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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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The Quick Fix? … Or the Whole Enchilada?

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Managers need information; that’s one of the laws of nature. The uses of information are endless, and managers constantly come up with new needs for reports, analyses and procedures. But information comes at a cost. The cost may be easy to calculate, as in the case of development hours required, or it may be an opportunity cost trade-off with the company’s other priorities.

Weighing Priorities

Whenever you have a need for information, here are the questions you’ll be asked:

1. How badly do you need it?
2. How soon do you need it?
3. If we can’t give you everything you need, what can you live with?
4. What are the projected cost savings or revenue increases?
5. What is the cost of getting the information?

Large organizations have developed sophisticated processes to allocate information resources among competing priorities, often involving some sort of ROI analysis. People do tend to exaggerate, though, so the objectivity and precision of the process comes under suspicion. Smaller companies, in my experience, tend to admit that they use more subjective methods to evaluate priorities.

The result is pretty much the same, though. Unless you have a critical need, such as compliance with a new accounting policy, a new line of business or an actual system breakdown…

You’re going to have to wait. Maybe forever.

The Quick Fix

The alternative to waiting for an exciting new series of reports and procedures, reconciled, actionable and fully integrated with all existing systems is the Quick Fix. This may be a compromise resulting from the answer to Question 3 above, or you may have to take matters into your own hands.

The Quick Fix is usually inexpensive, fast and gives you most of what you need. It can be a viable alternative to waiting for an entire new application to emerge from the murky dungeons of the development process. Or it can get you started on a new initiative without waiting for months, even years, to get the Whole Enchilada.

The Quick Fix isn’t always the right answer, though. Here are some situations I’ve observed over the years.

A Retailer

As CFO of a retailer, we received systems support from the specialty stores division of the internationally known parent company. The problem was that the specialty stores division was a shoe company, and we were a fashion apparel company. Many important issues needed to be resolved to customize the systems so our merchandisers could conduct business. So it was no surprise that when the accountants had a serious problem calculating Gross Profit and Inventory, we were sent to the back of the line, and told to wait.

For a small fee, we hired a programmer to develop a custom report that not only gave us reliable Gross Profit and Inventory results, but also provided the merchandisers with a clear picture of their operating results. It only took an hour or two a month to update the program, so the Quick Fix became a satisfactory permanent solution.

Some years later, a senior executive of the parent company saw our report, and ordered it installed in all the other operating companies. The systems development people jumped on it, and rolled it out to the entire company with great fanfare. But we just shrugged our shoulders… there was no need for the Whole Enchilada.

Real Estate Services

A real estate services company had passed the level of revenues that required them to change their tax accounting from the cash method to the accrual method. They recently asked me to help them make the transition.

The company had grown rapidly, but was still using Quick Books as its accounting system. It was certainly time for an upgrade, and the accounting conversion made it a perfect time to make the change. The only problem was that it would take months of time, and a substantial cash investment to research, purchase and install a new accounting package, and to integrate it with the business operations system. Meanwhile, the tax filing deadline was coming up fast.

My first suggestion was the Quick Fix. I suggested they continue using the methods the accounting staff were used to, and just make journal entries at the end of each month to adjust to accrual accounting. The CEO, however, wanted a deeper change, including a daily reconciliation to the output of their highly sophisticated operating system.

The situation clearly called for the Whole Enchilada, but timing was such that we needed a transitional Quick Fix to meet reporting requirements, and to fill in the gaps while we studied a fully integrated system overhaul.

I reviewed the business operating system, and found it to be sufficiently reliable to use its output as the source of accounting entries. The problem was that there were no accounting cutoffs or similar checks and balances for reconciliation, so I worked with the programmers to develop daily reports that verified the integrity of the data.

As a result of the project, management realized they needed to increase the sophistication of their financial department, and hired an experienced controller. I’m looking forward to hearing how they ultimately proceed.

A Homebuilder

A homebuilder had developed an elaborate and sophisticated construction management system, and its reporting mechanism was tied to an accounting package. Oddly enough, they also continued to maintain the original general ledger system that dated back to the 1970s. The problem was that the two systems generated very different information, and the senior managers each had favorite reports that didn’t agree with those used by other managers. Massive amounts of time were wasted in meetings, and one vice president spent most of his time reconciling the divergent reports. Needless to say, accounting was a nightmare.

The CEO had been instrumental in developing both systems, and was unwilling to see the need for change. The Quick Fix was practiced on a daily basis, but by the time the results were available, it was often too late to act on the information. An irreverent senior executive used an automotive metaphor, suggesting that when you opened the hood, the engine was run by squirrels on a treadmill.

The situation was crying out for the Whole Enchilada, and the Quick Fix just wasn’t working. Yes, the company went bankrupt.

A Land Developer

When I arrived for my first day as CFO of a land developer, I asked the controller for the most recent financial statements. “What do you mean?” she asked. That was the first sign of trouble. I soon learned that we had land on the books that we didn’t own, just as we owned land that wasn’t on the books. It was the same thing with loans and other assets and liabilities. In an organization with over 60 different companies, each with its own separate equity and debt financing, this was intolerable.

There was no Quick Fix to be found, so we shortly purchased a well-known industry-specific accounting package, and herded the numbers into their proper places.

The Whole Enchilada was the only option.

How does your company weigh the costs and benefits of implementing the Quick Fix or the Whole Enchilada?

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?

