This article presents an overview of the economic benefits a rental property provides for investors.
The benefits of group investments
The greatest benefits a syndicator and his group of investors are able to receive from an investment come from the ownership and operation of multimillion-dollar, income-producing properties. All other investment fundamentals being equal, multimillion-dollar properties are generally more efficient and typically yield a greater return on their price than lesser-valued properties do.
Investing in a multimillion-dollar property gives the syndicator and his group an economic advantage over most individual investors. A syndicator pools capital from several investors, which enables him to acquire more valuable property than most individual investors can afford by themselves.
Also, the syndicator’s compensation, typically based on the price of the property acquired and its flow of income, is far greater when his time and effort is spent on multimillion-dollar properties.
Less experienced syndicators, however, should initially stay with low-value properties, as they are less tricky to syndicate. Multimillion-dollar properties are more difficult to investigate and manage. Errors due to lack of experience and knowledge are dramatically compounded in larger properties and thus more costly to correct.
Earnings from rental property
Residential or nonresidential rental properties generate annual returns for co-owners based on four financial aspects of ownership, listed in the following order of economic importance:
· net spendable income;
· loan reduction;
· increased property value; and
· tax benefits.
Net spendable income
The rents received from tenants make up the property’s gross operating income. Operating expenses and loan payments are paid out of the gross operating income. If rental income is insufficient to cover expenses and loan payments, members are called upon by the manager to contribute additional funds to cover the negative cash flow.
Conversely, any income remaining after disbursing operating expenses and loan installments is referred to as the property’s net spendable income. When a property generates a spendable income, the property is said to have a positive cash flow. Spendable income is the primary source of cash for distributions to investors, called cash- on-cash income. The spendable income acts as a cushion against negative cash flow brought about by a drop in the property’s net operating income (NOI).
Spendable income generated by the investment is a return calculated as a percentage of the investors’ capital contributions. It is roughly comparable to interest received on money-market accounts and dividends paid on common stock. Thus, periodic returns on both vary from time to time due to inflationary price pressures and the central (federal) bank’s management of the money supply.
The possibility of earning a flow of spendable income without having to be involved in the day-to-day management of a property is a major inducement motivating investors to become contributing members in an LLC program.
The dollar amount of the annual principal reduction on a trust deed loan, due to the systematic amortization of the debt built into the loan’s payment schedule, represents a return of invested capital. The amount of the loan reduction is calculated for investors as a percentage yield on their cash investment. This loan reduction yield is a significant but secondary source of earnings, since it exists as an equity buildup, which cannot be distributed to investors as it occurs.
The annual principal reduction is best viewed as a return of capital since the loan amount originally funded part of the total capital the co-owners invested in the property. Taxwise, the amount of the annual depreciation deduction, which represents a tax-free return of capital, more than “shelters” the rental income used to make loan payments from taxation for approximately two thirds or more of the life of a 30-year loan.
The principal balance owed on a long-term real estate loan is systematically reduced by loan payments through a process called amortization. The reduction in the loan amount enlarges the property’s equity in an equal amount (a “build up” in equity) as long as the value of the property remains at or above the purchase price throughout the life of the loan.
Thus, a constant recapitalization of the investment occurs each month during ownership when the amount of the loan principal is reduced by installments made, paid for from rent. While the property’s value may remain the same, the equity in the property is increased by the amount of the debt reduction, an ongoing restructuring of invested capital.
When income property produces spendable income, all monthly installments due on purchase-assist financing are paid out of the rental income received from the tenants. No further capital contribution is required from the investors to carry the payments on the principal of loans encumbering the property.
On resale of the property, the equity built up by the amortized reduction of loan principal is cashed out, generating profits (due to depreciation) and a return of the remaining capital for the investment group.
Typically, the investment circular contains a schedule that charts the annual dollar amount of loan reduction over a ten-year period of ownership. The annual equity buildup attributable to the loan reduction during each of the ten years is then represented as an average annual percentage return on the investors’ original cash contribution of capital, which includes the debt incurred to fund the investment.
A property’s net worth over time
The equity in a property represents the net worth in the property. Equity is calculated as the difference between the property’s market value and the principal balance remaining on any financing or other monetary liens that encumber the property.
An owner’s equity in a property is the result of:
· cash invested to purchase or improve the property, called a down payment, which does not include cash required to cover any negative cash flow during the ownership of the property;
· loan reduction through amortized loan payments and any additional payments of principal, called equity buildup; and
· increased market value of the property due to inflation, appreciation or management, called growth factors.
An increase in property value
Real estate located in areas experiencing growth in population and wages tend to increase in value over time due to a combination of monetary inflation, local appreciation and efficient management of income and expenses, called growth factors. Meanwhile, the physical aspects of the property remain unchanged due to the elimination of obsolescence and wear through proper maintenance.
Inflation is a decline in the purchasing power of the dollar, measured by the federal government and reported through the consumer price index (CPI). Thus, over time, more dollars are required to purchase the same property in the same condition, called monetary inflation. Inflation is reported as the periodic increase in the dollar price paid for goods and services, not a decrease in the quantity of goods and services the dollar will now buy. Over the years, the value of properly maintained real estate tends to keep pace with inflation, as long as:
· the location of the property has a static or increasing population and employment base; and
· the per capita income (wages) of potential tenants increases annually at a rate no less than the rate of inflation.
To reap the “benefits” of inflation, the manager of a property does not need to do anything more than maintain the property by keeping it in good repair and replace fixtures to eliminate physical obsolescence.
Occasionally, property appreciates in value in addition to the rate of inflation. Appreciation is the result of local economic conditions, comprised primarily of consumer demand for the location, which then leads to an increase in the local population. It is the syndicator’s task to choose a property that is likely to increase in value beyond the annual rate of inflation. To garner this future, additional increase in the property’s market value, the syndicator selects property located where conditions within its immediate vicinity will likely cause an increase in population density (or per capita income) and thus an increase in demand and rents for residential and nonresidential rental space.
Finally, an increase in property value exceeding the effects of inflation or appreciation may be achieved by the syndicator’s management capabilities in cutting operating costs and increasing rental revenues. Efficient management tends to increase a property’s NOI. As a result, the value of the property tends to increase since capitalization rates for setting a property’s value are applied to the NOI the property produces.