The Flip Side of Falling Property Prices

Issue #2342

• WEALTHY: The skinny on PGI, GRM, NOI - how they can help you rake in cash (Justin Ford)
• HEALTHY: Why these foods should be a staple in your diet (Shane Ellison)
• WISE: Socrates on true knowledge

ALSO IN THIS ISSUE:

• If you check e-mail more than twice a day… (Jason Holland)
• How to separate what’s true from what’s false (Steven D. Levitt)
• It’s Fun to Know… about an unexpected cannibal
• Add "provender" to your vocabulary

== Highly Recommended ==

Your gut started telling you something wasn’t right, didn’t it?

You did your part. You tried out some of the Internet programs, maybe even put up a website or two, but it didn’t happen as expected did it?

And yet, you KNOW a few are getting rich off the Internet by pushing a button. You see them in coffee shops with their backs to the wall, smiling at their laptops. I should know, I’m one of them…

I was about to take the rest of the week off as usual, but something compelled me to grab another coffee and write you this letter. They say writing all your frustrations down eases them. Maybe so, but I just want to be able to sleep soundly tonight… Click to continue.

"True knowledge exists in knowing that you know nothing."

Socrates

The Flip Side of Falling Property Prices: Rising Income Opportunities

By Justin Ford

As real estate prices fall, the income you get per dollar invested rises. This means greater cash flow and the ability to deliver bigger dividends to your investors.

Dividends (or distributed net income) are usually the main attraction for investors in real estate investment trusts (REITs), and they can be the key benefit you offer to equity investors in your next project.

Let’s see why you might want to shift your emphasis to distributed net income in today’s market.

A Bird in the Hand

Will Rogers said it: "More important than the return on your capital is the return of your capital." During the bull and bubble market, the conservative approach reflected in that statement was very much out of fashion. In today’s market - where so many speculators have lost money - that sentiment is well received once again.

Often, when you pay a dividend (or distribute cash flow) to your equity investors, you are, in effect, returning a piece of their original investment. In fact, in private partnerships, early distributions are typically treated as return of investment capital. So you and your equity investors typically get to defer taxes on distributions for a while.

The investor in an income property gets…

• A lower risk investment, as he is buying into an investment that "pays for itself" and because pieces of his investment are returned sooner
• Possible tax advantages on early distributions
• Completely passive income
• The expectation of additional gains through amortization
• The potential for additional gains from leveraged appreciation

A steady stream of income and the possibility of capital appreciation later, with relatively low risk, is an attractive offer, especially in a marketplace that is otherwise highly volatile.

Key Terms for Evaluating Yield

When you consider income property, there are a few terms you should be familiar with: potential gross income (PGI), gross rent multiplier (GRM), net operating income (NOI), and the capitalization rate (or "cap rate").

Potential Gross Income is just as it sounds. Imagine you have a 10-unit building with market rents of $1,000 per unit. Your PGI is $10,000 a month or $120,000 a year. If you have laundry machines too, and you figure an average revenue from them of $25 per unit, your PGI is then $10,250 per month or $124,000 per year.

Gross Rent Multiplier is a ratio. It’s the purchase price of a property divided by the annual PGI. So if you pay $620,000 for the abovementioned property, you’re paying five times PGI. Your GRM is five.

Net Operating Income is the most important number in all of real estate. It’s your PGI minus vacancy and collection losses minus expenses. Period.

Capitalization Rate is the most quoted number in commercial real estate. It tells you how much income you are getting per dollar invested. Here’s the formula: NOI divided by purchase price equals the cap rate.

Now let’s look at a few key details about using these numbers correctly.

Base Your PGI on Current Numbers - Not Projected or Inflated Figures

When you’re a buyer, work with the lower of actual numbers or market numbers. Here’s what I mean.

Let’s say a seller has that 10-unit building we’re talking about. Two units are vacant. He says you can raise the market rent to $1,100 a month for all the units so that soon you’ll be getting $11,000 a month in rent, plus the $250 in laundry. So, according to him, you should base your offer on a PGI of $11,250 a month or $136,000 a year.

Don’t do it.

Base your offer on current numbers. If he can get $1,100 a month, why doesn’t he? When using the PGI, use the current rents per the owner’s current leases. The only time you wouldn’t do this is if he’s artificially inflated the rents.

For instance, say he has illegally turned the property into a boarding house, renting by the room. You have no intention of using the property that way. So, just because he’s getting $500 per room or $20,000 per month, don’t use those numbers unless you want to operate an illegal boarding house. Instead, use legit market numbers.

If the property would normally have a PGI of $124,000 and in this location you figure a GRM of five or less would be a good deal, then your max offer would be $620,000. If you accepted his numbers based on illegitimate usage, you’d be prepared to pay nearly twice that - even though you were using the same GRM.

