Discounted Cash Flow Analysis of Realty Investments

Discounted Cash Flow Analysis of Realty Investments

You can calculate capitalization rates and property overall rates of return by hand, on a piece of scratch paper or with a calculator. And you can get a general idea about the effect of financial leverage using a simple rule of thumb...Positive leverage occurs when the property's overall rate of return exceeds the loan interest rate.

Unfortunately, you can't estimate precise rates of return on leveraged investments that include all of these factors except with a computer's help.

Fortunately, if you do have a computer and know a little bit about working with Microsoft Excel, you can easily and very precisely calculate what happens when, for example, you borrow money costing four percent to invest in a property that generates a five percent capitalization rate and that appreciates by three percent.

In this discussion, therefore, I'm going to describe in step-by-step fashion how to calculate precise rates of return generated by leveraged rental property investments using the Short Sale Investment Analyzer available at here at this website.

Entering Data into the Short Sale Investment Analyzer

To enter the data into the worksheet, start Excel, open the Short Sale Investment Analyzer workbook, and then follow these steps:

Note: Worksheet cells into which you enter values appear green.

1. Estimate the property appreciation.

To describe the appreciation you expect over the worksheet’s ten year forecasting horizon, enter the inflation rate into cell B2. As noted earlier, I use a 2%, or .02, inflation rate for estimating the appreciation in short sale property. In essence, I’m saying that over ten years, the short sale discount will “disappear” and mean in the end I can sell the property for roughly twenty percent more than I paid for it. You may however want to use 3%, or .03, since that’s the long-term inflation rate.

2. Estimate a vacancy rate.

To account for the average effect of vacancies, enter the area vacancy rate into cell B3. You can surely get this information by Googling the name of your town or neighborhood and the phrase “vacancy rate.” To learn the vacancy rate in Seattle, for example, one can Google on phrase “vacancy rate Seattle.”

3. Describe the purchase terms.

To describe the purchase, enter the selling price into cell B6, the down payment you’ll make into cell B7, the depreciable basis of the building (house or condo) into cell B8, and the amounts you’ll pay for closing and for pre-rental renovation. The selling price is what you think you’ll offer, of course. The down payment is the amount you’ll pay toward that price out of your funds rather than the lender’s funds. The depreciable basis is the amount of the sales price that you’re paying for the building. For example, if you pay $150,000 for a rental house but $120,000 of this amount is for the structure and $30,000 of this amount is for the land, the depreciable basis equals $120,000. The closing costs figure needs to include the escrow and closing costs and any pre-rental renovation or clean www.irs.govup costs you’ll incur (painting, appliances, reseeding lawns, repairs and so forth).

4. Describe your financing arrangements.

To describe the loan you’ll use to finance your investment, enter the loan fee into cell B12, the loan amount into cell B13, the annual interest rate into cell B14, and the loan term (the number of months over which the loan will get paid off) into cell B15. After you enter this information, the worksheet calculates your loan payment, displaying the value in cell B17.

5.Identify your marginal tax rate and expected capital gains tax rate.

To describe the tax effects of the real estate investment, enter the marginal tax rate you pay on your last dollars of income into cell F2 and the capital gains rate you expect if you sell your property at a profit into cell F3. You can get current marginal tax rate information from the www.irs.gov website and (if you live in a state with income taxes) from the equivalent state revenue agency tax website. Note that many short sale property investors will enjoy above average family incomes, so the example set of inputs in the worksheet shows the marginal tax rate as 25%, or .25, and the capital gains tax rate as 15%, or .15. If your income is truly “average,” your marginal tax rate may be 15% and your capital gains rate may be 0%. (Note: The 15% and 0% capital gains rates expire at the end of 2012. You may therefore just want to use the same rate for both the marginal and capital gains tax rate.)

6. Provide an exit capitalization rate.

One of the conventional ways to forecast the ultimate selling price you receive when you sell an investment property is to estimate the future annual net income of the property and then “cap” this income using a future, “exit” capitalization rate. To provide this input to the Short Sale Investment Analyzer workbook, you enter an exit capitalization rate into cell F6. (Note: I think it’s probably most conservative to say that capitalization rates for small rental properties will stay constant and that, therefore, your “exit” cap rate will roughly equal your “entry” cap rate. But you might want to use a lower exit cap rate than the entry cap rate because the entry cap rate should be higher due to the short sale discount. You should also enter an estimated selling costs percentage into cell F7.

