Norada Real Estate Investments

Real Estate Notes Investing: Should You Buy Notes in 2022?

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Mortgage note investing is one of the most profitable real estate investment strategies accessible, yet it receives little attention. We will explore the many forms of mortgage notes and how to invest in them in this article. Mortgage note investing is the process of owning real estate without managing it or becoming a landlord, in which the homeowner pays the investor rather than the bank. It is a low-cost method of investing in real estate.

Note investing can be an incredible vehicle for building passive income but there are many things that you should be aware of. Mortgage notes are also known as real estate lien notes and borrower’s notes and they have become a popular asset class over the past few years. Investing in mortgage notes has many benefits such as — rates of return that are higher than the bank's traditional low-yield bonds; and higher than most stock dividends.

Notes are available through note exchanges, note brokers, and organizations. Both performing and non-performing notes are almost always sold at a discounted price, although non-performing notes will likely sell for steeper discounts, and real estate investors can realize significant profits. Consider using a mortgage broker or an investment advisor to help you find the best options. If you are experienced enough, you can potentially find and purchase your mortgage notes. 

What is a Mortgage Note?

real estate mortgage note investing

A real estate mortgage note is a promissory note secured by a mortgage loan. It’s a way of saying promissory notes secured by a piece of property. That security instrument can be either a mortgage or a Deed of Trust. It depends on what state you’re doing business in or which security instrument you’re using.

So, you’ve got a note, which is the promise to pay, or a promissory note. Then that is piggybacked with another document which is the security instrument, and that’s either a mortgage or a Deed of Trust depending on what state you’re in. It’s a two-part instrument and they move together.

The promise to pay is called a promissory note, which states how big the loan is, the interest rate, and the terms of the loan. That security instrument which is the mortgage note or the Deed of Trust, that’s the thing that ties that note to the piece of property, and what makes that promise to pay have much strength.

It’s either the borrower pays you as agreed or you get to foreclose on that property, and ideally foreclose on that property for pennies on the dollar. The difference between a mortgage and a Deed of Trust is that a Deed of Trust is what’s called a non-judicial foreclosure action. If someone doesn’t pay you, then you file a notice in the public record that it’s such and such a date.

On the courthouse steps, this property will be auctioned for sale. That’s it. As long as you comply with the timing and the noticing, then that sale goes through. A mortgage is different from a Deed of Trust in that you have to go to court to get the court to foreclose on the property for you. As an example, when you take out a home loan, the lender will probably require you to sign both a promissory note and a mortgage.

Suppose you want to buy a property worth $150,000 but you don't have enough cash. In this case, you can apply for a loan whereby you can pay part of the purchase price as a down payment and borrow the remaining amount from a lender. Normally, you need to pay 20% as a down payment.

Therefore, the loan amount would be $120,000. In exchange for $120,000, the lender would make you sign a promissory note and a mortgage. Here a promissory note is being signed by you as a borrower, and it is a promise to repay the debt incurred by you in the purchase of your property.

The note will state who borrowed money from whom, the loan amount, the interest rate, the tenure of repayment, and what happens in the event of a default. A mortgage is a separate document that collateralizes the lender and is secured by the property. It is a contract that hypothecates a lien on the property, or the mortgage deed may be updated to specifically give the lender foreclosure property if contractual terms aren’t met. It will say who is personally responsible for the debt, whether it is an individual, a couple, or a corporation.

The Contract For Deed vs Mortgage

A contract for deed is an agreement to buy a home from a seller, while the seller keeps ownership of the home. It is not the same as a mortgage loan. The buyer agrees to pay the seller monthly payments, and the deed is turned over to the buyer when all payments have been made. Buyers make their payments directly to the seller for a certain number of years and then a balloon payment (or remaining balance) is due.

One major difference is you do not have the same protection rights, since the seller retains ownership. The seller determines the
interest rate and how much of your payment is used to pay the principal (or balance). Generally, you pay the seller directly for property taxes and insurance. Unlike a traditional mortgage, a defaulting buyer in contact for deed may only have 30-60 days to cure the default or move out.

With a mortgage note secured by the mortgage deed, sellers don’t have to go through foreclosure proceedings to seize the property. A seller can terminate the contract right away without going through all of the legal procedures required for a mortgage holder to foreclose on a home.

If the seller cancels the contract you have 60 days to resolve the reason. If the contract is not reinstated, you are required to leave the home. You also lose any money you have paid the seller.

Different Types of Real Estate Mortgage Notes

There are both commercial and residential mortgage notes, and both are open to investors. They’re both promissory notes secured by a certain property. All mortgage notes should specify the roles and responsibilities of all parties and what qualifies as a breach of the agreement. One of the major differences between real estate mortgage notes is the loan terms.

Fixed-Rate Mortgage Loans

A fixed-rate mortgage or FRM is a loan that has a fixed interest rate and set payments. This is the most common type of mortgage offered by banks, but it can be offered by private individuals. The greatest benefit of this loan is that the borrower has the same payment every month.

The Graduated Payment Mortgage

The graduated payment mortgage or GPM has a fixed interest rate with adjusting payments. It typically has a low initial monthly payment that increases over time. These loans are sometimes used for student loans, but they can be found in real estate, too. This is a type of negative amortization loan. There is a risk that the person who purchased the home will be unable to make the later, higher payments.

An Adjustable Rate Mortgage

An adjustable-rate mortgage or ARM has an interest rate tied to some third-party indices. Banks will tie the interest rate on the adjustable rate to the interest rate offered by the Federal Reserve, and the interest rate on the mortgage will rise and fall with it. This is why they’re sometimes called variable-rate mortgages. For consumers, the ARM may result in lower payments when interest rates are low.

However, it brings the risk that they can’t afford their house payment when interest rates rise. Lenders are protected from losses if interest rates rise. Private lenders have to deal with more complicated loan administration. Buyers have the option of sending in the same monthly payment, but the amount of principle applied to the loan with each payment varies.

A Balloon Payment Mortgage

A balloon payment mortgage is generally a fixed-rate mortgage with a large payment due at the end. This is in contrast with traditional mortgages where the final payment pays off the debt entirely. Balloon payments may be accepted by a borrower who can’t manage the monthly payments without them.

They may hope to qualify for a conventional home loan at the end of the private mortgage to get the money to pay off the balloon payment. The occupant runs the risk of losing the home if they can’t make the balloon payment. This is separate from the mortgage acceleration clause that makes the entire amount due after a payment is missed.

The Interest-Only Loan

An interest-only loan is a mortgage where the person only pays interest on the loan. Some people take out an interest-only loan because they can’t afford to pay on the principle. This borrower demographic is very high risk. Yet interest-only loans are attractive because of the low monthly payments. This is a popular loan for property developers. You get the money to buy the property. You expect to sell it for a profit and pay off the mortgage note.

Interest-only loans were commonly used in hot real estate markets before the Great Recession, but they’ve almost disappeared from the residential real estate market because people aren’t making progress on the loan balance. This left many people underwater, owning more than their home was worth.

In these cases, people are expected to be able to refinance the interest rate mortgage into a fixed-rate mortgage once the home’s value has appreciated. The interest-only mortgage had the benefit of allowing them to get into a home now before prices went up further. These loans often became negative amortization loans, because financially stressed people missed payments and saw the total loan balance increase.

Minimum payments that didn’t even cover the full interest payment led to an accrued interest to compound, as well. We consider interest-only loans to be a high risk unless you’re dealing with a real estate developer. Interest-only hard money loans would fall into this category. You can issue an interest-only loan with a recast period, where you force them to refinance the loan or pay off your loan with a third-party mortgage after a set period of time.

Real Estate Mortgage Note Investing

Mortgage notes can be a good real estate investment for people seeking passive income. When you buy a mortgage note, you receive monthly payments that include both interest and principle. It is a steady stream of income like you’d receive from a rental property, but there is no need to maintain the property like a landlord.