Verify the NOI

In commercial property, cap rate is the most common way of determining value and justifying asking and offering prices. But a true cap rate depends on a true NOI - and NOIs are fudged more than government budgets in an election year! To get an accurate gauge of a property’s NOI, you must insist on getting proof from the seller for his numbers, and you must be prepared to do a little number crunching yourself.

Let’s say the seller of our 10-unit building claims he gets NOI of $100,000 a year. Right away, you’d have a strong suspicion he’s overstating the income. After all, you know the PGI is just $124,000. So to really end up with $100,000 in net, his lost rent from vacancy and his expenses would have to total no more than $24,000 - or about one-fifth of his PGI.

As a rule of thumb, you’ll find most apartment buildings have expenses in the neighborhood of 40 percent to 50 percent of the PGI. Add in rent losses due to vacancy of 5 percent to 10 percent of the PGI, and you usually have total expenses and vacancy totaling 50 percent to 60 percent of the PGI. That leaves the rest - 40 percent to 50 percent - for you as net operating income.

So if we assume expenses and vacancy to reach a total of 60 percent of PGI, your NOI would be the remaining 40 percent. Take 40 percent of $124,000 and your NOI is $49,600. If you insist on a minimum cap rate of 8 percent (8 cents in net income for each dollar you invest), then the maximum you would pay for this property would be $620,000.

You would have arrived at that number as follows: NOI/cap rate = maximum offer price… or $49,600/.08 = $620,000.

That can give you a good, quick estimate of what you might pay. But when you get to the offer stage, you’ll want to base it on the actual numbers.

Get Key Docs and Take All Expenses Into Account When Gauging NOI

Ask to see the last few years’ tax returns for the property (or the seller’s schedule E if he owns it in his personal name), bank statements, profit and loss statements, and general ledger. Request current leases and verify them. In your projections, use a conservative vacancy rate of 8 percent to 10 percent. Don’t accept overly cheerful projections of 3 or 4 or even 5 percent. That will just increase the estimated NOI and, hence, your offer price.

Request recent utility bills paid by the owner. Estimate what your property taxes will be based on your purchase price and local millage rate (a tax rate) when determining your NOI. Don’t use his tax rate, since yours will likely go up substantially if you’re buying the property at a higher price than he paid years earlier.

Make sure you account for all expenses you’re likely to incur. If the current owner cuts the lawn and shovels the sidewalks, budget to have someone do that for you. If he manages the property, budget to have someone manage it for you, including handling bookkeeping and taxes.

In other words, base your NOI on having a professionally managed property and not one where you have to do a lot of the maintenance, handyman work, and management.

There is a good deal more to look into when evaluating NOI. I’ll go into it further in future articles. But we’ve just looked at some major points that can help you gauge a true PGI and NOI. When you can do that, you can look for the best priced properties with the highest legitimate cap rates and lowest GRMs in any given area.

Then you can structure deals where you offer investors healthy current yields of 6, 7, 8 percent and more, as well as the prospects for capital gains though amortization and long-term appreciation.

[Ed. Note: Justin Ford is the author of Main Street Millionaire, a value-focused real estate investment program. At ETR’s recent Profits in Paradise Wealth-Building Summit, 14 of the world’s experts in wealth - including real estate specialists Dave Lindahl, Marko Rubel, and Jim Fleck - divulged their biggest secrets to churning out cash. Take advantage of their proven money-making strategies with ETR’s Profits in Paradise DVD Library. Get the details here.]

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== Highly Recommended ==

The Greatest Medical Discovery of the Century

Scientists have discovered a remarkable substance that has the power to prevent diabetes, stop heart disease before it starts, and kill cancer cells on contact. In fact, this substance has been shown to prevent and treat more than 20 major diseases in all!

However, more than 85% of the population is deficient in this disease-killer at least part of the year. And believe it or not, medical professionals and health authorities actually advise people to avoid the single greatest source of this vital substance.

Click here to learn why you probably haven’t heard about this revolutionary discovery.

Reader Feedback: "The idea came to me just in time."

"I wanted to thank you for posting the article ‘Creating Cash Flow Without Ownership‘. The idea came to me just in time.

"I was renting an apartment in Norcross, GA for $720 per month. Two bedrooms, two full baths, and my lease was up. I was going to try to move into an inexpensive one-bedroom until I could afford something nicer. After I read Justin’s article, I started looking on CraigsList for something where I could probably talk a landlord down in price. I found a two-bedroom, two-full-bath condo for $750 per month, and I talked her down to $700. She even said after I live in it for one year, I can buy it if I want to.

"After giving her my security deposit, my apartment complex notified me that if I renewed my lease my rent was going up to $805 (because they were replacing the carpet and tile flooring). I said, ‘Thank you God and ETR for having this property come before me just in the nick of time.’"

