideal investment a prospective property has, the more ideal it is. Small apartments have all five.

*Lance provides an illustrative example of how the math behind the IDEAL investment works. He suggests a $500,000 “class B” (middle income) property., where residents are paying an average of $700 rent per month across eight units. The property has a 90% occupancy and it’s performing at the market cape rate of 6%. You’ve bought it at retail value ($500,000). It doesn’t need any rehab. You buy it for 20% down, $100,00 cash with a mortgage and a 4% interest rate. It has a 25-year amortization.  

*Connecting this example to the five IDEAL attributions, Lance says we’re buying into leverage, which means return on income, return on depreciation, return on equity and return on appreciation. We’re going to raise the rents 2.5% from $700 to $718. We’re also going to build in some other income, like charging for parking spaces or billing back the water or gas bill. You can also bill back for trash fees, like $15 a door for trash pickup. The other income on properties can range from 0 to 15%.

*Next is lowering expenses 5%. The main expense areas are taxes and insurance. First, we can dispute the taxes, which the current owner has done for a while. Second, we can shop for new insurance. These are little tweaks to our cash flow. We will net $8400 a year after paying the mortgage after paying all the maintenance and management fees. We’re going to hire a management company. We measure the $8400 by something called the cash on cash return. Getting $8400 dollars back per year cash flow off $100,000 down means an 8.4% return on investment per year. Lance says, “Let’s compare this to the CD you might have right now at the bank, which may be paying a 1% cash on cash return.”

*The total says ROE in Red, which is the return on equity, meaning our cash in the deal. Equity occurs when the tenant pays down the mortgage balance via monthly rent. In the example Lance gave, it was 80% loan to value on the mortgage, a 4% interest rate on the mortgage. After five years, the total mortgage paid down is $51,000 and change. So the average equity we gain is $51,500 in equity at the end of five years. If we sell, we get $51,000 back in cash because we paid down the mortgage. That $51,000 divided by the $100,000 of cash in the down payment spread out over five years is 10.3% per year return on our cash. This is equity in the property because we paid on the mortgage. So our total ROI we put into the property is 8.4% cash on and cash flow and the 10.3% per year equity gain from paying down the mortgage. 

*Bottom line, we’ve now got an 18.7% per year return on our investment in cash. Then we implement forced appreciation. Anytime we do anything to raise the net operating income, we raise the value of the apartment building, which translates to equity for ourselves. Lance says, “I divide up the market cap rate, which is 6% in this example. I raised the rent 2.5%. I put in 3% other income and lowered expenses 5%. That gives me a new hire in NOI. I raised revenue and cut expenses of higher net income. In this scenario, the new value of this apartment is $563,000. We bought it for $500,000 so the new equity I’ve gained through appreciation is $63,000. That equity divided by my $100,000 cash I put in divided by five years is 12.6% per year return on my cash.”

*Forced appreciation is how fortunes are made in this business, by tweaking rents, getting really smart about putting other income into it and chipping away at your expenses.

*After reviewing the numbers so far, Lance discusses the Depreciation space, which some people don’t appreciate the power of. He shows us how to basically pay zero income tax on whatever you’re currently earning at your job. Depreciation is where the IRS assumes that the value of our buildings is decreasing each year (going down in value) when in actuality they’re going up in value. So it’s a paper loss. We’re losing value on our buildings every year and that lost value can be deducted on our income tax return. With apartments, the IRS does a straight-line depreciation method. They assume that after 27.5 years the value of that building will be zero. It will be the exact opposite of that. (Lance continues with the mathematical process with the hypothetical property he’s been discussing, with the IRS starting with a credit based on an annual depreciation/loss of $14,500).

*A very important tip: In order to declare 100% of the deduction every year, you have to declare yourself a real estate professional. That doesn’t mean you have to have a real estate license. It simply means you spend 750 hours per year, or 15 hours per week) on your real estate business.  Your CPA simply needs to check a box on your tax return and declare you a real estate professional for you to get all that savings. If you don’t include that designation, the IRS limits your deduction to $3500 per year. So if you had a $14,500 deduction, you would only be able to claim the $3500.

*Lance explains that you can actually accelerate the depreciation with “component tithing,” which says the building will depreciate over those 27.5 years, but the IRS will also allow us to depreciate the appliances and the AC equipment on shorter schedules – which you can break up. You can accelerate it, so instead of getting a 3.6% per year return on your cash, you get 4, 5 or 6% or more, depending upon the rigor in which you depreciate legally.

*Lance discusses exit strategies. You can always sell the property, cash out and take all your equity and pay taxes on it. The good news is, you’re paying a long-term capital gains tax which is the lowest possible rate. “But if you really want to speed wealthy on steroids,” he says, “what you’re going to do is refinance the building. Harvest your equity and use that cash as a down payment. Another building, do the same thing again. Now you own two properties paying you a 30% return on your cash.”

*Another option if you want to sell the building is to sell it on the 1031 Exchange, another IRS benefit to us. This means, if you sell it and take all the cash harvest, you won’t have to pay taxes if you reinvest that cash in another building within six months. You can do that over and over without any limitations, and pass it on to your heirs. “The whole point,” Lance says, “is that we’re using leverage. We’re using all the different ways of getting return on our investment, and not paying taxes. The only thing that’s taxes is the passive income cash flow.” 

*Lance spends the remainder of the podcast answering listeners’ questions on various topics, starting with investing in residential assisted living homes. “In this special-needs area,” he says, “I would collect premium rent. The numbers are going to be even higher because your cash on cash are going to be higher.” He responds with a “yes” to the next question about buying properties as part of his apartment buyer society program.” Following up on the original assisted living question, Lance adds, “Yes I would create two LLCs, one for the business side and one for the real estate side.” Lance then mentions the IDEAL calculator, which helps prospective investors get automatic calculations on the buildings.

*Lance then answers questions related to the variant prices per door you should seek out depending on the class of property; how our offer price should relate to asking price on properties not in distress that you find on the MLS; and the wisdom of using “component tithing” strategy over seven, 10 or 15 years. On the latter question, he says, “Should you accelerate your depreciation and hold the property for a shorter period of time? You absolutely could do that!”

*Lance explains his “leverage and velocity” strategy. Leverage means you’re buying the property. It’s money. Velocity means you extract that, harvest the equity as fast as you can and roll it over into something else. Instead of the 1031 Exchange, you could refi after three years and hold onto it, then use the cash you harvested from the refi and do the same thing here.



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