7. Provide a pretax discount rate, or “threshold” required rate of return.

Here’s the one, rather tricky conceptual part of doing discounted cash flow analysis: You need to enter the pretax discount rate you expect into cell F10 and the after-tax discount rate you expect into cell F11. If you’ve taken a finance course, you can change the values shown in cells F10 and F11. (The example set of inputs in the Short Sale Investment Analyzer worksheet show as 12% and 9%.) But if you’re not familiar with how discount rates work, don’t worry about changing the default values just yet. I’ll talk about this more in a few paragraphs, but essentially the discount rate inputs let you verify that you’re earning a specified pretax, threshold rate of return. If you enter a pretax discount rate of 12%, for example, the worksheet lets you see in dollars whether you’re achieving the 12% return—and if so, by how much. The after-tax discount rate works the same way. If you set the after-tax discount rate to 9%, or .09, the worksheet checks that you’re earning an after-tax 9% rate of return.

8. Forecast your starting monthly rent.

To allow for a forecast of the income the property will generate, enter the monthly rent into cell B23. The worksheet range B24:C26 lets you include additional income in your forecast. In the case of a single family home, you may not have any additional income. But if you have coin laundry machines, you can enter the price per wash load into cell B24 and the number of wash loads into cell C24. You can forecast late fee income by entering the late fee you’ll charge a tenant into cell B25 and the number of times you think you’ll assess a late fee each year into cell C25. If you charge for parking, you could enter the monthly parking fee into cell B26 and the number of parking spots into cell C26. You can experiment with different sets of values to see how the formulas in D23, D24, D25 and D26 work. But know that the only income amount you need to enter is the monthly rent amount shown in cell B23 and that the worksheet annualizes your monthly values to turn them into annual forecasts.

9. Forecast your starting annual operating expenses.

To describe the operating expenses of the rental property, enter the annual budgeted expense amounts into the worksheet range D35:D46. For example, if you expect to pay an advertising charge equal to $50 the first year, enter 50 into cell D35. If you expect to spend $50 on car or truck expenses (perhaps because you run by the property each month), enter 50 into cell D36. You can leave some cells empty. But know that on average operating expenses probably run about 45% if you’ll out-source the management and maintenance. If you’ll do the maintenance and management yourself, your total operating expenses may drop to 25%.

Using the Short Sale Investment Analyzer

After you enter the inputs into the Short Sale Analyzer worksheet, Excel calculates estimates of the property’s profitability, including the operating income, the pretax and after-tax cash flows, and the rates of return measures. These rate of return measures let you see what sort of return you can expect on an investment in the property.

Tip: Be sure to try different sets of inputs, experimenting with variables that may easily change such as the inflation rate, the vacancy rate and so forth. Trying different “what-if” scenarios will help you size up both the potential profitability and risks of a particular property.

Reviewing and Understanding the Forecasted Income

Part I of the Short Sale Investment Analyzer worksheet estimates the operating income, operating expenses and cash flows from the property and appears in the worksheet range A22:N49. Essentially, the worksheet takes your year 1 estimates and then inflates these values annually using the inflation rate you provided.

For example, if your year 1 estimate of the monthly rate is $1500 that means the year 1 annual rent equals $18,000, because $1500 a month times twelve months equals $18,000. If you’ve set your annual inflation or appreciation to 2%, in year 2 the worksheet inflates the $18,000 year 1 annual income by 2% to $18,360. And expenses work the same basic way with your starting (year 1) values getting annually bumped by the inflation rate you specified.

Part I of the worksheet totals forecasted income and expenses and then estimates the operating income by subtracting the expenses from the income. The operating income shows in the worksheet range D49:N49. The worksheet also shows the first year’s cap rate in D51.

Reviewing and Understanding the pretax Cash Flows and Rate of Return Measurements

Part II of the Short Sale Investment Analyzer worksheet, which appears in the worksheet range A53:M68, estimates the pretax cash flows that the property generates. To estimate these values, the worksheet range calculates the initial investment required to “get into” the investment (this includes the down payment, any closing costs, and any upfront renovation costs), the annual cash flows (which include the operating income and the loan payments), and the sales proceeds you’ll receive if you sell the property in ten years based on the forecasted year 11 income being capped using your exit cap rate from cell F6.

