Reviewing Some Basics — Some Real Estate Investment Terms — What’s He Mean, Gross?

Posted @ 12:26 am - Filed under 1031 Exchanges, Investment Lessons, Real Estate Investing

The pictures today are not in any way related to the post. Sometimes I like it that way. Why? Because I can.

Today’s post.

Allow me to begin with a story about my first days as a fearless real estate investment broker. It was in the last days of 1976, I was all of 25, (with a bunch of blonde hair) and I was trying to figure out all the nomenclature of this side of the business. I’d made a great couple of contacts, and ended up at what was then known as an ‘exchange group’. (club?)

Anyway, it turns out my contact, a title rep with whom I’d done much business, and become great friends, wangled me an invitation to one of the truly elite groups. They limited their membership to just 20, all of whom were magnificently experienced. My home was a 45 minute drive from their meeting site — in those days, without any appreciable traffic. It was worth it.

It was held at the Rancho Bernardo Inn, a pricey place not to be confused with yer local Hotel 6. To say I was nervous would be misleading, as I nearly had to concentrate on breathing normally. These were serious guys with about a zillion years of experience between them. I was a 25 year old wannabe — smart enough to be seen and not heard.

The meeting began, and the moderator started to write stuff on the board about the client, subject property, and main objective of the client. I was entranced immediately. Then it happened.

The moderator asked the presenting member to summarize his client’s agenda. As closely as I can remember, here’s what he said:

“We’re looking to do a section, acquiring one to two upleg properties. We can add cash if required, and might even consider cranking the current and/or upleg properties to make things happen. As long as the cap makes sense, we’ll be good to go. Our property is under 7.5 times. We’re not area bound, and will consider a carry, as long as we can pass it. Hypothecation is always an option there. We’re not opposed to taking a reasonable amount of boot, but would like to avoid it if possible.”

Hey!! my mind was screaming, ‘Does anyone speak English here?!’

The expression on my face must have betrayed me, cuz my buddy’s shoulders were bouncing up and down, as he was trying in vain not to break out laughing out loud. He knew I hadn’t understood anything the guy had just said. When they broke for coffee & donuts, he happily translated for a very relieved young man.

Here’s what the guy said — only this time in English.

We’re looking to do a section.

Though this term isn’t used these days, I still hear it once or twice a year from old schoolers. It simply refers to Internal Revenue Code Section 1031 — which deals with tax deferred exchanges.

Upleg Properties or just Upleg(s)

The properties in a tax deferred exchange to which an investor is exchanging. More plainly put, the properties you’ll end up with at the end of your exchange. Oh, the upleg. Now I get it.

Cranking A Property

I still use and hear this from time to time, but only from seasoned pros. It means taking cash out by way of refinancing a property. The investor would be cranking cash from the property.

Cap

Shortened from Capitalization Rate. This one is thrown around, but often misunderstood by new investors. It’s really a simple concept though. Here’s how you arrive at a property’s ‘cap rate’.

(Note: Always use numbers on an annual basis when analyzing investment properties.)

(Note: Many will include a sinking fund as an additional operating expenses — anticipating say, a new roof down the road. We don’t, due to the age of properties into which we put our clients. Also, see Sominex Accounts.)

Start with the gross scheduled income (GSI) for the year. Subtract the area’s appropriate vacancy rate in dollars. From the remainder, subtract the property’s operating expenses. That figure is your Net Operating Income. (NOI)

Review

Gross Scheduled Income (GSI)
- Vacancies
- Operating Expenses
= Net Operating Income (NOI)

To arrive at the property’s capitalization rate, simply divide the NOI by the Price.

If your NOI is $20,000 — and your price is $250,000 — $20,000 ÷ $250,000 = .08 or 8%. The property’s ‘cap rate‘ is 8%.

