This article assists in the clarification of the many components of a sales price and its mathematics. Also see our April 2008 article “Short payoffs on loans in foreclosure“.
Different views, different aspects
Quite often, and properly so, brokers and listing agents advise sellers on the amount of net proceeds they can expect from the sales price. Agents do so by preparing and reviewing a seller’s net sheet, based initially on the listing price. The preparation is repeated to analyze the price offered in each purchase agreement offer submitted.
The seller’s net sheet is enough to estimate the dollar amount of the seller’s net equity and the net proceeds likely to be received on a sale.
But what about the profit (or loss) which is also a component of the sales price? Taxwise, the data is important. A sale at a profit produces a tax liability, unless exempt or excluded. Sellers frequently believe the profit on which they will pay taxes is somehow related to the amount of net proceeds they will receive on the sale.
In other words, a belief commonly held by sellers is that their equity equals their profit, however, it does not. The differences become more distinguished when the seller has refinanced the property and increased the debt encumbering the property.
The equity in a property and the profit on a sale are derived from different data, respectively, the debt and the basis. On a sale, they are never the same amount.
Before breaking down the sales price into its components for various purposes, several economic fundamentals of real estate ownership must first be understood and differentiated:
- capital investment made to acquire and improve the property (cash contributions and funds from loans);
- annual operating data generated by rents and expenses of ongoing ownership; and
- tax consequences of buying, ownership operations and selling.
A property’s sales price, also called market value, is the only term common to all economic analysis regarding the ownership of a home, business-use property or rental real estate, residential or nonresidential. However, homebuyers are not (yet) demanding much information disclosing a residence’s operating data (and the state legislature has not yet required it). Also, homebuyers are less informed. Thus, they are less inquisitive about acquisition costs, operating expenses and income taxes than are buyers of business or investment real estate.
Capital aspects of the sales price
When marketing real estate for sale, the published sales price of a property can be quickly broken down into its debt and equity, as it should be, by any buyer interested in the property. It is the seller’s equity a buyer is cashing out, no matter how the buyer might be financing his purchase.
The amount of debt encumbering a property is deducted from the sales price to determine the seller’s gross equity in the property. However, debt never aids in the determination of the seller’s profit on a sale.
Also, a seller’s present capital interest in a property is the total sum of the dollar amount of the property’s current debt and equity or the property’s current fair market value — its price. The capital interest is distinguished from the seller’s previous capital investment in the property of cash and loan proceeds, originally used to purchase, improve or carry the property, that establishes his cost basis in the property.
Buyers seeking information about a property should be interested in the dollar amount of equity the seller has in the property. The buyer acts to “buy out” the seller’s equity, the seller’s net worth in the property, when the buyer purchases the property and generates net sales proceeds for the seller.
Any debt encumbering the property is either assumed by the buyer or paid off with funds from the buyer. Neither action ever puts money in the hands of the seller. Funds received by escrow for payoff of an existing loan are either advanced by the buyer or obtained from purchase-assist financing arranged by the buyer.
Further, the market value (the sales price for the property) bears no relationship to the seller’s original capital investment in the property, whenever it was made. The sales price does not reflect a value based on a trend line of the historic value or equilibrium value of property, much less the seller’s book value (which is the depreciated cost basis remaining from the original capital investment).
A related financial concern is interest paid on mortgage debt borrowed to provide capital to purchase investment property. Interest is a cost of capital and is incurred by owners who are not solvent enough to own “free and clear” property. Interest paid on the debt is not a capital investment expended to acquire or improve property. Further, as a cost of capital, interest is not an operating expense incurred for the care and maintenance of the property. Thus, interest is not included in a rental property’s net operating income (NOI).
However, to determine a property’s income or loss for annual tax reporting, interest, like depreciation, is deductible from the property’s NOI. While interest is not an operating expense incurred by the property, it is an allowable deduction for undercapitalized owners who must borrow to obtain capital to acquire property.
Operating data sets the sales price
A property’s sales price is also viewed as the capitalization of the property’s NOI based on a yield, an alternative to other methods of property valuation. The income and expense data comprising the NOI are the fundamentals upon which value, and thus the sales price, is established.
As a reference to value, the mathematical relationship between the sales price and NOI produces a multiplier (a ratio) and a rate of return (a percentage). These are used to calculate probable value and are reciprocals of one another. The same indicators are used in the stock market for a cursory analysis of share value, called “price-to-earnings ratios.”
Rental properties produce income by way of rents paid by tenants. In exchange for receiving rent, landlords incur expenses to care for and maintain the physical condition and earning power of the properties. Collectively, the rents and expenses produce the NOI of a property, which in turn give the property a value — the sales price.
A rental property’s operating expenses do not include interest payments or capital recovery through depreciation schedules. Interest is related (as a cost of capital) to the financing of the owner’s capital investment which is needed to purchase or improve the property, not to operate the property (unless it produces a negative cash flow).
Depreciation is an orderly, tax-free recovery from rents of that portion of the owner’s total capital investment allocated to improvements. Interest and depreciation deductions are unrelated to the operation of the property or the property’s current sales price. Arguably, however, an above market interest rate on a locked-in loan which cannot be prepaid would depress the property’s sales price.
Each parcel of income-producing property has a calculable scheduled income: the total rents collectible if the property is 100% occupied, without reduction for vacancy, turnover or uncollectible rents.