With the pretax cash flows estimates, the worksheet calculates two, incredibly useful rate of return measures: The pretax IRR, or internal rate of return, shown in cell C66 and the pretax NPV, or net present value, shown in cell C68.

The pretax IRR value gives you the annualized, before taxes return you would expect to earn annually given your estimates of operating income, annual inflation, and the effects of financial leverage. You can compare these values, for example, to the rates of return that mutual funds and investment managers tout. Keep in mind, however, that you cannot always calculate an IRR on a real estate investment.

Note: Just to make this important point, when you see that some investment (a mutual fund) or that some investor advisor has earned 14% in some year, that percentage is a pretax internal rate of return. You can therefore compare the estimated pretax internal rate of return from the worksheet with these sorts of actual historical pretax returns. It’s obvious, I hope, that real estate investors should do this...

Caution: Without getting into the mathematical complexities, some investments don’t have IRRs. For example, if you truly get into a property with no money down, you can’t calculate an IRR because logically there’s no “investment” to use as the denominator in the return on investment calculation. Furthermore, sometimes IRRs become sort of meaningless for properties with cash flows the fluctuate—some years showing positive cash flows and other years showing negative cash flows.

The pretax NPV value shows you whether the investment property you’ve described achieves or falls short of a specified rate of return. With the example real estate investment shown initially in the Short Sale Investment Analyzer worksheet, the pretax NPV value equals $10,504 based on a 12% pretax discount rate. What this means is that the example investment exceeds a 12% return by $10,504 in present dollars. Note that if the NPV equaled zero, that would mean the investment generates exactly a 12% return. Furthermore, if the NPV equaled a negative value, that would mean that the investment falls short of the 12% threshold implied by a 12% pretax discount rate.

Two quick points about the NPV measure: First, you should set the discount rate to the threshold investment return you want to achieve on a property given your other investment options. A 12% pretax discount rate is common for real estate and would essentially be like saying, “well if the stock market produces 10% over long periods of time, I want to be able to earn at least 12% on my real estate deals given the extra risk and time involved.”

A second quick point: You can easily compare investments using NPVs. The investment with the highest NPV is the one you should select since that’s the one that will make you the most money. Note that you can’t use the IRRs to pick confidently the best investment in many circumstances. For example, using only IRRs and being a little exaggerated, blind application of the IRR measure would mean that you could tell yourself that it’d make more sense to invest in a small $10,000 property that delivered a 20% rate of return for one year, instead of a $100,000 property that delivered 19% return for, say, fifty years. (Just think about this for a minute if you don’t get at first why the second investment is better...)

Reviewing and Understanding the After-tax Cash Flows and Rate of Return Measurements

Part III of the Short Sale Investment Analyzer worksheet, which appears in the worksheet range A70:M93, estimates the after-tax cash flows that the property generates by taking the pretax operating cash flows and then adding any tax savings and subtracting any tax expenses that the investment generates either through positive income or because you enjoy a profit when you sell.

Note: I talk more about the tax accounting issues related to real estate investment in "Appendix B - Understanding Real Estate Tax Accounting,” but the two new deductions that appear in Part III are the building depreciation deduction and the loan fee amortization. These extra expenses along with the deductible mortgage interest you pay on any financing may mean, as discussed in Appendix B, that you pay income taxes on investment profits or that you save taxes because the investment shows a loss.

With the after-tax cash flows estimates, the worksheet calculates two, after-tax rate of return measures: The after-tax IRR, or internal rate of return, shown in cell C91, and the after-tax NPV, or net present value, shown in cell C93.

Reviewing the Loan Amortization Schedule

The second sheet in the Short Sale Investment Analyzer workbook, “Loan Amortization Schedule,” shows the monthly payments for each month of the loan, the breakdown of payments into interest and principal components, and the remaining mortgage loan balance after the payment of principal.

Part II and Part III of the Short Sale Investment Analyzer workbook use data from this worksheet in their calculations. But you can also use the loan amortization schedule to see how the loan balance declines over time and to guess at the loan balance at particular points in time.

Understanding Real Estate Tax Accounting

Understanding Real Estate Tax Accounting

Tax accounting gets a little tricky for real estate investments. Accordingly, I want to provide you with a quick overview so you make better decisions—and so you can exploit any tax planning opportunities.