Times (X)

Sometimes we use a down and dirty rule of thumb known as ‘times gross’. Also simple, this takes a property’s gross schedule income, and multiplies it by a number. The higher the number, the higher the price. In San Diego it’s a far higher number than say, Kansas City. If the GSI is $25,000 — and the area’s ‘times gross’ factor is 9.5 — all you do is multiply the two numbers. $25,000 X 9.5 = $237,500. In San Diego it’d be more like 14-17. It’s quick, and easily calculated. It allows the investor to quickly compare many properties. It is also potentially very misleading. Why? When the investor compares two seemingly similar properties this way, there’s no accounting for significant differences in operating expenses. If one property has separate water heaters, while the other has just one shared big one, the net operating income for the property with the separate water heaters will be higher, as the tenants are paying for heating their own water.

Just remember, when using the Times Gross approach to comparing properties, it’s ‘grossly’ superficial — and almost guaranteed to be misleading at best, and the reason for a poor purchase decision at worst.

Area Bound

Nearly self explanatory. It means the investor is going to keep themselves ‘bound’ to a certain area, refusing to invest outside of that area. Usually it means where the investor lives, though not necessarily. Being area bound is one of the most common tactical mistakes made by investors. This is especially true, if it’s because they want to be able to ‘drive by’ the property.

Carry or Carry Back

Simple — all this alludes to is seller financing. They ‘carry back’ a note secured by a trust deed. The seller is lending the buyer part of the purchase price by having the buyer execute a note, secured by a deed of trust, in favor of the seller.

Pass It

Another phrase I don’t hear much any more, unless I’m dealing with another pretty experienced investment guy. It merely means the owner, having taken something other than cash as part of the purchase price, will ‘pass it‘ along to the seller of the property to which he’s exchanging to. (upleg) In the old days, we’d do exchanges which included cars as part of the consideration. The exchange client wouldn’t care — as long as they could ‘pass it‘ up to his next property. This often resulted in some pretty interesting stories. We had boats, gems, cars, antiques, trust deeds, and whatever else you might possibly imagine, thrown into tax deferred exchanges. (Another post entirely.)

Hypothecation

It’s pledging a property as collateral without giving up possession of it. You own a note secured by a trust deed for $100,000. You’re short $50,000 in the purchase/exchange of income property. The seller doesn’t want your note/trust deed, but will take your personal note secured by the note and trust deed he didn’t want. Why? Simple — if you default on the note you gave, the seller then receives the collateral or security for the note. That would be the $100,000 note and trust deed. So the $50,000 note he took in the sale of his property, was secured by a note/trust deed of twice the value. The seller wouldn’t do this unless his due diligence clearly indicated it was a very secure note and trust deed.

In interesting times, I’ve used hypothecation as part of an exchange a handful of times. If done correctly, it can actually be separated from the exchange, and gain installment sale treatment. (taxed differently)

Ah, those were the days.

Boot

This is not a cool word to an experienced investor versed in the execution of tax deferred exchanges. The receipt of ‘boot‘ in an exchange means: It’s money, or the ‘fair market value’ of personal property, received by the taxpayer in an exchange. In this instance, ‘received‘ means the taxpayer kept it, not using it to acquire his ‘upleg’ in his tax deferred exchange. Boot, absent a very knowledgeable advisor, will nearly always result in the boot being taxed.

For example: You trade your duplex for my two fourplexes. As part of our agreement, you add your ‘55 Chevy, valued at $40,000 as part of the consideration. I keep the car, and don’t include it in my exchange. That’s boot, and it’s 100% taxable. These days boot is almost always cash kept by a taxpayer in an exchange, with the investor usually fully aware of the tax ramifications. A few times a year, an investor is referred to me who has taken boot, unaware of the tax consequences. I’m then forced to break the bad news.

If you know a really knowledgeable and experienced real estate investment broker, he’d probably be able to show you how to take boot and still not owe taxes .

After my pal explained all that, during the 10 minute coffee & donut break, I then understood how much I needed to learn. It was a tremendous day for me, as I then knew what I didn’t know.

Over the next few years, I was invited to become a full member of the group. Ultimately I did business with 14 of the other 19 members. I’ve never been a part of, or seen firsthand, a group as effective as that one since.

This entry was posted on Friday, December 7th, 2007 at 12:26 am and is filed under 1031 Exchanges, Investment Lessons, Real Estate Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.