It is far easier to invest in real estate located around the country because you don’t have to deal with local rules regarding real estate licensing or taxes. The mortgage note spells out the loan duration. You know how long you’ll receive loan payments, and it may be 10 to 30 years. You may be able to increase the value of the mortgage note by buying from a distressed note holder. For example, you may find a farm or family property sold via owner financing.

The person sold their home, but now they have to manage the loan. They may require the money, whether it is to allow them to buy a new home or simply get cash to fund their retirement. In these cases, you might offer 80,000 dollars to buy a 100,000-dollar note. If they accept, you receive the interest and principal on a 100,000-dollar loan but only paid 20,000 dollars for it.

Another class of desperate sellers is the private lender with a slow or non-paying borrower. They’re not getting the income they expected. They may be reluctant to foreclose on a slow-paying family member. Or they may not want the property back.

You can buy these notes for far less than their face value. However, you’re going to either need to ramp up collection efforts or foreclose on the property. Only buy notes like this if you have a plan for how to monetize the property, whether you rent it out, sell it to someone else or redevelop the property.

Advantages of Buying a Real Estate Mortgage Note

  • High Yield Returns – Rates of return that are higher than the bank's traditional low yield bonds; and higher than most stock dividends.
  • Monthly Income – If you are looking for additional monthly income for retirement, for living expenses, or to build your savings account, we can help.
  • IRA Friendly – This investment provides investors with a way to put to use their self-directed traditional IRA or Roth IRA.  We can recommend several custodian companies that handle the paperwork and hold your IRA while the funds are invested with us.
  • Rollover Option – Option to automatically roll over your investment so you don’t miss out on earning interest or future investment opportunities.

How To Buy To Real Estate Mortgage Notes?

It is hard to find the farmer who sold their property to an up-and-coming farmer or family member who wants to sell the note so they have the money they need to pay for long-term care. This is why many investors go through brokers to find mortgage notes for sale. These brokers specialize in locating both private and public deals.

There are even online marketplaces like NotesDirect to help you find, vet, and buy notes. You can try to find deals through real estate investor groups. In this case, you’re buying notes from people who trade future income for liquid funds. Mortgage notes are often associated with owner financing.

You might find mortgage notes for sale by going through for-sale-by-owner groups and making offers to former property owners who are desperate for cash. Furthermore, mortgage notes may be sold by real estate investor groups or real estate investment trusts.

In the latter case, you could even buy a mortgage for a multi-family apartment building. If you are buying a nonperforming mortgage, investing in real estate notes is one of the cheapest ways to acquire such properties.

how to invest in mortgage notes

Buying a Non-Performing Note vs Performing Mortgage Note

A non-performing note is a note where the borrower is not paying as agreed. The borrower who is behind on their loan payments or regularly made late payments is the reason why you have non-performing notes. Performing notes are those where the payments are made on time and in full. Performing notes sell for 75 to 100 percent of their current value. Sub-performing notes can be found for 50 to 80 percent of their current value.

That lower price tag is what attracts some investors. They’re also priced to factor in the risk of someone who hasn’t paid their mortgage in the past 15 to 60 days or has had missed payments in the past.

Non-performing notes are notes that are already in default. They are attractive to investors because you might buy the property for 10 to 30 percent of its actual value. It can be a cheap way to buy a real estate investment property. It does come with the hassle of renegotiating the deal (rarely done) or foreclosing on the property.

If you’re considering buying a mortgage note for a multifamily property, you cannot consider the property without doing detailed research. It doesn’t matter if they have almost every unit full if only half the tenants are paying their rent. What is the property’s condition? You don’t want to buy a multi-family property that is falling apart.

The Risks of Investing in Mortgage Notes

These notes are not FDIC insured. Instead, it is secured by a property whose condition may not be great. And you’re not responsible for its upkeep. Yet you want to verify the condition of the property before you buy it, or else you’re paying less than the property is worth. You run the risk of having to pay money to get what you’re owed.

You will have to pay various legal fees to foreclose on the property. You may have to sue to get back mortgage payments, too. Know the foreclosure laws for the area where the property is located, especially if you’re considering buying a non-performing loan. Non-performing assets also depreciate because while your expenses continue the property is most likely not be well kept. Even if there is some appreciation in the property value, it is usually offset by the expenses you are spending. They have a high risk of default which is bad for your cash flow.

The mortgage note investing industry is not very regulated as of now. Before entering the mortgage note investing space know the fact that this is a risky business. You can buy a mortgage note without the permission of the person who lives in the property. When you buy a note and mortgage from the lender, you're buying the debt that remains to be paid on the note, secured by the asset outlined in the mortgage.

You're not buying the property. Sometimes, you do run the risk of property owners initially refusing to pay you because they don’t think they owe you the money. The solution to this is good communication, including the initial note holder informing them that the loan is being transferred.

Do your research. Don’t buy a multi-family property note before you know the percentage of the units that are occupied by rent-paying tenants. Know if you have a say in the property manager in charge of the property because putting a good one in could increase occupancy rates, payment rates, or even the average monthly rent.

Know how to get a copy of the original note along with all amendments and assignments. You don’t want to buy a mortgage note and get sued by someone else who had the title. You may want to pay a title search company to do such a search before you buy the note, though this is an expense you have to pay out of pocket even if you don’t buy it. Know your lien position, so that the house isn’t sold to pay a different creditor while you get less than you’re owed.

Summary

Real estate mortgage notes may allow you to get a regular stream of income without the hassles of a landlord, or you can buy the note and sell it later to another investor. Or it can be a way to secure properties for less than their market value. But real estate mortgage notes are a good way to invest in real estate with relatively little work beyond the initial search and purchase.

Also Read: Mortgage Interest Rates Forecast 2022 & 2023

References

  • https://en.wikipedia.org/wiki/Mortgage_note
  • http://www.differencebetween.net/business/finance-business-2/difference-between-mortgage-and-note
  • https://www.fool.com/millionacres/real-estate-investing/articles/complete-guide-investing-real-estate-mortgage-notes/#
  • https://www.realtor.com/advice/finance/what-is-a-mortgage-note/
  • https://www.multihousingnews.com/post/6-things-to-consider-before-purchasing-non-performing-notes
    https://money.usnews.com/investing/real-estate-investments/articles/why-buying-mortgage-notes-are-good-real-estate-investments
  • https://www.multihousingnews.com/post/6-things-to-consider-before-purchasing-non-performing-notes
    https://www.biggerpockets.com/blog/2011-02-09-differences-performing-and-non-performing-notes
  • https://noteinvestor.com/how-to-buy-mortgage-notes

1031 Exchange Rules 2022: How To Do A 1031 Exchange?

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All About 1031 Exchange Rules in 2022

Taxes rarely make for exciting reading material, but if you own an investment property, there’s at least one set of IRS regulations you absolutely will want to understand: 1031 Exchange Rules. Real estate investors like you have the option of using a 1031 Exchange. Most investors find it to be a useful instrument for reducing capital gains and other taxes on their earnings. Why? Because normally when you sell an investment property for more than what you paid for it, you’d have to pay a hefty capital gains tax. But with a 1031 Exchange, you get to defer paying those taxes if you reinvest the proceeds in a new property, making an “exchange” rather than a sale.

The 1031 Exchange allows you (as an investor) to postpone paying capital gains taxes on the sale of investment property. Taxes on capital gains might be as high as 20-30% in a typical sale. Those taxes, however, can be avoided if the proceeds of the sale are reinvested according to the rules outlined in IRC 1031. You can leverage funds otherwise needed to pay capital gains taxes to acquire more desirable property. As the name implies, a 1031 Exchange is a swap of one investment property for a like-kind property instead of a traditional sale.

This article answers the following questions:

  • What is a 1031 Exchange?
  • What Are The Types of 1031 Exchanges?
  • What Are the Rules for a 1031 Exchange?
  • What Are the Deadlines in a 1031 Exchange?
  • When To Do a 1031 Exchange & Its Benefits?
  • Examples To Understand a 1031 Exchange Process

What is an IRS 1031 Exchange?