Tip: I also provide a longer e-book about real estate tax loopholes and secrets at this website that provides a much richer discussion of real estate tax accounting.

Measuring Taxable Income or Losses

Here’s the first thing to know about real estate investment tax accounting: For each property you own, you need to calculate and report the property’s taxable income. To calculate your taxable income on a property, you calculate the operating income and then (typically) you subtract a couple of additional items: the depreciation on the property and the mortgage interest on your financing. For example, earlier in the ebook, I displayed the following table to show the operating income for an example real estate investment:

	Monthly	Annually
Rental Income	$1,000	$12,000
Less: Vacancy Allowance	$50	$600
Net rental income	$950	$11,400
Expenses
Insurance	$50	$600
Property taxes	$100	$1,200
Repairs & maintenance	$200	$2,400
Total expenses	$350	$4,200
Net Income	$600	$7,200

Table 3: An example net income statement for a single family home

I also said a property like this might cost $140,000 but would require $2,000 in closing costs and then need right after closing another $2,000 in renovation costs.

I then also referenced a loan and mentioned its loan fees might equal $2,000. Though I actually didn’t provide a loan amount or interest rate, let’s say for sake of illustration that the loan balance equals $110,000 and that the loan interest rate equals 4%.

With these inputs, one gets to add three tax deductions to the operating income calculations just shown: loan interest, building depreciation, and loan fee amortization.

For example, if there’s a $110,000 mortgage loan charging 4% interest, that over the course of a year means roughly $4,400 of interest deduction. (I’m going to pretend that the mortgage only requires interest payments to keep the example simple.)

And then there’s the building depreciation. Building depreciation gets calculated by first guessing at the part of the purchase price that represents the structure. Commonly, people guess the structure equals 80%, though a better way to estimate the structure piece is by using the county assessor’s property tax percentages. But say that you are calculating depreciation for a building you spent $140,000 on plus $2,000 of renovation. In this case, 80% of the $142,000 equals $113,600. Tax laws say you can depreciate residential rental property over 27.5 years, so because $133,600/27.5 equals $4,131. That $4131 is another deduction that gets included in your taxable income calculations.

Finally, inevitably, other costs get depreciated, or spread out, over a number of years. The simple example that we’re using here doesn’t include appliances or furniture, but these items, if part of the property, would be depreciated, too. And in fact, the simple example here does include another cost that needs to be spread out over a number of years: The $2,000 loan fee which gets spread out (“amortized”) over the thirty years that loan payments will be made ($2000/30 = $67).

Table 4 shows the additional tax deductions appended to the end of the annual income statement data from Table 3. In this example, on paper, you lose $1,393 on the real estate investment. And that’s the number that gets plugged into your tax return.

	Annually
Rental Income	$12,000
Less: Vacancy Allowance	$600
Net rental income	$11,400
Expenses
Insurance	$600
Property taxes	$1,200
Repairs & maintenance	$2,400
Total expenses	$4,200
Net Operating Income	$7,200
Additional tax deductions
Mortgage Interest	$4,400
Building Depreciation	$4,131
Loan Fee Amortization	$67
Taxable Income (loss) on Property	($1,398)

Table 4: An example taxable income statement

Note: Appliances and other fixtures get depreciated over seven years, while residential rental furnishings get depreciated over five years. Tax law specifies dozens of other depreciation rules, too, but usually you don't have to worry too much about the details because the tax accounting software or the tax accountant that handles your accounting just does all this for you.

Understanding the Tax Effect of Real Estate Profits and Losses

If the bottom-line number that appears on the taxable income schedule is positive—this isn't the case in Table 4 by the way—then the investor just adds the income to his or her other income. And everything works pretty simply. If the investor's total income is high enough after taking account of adjustments, personal deductions and personal exemptions, for example, the investor may pay income taxes on the real estate profits.

If the bottom-line number that appears on the taxable income schedule is negative—meaning there's a loss like is the case in Table 4—the tax accounting gets a little tricky. Some people can use the rental property loss as a deduction on their tax returns, thereby offsetting other income. But many people can't.

And so now I'm going to go over the main rules...

