© 2015 OnCourse Learning

California Real Estate Finance

Fesler & Brady10th Edition

Chapter 15Financing Small

Investment Properties

Objectives• After completing this chapter, you should be

able to:– Describe financing alternatives for residential

income, commercial and industrial properties.– List and briefly explain advantages and

disadvantages to investing in each of the categories of investment property.

– Calculate and apply “break even analysis” to income producing properties.

– Discuss how financing conditions affect prices of income producing properties.

– Compute debt-coverage ratios.

Outline• The Single-Family House as Income Property• The Two- to Four-Unit Residential Property• The Five-Plus Unit Residential Income Property• Break-Even Analysis• Financing Starts with the Listing• Introduction to Commercial and Industrial

Properties• Debt Coverage Ratio

The Single-Family House as Income Property (Slide 1 of 4)

• Key Characteristics– Large supply– Management is easier– Active resale market– High degree of liquidity– Sold outright or tax

deferred exchange

The Single-Family House as Income Property (Slide 2 of 4)

• Non owner occupied 75% loan to value• Fannie Mae and Freddie Mac use 80% loan to

value• But require one year experience as landlord• Or six months PITI in reserve• ¼ to ½% higher interest• Higher loan fee• Fixed rate• Prepayment penalties only within first three years

– For owner occupied– But rental properties can differ

The Single-Family House as Income Property (Slide 3 of 4)

• Flipping– Buy a house with long escrow– Value appreciates– Sell before closing first escrow– Works well with appreciating values– With depreciating values, buyers “walk

away”– Lenders become reluctant to offer non-

owner occupied loans

The Single-Family House as Income Property (Slide 4 of 4)

• Advantages– Larger selection of

properties– Management is easier– Investment is more liquid– Tenants pay for utilities,

gardening, and minor repairs– Depreciation tax shelter– Tenants remain longer– Passive loss rules apply up to

$25,000– Low vacancy factor– Hedge against inflation– Leverage during inflation– “Walk away” during decline– 1031 Exchange available

• Disadvantages– Could be negative cash

flow– Rent/ft2 lower– 100% vacancy– You are the manager– But could get professional

management (10% of rent)

– Owner pays for repairs– If owner has many houses,

no economy of scale– Tax deductions can be

changed by Congress

The Two- and Four-Unit Residential Property (Slide 1 of 2)

• 75% loan to value• 15% down• Many sellers will carry second• ½ to 1% higher interest• Higher loan fees• If owner lives in one unit

– Get owner-occupied financing• Prepayment penalties

– Six months unearned interest– 20% payoff allowable in any one calendar year

The Two- and Four-Unit Residential Property (Slide 2 of 2)

• Advantages– Many available– Owner can be manager– Tenants pay utilities,

etc.– Rent unfurnished– Tenant may be manager– More privacy for renter– Good LTVs– Depreciation tax shelter

• Disadvantages– Expensive– Negative cash flow– Higher qualification

requirements– Repairs and

replacements– Reserves needed– Owner pays water,

outside lights and laundry room utilities

– Reluctance to raise rents

The Five-Plus Unit Residential Income Property (Slide 1 of 3)

• Characteristics– Better buy than 2-4 units– Larger down payments required– Demand is lower– Keeps prices down– Sell at prices relative to income– Not much vacant land for building– Need parking and open space for new construction– Environmental factors make apartments more

difficult to build

The Five-Plus Unit Residential Income Property (Slide 2 of 3)

• 60 – 75% loan to value• 30% down• ½ - 2% higher interest• Higher loan fees• Amortized for 30 years, but due in 1-10

years• Lenders use appraisal and capitalized

income stream to determine loan value• Need better than good credit

The Five-Plus Unit Residential Income Property (Slide 3 of 3)

• Advantages– Constant demand for

housing– Concentrated

management– Resident manager

possible• >16 units requires one

– Cost/unit is less– Fewer being built– Tax shelter– Equity appreciation

• Disadvantages– Lots of expenses– Need reserves– Changing

neighborhoods– Owner-tenant laws– Rent control– Need patience– No tenant pride of

ownership

Break-Even Analysis (Figure 15.1)

• Sales = Fixed Costs + Variable Costs

Financing Starts with the Listing (Slide 1 of 2)

• Reasons for selling?– Improvements– Neighborhood change– Rent control– Exchange up– Wants more/less units– No depreciation left

• Existing financing information– Lender, balance due, interest rate– Assumable– If more than one loan, same info– Minimum credit score– Short Sale?

Financing Starts with the Listing (Slide 2 of 2)

• New financing– Will lender allow assumption– Minimum credit score– Prepayment penalty negotiations– Down payment– Interest, term, prepayment penalty, acceleration clause,

loan fees, down payment, impounds– Second loan

• Capitalization Rate– Cap rate = Net Operating Income/Sales Price– Compare to interest rate

• If rising, cap rate decreases• Does it make good sense without tax shelter?

Introduction to Commercial and Industrial Properties (Slide 1 of 3) • Strip malls

• Free standing commercial buildings• Convenience centers• Supermarkets surrounded by other

stores• Department stores• Service stations• Garage buildings• Franchise outlets• Quick service restaurants• Motels, hotels, mobile home parks• Office buildings• Rest homes and convalescent

hospitals• Other special purpose (drive in banks)

Introduction to Commercial and Industrial Properties (Slide 2 of 3)

• Industrial– Small

• 10,000 – 100,000 ft2

– Larger • One tenant/long term lease

– Industrial parks• Developer buys land and develops individual building

to specs of master plan• Office Parks

– Could include restaurants, shops and hotels

Introduction to Commercial and Industrial Properties (Slide 3 of 3)

• Advantages– Steady income– Low vacancy– Lessee makes major

improvements– COLA clauses or

percentage lease– No rent control– Business tenants are

easier to deal with– Lease insurance

available

• Disadvantages– Higher prices– Vacancies during down

times– “Main Street” vs. newer

centers– Fixed rents– City codes

Debt Coverage Ratio• Debt coverage ratio =

Annual Net Operating IncomeAnnual Debt Service

• Should be >1.1

Questions and Comments?