Property owners may exchange real estate held for investment for another property of like-kind and so long as the properties are held for investment, all real estate is deemed to be like-kind. If the transaction qualifies, any realized capital gains are deferred until the replacement property is sold at a later date. Many investors would like to do a 1031 exchange. Some of them who do fix and flip call us for a 1031 exchange to roll the gain over into the next property. But can they?

Although confusing, understanding IRS Code Section 1031 is worth it. It’s just that this transaction is subject to some strict regulations, so you’ll need to follow the 1031 exchange rules to the letter. For example, an exchange can only be made with like-kind properties, and IRS rules limit use with vacation properties. Another common misconception is that property sold in a particular state must be replaced by a property in the same state.

But that's not true as the “like-kind” requirement is very general and allows for the property owner to acquire property outside of his state should they wish to do so. However, some complications can arise where multiple states are involved. For example, California has a “clawback” requirement for California investment property sold in a 1031 exchange and subsequently replaced with a non-California investment property per California FTB Publication 1100 Irev 2007, section F.

Any capital gains accrued on California real estate will be subject to California tax upon the ultimate sale of the real property even if the investor had sold his or her California real estate and subsequently 1031 Exchanged into investment property located outside of California. Therefore, if the replacement property is out-of-state, California aggressively tracks when the replacement is ultimately sold.

When the replacement property is sold, California treats the gain as California source income to the extent of the original deferred gain. That is so even if you no longer live in California and if you are selling the non-California property twenty years later. Several other states follow this rule, but California may be the most aggressive in enforcing it. So what's the drawback?

The “clawback” provision can affect you negatively when you try to exchange out of California's stringent tax system into a friendlier state tax system such as Nevada or Texas as both of these have no state income tax.  Here’s all the more you need to understand and execute a 1031 Exchange process successfully in 2021.

A 1031 Exchange is an incredibly useful tool for many real estate investors. It is an exchange of two (or more) pieces of real estate under Section 1031 of the tax code. A simple definition of 1031 exchange properties is the property being sold and the property being purchased under Section 1031 of the tax code. In the simplest case, you're swapping one property for another.

Internal Revenue Code Section 1031 allows individuals and entities to “exchange” investment property or other property that is held for productive use in a business or trade but not primarily for sale. The IRS Code Section 1.1031 states that no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment.

The important words are are property and held. “Property” refers to real property while “held” means the time when the property is used in productive use of a business or investment. The shorter the time held, the greater the facts need to be to substantiate that the property is used for the proper intent rather than for a flip or for profit. Properties that do not come under 1031 consideration include primary residence, inventory, partnership interests, indebtedness, stocks, securities, and notes.

1031 exchnage can come with high legal fees and strict limits. However, this is often worth it, given the great benefits of a 1031 exchange. This explains why the 1031 exchange is used by businesses to “move up” in buildings, selling their existing ones to buy a larger facility with minimal taxes. Although, a 1031 exchange process is complex it is one of the best tax advantages real estate investors have at their disposal.

There are several initial steps to a successful 1031 exchange process. For example, you'll want to find a qualified intermediary before you sell the property. Then there is the process of listing the property you want to sell. The first step in the 1031 exchange is selling the first property. It is advisable to have potential replacement properties identified at this point.

However, you don't have to close on these properties immediately. If the 1031 exchange properties cannot be closed simultaneously, the money must be held by a qualified intermediary. This means the taxpayer doesn't receive the money from the sale of the first property.

The second step in a 1031 exchange is formally identifying your replacement property. This must be done within 45 days of the sale date of the first property. Ideally, you'd have begun the purchase process.

The third step of the 1031 exchange process is to complete the purchase of the replacement process including payment and retitling of the property. The facilitator will hold the cash from the sale of the first property and send it to the seller of the replacement property. Then the 1031 exchange is treated as a swap by the IRS and considered done once you fill out the IRS form.

In general, you have 180 days from start to finish. However, you may have to do so even faster. For example, you generally have to complete the process before you file your tax return claiming the 1031 exchange. This means you'll want to complete the 1031 exchange started last tax year before you file your tax return the following April.

If you actually acquire the replacement property before the first one sells, this is called a reverse exchange. The property must be held by an exchange accommodation titleholder. This could be a qualified intermediary. You'll get the title transferred to you when the first property sells.

What happens if there is money left-over after the new property has been purchased? Maybe the new property costs less than you expected after all costs are taken into account. Or you didn't use all of the money toward the purchase of a new property. A tax penalty will be owed, but it is typically only for the amount that wasn't rolled over into the new property.

What Are The Four Types of 1031 Exchanges?

Types of 1031 Exchanges

Simultaneous 1031 Exchange

The simultaneous exchange is defined by having the 1031 exchange happen on the same day. It was also the original form of the 1031 exchange until updates to tax law made the others possible. There are several ways the simultaneous exchange may happen. You might have a two-party trade.

In this case, two parties literally exchange or swap deeds. In a three-party exchange, an accommodating party facilitates the exchange by transferring ownership between the parties so they close on the same day. Another option is using a qualified intermediary who handles the entire exchange.

Delayed 1031 Exchange

The delayed exchange is one where you sell a property one day, receive the money, and buy the property after a delay. It could be anywhere from one day to several months before acquiring the replacement property. If you don't buy replacement property within the time limits set by the IRS, you will have to pay capital gains on the proceeds from the original property sale. The money from the initial sale must be held by a third party “exchange intermediary”.

This third party may also be called a Single Purpose Entity. The 180-day time limit starts the day you execute the sale and purchase agreement for the first property. However, you have 45 days to identify a new piece of real estate and you have 180 days to complete the transaction. Fortunately, this gives you several months to negotiate the purchase price, arrange for the seller to make repairs, and perform a proper title search.

Improvement 1031 Exchange

An improvement exchange or construction exchange is one that lets you improve on the replacement property using tax-deferred dollars, though the money is held by a qualified intermediary. There are several requirements you must meet if you want to defer all of the gains from the sale of the relinquished property.

First, all of the exchange equity must be used as either a down payment on the new property or spent on completed improvements. You'll run into problems if the work isn't completed within 180 days. And remember that this 180-day time frame includes the time spent shopping for replacement property and planning the renovations. The SPE theoretically is the one making the renovations or at least paying for them.

Second, the construction or improvement exchange requires having “substantially the same property” that you identified by day 45 of the 1031 exchange timeline. The replacement property must end up with the same or greater value when it is deed back to the taxpayer. This approach allows you to buy a fixer-upper and make renovations within the 1031 exchange rules, but it requires careful project planning.

In theory, it allows you to buy land and build something, but that is not recommended due to the heavy tax bill you'll face if you're wrong. However, the like-kind rules are so liberal you could sell a rental house and buy a strip mall or sell raw land in an urban area and buy a ranch. However, if you sell property inside the United States, the replacement property must be within the U.S. as well.

Note that properties must be considered like-kind for the 1031 exchange to be approved. As a property investor, this means you can use a 1031 exchange to upgrade from a single-family home rental property to a triplex. And you can upgrade from the triplex to a 20 unit apartment building. There is no limit to how many times you do a 1031 exchange. Nor is there a limit to how frequently you do 1031 exchanges, only the time frame for the 1031 exchanges themselves.

You could avoid paying capital gains taxes as you continually roll over gains from one piece of property to another until you eventually sell for cash. What happens if you sell improved land (with buildings) for unimproved land? The depreciation for the buildings on unimproved land may be recaptured as ordinary income and taxed as such, though you may avoid general capital gains. This is why you must have a professional guide you through this process.

Reverse 1031 Exchange

A reverse exchange can be described as buying first, exchanging later. In this case, you're buying the “replacement” or upgraded property first. Then you arrange for the sale of the second property. In the interim, the “relinquished” property is held by a Single Purpose Entity or SPE. Reverse exchanges are not very common, because they have to be all-cash deals. After all, you don't have the equity from the first property available to pay for part or all of the second property.