$25,000 Special Allowance for Rental Property Investors

If the taxpayer's income is less than $100,000 and the taxpayer actively participates in a real estate investment (meaning the taxpayer participates in managing the property), the taxpayer can deduct up to $25,000 of special allowance real estate losses.

What this means is that as long as the taxpayer's income is less than $100,000, real estate losses like the $1,398 shown in Table 4 can be deducted on the taxpayer's tax return, thereby offsetting income, including wages, interest and dividend income, capital gains and so on.

If the taxpayer's income is $100,000 or more, then the $25,000 special allowance gets reduced by $1 for every $2 the income exceeds $100,000. Someone who makes $110,000, for example, loses $5,000 of the special allowance. So this means they can only deduct $20,000 of real estate losses. And someone who makes $150,000 can't use the special allowance rule at all because at $150,000, the “$1 lost for every $2 over $100,000” rule means the $25,000 special allowance has been wiped out.

Real Estate Professionals Rule

If the taxpayer is a real estate professional—which means someone who spends more than half of their work time and more than 750 hours a year working in real estate development, construction, property management or brokerage—then the taxpayer can write off real estate losses against their other income, including wages and investment income.

One wrinkle here, though, is that getting to the 750 hours is trickier than you might think. If you have, for example, three properties and spend 250 hours on each property, you don't pass the 750 hours rule unless you tell the Internal Revenue Service that you want to treat the work you do on all three rental properties as a single property management “activity.” (You should work with a good local tax accountant if you want to try this.)

Everybody Else Gets Limited And Delayed.

If you're not a real estate professional and can't use the $25,000 special allowance rule, you can't deduct real estate losses except to the extent you have real estate profits.

For example, if you lose $1,398 on one property but make $1,398 on another property, you can offset the two amounts.

But if you only have the $1,398 loss and no other real estate profits, the $1,393 loss isn't used until some future year when you do have real estate profits.

If you never get to use the loss—because you never make money on a single real estate deal—the loss finally gets included on your tax return when you dispose of the property. Although, I need to mention something here: you may remember that a few paragraphs ago I said that you might be able to qualify as a real estate professional by aggregating the hours you spend managing three properties. In this case, because you manage your own properties, by making an election to treat the properties as a single “activity,” you don't unlock the real estate losses until you sell the last property in the activity.

Like I said earlier, if you want to qualify for the real estate professionals rule by aggregating multiple properties as a single “activity,” you should probably work with a good local tax accountant just to make sure you don't screw things up.

Material Participation Matters

I need to make one other comment about real estate losses.

In order to deduct any real estate loss, you need to materially participate in the activity. Material participation (even if you're a real estate professional) means for real estate, practically speaking, that you meet one of the following tests:

1. You participate in the activity more than 500 hours a year, or
2. You are the only person who participates in the activity, or
3. You spend more than 100 hours in an activity but nobody else participates more, or
4. You spend more than 100 hours in a single activity and you can add up more than 500 hours of participation in multiple activities, or
5. You've meet a material participation test for an activity for at least five of the last ten years, or
6. You've spent more than 100 hours on the activity and your participation is regular, continuous, and significant.

These kinds of mind-numbing rules may make you want to pull your hair out. But probably you won't be restricted from taking a real estate loss because of failing to materially participate if you're actively involved in a rental property short sale investment.

The people who fail the material participation test “flunk” because they're involved only tangentially in a real estate deal. You should, in the case of a short sale property, find you've got more than enough material participation under one or more of these rules as long as you haven't delegated all the work to someone else.

Repairs, Maintenance and Improvements

As we near the end of this little e-book, I want to provide a short discussion of accounting for repairs, maintenance, and improvements. Misunderstanding these items can wreak havoc with your tax planning.

If you spend money on repairs or on maintenance, that spending creates a deduction which gets included in your taxable income or loss calculations. If you're able to take losses because of the special allowance rule, the real estate professional rule, or just because you've got other real estate investments generating profits, repairs and maintenance spending generates immediate tax deductions. And those tax deductions generate immediate tax savings.

What are repairs? A repair returns an item to its previous condition. For example, if you have a pipe burst and need to replace sheetrock and carpets because of the water damage, that's a repair. If an appliance breaks and you call the service technician to replace a part, that's a repair.

What is maintenance? Maintenance maintains some item in working order. Painting the inside or outside of the property is maintenance. Replacing carpet every three years is maintenance. Regularly replanting foliage or reseeding lawns is maintenance.