Thinking About Year-End? … You Should Be

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Year-end is almost upon us again. Now is the time to get your house in order – it will take a huge amount of stress off the closing process a couple of months from now.

Being truly ready for the auditors can save audit time and fees, reduce stress on your staff during the audit, and maybe make your financials available for lenders and investors a little earlier. Equally importantly, audit-readiness is a good indication that your accounting department is organized and up to date. How many other ways do you really have to determine that? Here are a few things you should consider:

Preparation of Financial Statements

Do the auditors historically require that you make embarrassing changes to the financials? What has been done to avoid that this year?

–          Does your accounting department prepare the financials, including notes?

–          Have you questioned any balances or accounts that seem surprising or unusual?

–          Did you do anything different this year? Are you sure it is accounted for correctly? Now is the time to sort that out, not during the audit.

–          Have any changes in accounting rules affected your business? Are there any changes not yet required that you could implement early?

Reconciliations

Reconciliations provide explanations for changes in Balance Sheet and P&L accounts, and your accounting department should be able to show them to you every month.

–          Do you know exactly what is in every balance sheet account?

–          Can you explain every change in the balance sheet?

–          Have expenses been calculated consistently every month?

–          Can you show how cost of goods sold affected inventory every month?

If you can say yes to all of these items, updating to year-end should be a piece of cake.

Updated Estimates

Where your monthly accruals and amortization calculations are based on volume or other estimates, have they been updated to be sure the year-end balances are correct? Again, a 2 month update at the end of the year is a lot easier than doing it for the entire year.

Variance Analysis

Has there been a thorough analysis documenting all significant P&L and Balance Sheet variances from last year? Are the explanations reasonable, and the underlying facts correct?

Documentation of Procedures

–          Are the fundamental internal control procedures properly documented?

–          The auditors typically make recommendations for improvements in procedures and controls if they find any deficiencies. Were last year’s recommendations fully implemented?

–          Have changes in staffing or procedures resulted in changes to the control environment? Now is the time to correct them.

Not sure if you’re going to be ready for year-end? Do you know who to call?

Profit Improvement – Allocation of Resources

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

Allocation of Resources

Where a company chooses to invest its resources has an important effect on its profitability and ROI. This can be managed at the time of the initial investment, but ongoing investment needs to be reviewed with a critical eye.

Profit maximization – A land developer and builder was very disciplined in its due diligence on land acquisitions. Land development is a surprisingly complex process involving massive investment, and is subject to a seemingly endless list of restrictions and costly requirements from all levels of government. So choosing between land investment opportunities is a painstaking process, but often subject to emotional responses. We built a linear programming model to maximize the profitability of our land use plans based on our budgets and timing, as well as the attendant marketing and government constraints. This removed much of the emotion from the land acquisition process.

Unprofitable operations – A homebuilder was focused on entry-level housing, and suffered from tight margins and the need for economies of scale and tight discipline in that sector of the business. At the same time, its land entitlement and development business was generating high margins and even higher returns on investment. With 80% of the company’s overhead, but only a small percentage of profits coming from homebuilding, we weighed the investment required to operate a full-scale builder in a higher price category against the potential return, and decided to walk away from the business entirely. Overhead was drastically reduced, and capital was redirected to the more profitable business of land development.

More profit with lower investment – A retailer was famous for the department stores it had operated for many years. Over time, though, these stores had lost ground to competitors, and capital investment had been cut back in proportion to declining profits. The company also operated a number of successful specialty store formats. A time of reckoning came, and the company realized it could make management changes and invest heavily in its department stores, possibly reaching the level of success, for example, of Target Stores. After an intense review, though, they recognized that specialty stores had a higher potential return, a relatively lower investment, lower risk and correspondingly low barriers to entry in niche specialty markets. Relying on its depth of experience, the company closed its famous department stores, and reallocated its funds and energies toward rapid growth in specialty retailing. It became one of the top-performing companies on the New York Stock Exchange.

Drawing on strengths – Another homebuilder operated in a single market, selling low margin homes during a downturn in the housing market. Recognizing its strength in efficient, low cost construction, it started looking for new opportunities. We focused on selling houses at full margin for rental by investment partnerships, expanding regionally into new markets through joint ventures, construction for hire of military housing and multifamily construction.

Does your CFO lead your management team in constant evaluation of your resource allocation process?

What? … Manage Return on Equity?

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Return on Equity, or ROE, is a widely recognized measure of a company’s performance. Even though some senior executives’ compensation is based on ROE or a similar measure, many regard it as an academic, technical calculation, and wait until year-end for the accountants to give them the result.

ROE tells you how effectively you are using your company’s resources, and it CAN be managed. It is a tool that should be evaluated and refined constantly to ensure your business is headed in the right direction. It can be managed by breaking it down into its separate components:

The calculation of ROE is:

ROE = Profit Margin X Asset Turnover X Financial Leverage

Profit margin is your profit as a percentage of sales. No surprises here. You know your industry, and you know your company, and you know how to improve your margins.

Asset turnover is your sales divided by your total assets. Turnover drops when you carry more standing inventory than you need, or make capital investments before you really need them. Faster collection of accounts receivable will improve your asset turnover… And obviously, increasing sales will improve your turnover.

Financial leverage is your total assets divided by shareholders’ equity. Negotiating longer vendor payment terms can increase financial leverage. So can increasing debt, but that is a complex decision that should be discussed in depth with your CFO.

Does your CFO work with you and your operating teams to improve the components of ROE?