Banks won't lend you money for a reverse 1031 exchange. In contrast, they'll be thrilled to loan you money to buy a stepped-up piece of property because of how much equity you'll have in it. In a standard 1031 exchange, you run into problems if you have money but not the second property. With a reverse exchange, you'll run into problems if you don't relinquish the original property within 180 days.

However, the same time frames apply to a reverse exchange as the conventional 1031 exchange. You have 45 days to identify the “relinquished” property you're going to sell and report it to the IRS. You have 180 total days to complete the sale and complete the reverse exchange with the replacement property.

1031 Exchange Rules

1031 Exchange Rules

As an investor, you can benefit from deferring the tax liability associated with the sale of real estate through a 1031 exchange. However, there are strict regulations and guidelines to be aware of that dictate what constitutes a valid exchange. Several rules need to be followed while doing a 1031 exchange. Rules related to tax implications and time frames may be problematic. If you're considering a 1031 exchange, here is what you should know about all the rules.

If you decide to do a 1031 exchange, once the money from the sale of your first property comes through, it will be held in escrow—an independent account monitored by a third party. You won’t be able to access the money until you close on a new property. Note that you're not allowed to use the money from the 1031 property exchange for anything else.

You can't sell two commercial 1031 Exchange properties, do two quick fixes and flips and then roll the proceeds into a new apartment building. The money from the first transaction will be held by a qualified intermediary who acquires the replacement property for the taxpayer. And this is fine, provided you follow a few more rules.

Here are the important 1031 Exchange rules and regulations to be mindful of:

1. Like-kind Properties Rule

1031 exchanges must be done with like-kind properties. The rules for like-kind properties have evolved over the rules. In 1984, Section 1031 of the tax code was changed so that the definition of like-kind was dramatically expanded. You now had the option to sell a rental house and buy a small apartment building. Before the rule change, you didn't just have to trade a house for a house but a three-story apartment building for a three-story apartment building.

The properties don't have to be in the same sector. For example, you could sell an apartment building and invest the proceeds in an industrial building. International and domestic properties are not “like-kind” 1031 exchange properties, either. Yet you can use almost any property in the United States for a 1031 exchange.  However, it is very important that if you cannot find the right property to reinvest the proceeds, don’t do a 1031 exchange. You should avoid buying the wrong property at the wrong time in the housing cycle.

2. Three-Property Rule

You can identify up to three potential properties to buy as long as you close on at least one of them. The federal government limits the rollover process to up to three properties. Most investors limit themselves to up to three properties to avoid being subject to more complex tests or simply minimizing the necessary paperwork.

3. 200% Rule

You can identify any number of replacement properties you want to purchase so long as their eventual combined fair market value isn’t more than 200% of your relinquished property. So let’s say you sell a property for $500,000. The combined market value of your purchase should be no more than twice that, or $1 million.

4. 95% Rule

You can ignore the 200% rule and identify any number of potential replacement properties for any amount as long as you buy 95% of the aggregate value of those properties. So if you sold a property for $500,000, you could identify five properties worth a total of $2,500,000. But you’d then have to actually buy at least $2,375,000 (that’s 95%) worth of those properties.

5. 45-Day Time Limit to Find a 1031 Exchange Property

The 1031 exchange used to have to be done nearly simultaneously. This caused a variety of problems because it can be hard to transfer titles and funds in a short period of time. However, the current 1031 exchange process still has a time limit. There is a strict 45-day time limit.

You must either close on or identify and report on the potential replacement property within 45 days of selling the original property. This time period includes weekends and holidays. If you pass that time limit, the entire exchange is disqualified. The IRS won't interfere in the purchase of the new property. However, you'll owe taxes on the sale of the old one.

6. 180 Days For the Transfer to Complete

After the sale, the clock starts ticking for you to find that new property: You have 45 days to identify a new property (or properties) you want to buy. Once the replacement property is selected, the investor has 180 days from the date the original property was sold to close on the replacement property. Since closing on a property can take time and is often unpredictable, many investors choose more than one property to buy with the hopes that at least one of them will come through.

7. Personal Residences Don't Count as 1031 Exchange Properties

You can't sell your personal residence and use part of the money to buy a rental. A general rule of thumb is that you can't use a 1031 exchange if you lived in it for at least two of the past five years. Vacation homes and second homes typically don't count, either. Paragraph 280 of section 1031 outlines the usage test that can be used to determine if a vacation home you rent out periodically can be included among 1031 Exchange properties.

8. Fix and Flip Properties Don't Count as 1031 Exchange Properties

To qualify for a 1031 exchange, both the new and old properties have to be held as an investment or used in a trade or business. Held for investment means holding the property for future appreciation. Used in a trade or business means income-producing, such as used in a business or used as a rental property. A fix and flip kind of property is regarded as property held for sale. You may be able to count it as a 1031 exchange if you end up renting it out for a few months before selling it to an investor.

9. Land that you're developing is not qualified for tax-deferred treatment under section 1031 of the tax code, though raw land might

A 1031 exchange can include build-to-suit exchanges, but the construction and property improvements must be completed by the 180-day time limit. In general, your interest in a partnership doesn't count under section 1031. If you receive non-like-kind property like liabilities or cash equivalents, this could result in a tax bill. After 2018, the 1031 exchange could only include real property. Yet the exchange can include money such as proceeds after a mortgage is paid off.

How To Do A 1031 Exchange?

How to Do a 1031 Exchange

Step 1: Decide to Do a 1031 Exchange

Remember that not every real estate deal is suitable for a 1031 exchange. The IRS put strict limits on the use of the 1031 exchange on vacation properties. A 1031 exchange cannot involve your personal property or primary residence. This means you can't use the 1031 exchange to eliminate the capital gains you may owe if you sell your family home for a significant profit. In theory, you can turn it into a rental and then exchange it, but the rules require you to meet very specific conditions, and we don't recommend it. In practice, the 1031 exchange only applies to investment properties like apartment buildings or commercial real estate.

Step 2: List the Property

List the property for sale. You may want to include language in the listing paperwork that says you want to do a 1031 exchange. This informs them of the fact that you have deadlines to meet. And it saves you from dealing with people who stretch out the purchase process because they're evaluating multiple properties.

Step 3: Start Looking for the Replacement Property

You could have identified several potential replacement properties after you decided to perform a 1031 exchange. However, you must formally identify one by day 45 after the relinquished property is sold. That's why we recommend looking for the replacement property while the current one is up for sale. The typical replacement property costs somewhat more than the one you're selling, because you may owe capital gains taxes if you end up keeping some of the proceeds of the property sale.

Step 4: Choose a Qualified Intermediary

You need a qualified intermediary in place to receive the money from the sale of property 1 before you can buy property 2 under the 1031 exchange. Only work with a professional experienced with 1031 exchanges. IRS laws explicitly state that you are not allowed to use your own attorney, employee, accountant, real estate agent, or a relative as the qualified intermediary. What is the qualified intermediary's role? If they receive the profits from the sale and roll it over into a new property, you never received the money. And you probably can't be charged income tax or capital gains taxes on it.

Step 5: Complete the Sale

The purchase agreement the buyer signs must clearly state that a 1031 exchange is taking place. This information will affect everything from assignments to disclosures. Like standard real estate deals, you'll have a title company and/or lawyer involved in the closing. Unlike other real estate transactions, the money from the sale will be transferred into the qualified intermediary's bank account, not yours.

Step 6: Identify Replacement Properties

You can identify up to three replacement properties within 45 days. The IRS gets notified via IRS Form 8824. You can in theory close on more properties if you close on at least 95 percent of them or the identified properties have a combined value of less than 200 percent of the sold property. In this regard, you could sell a 500,000 dollar house and buy four 250,000 dollar houses.

You've bought smaller properties, but you still get to take advantage of the 1031 exchange because it has a higher total dollar value than what you sold. Most 1031 exchanges involve buying a property that is a step up. By identifying several replacement properties such as apartment buildings, you ensure that you remain within the rules if your first choice falls through.