Money you spend on an improvement, however, shouldn't be simply deducted. Rather, improvements need to be depreciated—usually over 27.5 years.

What is an improvement? Improvements either extend the life of the property or increase the utility of the property. Improvements include items such as roof replacement, new siding, and new gutters because these items all clearly extend the life of the property. Improvements also include items such as a new air conditioning system, an attic built-out, new landscaping, and an irrigation system because these items all clearly increase the utility of the property.

Discerning whether a particular item is repair, maintenance, or improvement is tricky. But you can probably roughly think about expenditures on repairs and maintenance as money you spend so you can continue to rent the property at current rent levels over the next year. You can think about expenditures on improvements as money you spend to increase your rents or to extend the life of your property.

Taxes on Sale of Property

One final topic should be discussed: how you get taxed when you sell the property. So let me just do that quickly.

You might think that if you originally bought a property for $100,000 and then sold the property for $200,000 that you'll only pay taxes on the $100,000 of profit. But the calculations are a little trickier than that, unfortunately.

You actually need to make three adjustments to the original purchase price. First of all, you'll need to subtract any depreciation you either deducted or that you were supposed to deduct from the purchase price value.

Second, if you have suspended passive losses, these get added back to the purchase price.

Third, finally, any selling costs also get added back to the purchase price.

For example, if you bought a property for $100,000, took $50,000 of depreciation over the years you held the property, were prevented from taking $25,000 of passive losses, and then spent $15,000 on selling costs, your actual real estate gain on sale gets calculated like this:

Original purchase price	$100,000
Subtract: depreciation	-$50,000
Addback: suspended passive losses	$5,000
Addback: selling costs	$15,000
Adjusted purchase price to use in profit calculation	$70,000
Selling price	$200,000
Gain (selling price – adjusted purchase price)	$130,000

Table 5: Calculation a real estate taxable gain

One other little wrinkle related to the real estate taxable gain: if a part of the real estate gain is really a reversal of the depreciation the investor has taken in the past, that chunk of the profit gets taxed at a higher tax return.

Specifically, “depreciation” profits are taxed either at 25% or at the taxpayer's marginal income tax rate when that marginal rate is lower than 25%.

I think I would not worry too much about getting precise about tax rate on the “depreciation” profits. (These “depreciation” profits are actually called “Unrecaptured section 1250 gain” and discussed in the Chapter 16 of IRS Publication 17, which is available at the www.irs.gov website.)

I don't actually make any effort in the Short Sale Analyzer workbook to calculate the extra “depreciation” profits tax you might pay in, say, ten years because a small chunk of the gain is taxed at a higher rate. The main things to know are that you may need to pay back some of the depreciation... and that things like suspended passive losses and selling costs factor into your gain calculations.

Understanding Why the Short Sale Discount Exists

Understanding Why the Short Sale Discount Exists

I want to talk first about why the short sale discount exists based on my personal experiences of trying to buy (and then actually buying) short sale properties.

By understanding the nature of the discount, you can more confidently invest. And by understanding the discount, you can avoid short sale investing if you're not really suited to this unique opportunity

I'm going to break my discussion and explanation into four parts, as shown below:

1. Traditional Real Estate Purchase Process The place to start any discussion of the short sale process and everything that's crazy about it is by looking at the traditional steps one takes to buy a property.
2. Short Sale Purchase Process Once you've got the steps in a traditional real estate purchase in the back of your mind, you can objectively consider all the weirdness that occurs when you try to buy or actually buy a short sale property. This weirdness, by the way, is largely what creates the great short sale investment opportunities you regularly see...
3. Additional Short Sale Complications and Issues Short sale investing burdens you with some additional headaches and hassles, and you'll want to carefully consider these issues if you choose to pursue investments in shortsale (or foreclosure) properties...
4. Making Sense of the Short Sale Purchase Discount With a solid understanding of the shortsale purchase process and all its complications, you can better understand why the shortsale discount often runs twenty percent or more--and how to verify you're getting the discount you deserve...

Putting It All Together: Short Sale Discounts, Cap Rates & Your Investing

Putting It All Together: Short Sale Discounts, Cap Rates & Your Investing

So, you've read this far. And perhaps grudgingly you may now be willing to consider the possibility that short sale investing is an unusual, historically unique opportunity you maybe should consider.

