Real Estate Powerful Words

Purchasing Commercial Real Estate – Apartment How-To’s

Exchanging is very important since it is an approach to marketing property which is not limited in order to tax deferral. The all important tax deferral idea of exchanging is still valid especially in times when depreciation basis may not be a factor. A taxpayer that is exchanging vacant land for a bigger tract of vacant land and is thinking about preserving equity by deferring increases in size, will most likely have to have a 1031 tax deferred exchange. Older taxpayers may find the 1031 exchange if the holding period may exceed their lifetime and give changed over basis after death. Ultimate tax deferral at death may be a motivation to change for certain older taxpayers. A complete discussion with the 1031 tax deferral concept is past the scope on this text and also the emphasis is on marketing rather than on tax deferral. 2 However we’re going to briefly examine the overall idea of tax deferral. Assume a sale nets the property owner $100,000, setting up a tax liability of $20,000. If your owner exchanges his property for a qualifying like-kind property and complies with the rules of Section 1031, the complete tax may be deferred. An outright sale would decrease the equity by $20,000, leaving the investor only $80,000 to take a position. Because of the chance to invest the proceeds within an investment with the after taxes of 10 percent on the equity invested, these after tax cash flows on the investor would be
realized.

You will find three general methods appraisers use to value real estate:

1. Cost Approach
2. Sales Comparable Approach
3. Income Capitalization Approach

The Cost Approach finds something by determining what it would cost to switch the house being assessed. The appraiser will conduct a study which will figure out what it might cost to get an identical piece of land and create a similar building. This value is also termed as the replacement cost.

The Sales Comparable Approach analyzes recent sales on comparable properties and makes assumptions based on the sale price per foot then applies that sale price per foot on the subject property so that you can arrive at an ongoing rate. The Income Capitalization Approach analyzes the income and expenses generated and incurred on the property then capitalizes the web Operating Income (cashflow before debt service) so that you can arrive at an ongoing rate. Typically, appraisers will conduct the three approaches then perform some form of reconciliation analysis so that you can arrive at just one final concluded rate. Despite just what the appraisal states however, lenders will still conduct their unique valuation analysis.

The most used and heavily relied on by lenders today, with the three methodologies as listed above, will be the Income Capitalization Approach. (This assumes naturally the house does in fact earn money. Some real estate loans are produced on development or construction projects for instance that will not earn money and therefore this method wouldn’t normally apply. The appraiser’s analysis only serves as a means of checks and balances on the lender’s own analysis. This can be a common misconception among borrowers. Some borrowers feel that the appraised value should be the value underwritten by the lender. Unfortunately for borrowers which is not always the case.

Reverting returning to the definition of the Income Capitalization Approach, we realize that so that you can arrive at something, a cashflow figure is capitalized utilizing a capitalization rate. The definition of a capitalization rate “cap rate” is expressed with regards to the following formula:

Cap Rate Net Operating Income / Value (or Cost)

A cap rates are merely an expression with the unleveraged annual return on one’s investment. It measures the borrower’s cashflow before debt service (NOI) in terms of a percentage with the value of the asset. In terms of underwriting however, the cap rates are an assumption that is used to into the underwritten value of the asset. From an underwriting standpoint, lenders restructure the formula as follows:

Value Net Operating Income / Cap Rate (input)

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