Step 7: Begin the Purchase Process

Sign a contract for your identified properties. We'd recommend having contingency clauses that let you back out on the other properties if the first deal goes through. Negotiate the purchase of the property, while your qualified intermediary works with the title company. An experienced intermediary is familiar with it.

Step 8: Close on the Replacement Property

When you close on the replacement property, the intermediary sends your money to the seller's attorney or their title company. The closing process will then proceed like any other. Yet you've avoided the associated capital gains taxes.

When To Do a 1031 Exchange & Its Benefits?

The primary reason to execute a 1031 exchange is to reinvest capital into investments that are greater in scale, more diverse, or more aligned with your current investment strategy. And because taxes are deferred, more of the sale proceeds can be immediately directed toward your new investment. A 1031 tax-deferred exchange allows you to roll over money from a recently sold investment property into another property.

You're able to defer capital gains taxes on the property's sale. This tax rate will range from 15 to 30 percent. Suppose you own a rental house. Sell that property and use the money to buy two more rental houses. You've avoided a capital gains tax bill on the profit for that property, and you've used it to buy two more.

Section 1031 Exchanges offer a great opportunity to diversify assets, whether by diversifying into another geographic region or simply from one property type to another. You can continue growing your portfolio over the years. You could continue to buy rental houses, or you could sell the properties and buy an apartment building. The 1031 exchange rules will let you roll the capital gains for 10 houses into a large multi-family project. You could in theory continue this until your death, potentially avoiding capital gains taxes until your estate has to deal with it.

Another benefit of a 1031 exchange is that it resets the depreciation clock. You'll be able to buy a new property and take advantage of depreciation to offset your income. This can really add up if you're selling a property that you've held for more than two decades. If you sell an investment property for more than its depreciated value, you will probably have to recapture the depreciation.

This normally results in the amount of depreciation included in your taxable income. A 1031 exchange avoids taxes on this amount that may exceed the official capital gains.

When do people want to do a 1031 property exchange?

The most common situation is when you want to avoid paying capital gains on the sale of a property. It may be done when you're consolidating your real estate portfolio, selling multiple properties to invest in a single larger building. Or it may be done when you're liquidating one property and investing in several more.

Also, if you have invested in properties that are low-income and high-maintenance, you could exchange the high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes. Or perhaps you want to move your investments from one location to another without the IRS knocking at your door.

Is 1031 Exchange Possible When There Are Losses Involved?

The goal of 1031 property exchanges is to avoid paying capital gains taxes on the sale of the property. In most cases, the 1031 exchange properties have a greater value than the one that was just sold. This may involve a more expensive home or a larger, multi-family unit. However, a 1031 exchange is possible when there are losses involved. Section 1031(b) specifically addresses cases where the transaction results in a loss.

The financial loss is not recognized at the time of the transaction. Instead, it is carried forward as part of a higher basis on the property you've received. Note that you can sell a property that you're losing money on and roll the money into a new property as part of a 1031 exchange. The full benefit requires the replacement property to be of equal or greater value than the one you're selling.

And if you're selling a flooded house or property where the tenant isn't paying the rent, almost anything you buy is a step up. If you are trading down in the property, you may get a “boot” in the form of debt reduction. Other forms of “boot” include prorated rent, utility escrow charges, service costs other than closing costs, and deposits transferred to the property buyer.

That money can be offset with cash used to purchase the replacement property. The boot used to include non-like-kind property including livestock, industrial equipment, and vehicles. This means you can't count the value of animals on a farm or equipment in a factory towards either losses or gains in a 1031 exchange.

Consult with a tax professional to understand your options for avoiding a capital gains tax bill if you receive money like this. The Tax Cuts and Jobs Act of 2017 mitigated losses of 1031 exchanges by giving taxpayers the ability to immediately deduct certain expenditures. This might be classified as either a “bonus deprecation” or a business expense.

Here is An Example To Understand This Type of 1031 Exchange

Before you make any decisions, you must know the “adjusted basis” of your property. As the term implies, over time you adjust the basis in a property. If the “adjusted basis” is less than what the property is sold for, then we have a “total gain”. If the adjusted “tax basis” is more than what we sell the property for we have a true loss in the eyes of the IRS.

The adjusted basis is calculated by taking the original cost, adding the cost for improvements and related expenses, and subtracting any deductions taken for depreciation and depletion. Suppose you buy a $150,000 home. When determining the basis, start with this $150,000 and add any associated fees such as real estate taxes the seller owed that you paid as part of the transaction.

This figure is your basis. To get your adjusted basis, add or subtract any associated costs or credits. For example, if you invested $50,000 in home renovations, add this $50,000 to the basis to get an adjusted basis of $200,000. If you had storm damage to your home and had to pay $5,000 for roof repairs, add this amount to get an adjusted basis of $205,000.

If you do a 1031 exchange, all the total gain, including the tax on recaptured depreciation, will be deferred. If you exchange property with a true loss, then the loss amount is added to the basis of the replacement property. A simple example would be if you had a vacation area lot that cost us $200,000 that we sold for $100,000 and exchanged for a $100,000 lot close to your home.

You would have a $100,000 loss in the eyes of the IRS and would add your loss to the new basis of your replacement property. Because of the exchange, the new lot would have a starting basis of
$200,000, even though you only paid $100,000 for the lot.

While these rules are complicated, they must be followed—there are no exceptions or extensions. If you mess up, the IRS could decide you don’t qualify for a 1031 exchange and send you a huge tax bill. So make sure you know how it works. If you’re in doubt, consult an accountant or real estate agent for more details. For more information on 1031 exchanges, go to IRS.gov.

More Examples To Understand a 1031 Exchange Process

There are several initial steps to a successful 1031 exchange process. For example, you'll want to find a qualified intermediary before you sell the property. Then there is the process of listing the property you want to sell. The first step in the 1031 exchange is selling the first property. It is advisable to have potential replacement properties identified at this point.

However, you don't have to close on these properties immediately. If the 1031 exchange properties cannot be closed simultaneously, the money must be held by a qualified intermediary. This means the taxpayer doesn't receive the money from the sale of the first property.

The second step in a 1031 exchange is formally identifying your replacement property. This must be done within 45 days of the sale date of the first property. Ideally, you'd have begun the purchase process.

The third step of the 1031 exchange process is to complete the purchase of the replacement process including payment and retitling of the property. The facilitator will hold the cash from the sale of the first property and send it to the seller of the replacement property. Then the 1031 exchange is treated as a swap by the IRS and considered done once you fill out the IRS form.

In general, you have 180 days from start to finish. However, you may have to do so even faster. For example, you generally have to complete the process before you file your tax return claiming the 1031 exchange. This means you'll want to complete the 1031 exchange started last tax year before you file your tax return the following April.

If you acquire the replacement property before the first one sells, this is called a reverse exchange. The property must be held by an exchange accommodation titleholder. This could be a qualified intermediary. You'll get the title transferred to you when the first property sells. What happens if there is money left over after the new property has been purchased?

Maybe the new property costs less than you expected after all costs are taken into account. Or you didn't use all of the money toward the purchase of a new property. A tax penalty will be owed, but it is typically only for the amount that wasn't rolled over into the new property.

Let's look at a few examples to understand what this means in practical terms. In the classic swap, you sell a rental property you bought for 150,000 dollars for 200,000 dollars and roll over the money into a 300,000-dollar duplex. While you'll owe closing costs, legal fees, and a few other expenses out of pocket, you avoid paying capital gains taxes on the 50,000 profit. That would result in a 5,000 to 10,000 capital gains tax bill depending on where you live.

What happens if you have a property you're going to take losses on? You bought a beach house at the peak of the market a decade ago for half a million dollars. You've maintained it but haven't taken steps to increase its value. The area is in decline, so the property is only worth 400,000 dollars. Then you finally get a good offer. Someone is offering you 450,000 dollars for the property.

From your perspective, this is a loss. From the government's perspective, you'll owe taxes on the 50,000 gain including the recaptured depreciation. If you do a 1031 exchange when selling this property, the theoretical gain and recaptured depreciation are deferred.

