Residential Real Estate Investment Notes

Investing in Residential Real Estate

Introduction

  • Investing in residential real estate can be a natural extension for homeowners.
  • This module will cover:
    • Definition of residential real estate.
    • Reasons to invest in residential real estate.
    • Ways to make money from residential real estate investments.
    • Common ways to finance residential real estate investments.
    • Lender expectations for investors.
  • An Excel example will be used to illustrate key concepts.

Defining Residential Real Estate

  • The residential real estate market is a huge market with over 200,000,000,000200,000,000,000 in value based on real estate sales and brokerage revenue.
  • Types of residential real estate properties:
    • Single family homes: Stand-alone houses on a single lot with no shared walls.
    • Condominiums: Single units within a larger building or community.
    • Townhouses: Hybrid between condominiums and single family homes; smaller than single family homes but larger than condominiums.
    • Multifamily: Properties with multiple living spaces, ranging from duplexes to quadplexes.
    • Manufactured housing: Mobile residential units.
  • Commercial properties, even with residences (e.g., large apartment complexes), are not considered residential real estate.
  • Multifamily properties with more than four units (larger than a quadplex) are considered commercial.

Reasons to Invest in Residential Real Estate

  • Ease and simplicity compared to other investments.
  • Lower price point compared to commercial property; investors may choose fixer-uppers.
  • Greater control over the asset compared to stocks and bonds; investors can make repair and renovation decisions.
  • Diversification of an investment portfolio.
  • Opportunity for regular cash flow, especially through rental properties.
  • Potential tax benefits based on financing and property tax deductibility, depending on the investor's situation.

Ways to Make Money from Residential Real Estate

  • Three main approaches:
    • Development: Building a property from scratch on raw land or redeveloping existing land.
    • Investment: Purchasing an existing property and renting it out to tenants.
    • Flipping: Buying a property at a low price, renovating it, and selling it at a higher price.

Buying Residential Real Estate

  • Indirect Buying:
    • Real Estate Investment Trusts (REITs): Investing through a company that owns, operates, and finances income-producing properties.
      • Modeled after mutual funds and traded like stocks.
      • Allows participation in returns from development and investment without direct involvement.
    • Real Estate Investment Groups (REIGs): Cooperative purchases made by like-minded investors.
  • Direct Buying:
    • Active role through buying and renting real estate.
    • Renting to long-term tenants:
      • Multifamily or single-family homes with leases typically six months to a year.
    • Renting to short-term or medium-term tenants:
      • Vacation properties listed on sites like Airbnb.
      • More complicated due to short-term rentals and require property managers.
    • Property Development:
      • Purchasing land and constructing units or redeveloping existing property.
    • Flipping Properties:
      • Short-term venture involving buying, renovating, and selling property at a profit.
      • Typically completed in less than one year.

Financing Residential Real Estate Investments

  • Conventional Loan:
    • Similar to loans for primary residences but with stricter lender requirements.
    • May require a higher down payment and stricter credit guidelines.
  • Hard Money Loan:
    • Short-term loan from private individuals, often used for flipping.
    • Faster approval process but higher interest rates.
    • Heavily collateralized using the investment property.
    • Loan amount and interest rate are based on the asset's value.
  • Private Money Loan:
    • Loans from one individual to another (e.g., friends or family).
    • The lender can use any criteria to set the loan amount and interest rate.
  • Home Equity Loan:
    • Borrowing against the equity of an existing home to finance an investment property.
    • Common for first-time investors with significant home equity.
    • Investors may borrow up to 80% of their home's value.

Differences Between Investment and Primary Residence Loans

  • Amortization:
    • Primary residence loans are typically fully amortized.
    • Investment loans often have a shorter term than the amortization period, resulting in a balloon payment at the end of the term.
    • The loan may be amortized over 20 or 30 years, but the term may only be 5 years.
  • Covenants:
    • Primary Residence: Debt to income ratio is a key consideration.
    • Residential Real Estate Investment: Debt service coverage ratio is used. The debt service coverage ratio looks at the monthly debt payments compared to the monthly income that is forecasted from that property.
      • Higher debt service coverage ratio indicates a lower risk of default.
    • Loan to Value (LTV) Ratio:
      • Primary residence: Lenders may accept high LTV ratios (e.g., 95-97%).
      • Residential real estate investment: LTV ratios tend to be much lower (e.g., less than 50%).