Common sense, though, means almost certainly that you've got a couple of concerns: First, how you can be sure you're actually getting the important short sale discount...and how you can be confident a particular real estate investment makes sense. Let me talk about both of these concerns a bit. 

Verifying You Get the Discounted Short Sale Price

First of all, with regards to the short sale discount, I think it's actually pretty tough for you or I to know whether we're getting the discount we deserve, need, or want on a particular property. The seller may not care much about the price, but both the real estate agent (whose commission is a percentage of the sales price) and the bank want as high a price as possible. And neither the agent nor the bank, in my experience, is very sensitive to the point of view that you deserve a discount purely because you've got the extra cost, risk and hassle of a short sale. You absolutely do deserve the discount by the way. But these guys aren't likely to intuitively understand that.

What I can say about the short sale discount though is that you should be paying less than the appraised value. And probably a fair chunk less than the appraised value. You certainly should not need to pay the appraised value inasmuch as short sale burdens you in all sorts of ways that a traditional sale (the sort considered a "comparable" by an appraiser) isn't burdened.

Remember, too, that a short sale probably burdens you with a bunch of deferred maintenance costs and other expenses that a traditional sale doesn't burden you with.

By the way, people will sometimes say that in a market with lots of short sales, these other short sales will affect every property's appraised value. Following this logic, a few short sales in the market will "automatically" cause the appraised values in an area to adjust downward for the short sale discount. But I don't think this is true-and haven't seen such as adjustment in my own experiences. Short sale transactions in the areas that I've looked at closely often represent a small percentage of sales. In some areas, for example, short sales represent only five to ten percent of real estate sales. And even in the worst hit areas, short sale transactions may represent only thirty percent of real estate sales.

Verifying You Make a Smart Investment
As for the question about whether or not a particular property makes a good investment, let me say a couple of things, one negative and one practical.

Here's the negative comment first: If the economy gets worse over the next decade, any leveraged investment may turn out to do poorly. So that's something you should consider. No investment is risk-free. And leveraged investments, as noted earlier, amplify losses.

Personally, however, I think the short sale investment opportunity is good enough to merit the extra risk on two or three short sale properties. Sure, I may be wrong. My financial profile is different than yours. And just so we're clear on this point, I would never suggest to someone that they make short sale investments the largest share of their investment portfolio. But with short sale properties you're getting a big discount on your investment in a hugely depressed market and you're funding your investments with super-cheap money. That should mean you get greatly leveraged, positive returns.

Furthermore, you should be able to improve your odds of short sale investment success by being really diligent about doing your investment analysis. Make sure that you've got a good cap rate by carefully doing the numbers. Be sure you have good inputs for things like the rent, the vacancy rate and the expenses. Make sure you're using a reasonable appreciation rate and that you're getting good, positive financial leverage with a good set of reasonable calculations.

I would think, for example, that your overall property rate of return should be in the 6% to 8% range with possibly a 4% to 5% cap rate and then maybe a 2% to 3% inflation rate. I've already mentioned that I think a 2% inflation rate is reasonable and probably (hopefully?) slightly conservative.

If you do get a nice 6%, 7% or 8% overall property rate of return and you can finance some of the purchase price with inexpensive 4%-ish mortgage money, you should enjoy a very good, albeit leveraged return on your investment.

Using the discounted cash flow worksheet described in "Appendix A, Discounted Cash Flow Analysis of Real Estate Investments" in the ebook (available as a download for $10.95), one can construct realistic scenarios that show 16% to 18% rates of return on single family homes if one receives a nice short sale discount and gets a good cap rate going into the investment.

One final comment: I think that if you do get a property that generates a 16% annual rate of return when using a solid set of inputs, you probably are getting a good short sale discount. In other words, another way you can be more confident of getting a good short sale discount is by doing discounted cash flow analysis and then, with a solid set of numbers, confirming that you're getting a rich rate of return.

If you do your analysis and you don't calculate a solid 4% or 5% cap rate or you do a discounted cash flow analysis and can't show, say, a rich double-digit rate of return, the problem may be that you're not getting the discount you deserve.

Analyzing Rental Property Investments

Analyzing Rental Property Investments

Analyzing a rental property investment is the thing I want to talk about next. And I will say at the very start that there are a couple of reasonable ways to do this.