Who Qualifies For a 1031 exchange?

Here are the basic requirements according to Los Angeles accountant Harlan Levinson:

The homes must be investment properties.  This transaction is not for regular homeowners who live in the home they’re selling (or buying). Both homes in question must be investments, whether you plan to (or did) rent it out to tenants or flip it after renovations.

The home you buy must be worth more than the one you sell.  People benefit from a 1031 exchange only when the property they buy is of equal or greater value than the one they’re selling—in other words, they’re trading up. For instance, maybe you bought a quaint summer cottage rental, but you want to cash that in for a larger mansion on the beach, or a duplex where you can rake in rental money from two families rather than one. If you intend to pay less for a new property, you’ll pay taxes on the difference.

Conclusion

A 1031 exchange allows real estate investors to grow their wealth more quickly because they avoid a hefty tax bill every time they reinvest the proceeds of a property sale. That is why it is a powerful tool for those who want to grow their portfolio. The savings of the 1031 exchange are so substantial that it is used by businesses and real estate investors alike to save money. The biggest reasons why people don't take advantage of them are because they either want to reduce their exposure to real estate or can't find a good replacement property in time.

So, next time you decide to do a 1031 exchange, you must keep in mind all these things to complete the process successfully:

  • Purchase another property of equal or greater value.
  • It has to be a like-kind property.
  • Everything has to be completed during the specified exchange period by a 1031 exchange.

Before you begin this process, you should thoroughly comprehend the process and its guidelines. We also advocate working with a 1031 Exchange specialist broker or property manager. Many investors are big fans of the 1031 exchange. It's a straightforward and effective investment tool to save serious money. But, it's not perfect. It also comes at a price. You need to be prepared to deal with the potential downside of a transaction like this.

References

What is a 1031 Exchange?
https://en.wikipedia.org/wiki/Internal_Revenue_Code_section_1031
https://fundrise.com/education/blog-posts/opportunity-fund-1031-exchange-tax-advantages-for-real-estate-investors
https://www.govinfo.gov/content/pkg/CFR-2011-title26-vol11/pdf/CFR-2011-title26-vol11-part1-subjectgroup-id46.pdf

When to do a 1031 Exchange & what are the benefits?
https://www.thebalance.com/how-to-do-1031-exchanges-1798717
https://www.cwscapital.com/what-is-a-1031-exchange/

The Rules for a 1031 Exchange
https://www.1031.us/PDF/1031ExchangeIfSellAtALoss.pdf
https://www.law.com/newyorklawjournal/2020/06/23/proposed-regulations-for-section-1031-exchanges/
https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips

How to Do a 1031 Exchange?
https://www.fool.com/millionacres/taxes/1031-exchanges/
https://www.biggerpockets.com/blog/step-by-step-1031-exchange
https://www.buildium.com/blog/what-is-a-1031-exchange/
https://www.thestreet.com/personal-finance/real-estate/what-is-a-1031-exchange-14881004

Cap Rate Calculation: How To Use Cap Rate In Real Estate?

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Capitalization Rate or Cap Rate is a term often thrown around in real estate discussions. Yet many people don't really understand what it means. After all, it can be confused with cash-on-cash returns and the rate of return. You will understand what a cap rate is in real estate in this post, from its definition to methods of calculation. When to utilize capitalization rate, how to calculate cap rates, what is a decent cap rate on investment properties, and why determining cap rates is crucial for real estate investors are among the topics covered.

What Is The Capitalization Rate?

The ability of a property to repay its initial investment and generate income beyond that is measured by its capitalization rate. It is one of the most fundamental concepts in real estate investing and is mostly referred to in calculations as Cap Rate. Cap Rate is defined as the rate of return on a rental investment property based on its income, according to Investopedia. This determines the investment's potential return.

When you invest in income-producing property, you are looking for cash flow. You also expect to realize a capital gain, selling the property at some time in the future for a profit. When analyzing investment opportunities, real estate investors evaluate a multitude of different factors. But a typical investor will be interested in the income that the property can generate now and into the future. That investor is likely to use capitalization of income as one method of estimating value. The capitalization rate is similar to the rate of return on investment.

It allows you to compare the relative value of real estate investments independent of their dollar value. The standard cap rate formula is net operating income divided by the market value. Cap rate is one of the most important calculations done by real estate investors. The cap rate is ideal for evaluating comparable properties in the same market area. A cap rate calculator is a useful tool as it allows you to quickly get an estimate of how much money the property is expected to make, and how this compares to similar properties in the area.

The two components of a Capitalization Rate are the Net Operating Income (NOI) and the purchase price of the investment property. NOI equals all revenue from the property, minus all reasonably necessary operating expenses. NOI is a before-tax figure, appearing on a property's income and cash flow statement, that excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization.

In other words, the cap rate measures a property's yield on an annual basis, making it easier for investors to compare the risk and return profiles of different assets. It is an estimation of an investor's potential return on a real estate investment. Several factors can affect the cap rate of a property, such as market demand or interest rates, but one of the most critical factors is its occupancy. A property's occupancy directly affects the amount of NOI it can generate.

A vacancy rate is the opposite of the occupancy rate. It refers to the percentage of units that are vacant or unoccupied in a given property. Vacancy rates play a big part in business and can help investors determine whether they're making a good move by putting their money into certain real estate deals. A fully occupied property will generate a higher NOI and a higher cap rate at a given price than one that is only half occupied.

Cap Rate Calculation

Cap Rate Calculation Example

The Capitalization Rate is the NOI divided by the purchase price and is represented as a percentage.

Cap Rate = NOI / Purchase Price

Now that you know the basic equations used to calculate the cap rate, below is an example to better illustrate how this is used. First, let’s find our values.

  • Property Value (or Purchase Price): $250,000
  • Total Revenue: Four units x $1,000/month in rent = $48,000/year

Total Expenses:

  • Property manager salary – $20,000
  • Cleaning and maintenance – $10,000
  • Inspection and broker fees – $5,000

Next, let’s calculate NOI. $48,000 (revenue) – $35,000 (expenses) = $13,000. Lastly, we can use this number to calculate the cap rate of the property.

$13,000 (NOI)/$250,000 (property value) = .052, or 5.2% Cap Rate.

The same formula can be used to calculate the purchase price if you have the Cap rate and NOI. To solve for the price, just rearrange the original formula to:

Purchase Price = NOI / Cap Rate.

Purchase Price = $13,000 / 5.2% = $250,000

Now, let us suppose that a similar investment property (B) has the same NOI but a higher Cap Rate of 6.5%.

Purchase Price of B = $13,000 / 6.5% = $200,000

Both the properties have the same NOI of $13,000 but a lower Cap produces a higher purchase price and vice-versa. As Cap rate increases to 6.5%, it decreases the property value by $50,000.

Note a very important consideration involving a Cap rate calculation shown above. The purchase price is based on an all-cash purchase. No loans or mortgages were involved or factored into the calculation. The leveraged money that is used to acquire an investment property must be accounted for in any calculation involving a rate of return. Therefore, a Cap based on an all-cash purchase can never equal a rate of return.

Using a Cap Rate Calculator in Real Estate

A cap rate calculator is used in real estate to find the comparative value of a piece of property to determine if it would be a good investment. It’s calculated by balancing the costs of owning and maintaining a property, the property’s market value, and the direct earnings received from that property.

For example, say your client wants to buy a property for $250,000. It currently has four units and receives $1000 in rent from each tenant each month. The current owner paid $35,000/year in inspection fees, maintenance and cleaning fees, and a property manager’s salary. The cap rate calculator takes each of these factors into account to come up with a simple percentage that’s easy to compare across properties.

Cap Rate Calculator Equation

The cap rate calculator equation is pretty straightforward, assuming you have all of the necessary information at hand. To calculate the cap rate, you take the Net Operating Income (NOI)/Property Value. You can typically take the asking price as the property value, or there are plenty of online tools available that can provide property value estimates as well.