Lender Expectations for Residential Real Estate Investors

  • Lenders focus on the financial viability of the project and the cashflows from the property.
  • Lenders consider forecasts of rents and vacancy rates.
  • Lenders review projected financial statements.
  • Lenders are concerned about cash flows, especially when working with corporations or partnerships.

Multifamily Project Analysis: Quadplex Example

  • Assumptions:
    • Purchase price: $575,000\$575,000
    • Acquisition cost: 2%
    • Four units (quadplex)
    • Average rental income per unit per month: $1,000\$1,000
      • Year 1 Projected Gross Income: $48,000\$48,000 ($1,000\$1,000/unit/month * 4 units * 12 months)
    • CapEx reserve: 2.5% of expected gross income
    • Year 1 operating expenses: 12% of potential gross income (typical range: 10-15%)
    • Vacancy and loss rate: 5% (average estimate range: 3-5%)
      • Going-in cap rate: 6.73%
    • Discount rate: 7%
    • Rent and expense growth: 3% per year
  • Financing assumptions:
    • Interest rate: 5.5%
    • Amortization: 20 years
    • Loan term: 5 years (not fully amortized loan)
    • Loan to Value (LTV) ratio: 50% (lender requirement)
    • Debt service coverage ratio: 1.5 (lender requirement)
    • Lender points: 1%
    • Annual payment: $23,732\$23,732
  • Disposition Assumptions:
    • Going-out cap rate: 6%
    • Selling costs: 4%
    • Commissions: 2%
    • Holding period: 5 years

Annual Cash Flows

  • Five-year holding period.
  • Potential Gross Income (PGI):
    • Cash flow if the property was fully rented.
    • $48,000\$48,000 (4 units * $1,000\$1,000/unit/month * 12 months)
  • Vacancies and Losses:
    • $2,400\$2,400 (accounts for units not being fully rented)
  • Expected Gross Income (EGI):
    • PGI less vacancies and losses.
    • $45,600\$45,600 in year one.
  • Capital Expenditures (CapEx) Reserve and Operating Expenses:Reduce EGI.
  • Net Operating Income (NOI): EGI less CapEx reserve and operating expenses.
  • Debt Service: Loan payments.
  • Before Tax Cash Flow (BTCF): NOI less debt service, representing operating cash flows before taxes.

Year Zero Cash Flows

  • Leveraged Before Tax Cash Flow:
    • Cash outflow related to the purchase, considering financing.
    • In this example, = $301,875\$301,875 (initial purchase price + acquisition cost + loan cost - incurred debt).
  • Unleveraged Before Tax Cash Flow:
    *Takes the same approach by factoring in the acquisition cost without factoring any debt.
  • Mirrors the NOI.

Disposition (Selling the Property)

  • Gross Sales Price: $747,732\$747,732 (based on going-out cap rate).
  • Selling Costs: 4% of gross sales price.
  • Commissions: 2% of gross sales price.
  • Balloon Payment: $242,041\$242,041 (due to the loan not being fully amortized).
  • Net Sales Proceeds: $460,827\$460,827 (gross sales price less selling costs, commissions, and balloon payment).

Year Five Cash Flows

  • Leveraged Before Tax Cash Flows:
    • Net sales proceeds added to NOI less debt service.
  • In comparison, the unleveraged before-tax cash flows remove the effect of the loan, where:
    • the initial cash flow at time zero would be $586,500\$586,500,
    • the operating cash flows are the same as NOI because there is no debt service,
    • the total cash inflow is equal to the gross sales price less commission.

Impact of Leverage on Returns

  • Net Present Value (NPV):
    • Leveraged project NPV: $15,000\$15,000 higher.
  • Internal Rate of Return (IRR):
    • Significantly higher for the leveraged project.