Buying a House … Residence vs Rental Property

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A common question my clients ask is “Should I buy a house?” A logical extension of the question is “Should I live in the house, or would I be better off renting it out?”

Actually, the question is more often phrased “What are the tax benefits of buying a house?” This can result in a barrage of technical information that doesn’t answer the real question.

THE TAX STUFF

Let’s get the technical tax stuff out of the way:

–  The interest portion of your mortgage payment and your property taxes are tax deductible
–  If you rent out the property, you can also deduct operating expenses like repairs, utilities and management fees
–  If you rent out the property, you can also deduct depreciation. The house itself is depreciated over 27.5 years. Improvements, furnishings and appliances are depreciated at faster rates
–  If you live in the house for more than 2 years, you don’t have to pay tax on the first $250,000 of capital appreciation – the exemption is $500,000 if you’re married and file a joint return
–  If you make under $100,000 you can deduct rental losses on your tax return. But if you make between $100,000 and $150,000, the deduction phases out to zero. The good news is you can deduct the disallowed losses when you sell the house
–  If you rent the property, your gain on sale is taxed at capital gains rates, which are lower than regular rates. Depreciation you deducted is recaptured at regular rates
–  If you pay Alternative Minimum Tax, all bets are off…but if you live in the house, your mortgage interest is a deduction for AMT purposes

There’s the barrage of information. Do you know what you want to do now? I don’t think so.

WHAT YOU”RE TRYING TO ACCOMPLISH

Living in your house accomplishes three main objectives:

– You stop paying rent to somebody else
– Tax deductions for mortgage interest and property taxes make your monthly payments more affordable
– With a relatively small down payment, you get the benefit of the full amount of any gain on sale. It’s not unusual to make a gain as big as your down payment. That’s a 100% return on your investment – and $250,000 or $500,000 of the gain is tax-free

When you rent out your house, the objective is to bring in enough rental income to cover your cash payments for mortgage, property tax and operating expenses. Depreciation doesn’t affect your cash flow, but it can be used to create losses for tax purposes if you are in an income range to benefit from the deduction. I’m sure there are places where you can generate positive cash flow from a rental home, while paying no tax because of the depreciation deduction. A few years ago I worked with a Midwest homebuilder where we marketed houses for exactly that business model, but I now live in Southern California, and positive cash flow is only a dream.

Your income mostly comes from the gain you make when you sell the house. This gain is taxable, but it’s taxed at a lower rate than your regular income.

The downside of renting out your house is that you still have to live somewhere. Any profit you make will be reduced by the rent you pay. If you already own your home, of course, that’s not an issue.

RESIDENCE OR RENTAL – WHICH IS BETTER?

Here’s an example that compares the results of living in your home and renting it out.

I made a number of assumptions as the starting point. I’m sure you can poke holes in some of them, but bear with me.

– You are currently paying rent of $2,500 a month
– You have $150,000 for a down payment
– You buy a house for $600,000 and sell it 5 years later for $700,000
– You take a $450,000 mortgage at 4.0% interest, and pay 2.0% a year for property taxes
– You can rent the house to tenants for $3,600 a month
– Operating costs are $3,600 a year for your residence, and $5,000 for the rental
– Your selling costs are 6% when you sell the house
– Your regular tax rate is 30%

Option 1 – Don’t Buy the House

If you don’t buy the house, you continue to pay $2,500 a month in rent. After 5 years, you have spent $150,000. End of story.

Option 2 – Live in the House

Your mortgage payment is $2,170 a month, and your taxes are another $1,000. You’re now paying for repairs and maintenance, but the tax benefit of the interest and tax deduction means you’re only paying about $200 a month more than when you were renting.

You make $100,000 in profit when you sell the house (less $42,000 in closing costs) but you don’t pay tax on the gain. You also get your down payment back, plus you paid off $43,000 on your mortgage.

Over all, your total cost after 5 years is $63,000. This compares with $150,000 you would have spent on rent. Congratulations – by buying the house you saved $87,000.

Option 3 – Rent the House

You rent the house out for $3,600 a month, which is pretty much exactly the amount you pay out for mortgage payments, property taxes and operating costs. You get a tax deduction of $16,000 a year for depreciation, but if you make more than $150,000 it just adds to your deferred loss.

You make the same $100,000 profit when you sell the house. This is taxable at capital gains rates, but the $42,000 closing costs are deductible. As above, you get back your down payment and the $43,000 you paid down on your mortgage.

Your after-tax income from the rental property is $82,000. Nice, really nice. You’ve made a pretax return on investment of 11% a year. Compare that with the return on other investments.

BUT… not so fast.

You still have to live somewhere while you’re renting out the house. Right? Assuming you continue to pay $2,500 a month in rent, that turns your rental profit into a net cash cost of $68,000. The good news is that you’re still miles ahead of where you would have been if you hadn’t bought the house at all, and only about $5,000 behind using the house as your residence.

