Commercial Loans: How You Win Even If You Lose

I was contemplating the economy, increasing interest rates, slowing real estate sales, and the possibility of us being in a real estate market “top” when I thought about how to protect myself against a potential fall in prices. My best choice for making an investment that would make sense in this environment had to be commercial real estate. Before I get to why, let me introduce you to an interesting extension of a concept long used in investment real estate: Other People’s Money (OPM). I would have asked Killer, my 21-year-old-real-estate-guru-wondercat to explain this, but he was taking another nap (wouldn’t you, if you were his relative age???).We all understand the basic OPM approach for investment property: Get some investors together, pool their money, buy a property together, and get a piece of the action for selecting and managing the property. This is a time tested method for growing a portfolio of commercial properties and a (nearly) passive income stream.? But this is not the only aspect of OPM in commercial real estate.Have you stopped to consider that the real estate loan you get from a lender, be it a bank, insurance company, conduit, or private source, is also OPM?? You should – it wasn’t yours and it came from someone else (depositors, investors, etc.)! So on the face of it, between the down payment and the loan, you can easily acquire an interest in commercial real estate without using a cent of your own money!But wait, there’s more! Did you realize that your tenants are providing a stream of cash from which you pay the expenses, make repairs, or service the debt?? In the final analysis, commercial real estate and other investment property are nothing more than a glorified bond – a series of regular payments. In this case, the bond happens to be made of sticks and bricks! But once again, the money you are receiving from your tenants is OPM. The important point here is that as you grow this income stream over time, your property’s value should also be increasing. But even if your investment property goes down in value, you’ll still make money!Hang on, because there is one more source of OPM to consider before I prove you win even if you lose. It’s called -depreciation. I know that you just went “huh.” So please, let me explain. Our tax code allows us to pretend that a piece of real property “wears out” over time (well, it does – but that’s another topic for another day). This wearing out is based upon a formula and in its simplest form allows an investor to reduce the original value of the improvements (not the land) by about 1/27th per year. We debit this amount against any net income the property might earn and it ends up sheltering some of this income from taxation. It’s OPM because without that deduction, you’d be paying a portion of your net income to our government. Isn’t this a great country?
Given all of this, how can we still “win when we lose” in commercial real estate? Let’s use an example. We buy a small retail property for $1MM that provides a net operating income (NOI) of $75,000 (a cap of 7.5%). If you raise $250M as a down payment and get a $750M loan at 6.5% for 25 years, you’ll have a net cash flow of about $14,200 in the first year. We’ll ignore increases in rent over time and we’ll get about $29M per year in depreciation, sheltering our net income and giving us another $4,500 per year in tax savings against other income*. Finally, let’s hold the property for 10 years and sell it at a big-time loss for $800M.How did we make out?With a sales price of $800,000 and a loan balance of $581,335, we get cash back of $218,664 (I’m ignoring closing costs). We’ve earned $142,000 in rent, $45,000 in tax savings, for a total income of $405,664. We pay back the $250,000 and we’ve made $155,664.So – we still made money when selling our property for a 20% loss and never put any of our own money at risk! So here’s the lesson for today: If you have to make an investment, consider commercial real estate very, very strongly and by all means, use someone else’s money.* The depreciation calculation assumed a 27.5 year straight-line on the 80% of the property’s value, leases were assumed to be NNN, and the combined tax bracket only 30% on other income.

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