To achieve the magnitude of investment activity referred to in my own personal example in Chapter 1, an investor must have clearly defined goals. The goals you establish will directly affect your financing strategies. Three primary financing elements around which all real estate investment activity centers are time, volume, and the type of property (see Exhibit 2.1). Once you have determined your time horizon, the rate at which you intend to buy and sell, along with the type of real estate you will invest in, the proper financial instruments may then be put in place.TIME HORIZON
Most real estate professionals incorporate the element of time into their investment strategy. The element of time refers to the duration of the holding period. In other words, it is the length of time a particular piece of investment property is intended to be held. While some investors, for example, prefer to adopt a short-term approach by “flipping” or “rehabbing” houses, other investors prefer to adopt an intermediate-term approach, which includes buying, managing, and holding rental property for three to five years. Still others prefer to purchase office or industrial buildings and hold them for periods as long as 10, 20, or even 30 years. Establishing your investment horizon before obtaining financing is crucial to developing a sound strategy. You must know beforehand if you are going to hold the property for just a short time, for many years, or for somewhere in between, since the variable of time is used to calculate interest rates. Time will also have an impact on whether you obtain a floating rate or a fixed-rate loan, as well as any prepayment penalties that may be associated with the loan.
Time can have a significant impact on the growth rate of your real estate portfolio. Time affects such things as the tax rate applied to your gain or loss. The long-term capital gains tax rate has historically been more favorable than the short-term tax rate. Time is also the variable in the rate of inventory turnover. Large retailers are willing to accept lower profit margins on items they merchandise in exchange for a higher inventory turnover rate. Would you rather earn twenty percent on each item, or house, you sell and have a turnover rate of one, or would you rather earn eight percent on each item you sell and have a turnover rate of three? Let’s do the math.
Turnover ratio = = × 20% = 20% = total return
or
Turnover ratio = = × 8% = 24% = total return
This simple example clearly illustrates that an investor can accept a lower rate of return on each property bought, sold, and earn a higher overall rate of return, if the frequency, or turnover rate, is increased. I should mention that this example does not take into consideration transaction costs. These costs may or may not be significant depending on your specific situation, but they must be factored in when analyzing a potential purchase.
Investment time horizons typically fall into one of three categories: short term, intermediate term, and long term. Short-term investors are defined as those individuals who buy and sell real estate with a shorter duration. They typically hold their investments less than one to two years. This class of investor most often seeks gains by adding value through making improvements to the property, or by taking advantage of market price inefficiencies, which may be caused by any number of factors, including distress sales from the loss of a job, a family crisis such as divorce, or perhaps a death in the family. The shorter holding period does not allow enough time for gains through natural price appreciation caused by supply and demand issues or inflationary pressures.
The short-term investor may furthermore seek to profit by using the higher-inventory-turnover strategy and, as a result, may be willing to accept smaller returns, but with greater frequency, thus realizing an overall rate of return considerably higher than the long-term approach, as demonstrated previously. Since current tax codes penalize short-term investors by imposing higher tax rates on short-term capital gains, they must factor this into their analysis before ever purchasing a property.
The proper financing mechanism is also a key part of an investor’s analysis. In a short-term strategy, an investor can often take advantage of a loan with a more favorable floating or adjustable rate as opposed to a longer-term fixed-rate loan. In addition, depending on the type of financial instrument procured, principal payments may not be required. This provision allows an investor to minimize his or her outgoing cash flow by making interest-only payments. Cash flow is the name of the game in real estate. Learn to use it to your benefit. Finally, you should be aware of any prepayment penalties that may be imposed on short-term financing. Banks are especially notorious for assessing this additional type of fee income on a loan. Their decision to do so is based on the premise that since the loan is short term in nature, they must charge additional fees to offset their other costs associated with making the loan, such as administrative costs. That argument, however, is the same one lenders use to justify charging a loan-origination fee, which is typically 1 point, or 1 percent. If you have a good record of accomplishment and are an established investment professional, prepayment penalties can usually be negotiated down to a minimum, and oftentimes will be waived all together.
Intermediate-term investors most often hold their properties for at least two years but no more than five years. This class of investor typically seeks gains through a combination of increases in property values, resulting from price appreciation due to supply and demand constraints in the local market, and by making modest improvements to the property. Reducing debt to increase cash flow is not as high a priority for intermediate-term investors as it is for their long-term counterparts. This class of investor also tends to be more highly leveraged than do long-term investors. Finally, since intermediate term investors hold their investment properties for a minimum of two years, they are able to take advantage of the lower and more favorable long-term capital gains tax rate. As the tax laws are currently written, income derived from the sale of assets with a holding period shorter than 18 months will be treated as ordinary income and therefore subject to a higher tax rate.
Once again, the proper financing mechanism is a key part of an investor’s analysis. In an intermediate-term strategy, an individual can take advantage of a more favorable floating-rate loan. If the time horizon is firmly established as one that will not exceed five years, I recommend using floating-rate instruments in most cases, since they usually carry lower interest rates than do fixed-rate loans. The exception to this recommendation is, however, that if rates are forecast to rise in the near future, it may be better to lock in a fixed rate now than to run the risk of rapidly increasing rates. Similarly, to short-term financial instruments, you may be able to obtain a loan in which principal payments are not required.
Depending on the needs of the seller, you may even be able to negotiate a deal, in which no periodic payments whatsoever are required. This includes both principal and interest. I’ve used this technique myself; in fact, I very recently closed on a land deal valued at $3.3 million that will not require any periodic principal or interest payments. The seller agreed to carry the note and allow the interest to accrue. The interest will become payable at the time individual lots from the land are released, which occurs when my company, Symphony Homes, builds a house on it. At that time, a construction loan is obtained to pay both the accrued interest and the principal balance to the seller. Interest-only payments are then made to the bank over the next four months or so until the house is completed and sold.
Long-term investors may purchase real estate properties and keep them in the family for generations. They will typically hold them for a minimum of five years, but oftentimes much longer. Long-term investors seek gains through capital appreciation by simply holding and maintaining their investments while making improvements on an as-needed basis. They sometimes seek to minimize the associated debt and maximize the cash flow generated by the property through an acceleration of both interest and principal payments. Although in the short term, investors adopting this strategy will decrease the property’s cash flow by making larger monthly payments, they will eventually increase its cash flow by eliminating the debt altogether. As a result, long-term investors are usually not fully leveraged. They generally prefer the positive cash flow to being excessively leveraged. Long-term investors are able to take advantage of the more favorable long-term capital gains tax rates when they do eventually decide to sell. In addition, long-term investors may elect to take advantage of deferring the tax liability indefinitely through a provision outlined in the Internal Revenue Code referred to as a 1031 exchange.
Investors adopting a long-term strategy will most likely desire to insulate themselves from variations that occur in a sometimes-volatile interest rate environment by locking in fixed-rate loans at the time of purchase. However, like short-term investors, they can take advantage of more favorable floating-rate loans. Depending on the type of financing instrument used, long-term investors may or may not be subject to prepayment penalties. Some debt instruments, such as conduit loans, carry heavy prepayment penalties in the early years. Conduit loans are reserved for larger income-producing properties and usually have a minimum loan amount of $1 million, although smaller loans are available. A complex prepayment penalty is usually imposed on these types of loans, since the loans are securitized and then sold to investors. The prepayment penalties are used to ensure that investors who buy the loans are guaranteed a minimum yield on their related investment.