Sandra Hawes

Norcross, GA

[Ed. Note: Want to get your name and opinions published in ETR? Let us know how reading ETR has helped you - maybe even changed your life. Send your comments to ReaderFeedback@gmail.com. Include your name and hometown… and we may print your e-mail in a future issue.]

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Checking E-Mail All Day? You’ve Got the Wrong Job

By Jason Holland

If your job requires you to check e-mail more than twice a day, you should probably be looking for a new position. That’s what Michael Masterson told me in a recent editorial meeting.

Customer service reps, IT techs, marketing assistants, and even middle managers - all of these people have to check e-mail constantly for work assignments, to answer questions from co-workers and supervisors, and to deal with crises. If they didn’t, they would probably be fired. Yes, the work they do is necessary for the success of the company. Problem is, because they’re tied to their inboxes, they are unable to focus on the more important aspects of growing a business: new product development, testing new marketing strategies, increasing profits, and the like.

But if you’re in one of these jobs, you don’t have to stay there. Your goal should be a high-level executive position - more freedom, more decision-making capability, more direct influence on your company’s profitability… and a higher income.

Here are several strategies that Michael has talked about in ETR and his books to help you climb the corporate ladder:

• Distinguish yourself from other employees by excelling at your present job.
• Don’t allow yourself to be typecast because of the work you’re doing now. Volunteer to take on new responsibilities outside of your job requirements.
• Network beyond your department. Reach out to powerful people inside and outside your company.
• Don’t burn any bridges on your way up. You never know whose help you might need in the future.
• Assist - and learn from - the person whose job you aspire to. They might even groom you to be their replacement when they move on.
• Develop a financially valuable skill - one that contributes to the company’s bottom line. As Michael said in Automatic Wealth for Grads, that means being involved in product creation, marketing, sales, or profit management.

E-mail is a useful business tool, but it shouldn’t rule your work and your career. If it does, you need to make a change.

[Ed. Note: Don’t be intimidated by the idea of trying to move your career onward and upward. Michael’s best-selling book Automatic Wealth for Grads… and Anyone Else Just Starting Out is full of great ideas and advice you can use to get a better position… or move on to a new job. Pick up your copy here.]

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Worth Quoting: Steven D. Levitt, Co-Author of Freakonomics on Figuring Things Out for Yourself

"So much of what we hear and what we’re taught turns out to be false on closer scrutiny. Whether it is expert advice, what you read in the paper, or what your mother told you, if it is important, take the time to figure out for yourself whether it is really true."

(Source: Business 2.0)

Click to comment on this article.

One Natural Method to Ward Off Three Health Disasters

By Shane "The People’s Chemist" Ellison, M.Sc.

Nuts and seeds like cashews, pistachios, and walnuts often get a bad rap for their high fat and calorie content. Yet, as you know from reading Early to Rise, they are among the best foods for igniting metabolism and controlling hunger. Even better than that, nuts and seeds can help protect against three major diseases.

Unlike sugary snacks, nuts and seeds do not spike blood sugar or the fat-storing hormone insulin. Why is this important? As insulin surges into the blood, it removes two anti-aging substances - growth hormone and insulin-like growth factor. Worse, excess blood levels of insulin lead to obesity, heart disease, and Type II diabetes. So choosing snacks - like nuts and seeds - that keep your insulin in check can actually help ward off these three health disasters

[Ed. Note: Shane Ellison is an author, organic chemist, and contributor to ETR’s free natural health newsletter. Learn more about how you can beat obesity, heart disease, and diabetes with Shane’s AM-PM Fat Loss Discovery package.]

Click to comment on this article.

It’s Fun to Know: An Unexpected Cannibal

Butterflies - sweet, gentle butterflies - are cannibals. Newly hatched butterfly larvae often eat their siblings.

(Source: That’s a Fact Jack!)

== Highly Recommended ==

Give Yourself a Nice Pay Raise - And A Three Day Weekend, Every Weekend

By the end of this week, you can give yourself a pay raise. How does an extra $20/hr sound… and schedule a few days of vacation while you’re at it!

After a month or two, how about another raise… to $2,000 a week.

It’s happening everywhere. Ordinary people — including folks who never finished school — starting their own businesses… and making side incomes in the neighborhood of $40,000… $60,000… even $100,000 or more a year.

They’re living the American Dream. Now it’s time for you to start living it too. Read on…

- Charlie Byrne

Word to the Wise: Provender

"Provender" (PROV-un-dur) is another way of saying "food." The word is derived from the Latin for "a daily allowance of provisions."

Example (as used by Simon Schama in The Guardian): " Frances Trollope, Captain Marryat, Colonel Basil Hall, and Charles Dickens in 1842 all commented on the way Americans wolfed down their provender as fast as possible, cramming the cornbread in their sloppy maws and, worse, doing so in grim silence, punctuated only by the noise of slurps, grunts; scraping knives, and hacking coughs."

Copyright ETR, LLC, 2008