Do you think you could increase the rent on the house over 5 years? That would make the results of renting vs living in the house about the same, wouldn’t it?

CONCLUSION

Sorry, I’m not giving you a conclusion. This was just one example, and your situation is almost certainly going to be different. My assumptions are just assumptions, and you would have to do a careful analysis of the facts before you move forward.

There are a lot of subjective issues as well. Do you want the headache of being a landlord? And what about unforeseen problems like bad or unreliable tenants? But what about the upside gain if rents keep climbing the way they are in Los Angeles these days?

I would be happy to discuss your specific situation, and run my model with assumptions that apply to you.

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Your Business – From a Buyer’s Point of View

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When you sell your business, you want to do everything possible to get the right price. That often means forgetting about how you have run the business, and looking at it from the buyer’s point of view.

What the Buyer is Buying

Generally speaking, a buyer will be willing to pay a price that is a multiple of the company’s annual cash flow. The multiple varies widely depending on the industry, the economy and many other factors. The price the buyer pays, though, will be a multiple of his expected cash flow – not yours.

The harsh fact is that the buyer doesn’t care how you ran the business. Certainly, he will keep what he sees as the best practices and procedures, and will probably keep most of your people, but his ideas on executive compensation, business development, human resources, inventory control, and a host of other subjects will probably differ from yours.

I actually saw a deal fall apart because the seller insisted on dictating how the business would be operated AFTER he was gone.

The trick is to know what the buyer believes he is buying.

Normalizing Results

It’s a useful exercise to adjust historical earnings for unique, unusual or non-recurring items, so future cash flow projections reflect the results the buyer is likely to achieve. This is called “normalizing” cash flow. Depending on how you’ve been operating the business, this process may identify certain assets or liabilities that should be valued separately.

Here are some examples:

Owner’s Compensation

A homebuilder’s owner paid himself a salary that was much higher than the CEO of any similar company would normally receive. It was his decision as to whether he wanted to receive the funds as salary or as a draw against earnings, but it did cause widespread resentment within the company, especially during lean times.

The important point here, though, is that by adding back the excess owner’s compensation into the cash flow projections, the company’s value increased by a multiple of say, 6 or 7 times that amount.

Below-Market Rents

A retailer had been in business for many years, and was such a desirable tenant that it could drive a very hard bargain with landlords. It was common to find 20 year leases at below-market rates, with 10-year extensions. A careful reading of the lease on the ideally-located head office revealed that it ran in perpetuity.

The low rents increased the company’s cash flow, and would have been taken into account if the company had been valued strictly on a multiple of that cash flow. Valuing leases uses much the same arithmetic as arriving at a multiple of earnings, but the terms of these leases were so unusual that we saw the need to evaluate them as a separate asset.

Ultimately, we prepared cash flow projections using much higher market-rate rents. This reduced the amount a buyer would pay for the company based on its projected cash flows, but it was more than made up by the higher value assigned to the leases as a separate asset.

Unusual Expenses

The owner of another company had a unique set of personal beliefs, and insisted that all of his employees and vendors share or participate in them – at considerable cost. Everyone was required to attend expensive week-long seminars by a California-based consultant who taught them how to deal with their personal fears. Another consultant was flown in from San Francisco for a week to realign the chakras of the executive staff. The owner catered lunches several times a week, so the entire staff would attend his meditation sessions. The company sponsored a project in which meditation experts gathered in Sedona to effect world peace.

It was highly unlikely that a buyer would continue these human resource policies, so we added back their cost to normalized cash flow, and substantially increased the asking price of the company.

Historic Land Values

A land developer and homebuilder had been in business for many years, and owned properties it had purchased up to 30 years previously. The profit margins on the houses it sold were significantly higher than they would have been if the land were acquired more recently.

There had been talk within the company of separating the land component of the business from the homebuilding component, in order to clearly see where the profit and returns on investment really came from, but the initiative never got off the ground.

The low historic land values were reflected in profits, but not in the actual operating cash flows, so a valuation based on a multiple of cash flow didn’t make sense. We prepared normalized cash flow projections for the homebuilding business based on market prices for the land, and did a separate valuation of the land reserves, based on those same market prices.

Non-Recurring Costs

Most companies have expenses they needed to incur a single time, or for a limited period. Examples I have seen include legal fees and settlement costs for lawsuits, discretionary bonuses for unusual personal or company performance and employee termination costs. I worked with a company that had incurred huge expenses trying to start a new line of business that was never realized. Another committed to a year-long sponsorship of a local sports team in a marketing effort that was judged a failure.

None of these costs can be expected to be repeated by a buyer of the company, and so should be added back to the normalized historic earnings, and to the cash flow projections used to place a value on the company.

