California Real Estate Finance
Bond, McKenzie, Fesler & Boone
Ninth Edition
Chapter 15
Financing Small Investment
Properties
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Objectives
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After completing this chapter, you should be
able to:
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Describe financing alternatives for residential income,
commercial and industrial properties.
List and briefly explain advantages and disadvantages
to investing in each of the categories of investment
property.
Calculate and apply “break even analysis” to income
producing properties.
Discuss how financing conditions affect prices of
income producing properties.
Compute debt-coverage ratios.
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Outline
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The Single-Family House as Income Property
The Two- to Four-Unit Residential Property
The Five-Plus Unit Residential Income Property
Break-Even Analysis
Financing Starts with the Listing
Introduction to Commercial and Industrial
Properties
Debt Coverage Ratio
© 2011 Cengage Learning created by Dr. Richard S. Savich.
The Single-Family House as
Income Property (Slide 1 of 4)
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Key Characteristics
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Large supply
Management is easier
Active resale market
High degree of liquidity
Sold outright or tax deferred exchange
© 2011 Cengage Learning created by Dr. Richard S. Savich.
The Single-Family House as
Income Property (Slide 2 of 4)
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Non owner occupied 75% loan to value
Fannie Mae and Freddie Mac use 80% loan to value
But require one year experience as landlord
Or six months PITI in reserve
¼ to ½% higher interest
Higher loan fee
Fixed rate
Prepayment penalties only within first three years
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For owner occupied
But rental properties can differ
© 2011 Cengage Learning created by Dr. Richard S. Savich.
The Single-Family House as
Income Property (Slide 3 of 4)
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Flipping
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Buy a house with long escrow
Value appreciates
Sell before closing first escrow
Works well with appreciating values
With depreciating values, buyers “walk away”
Lenders become reluctant to offer non-owner
occupied loans
© 2011 Cengage Learning created by Dr. Richard S. Savich.
The Single-Family House as
Income Property (Slide 4 of 4)
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Advantages
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Larger selection of properties
Management is easier
Investment is more liquid
Tenants pay for utilities,
gardening, and minor repairs
Depreciation tax shelter
Tenants remain longer
Passive loss rules apply up to
$25,000
Low vacancy factor
Hedge against inflation
Leverage during inflation
“Walk away” during decline
1031 Exchange available
Disadvantages
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Could be negative cash flow
Rent/ft2 lower
100% vacancy
You are the manager
But could get professional
management (10% of rent)
Owner pays for repairs
If owner has many houses, no
economy of scale
Tax deductions can be
changed by Congress
© 2011 Cengage Learning created by Dr. Richard S. Savich.
The Two- and Four-Unit
Residential Property (Slide 1 of 2)
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75% loan to value
15% down
Many sellers will carry second
½ to 1% higher interest
Higher loan fees
If owner lives in one unit
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Get owner-occupied financing
Prepayment penalties
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Six months unearned interest
20% payoff allowable in any one calendar year
© 2011 Cengage Learning created by Dr. Richard S. Savich.
The Two- and Four-Unit
Residential Property (Slide 2 of 2)
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Advantages
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Many available
Owner can be manager
Tenants pay utilities, etc.
Rent unfurnished
Tenant may be manager
More privacy for renter
Good LTVs
Depreciation tax shelter
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Disadvantages
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Expensive
Negative cash flow
Higher qualification
requirements
Repairs and replacements
Reserves needed
Owner pays water, outside
lights and laundry room
utilities
Reluctance to raise rents
© 2011 Cengage Learning created by Dr. Richard S. Savich.
The Five-Plus Unit Residential
Income Property (Slide 1 of 3)
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Characteristics
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Better buy than 2-4 units
Larger down payments required
Demand is lower
Keeps prices down
Sell at prices relative to income
Not much vacant land for building
Need parking and open space for new construction
Environmental factors make apartments more difficult to
build
© 2011 Cengage Learning created by Dr. Richard S. Savich.
The Five-Plus Unit Residential
Income Property (Slide 2 of 3)
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60 – 75% loan to value
30% down
½ - 2% higher interest
Higher loan fees
Amortized for 30 years, but due in 1-10 years
Lenders use appraisal and capitalized income
stream to determine loan value
Need better than good credit
© 2011 Cengage Learning created by Dr. Richard S. Savich.
The Five-Plus Unit Residential
Income Property (Slide 3 of 3)
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Advantages
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Constant demand for
housing
Concentrated management
Resident manager possible
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>16 units requires one
Cost/unit is less
Fewer being built
Tax shelter
Equity appreciation
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Disadvantages
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Lots of expenses
Need reserves
Changing neighborhoods
Owner-tenant laws
Rent control
Need patience
No tenant pride of
ownership
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Break-Even Analysis (Figure 15.1)
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Sales = Fixed Costs + Variable Costs
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Financing Starts with the
Listing (Slide 1 of 2)
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Reasons for selling?
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Improvements
Neighborhood change
Rent control
Exchange up
Wants more/less units
No depreciation left
Existing financing information
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Lender, balance due, interest rate
Assumable
If more than one loan, same info
Minimum credit score
Short Sale?
© 2011 Cengage Learning created by Dr. Richard S. Savich.
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Financing Starts with the
Listing (Slide 2 of 2)
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New financing
 Will lender allow assumption
 Minimum credit score
 Prepayment penalty negotiations
 Down payment
 Interest, term, prepayment penalty, acceleration clause, loan
fees, down payment, impounds
 Second loan
Capitalization Rate
 Cap rate = Net Operating Income/Sales Price
 Compare to interest rate
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If rising, cap rate decreases
Does it make good sense without tax shelter?
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Introduction to Commercial and
Industrial Properties (Slide 1 of 3)
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Strip malls
Free standing commercial buildings
Convenience centers
Supermarkets surrounded by other stores
Department stores
Service stations
Garage buildings
Franchise outlets
Quick service restaurants
Motels, hotels, mobile home parks
Office buildings
Rest homes and convalescent hospitals
Other special purpose (drive in banks)
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Introduction to Commercial and
Industrial Properties (Slide 2 of 3)
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Industrial
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Small
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Larger
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One tenant/long term lease
Industrial parks
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10,000 – 100,000 ft2
Developer buys land and develops individual building to
specs of master plan
Office Parks
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Could include restaurants, shops and hotels
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Introduction to Commercial and
Industrial Properties (Slide 3 of 3)
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Advantages
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Steady income
Low vacancy
Lessee makes major
improvements
COLA clauses or
percentage lease
No rent control
Business tenants are easier
to deal with
Lease insurance available
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Disadvantages
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Higher prices
Vacancies during down
times
“Main Street” vs. newer
centers
Fixed rents
City codes
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Debt Coverage Ratio
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Debt coverage ratio =
Annual Net Operating Income
Annual Debt Service
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Should be >1.1
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Questions and Comments?
© 2011 Cengage Learning created by Dr. Richard S. Savich.