In the paragraphs that follow, I describe a method that everyone can use, the income capitalization rate. But there's another, even better way to analyze real estate investments-and that way is by using a discounted cash flow analysis that calculates very precisely how good (or bad) a potential real estate investment really is.

Note: I describe how to do discounted cash flow analysis in "Appendix A, Using Discounted Cash Flow Analysis for Real Estate Investments" of the ebook (available for download for $10.95) and also provide a Microsoft Excel workbook with the e-book download which you will need to do the discounted cash flow analysis.

But back the discussion of the simpler analytical approach, the income capitalization rate...

With an income capitalization rate, you estimate the net income generated by a property, express this net income as a percentage of the property value, and then adjust for expected appreciation. This sounds complicated, but let's break the process down into five steps to show you how this all works:

• Step 1: Estimating Net Income of Short Sale Investment
• Step 2: Calculating Short Sale Property's Value
• Step 3: Estimating Cap Rate of Property
• Step 4: Determine Overall Property Rate of Return
• Step 5: Assessing Effect of Financial Leverage

Analyzing Short Sale Investments

Analyzing Short Sale Investments

I hesitate to use the word "investment" to describe a vacation home purchase. I doubt many vacation homes, when the costs are accurately tallied, make their owners money. Nevertheless, you can and should financially analyze the vacation home purchase decision using a simple formula: the equivalent nightly room rate formula.

To use the equivalent nightly room rate formula, you total up the annual costs of owning a vacation home, adjusting for any income tax savings stemming from the mortgage interest and property tax deductions.

After you have the total annual costs value, you divide that value by the number of nights you'll use the property. The formula result shows you the per night cost of the vacation home and, conveniently, can be compared to what you'd pay for a hotel room or suite.

Suppose, for example, that you're looking at a buying a golf course bungalow in Palm Springs for $200,000 using a 4% interest-only mortgage. Table 1 shows and explains the annual costs of ownership and adjusts for the tax savings. In this example, the total annual costs of vacation home ownership equal $20,000.

Description of cost                                                                             Amount
Mortgage payment (interest-only mortgage)                                      $8,000
Annual property taxes                                                                         $4,000
Homeowners association dues                                                            $6,000
Utilities, homeowners insurance, repairs                                            $5,000
Less: Tax deduction savings (assumes 25% marginal tax rate)         -3,000
Total annual costs of owning golf bungalow                                      $20,000

Table 1: An example worksheet that calculates annual vacation home costs.

With the total annual costs of vacation home ownership, you can easily calculate the effective "nightly hotel room charge" you're paying for your bungalow. If you can use the bungalow 40 nights a year, you're paying $500 a night for your lodging: $20,000 divided by 40 equals $500.

So is a $500-a-night vacation home a good financial decision? Well, that's up to you. But with the second home's cost expressed as equivalent nightly room rate, you can easily compare its cost to a room or suite at a hotel or resort complex. What you want to do is make sure the equivalent nightly room rate is at least close to or, ideally, less than what you'd otherwise pay for a room.

And a couple of other comments in closing, too.

First, the nightly room rate is very sensitive to the denominator, which is the number of nights you use the property. If you use your $20,000-a-year golf bungalow for only ten nights a year, you're paying $2,000 a night. Ouch. For sure, owning your own place doesn't make sure in this situation.

On the other hand, if you're staying someplace 200 nights a year, well, that's $100 a night and probably $100 a night is a pretty good deal.

Second, if the vacation home property goes down in value that obviously means there's an additional cost of vacation home ownership: the money you lose at resale. However, with the large short sale discounts now available, it seems very likely that you will not lose money. And if you do make money, that profit will in effect drop your effective "nightly room rate."

A $200,000 golf bungalow might really be worth $250,000 in a traditional sale, for example. If you own such a property for ten years and the short sale discount goes away over that time, you might make back $50,000 over ten years. That's $5,000 a year. And that obviously drops your annual ownership costs by $5,000.

I personally would not count the discount as a reduction in the annual cost. But I do think you can use the discount as a "nudging factor" or "tiebreaker."

If everything else about the finances of buying a vacation home work for you and you're at the point of trying to determine whether or not it makes sense to buy a short sale property, you can look at the discount as a mild, extra financial benefit that will probably make the deal a little better than the formula results show.