How to Calculate Net Operating Income (NOI)

Cap Rate

Coming up with the NOI for a property is a bit trickier, not because the math is complicated, but because it requires a lot of different numbers upfront. The equation for NOI is Total Revenue – Total Expenses. Total revenue is typically the yearly rent collected from tenants and/or the interest gained over the year. Expenses can include any number of factors such as:

  • Broker or inspection fees
  • Pest control
  • Maintenance
  • Property management salary
  • Tenant screening
  • Property taxes

To find NOI, you add together your revenue sources for the year, then subtract the combined expense amount. You can then use this number to calculate the cap rate. It’s important to note that the cap rate does not take the mortgage payments into account, as this is not a factor that affects the value of the property itself.

Benefits of Using a Cap Rate Rental Property Calculator

Understanding Capitalization Rate

There are many ways to use the cap rate when evaluating rental properties. In general, you can think of the cap rate as an estimate that’s used to get the lay of the land for real estate investing. Examples of the different uses for a rental property cap rate calculator include:

  • Understand the value of a property in relation to its neighbors – It stands to reason that properties in similar neighborhoods with similar assets should have similar cap rates. You can use the cap rate to identify if a particular property is priced too high or too low, or if there may be underlying issues contributing to an unusual cap rate.
  • Get a picture of larger market trends in an area – Cap rate is a useful indicator of wider changes in a certain city or area within a city. For example, cap rates changing in a specific neighborhood but staying flat in another similar area can indicate a shift in buyer/renter interest.
  • Provide useful estimates to clients – For agents, the most important use for a cap rate calculator is to be able to provide accurate estimates to clients for the value of the property, an important factor when making a buying decision.
  • Identify under-the-radar opportunities – If a property has a conspicuously high cap rate for the area, this could be an indication of mismanagement and an opportunity for a higher return on investment if operations were to be more streamlined and yearly expenses minimized.

Drawbacks of Using a Cap Rate Rental Property Calculator

Though the cap rate is undoubtedly a useful estimate of a property’s value, there are a few limitations to using this metric.

  • Requires comparisons to be useful – Because cap rates are most often used in comparison to properties of similar sizes, assets, and areas, they require a robust market to be valuable. This limits their usability in both smaller markets and for unique properties like tourist attractions, where there typically aren’t enough similar properties to compare to.
  • Relies on knowing historical costs – Since the cap rate calculation incorporates net operating income, which in turn requires knowing the property’s yearly expenses, it can be difficult to get an accurate estimate without the proper records. For mismanaged properties or even properties that have been owned by a single family for a long time, tracking down this information may not be possible.
  • Only accurate with steady income and expense costs – Like any estimate, the cap rate can be thrown off by any outlying data points in terms of extra income or unexpected costs. Things like flooding damage can skew maintenance cost data for that year or unexpected seasonal business can drastically increase income, causing an inaccurate cap rate that may not actually be the typical amount year to year.

What is Cash-on-Cash Return?

The cash-on-cash return of an investment property is a measurement of its cash flow divided by the amount of capital you initially invested. This is usually calculated on the before-tax cash flow and is typically expressed as a percentage.

Cash-on-cash returns are most accurate when calculated on the first year's expected cash flow. It becomes less accurate and less useful when used in future years because this calculation does not take into account the time value of money (the principle that your money today will be worthless in the future).

Therefore, the cash-on-cash return is not a powerful measurement, but it makes for an easy and popular “quick check” on a property to compare it against other investments. For example, a property might give you a 7% cash return in the first year versus a 2.5% return on a bank CD.

The cash-on-cash return is calculated by dividing the annual cash flow by your cash invested:

Annual Cash Flow / Cash Invested  =  Cash-on-Cash Return

  1. Calculate the annual pre-tax cash flow for the property.
  2. Determine how much you'd put down on the property from the down payment to rehab costs. Total these expenses to find your total cash investment.
  3. Divide the annual pre-tax cash flow by the total cash invested.
  4. The result is the cash-on-cash or CoC return.

Let's make sure we understand the two parts of this equation:

  1. The first-year cash flow (or annual cash flow) is the amount of money we expect the property to generate during its first year of operation. Again, this is usually cash flow before tax.
  2. The initial investment (or cash invested) is generally the down payment. However, some investors include their closing costs such as loan points, escrow and title fees, appraisal, and inspection costs.  The sum of which is also referred to as the cost of acquisition.

Let's look at an example. Let's say that your property's annual cash flow (before tax) is $3,000. And let's say that you made a 20% down payment equal to $30,000 to purchase the property. In this example, your cash-on-cash return would be 10%.

     $3,000 / $30,000  =  10%

Although the cash-on-cash return is quick and easy to calculate, it's not the best way to measure the performance and quality of a real estate investment.

Let's look at one more example taking into account repairs and renovations:

Suppose you want to put 20,000 dollars down on a $100,000 house. This is 20 percent down. You'll have to pay 2,000 dollars in fees. You're renting it out for a thousand dollars a month to a tenant. This yields 12,000 dollars a year in rental income per year. And you've got an ultra-cheap 3000 dollars a year or 250 a month.

The annual cash flow is $12,000 – $3,000 or $9,000.

The total cash invested is the down payment and fees. In this scenario, it is the 20,000 dollar down payment and 2,000 in repairs for a total of 22,000 dollars.

The cash-on-cash return is 9000 divided by 22,000 or 0.41. This translates into a 41 percent return.

What if the property had no additional repairs necessary? Then the total cash invested is 20,000. The cash flow is unchanged at 9,000 dollars.

The cash on cash return is then 9000/20000 or 0.45 or 45%.

If the property needed 10,000 dollars in repairs and renovations, the cash invested hits 30,000 dollars. Divide 9,000 by 30,000 and the cash on cash return is 0.3 or 30%.

You can use the cap rate to estimate the NOI. The NOI is going to be the market value of the property multiplied by the capitalization rate. If they're selling a property for 150,000 dollars and say it has an 8 percent cap rate, then the NOI is 12,000 dollars a year. For comparison, it is reasonable to assume an NOI of roughly one-third of the rental income.

And the fair market value of any property can be estimated using the cap rate. Divide the NOI by the cap rate. A property with a 12,000 dollar NOI and an 8 percent cap rate is worth 150,000 dollars in the scenario above.

You can use the cash on cash return to gauge the return on renovations that allow you to raise the rent. Add the renovation or upgrade costs to the total cash investment number, and determine how much more you could charge in rent for the nicer property.

The ratio compares the total cash earned on an annual basis (pre-tax) to the amount of cash invested. Cash-on-cash ratios are used instead of return on investment since ROI calculations are skewed when you buy a property with a large amount of debt.

Difference Between Cap Rate and Cash-on-Cash Return

The capitalization or cap rate is often confused with the cash on cash or COC return. That problem is compounded by the fact that the cap rate and cash on cash returns are the two main metrics used to assess individual real estate deals. As discussed above, Cash on cash or CoC return calculates the cash income earned on cash returned on investment.

Cash on cash return excludes debt and only looks at the cash amount invested; this is generally the down payment on the property. If you pay all cash for a property, the Cash-on-Cash rate will be the same as the cap rate. However, most property investors don't pay 100 percent of the cash for properties. Yet the cash on cash calculation can still be of benefit to them.

You need the cash-on-cash calculation to properly compare projects that will require significant investment in the form of loan fees, rehab costs, and closing costs in addition to a down payment or cash purchase. Anything you need to pay to get the property ready for tenants falls into this category.

The cap rate can be used to gauge how good of an investment the property is, while cash on cash calculations allow you to determine which deals have the highest returns.

How to Use Cap Rate as a Rental Property Investor?

Easy Cap Rate Calculation

The cap rate can be used to compare your relative success as a real estate investor or the value of a given property. For example, you can calculate the cap rate for your entire portfolio and identify under-performers. Or you can learn the average cap rate for a given neighborhood and then gauge the value of a property based on its cap rate. If it has a lower cap rate, then it is worth less than a comparable home with a higher cap rate.