Does your CFO understand the value of normalizing your cash flows from a buyer’s point of view?

Cap Rate … What is it?

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For every commercial real estate opportunity, someone is going to tell you the Cap Rate. We all know that the Cap Rate, when divided into Net Operating Income (NOI) gives you the purchase price. We also know that the Cap Rate roughly represents the return for one year on a commercial real estate investment. But does that mean it’s the right rate for you?

It’s useful to break down the Cap Rate between the mortgage component and the equity component. Here’s an example:

What We Know

The things we know (or should know) when we’re contemplating a real estate purchase include:

Net Operating Income (NOI) – $1,000,000 annually. Remember that a property’s NOI does not include debt service – principal or interest payments. This isn’t the time for a lengthy discussion, but be sure to do your due diligence to prevent unpleasant surprises.

Mortgage rate – 5.0%

Mortgage term – 25 years

Loan to value ratio (LTV) – 75% of purchase price

Mortgage Component – Calculate the Mortgage Constant

The mortgage constant is the annual payment, or debt service, expressed as a fraction of the total mortgage. From the bank’s point of view, this is the Cap Rate on their investment in the loan.

In this example, the annual payment on a $100,000 mortgage (any amount will give the same result) at 5.0% amortized over 25 years is $7,015.08. This is the portion of NOI that goes to make debt payments.

Annual debt service of $7,015.08 is 7.0158% of the $100,000 mortgage in this example, so the mortgage constant is .0701508

Equity Component – Calculate the Equity Constant

How much do you want to make on your equity investment? Let’s say you’re looking for a 15% cash on cash return.

Your return is 15% of your equity investment, so the equity constant is .15.

Calculate the Cap Rate

Mortgage component of the Cap Rate:

Mortgage constant (.0701508) x LTV (75%) = 5.26%

Equity portion of the Cap Rate:

Equity constant (.15) x Equity contribution (25%) = 3.75%

Cap Rate:
Mortgage component (5.26%) + Equity component (3.75%) = 9.01%

Calculate the Purchase Price

Net Operating Income ($1,000,000) ÷ Cap Rate (9.01%) = $11,097,165

If you pay more than $11,095,165 for the property, you won’t make your target return. This may limit you to certain types of property investments, so you may want to adjust your expectations. If you are willing to accept a 12% return on your equity investment in this example, your Cap Rate would drop to 8.26%, and you could pay $12,104,617 for the property.

Capital Appreciation

Of course, 101 other questions arise when you are contemplating this sort of decision. Foremost among them is how you view capital appreciation. With a 75% mortgage, if the property value increases by 1% a year, you gain 4% on your invested funds. If you build appreciation and/or rent increases into your projections, you can pay a lot more for the same property and still make your target return. That’s how high quality properties can sell at a 4% or 5% cap rate.

Do you know who to call to discuss Cap Rates?

Overhead… Who Cares?

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You probably couldn’t stop your accountants from allocating overhead to your operating profit centers, even if you tried. I’m not a business historian, but somewhere along the line, accountants everywhere became convinced that allocating overhead to operating unit P&Ls results in a better understanding of profitability. That may or may not be true, but let’s not use an accounting concept for making business decisions.

What is Overhead?

Overhead has a different meaning in every company, and its calculation varies widely. Generally speaking, though, it is considered to be the cost of running a head office, including centralized costs such as executive salaries, office rent, computer systems, etc. When the accountants allocate overhead, it is often in the form of a percentage of gross revenue. If a company has a division that contributes 10% profit, and another that contributes 8%, a 4% overhead allocation would reduce these results to 6% and 4%.

In this example, it would appear that the first division is 50% more profitable than the second, and management might be tempted to allocate resources accordingly. But its contribution margin is only 25% higher, so the result could be misleading.

If you can’t tell if your operations generate enough profit to cover overhead, you might consider looking for a different occupation. For the record, I’m sure many intelligent people disagree with me.

Don’t include Overhead in your business decisions

In my experience, many accountants don’t really appreciate that accounting conventions have no place in business decision-making, and operating executives often don’t feel confident enough to challenge the accountants on their own turf. Some things to remember:

Overhead is just an accounting concept
Overhead does not affect cash flow
Overhead allocations do not affect total company profitability
Overhead is calculated differently in every company

I have seen some dysfunctional results arise from trying to shoe-horn an accounting concept into business decisions.

A Retailer

A retailer had several stores that were not only losing money, but had a negative cash flow. That is, their operating loss was greater than their depreciation and amortization. The stores clearly needed to be closed to stop the damage.

The CEO, however, had done his math. If he closed the failing stores, the overhead allocated to those stores would have to be redistributed to the remaining stores, reducing their accounting profit after overhead. The CEO could not be persuaded that closing the losing stores would improve the company’s total profitability.