Also, the sales price of a residential or nonresidential rental is often roughly stated as a gross multiplier or percentage of value based on the scheduled income, called rules-of-thumb. As approaches to pricing, these determinations are preliminary and superficial.
Historically, the scheduled monthly rents for a residential rental, when viewed as a percentage of value, are said to represent about 1% of the sales price, an unsophisticated but initial indicator of value. This monthly income indicator is used to approximate a reasonable price for a property which enjoys reasonable income and expenses in a market based on minimal current and expected future inflation rates.
The asking price of income property is often tested for its reasonableness by the application of a multiplier to the scheduled annual rents or the NOI, another variable which helps predict a property’s value. Historically, a gross multiplier of 7 or 8 (arguably higher at 10 to 12 during periods of excessive asset inflation) times annual rents is used on residential units as a quick glimpse into the reasonableness of the sales price.
However, an analysis of a sales price is more properly based on the NOI a rental property is expected to produce each year in the future. The NOI is the annual return a property produces based on collectible rental income minus operating expenses. Again, interest on the mortgage debt is of no concern to a buyer when evaluating property which is or will be financed by the buyer at interest rates no greater than the buyer’s capitalization rate, his rate of return.
The annual rate of return sought by a buyer is applied to the NOI to produce a sales price the buyer will pay for the property — its value to a buyer before considerations for financing the price.
The annual rate of return expected from ownership of a property is called a capitalization rate or yield.
The capitalization rate applied to the NOI comprises an implicit, anticipated future inflation rate (CPI) of, for example, 2% annually, a recovery of the seller’s investment of 3% annually, and a “real” (after inflation) rate of return for the buyer of 3% to 4% annually. During the early to mid-1990s, this aggregate capitalization rate was represented by a 9% to 10% annual yield (a gross multiplier of 11 or 10).
The large sums of equity (stock) market financing available to real estate investment trusts (REITs) and secondary mortgage pools in the late 1990s drove the annual expected yield for real estate income down to around 6.5% to 7% and lower into 2004 (a multiplier of 14 to 15 times NOI and higher into 2004). The excessive demand for assets and readily available and historically cheap mortgage financing pushed prices up, possibly in anticipation of strong future increases in rental income or a reduced risk of lost value due to cyclically collapsing real estate markets.
Tax components in the sales price
Taxwise, the sales price is broken down into basis and profit to determine the income tax consequences of a sale. The short formula for profit is: price minus basis equals profit.
However, a tax analysis of the price only reflects the consequences of a sale. Neither a seller’s remaining basis nor the profit he may seek plays any role in setting the market price a buyer may be willing to pay for a property.
A seller’s basis and profit, an element of state and federal tax reporting, are of no concern to a buyer. A buyer can never acquire a seller’s basis, and a seller’s basis does not in any way contribute to or help a buyer establish a property’s value.
Also, a seller’s remaining cost basis in a property never is equal to the amount remaining unpaid on the loans encumbering the property. Likewise, deducting basis from the sales price sets the seller’s profit; basis never sets the equity acquired by the buyer because price minus debt equals equity.
When a buyer acquires property, a cost basis, also called book value, is established as a total of all the expenditures related to the purchase of the property and the improvements necessary to attract tenants, called “placing the property in service.” During the period of ownership prior to resale, a property’s cost basis is adjusted periodically due to depreciation (capital recovery), hazard losses and further improvements.
Taxwise, the cost basis remaining at the time of resale is deducted from the net sales price to determine whether a profit or loss has been realized by the seller.
A buyer’s payment of the purchase price is his capital contribution. The price paid consists of any cash contributed to fund the price and transactional costs, the principal balance of existing trust deed loans assumed, net proceeds from new loans and the fair market value of the equity in other property (except §1031 like-kind real estate) used to purchase or improve the property acquired, collectively called costs of acquisition.
Editor’s note — If the purchase price paid includes an equity from §1031 like-kind real estate, the basis in the property purchased will include the remaining cost basis in the property sold (not its sales price), adjusted for additional contributions or the withdrawal of money (cash boot) and differences in the amount of existing debt (mortgage boot) on the properties.
Adjustments to value
Additional improvements do contribute to a property’s value. Thus, the expenditures for the cost of improvements are added to the basis in the property. Conversely, expenditures for the upkeep, maintenance, repair and operations of the property are operating expenses deducted from rental income. While operating expenses add nothing to the cost basis in the property, they do maintain — and often increase — the property’s value and sales price.
Net cash proceeds from refinancing or equity financing which are not used to purchase or improve property do not contribute to the cost basis (or affect the property’s value). While any financing affects a property’s equity, the assumption (take-over) of existing financing and the investment of funds from the proceeds of a purchase-assist or construction loan will make up part of the buyer’s cost basis on acquisition.
The depreciation allowance is a tax-free annual return to an owner (from rents) of the percentage of his total capital contribution allocated to the improvements. Accordingly, the cost basis, being the total capital contribution, is reduced each year on the deduction of the annual depreciation allowance from the NOI, and establishes the property’s current cost basis on the owner’s books.
Assuming the property will receive future maintenance, none of the depreciation taken in anticipation of deterioration and obsolescence weighs in to set the sales price. Again, tax accounting and book value do not play a part in the calculation of a property’s market value (sales price).
On resale of a property, the seller’s initial tax concern is the amount of profit that exists in the sales price. The structuring of the terms for payment of the sales price or reinvestment determines whether the profit in the sales price will be taxed, and if so, when the seller will pay those taxes.