Know that you don't have to go into high cap areas to find profitable investments. A low cap area may have room for significant improvement. Look for areas where there are rapidly increasing rental rates because these are the places where the cap rate will be better next year than this year. And that higher cap rate will lead to property values increasing in a year or two.

The ideal properties will have rising rents combined with unchanged expenses. However, if the operating expenses are skyrocketing, NOI will go up and kill that great cap rate for the current calendar year. This is a risk with older buildings that need major work. If you can find properties in good condition and even rehabbed older ones, you could create long-term value by buying something through NOI increases.

Estimating Property Value With The Capitalization Rate

The Cap Rate merely represents the projected return for one year as if the property was bought with all cash.  But since we don't normally buy property using all cash we would use other measures, such as the cash-on-cash return, to evaluate a property's financial performance.

The Cap Rate is calculated by taking the property's net operating income (NOI) and dividing it by the property's fair market value (FMV).  The higher the Cap Rate, the better the property's income and market value.  The Cap Rate is calculated as follows:

     Capitalization Rate = Net Operating Income / Value

Let's look at an example.  Let's say your property's net operating income (NOI) is $50,000.  And let's say that the market value of your property is $625,000.  Your Cap Rate would be 8%.

Capitalization Rate  =  Net Operating Income / Value
Capitalization Rate  =  $50,000 / $625,000
Capitalization Rate  =  8.0%

As another example, let's suppose you are looking at purchasing a property that has a net operating income of $20,000.  From doing a little research you know the average Cap Rate for the area is 7.0%.  By transposing the formula we can calculate the estimated market value as follows:

Value  =  Net Operating Income / Capitalization Rate
Value  =  $20,000 / 7.0%
Value  =  $285,715

An advantage of the Cap Rate is that it provides you with a separate measure of value compared to appraisals where value is derived from recently sold comparables (which are primarily based on physical characteristics).  This is especially true when comparing commercial income properties.

Note that a small difference in the Cap Rate may not seem like much but it can make a large difference in your valuation.  For example, the difference between a 7.0% and 7.5% Cape Rate, a mere 0.5% difference, on a property with a $50,000 net operating income is a $47,619 difference in value!  So be sure to double-check the accuracy of your numbers.

As always, you want to look at multiple financial measures when evaluating income property including the cash-on-cash return, debt coverage ratio, and internal rate of return.

Commonly Asked Questions About Cap Rate

Below are a few additional clarifying answers to some of the frequently asked questions about cap rate calculators.

What is a Good Cap Rate?

The capitalization rate for real estate can range from a negative number to a double-digit return. A standard cap rate is typically between 4% and 8%, according to CBRE’s 2019 North American Cap Rate Survey. However, there is no such thing as a “good” cap rate. It all depends on the level of risk the property owner is comfortable with and how the cap rate compares to similar properties in the area.

Some investors say they won't buy anything with less than an 8 percent cap rate. It is difficult but possible to find properties with a 20 percent cap rate.

A high cap rate is generally caused by a low purchase price (including distressed sellers) or a high NOI. The key is knowing why the cap rate is higher than normal, not rejecting a property because the CAP rate is much higher than average.

A low cap rate is less risky, while a high cap rate is riskier but there is an opportunity to make more income. As we mentioned earlier, an unusually high or low cap rate (compared to other properties in the area) can indicate that something is “off” with the property.

What Does a 7.5% Cap Rate Mean?

A 7.5% cap rate doesn’t mean much by itself. Rather, it indicates the ratio between a property’s net operating income and its market value, in this case, 7.5%. Cap rate is a way of displaying how much the property is expected to make in a year using the relationship between revenue, operating costs, and market value for the property.

What this means in terms of good or bad investment or dollar amounts depends on the situation. For example, let’s say you want to buy a home that costs $1 million, with an expected net operating income (AKA yearly revenue) of $75,000. Using the cap rate equation of NOI (75,000)/property value (1,000,000,) you would get a cap rate of 7.5%. You can then easily compare to other cap rates in the area to evaluate your investment.

What is an Acceptable Cap Rate?

An acceptable cap rate varies depending on the situation. An average cap rate is typically between 4% and 8%, but what is acceptable varies on how much risk the investor is comfortable with.

Is Higher Cap Rate Better?

A higher cap rate is not necessarily better. Again, it depends on the level of risk the property owner is willing to deal with. A wealthy investor looking to make some quick income by flipping a property may be happy with a higher cap rate because of its greater earning potential, while the associated risk isn’t a concern. On the other hand, a young couple who wants to settle in a home and raise kids there for the foreseeable future will likely want a low cap rate, which has a correspondingly lower risk and will likely increase slowly over time.

Why is a Higher Cap Rate Riskier?

Not always. Capitalization rates in real estate are not necessarily an indicator of risk. This is in sharp contrast to stocks and bonds, where the rate of return is proportional to the risk. However, the cap rate can only be used with income-producing property. The formula just doesn't work if you're going to buy property now to sell it later, such as when you're looking for a fix and flip.

Note that the cash on cash return doesn't take taxes into account. High taxes can wipe out any potential investment return. This means that the actual returns you see after-tax are lower than the cap rate. The cap rate will vary based on several things, not all of which directly affect the property's value.

The age of the property, the desirability of the area, and the demand for rental properties in the neighborhood are a few such factors. If there is a greater demand for rentals than the market supplies, rental rates, and NOI may be relatively high despite the moderate home values.

And if there is an oversupply of luxury rentals in the area, you're going to see a low NOI and de facto ROI via the cap rate, because your property may sit empty for a long time or not rent for enough to cover your operating expenses.

There are other issues with the cap rate that explain why you need to know additional values like the cash on cash return. For example, the CAP rate is an annual figure. It will crash if the property was vacant for several months through no fault of the current owner. Yet the metric will rise automatically with inflation if the rents have kept up with market rates.

The cap rate does not tell you how the property has performed over time; vacancy rates and income statements will do that.  A higher cap rate is riskier for the same reason that any high percentage investment is riskier. It all has to do with probability and potential uncertainty, something called the Risk-Return Tradeoff, a well-known investment principle.

The math behind the Risk-Return Tradeoff is a bit complicated, but this guide from Model Investing breaks things down into easily understandable sections if you want to get into the nitty-gritty.

Is Cap Rate the Same as ROI?

No, the cap rate is not the same as ROI. Though both metrics use NOI in their calculations, they’re measuring different things. Cap rate is used to evaluate how profitable a piece of property should be in comparison to the market, regardless of buyer, while ROI (return on investment) is a more concrete calculation showing how much a specific owner will make each year. ROI incorporates mortgage payments while the cap rate does not.

The equation for ROI is the annual return/total investment. For example, a person living in a $200,000 home with an NOI of $12,000, an annual mortgage payment of $5,000, and a down payment of $40,000 would calculate ROI as follows: $7,000 annual return ($12,000 NOI – $5,000 mortgage)/$40,000 total investment (down payment) = 0.175 or 17.5% ROI. The cap rate for the same home would be 6% ($12,000 NOI/$200,000 property value).

How to Calculate Property Value using Cap Rate & NOI?

Using the cap rate and net operating income to determine the real estate value is known as the income approach to valuation. The Net Operating Income equals all income from the property minus all reasonable operating expenses. This is a before-tax figure. It doesn't include amortization, depreciation, capital expenditures, and mortgage payments. The NOI is equivalent to the earnings before interest and taxes if you're comparing the capitalization rate of a business that's for sale.

  1. Find the annual net operating income or NOI.
  2. Divide the net operating income by the cap rate.

For example, a rental property in Dallas with a net operating income of $30,000 and a cap rate of 7 percent is valued at $428,571. The same property with a 10 percent cap rate would have a value of $300,000. In other words, the higher the cap rate, the lower the property’s value.

We hope that the following explanations were helpful for any agent looking to provide a more holistic view of property options to their clients.

Now that you understand how cap rates work, here is an easy calculator that you can use.

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