The failing stores continued to lose cash flow, and the overhead was allocated to all stores… until the CEO was replaced.

A Homebuilder

A homebuilder had a target IRR for new community construction projects. IRR is a measure of cash flow that calculates the return realized on a cash investment. The CFO, an accountant by training, insisted that all cash flow projections include a 3% charge for overhead, despite the fact that overhead has nothing to do with the incremental cash flow generated by a new construction project. He argued that when the project was under way, overhead would be allocated for accounting purposes, so the pro formas should reflect that. The pro formas then became just a forecast of the accounting records, and IRR, the real reason for making the investment, was calculated incorrectly.

At least the pro formas were conservative as a result of this allocation, but the company probably missed out on some good opportunities whose IRR projections fell below the hurdle rate. As it happened, the company’s actual overhead was not even 3% at all.

Another Retailer

Some retailers charge the cost of their distribution centers directly to expense, in the manner of unallocated overhead, while others include it in the cost of their merchandise, charging it directly to operations.

In a year when earnings were tight, I was encouraged as division CFO to find ways to increase reported profit, so I capitalized the distribution center costs. This resulted in a large transfer of costs from expense to inventory, substantially increasing reported earnings. The parent company paid senior management large bonuses that year, regardless of the fact that nearly all our profit came from an accounting change.

Although we reported more profit, the actual economic impact on the company was a negative cash flow in the amount of the bonuses that were paid. Was the accounting technically correct? Yes. Was it the most appropriate accounting under the circumstances? Maybe not. Would I do it again? … Well, I did like that bonus.

A Land Developer

When a land developer sold finished and partially finished lots to homebuilders, they did a land residual calculation to arrive at the asking price. That is, they estimated all the builder’s costs and revenues, and priced the lots so the builder could achieve a specified percentage profit margin. But one of the costs included in the analysis was 3% – again 3% – for overhead. If they didn’t include the overhead, they could have started with a higher asking price, and maybe sold the lots for a higher price.

Does your CFO take a practical view of Overhead?

Valuing a Consulting Business

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There are probably hundreds of reasons why you might contemplate selling your consulting business. Among them would be retirement, changing markets, illness or just the urge to move on and do something new.

Who is the buyer?

The buyer will probably be another consultant – either a competitor or a firm with a desire to expand their offering to include your area of expertise. It is unlikely that there will be financiers, or others with no direct experience standing in line to buy your business. There is, however, a pretty good chance the buyer will be a partner or an employee, in which case you need to start talking to financial planners long before you expect to do the transaction.

What are they buying?

When you think of selling the business, you tend to think of it as just that… the business. When we start thinking about its value, though, it is a good idea to put ourselves in the buyer’s position. What specifically does the buyer hope to acquire?

–          Your client list / existing relationships.

–          Expertise in a new field, or the opportunity to serve a backlog of client demand.

–          Name and reputation.

–          An instant start in the business with a functioning team – it saves the time, energy and uncertainty of building the business from scratch… as long as the cost isn’t too high.

–          Ability to leverage your client base – the buyer can provide services from your business to his existing clients, or alternatively, sell new services to your current clients.

–          Owner to stay on through a transition period – to facilitate the smooth transfer of relationships, retention of staff, transfer of knowledge and expertise.

What is the price?

Consulting firms typically have relatively little in the way of assets, so one way or another, the selling price is likely to be a multiple of earnings or cash flow. EBITDA (earnings before interest, depreciation and amortization) is a traditional measurement of cash flow, but why not add back your salary and any special items such as health care and travel that could be considered personal, and would not be costs to the company after the sale? Also consider accounting, legal, insurance etc. costs that will go away after the acquisition.

The value of a single-person operation will probably be lower because of the impracticality of having the seller stay on through a transition period, and the higher risk of losing clients.

The purchase price will depend on the exact fit with the buyer’s business, and the time and cost of entering the field. Remember that if you ask too high a price, the buyer may decide to start the business from scratch, maybe even hiring your best employees away from you, and competing for your existing clients.

Rules of thumb – selling prices generally fall between 2.5 and 3.5 times earnings (high utilization rates and low costs will result in a higher value) OR .75 to 1.25 times gross revenue, which probably yields the same value, depending on your profit margins.

The purchase price will be higher if you stay on through a transition period. You would draw a salary, of course, and it doesn’t hurt to be there to keep an eye on your payout.

Payment Structure

You’ll get the highest price if it is paid out over time, say 2 – 3 years. An up-front payment in the range of 25% is common.

Remember that if a buyer pays 3 times earnings up front, he will get no return on his investment for 3 years, a situation that few investors can tolerate. Even if there are synergies that result in additional business, the buyer would probably have to lay out additional investment to realize them.

 

Do you know who to call if you need help selling your business?