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Using Leverage to Build Equity in Investment Real Estate – July 2015

Leverage has always been a great tool to allow for more rapid growth of equity when owning investment real estate while being able to deduct the annual interest expense. Although buying power is increased with the use of leverage, each property purchase or mortgage refinance that utilizes a new loan should be carefully evaluated.

Every investor’s tolerance for risk is different. Knowing your monthly payment will not change using a fixed-rate mortgage can be a good thing when the property type could have uneven cash flows from time to time; however, if the loan-to-value ratio was maximized to provide for the highest internal rate of return from the real estate investment, the ability to cover a high monthly loan payment can be challenging during periods of lean cash flow.

Use of less leverage, or even no leverage, may be the safest investment strategy to cover market swings in cash flow, but will generate the lowest rate of return on equity.

Having some of the loans in your investment real estate portfolio highly-leveraged, but not all, may be one strategy to diversify risk. Positive cash flow generated from those investments that utilized less leverage can sometimes cover for periods of lower or even negative cash flow in the more highly-leveraged investment properties. A few examples to demonstrate this point are provided below:

Investment Real Estate Example – No Use of Leverage

Assumed Value of Investment Real Estate: $500,000
Assumed Annual Net Operating Income From Property: $45,000
Cash on Cash Before-Tax Annual Rate of Return: 9%

Investment Real Estate Example – Same Property but Use of 75% Leverage

Assumed Value of Investment Real Estate: $500,000
Assumed Equity: $125,000
Assumed Mortgage: $375,000
Assumed Annual Net Operating Income From Property: $45,000
Assumed Annualized Mortgage Payments: $29,575 (20-year amortization, 5% interest)
Before-Tax Cash Flow Remaining on Equity: $15,425
Before-Tax Annual Rate of Return on Equity: 12.34%, plus growth in equity from paying off mortgage over 20 years and deducting the mortgage interest expense

Investment Real Estate Example – Same Property but Use of 50% Leverage

Assumed Value of Investment Real Estate: $500,000
Assumed Equity: $250,000
Assumed Mortgage: $250,000
Assumed Annual Net Operating Income From Property: $45,000
Assumed Annualized Mortgage Payments: $19,717 (20-year amortization, 5% interest)
Before-Tax Cash Flow Remaining on Equity: $25,283
Before-Tax Annual Rate of Return on Equity: 10.11%, plus growth in equity from paying off mortgage over 20 years and deducting the mortgage interest expense

Another way to minimize risk is to use higher leverage for lower-risk property types, and lower leverage for higher-risk property types. Actual and perceived market fluctuations can affect the amount of risk associated with various property types; however, there are some characteristics that generally result in one property type being more risky than another. Hosch Appraisal & Consulting, Inc. can provide resources for evaluating and comparing different property types relative to client risk tolerance. Once an investment real estate portfolio is established, especially if leverage is utilized, it can be helpful to review the property types relative to the current and projected market conditions every few years to maintain a manageable level of risk while striving to achieve individual investment goals.

INCREASING CAPACITY AND VALUE OF EXISTING INVESTMENT PROPERTIES – JANUARY 2014

During the recession, and over the past few years throughout the recovery, many investment property owners have been in a holding pattern for several reasons. Retaining existing tenants that pay rent on time was a priority, especially during the market decline when cash flow may have made the difference in order to refinance an existing mortgage and/or not be forced to sell the property to generate liquidity. Caution was in the air for several years as owners worked through the challenges brought by vacancy, rent reductions, difficulty in obtaining financing and fewer opportunities for “willing sellers” to sell at market value when having to compete with foreclosure sales.

Many market sectors have stabilized or began improving to a level where it may now be worthwhile to evaluate the property’s market position and potential for increasing its value. Real estate that is developed with existing building improvements that maximize the site may have potential for repositioning through remodeling and/or renovation to attract a new tenant, improve operations of the existing occupant or prepare the property for sale. Underutilized properties having excess space within an existing building, or excess land capable of allowing for expansion and even development of additional buildings that can utilize current site improvements, can create opportunities for improved cash flow and/or a higher value.

Any highest and best use exercise begins with an understanding of underlying land value. Quickly contrasting the value of the property under its existing use with the underlying land value can reveal if the existing improvements contribute value. Sometimes this is a relatively straight forward conclusion to reach when the existing building is newer, the site is efficiently developed and market conditions are stable; however, in areas that have experienced significant new development or redevelopment, existing properties should be carefully evaluated beginning with the estimated land value. Those determined to have at or near 100% of overall value consisting of land value may be ripe for redevelopment as warranted by market conditions of a proposed use. If the existing use is underutilizing the site, and additional development can be accommodated while retaining the existing building (or building shell), this should be thoroughly evaluated so any contributory value of existing buildings/site improvements is retained.

It is not uncommon for us at Hosch Appraisal & Consulting, Inc. to encounter properties that are currently underutilized with growth potential. Our highest and best use analyses and consulting assignments have assisted clients in evaluating their options in order to maximize the value of their investment real estate. The cautiously optimistic outlook among business owners and investors, coupled with a competitive bidding environment from contractors working to win back market share, could create opportunities for creative buyers, sellers or existing owners trying to increase equity by repositioning or redeveloping their investment real estate.

POTENTIAL REAL ESTATE INVESTMENT OPPORTUNITIES – GREATER TWIN CITIES METROPOLITAN AREA – SEPTEMBER 2013

POTENTIAL REAL ESTATE INVESTMENT OPPORTUNITIES – GREATER TWIN CITIES METROPOLITAN AREA – SEPTEMBER 2013
Based on our observations and recent activity, current market conditions appear favorable for several property types in the Twin Cities metro area and outlying counties including, but not limited to, the following:

Immediate 13-county Metro Area

-Small Office and Commercial Properties
Following the recession, several smaller freestanding office buildings, office condominium units and small industrial properties falling below 5,000 square feet in size were vacated, foreclosed upon and available for purchase at prices falling significantly below replacement cost. Prices and available inventory have firmed up. As the economy continues to recover, such properties should allow for value appreciation if located within or near areas of population density.

-Large Industrial (generally 100,000 square feet or larger with clear heights above 24 feet)
Users continue to seek functional distribution space with high-clear ceilings to increase efficiencies. Large blocks of modern, well-located space are quickly being absorbed as tenants take advantage of the few remaining options market-wide. Users looking for space in large industrial buildings offering high clear heights are facing a lack of inventory. The shortage of large, prime space options will limit the number of leases signed unless more product is added. Rates in the best properties will likely continue to increase, while landlords of older, less-functional space will have to continue offering aggressive rates and incentives to fill their buildings. Upward pressure on pricing is expected for user-buildings because of the lack of available space for lease and lack of user-building inventory. Continue reading