While residential investors are at the mercy of the market for appreciation, commercial real estate (CRE) investors can actually make their properties appreciate regardless of market conditions.

We’ve all been hearing about the decline of the housing market. The residential investor’s equity is eroding away right before his/her very eyes. Until market conditions improve, residential investors shall remain at the mercy of the market for their profits.

Although appreciation resulting from market conditions is a consideration to the CRE, investor, CRE can be increased in value by increasing the cash flows called Net Operating Income (NOI) from the property regardless of market conditions.

Because property value is based on NOI, if you can increase the NOI, you can not only increase your cash flow, but you can also increase the property’s value.

Let’s take an example. A 100 unit apartment complex producing $100,000 of NOI in a 10 Cap market is valued at $1,000,000.

NOI/Cap Rate= Value

$100,000/.10=$1,000,000

By increasing that NOI to $190,000, in that same 10 Cap market (meaning the market pricing that investors will pay for that income (NOI) hasn’t changed), POOF, the property is now valued at $1,900,000.

$190,000/.10=$1,900,000

So in addition to putting $90,000 per year more cash in your pocket you just increased your equity by $900,000. Sound good?

Are you amazed by way I quickly manipulated those numbers to make the example fall into place? Are you saying to yourself, “Well Karen, that’s all good on paper, but how could I just magically increase the NOI by $90,000?” Well, after all of the articles I’ve written as an authority on CRE, you should just trust me but since you’re the skeptical type, I’ll show you!

As stated previously, if you can increase NOI, you can increase the value of the property. There are 2 ways to increase NOI.

1. Take in more money
2. Spend less money to operate the property.

Notice I didn’t say, reducing the debt service paid to the lender. Although this will ultimately increase your cash flow before taxes, it has absolutely no effect on the value of the property. The property is worth the same amount of money whether it has a mortgage or is owned free and clear. Make sense?

Let’s just say that after you purchased this 100 unit apartment complex, as the leases expired and were either renewed or the units re-rented, you increased the rent by a mere $25 per month. That’s a monthly increase of $2,500 and a yearly increase of $30,000.

$25 x 100 units = $2,500 per month

$2,500 x 12 months = $30,000

So poof, you just gave yourself a raise of $30,000 per year. Congratulations! That is the beauty of commercial real estate!

By the way, how much would you have gotten if you increased by $25 a single family house? That’s right… $25!

Now, let’s just say that to reduce operating expenses you make the capital investment into individually metering the units with their own utility meters so the tenants can pay for their own utilities instead of you, the landlord. If the savings to you is a mere $50 per month, that would equate to $60,000 increased NOI because of decreased expenses.

$50 x 100 units = $5,000 per month (decreased expenses)

$5,000 x 12 months = $60,000

So POOF, you just saved yourself $60,000 per year in utility expenses thereby putting the extra $60,000 into your pocket each and every year you own the property. Remember you earn these cash flows year after year, not just once.

Now let’s look at the effect on value in the same 10 Cap market.

$100,000 + $30,000 (increased rents) + $60,000 (decreased expenses) = $190,000.

IF: $100,000/.10 = $1,000,000

THEN $190,000/.10 = $1,900,000

So you can see that you can not only influence the amount of money you earn from cash flow, but you can also control the value of your investment regardless of market conditions.

In residential investing, there is only one strategy. Regardless of how you acquire the property (foreclosure, etc.), the goal is to buy low and wait for the market to go up so you can sell at a profit or refinance.

In this market, residential investors may be waiting a long time… a very long time. Additionally, if they don’t have positive cash flow in the interim, they will not see a return on that investment for years to come.

By investing in CRE, you earn a return on your investment from Day 1 because of the significant cash flows. Additionally, by improving the NOI through your own efforts, you can increase the value of your property regardless of market conditions.

It is for these reasons that CRE is a much safer and more profitable investment than residential investing.

Lenders have developed general classifications of apartment buildings so that they can communicate amongst themselves and other members of the industry with some level of uniformity. The classifications are Class A, Class B, Class C, and Class D.

1. Class A Newer, Institutional Grade

2. Class B Older, Institutional Grade

3. Class C Older, Declining Area

4. Class D Older, Declining Area, Poor Condition

Class A Apartments

Institutional buyers like new, larger apartments in prime locations because of low deferred maintenance. These properties are typically occupied by white collar workers and have amenities such as garages, in-unit washer/dryers, pools, spas, exercise gyms, the latest technology, etc. They are typically between 1-10 years old. Typically they are in the path of progress and as of this writing (July 2008) can be bought at cap rates of 7%. They will likely have less cash flow than properties with higher cap rates but will have greater appreciation potential.

Class B Apartments

Class B buildings are in good areas with many of the same amenities as Class A properties, but Class B buildings are 10-20 years old and occupied by both white and blue collar workers. Class B properties are often owned by investment groups, such as limited partnerships and limited liability companies. As of this writing (July 2008) they can typically be bought at cap rates of 8% - 9%. These properties will have decent cash flow and decent appreciation potential.

Class C Apartments

These apartments are older properties built within the last 21-30 years in working class areas typically occupied by blue collar workers and even some Section 8 tenants(please see my article on Section 8). The properties may be in declining areas but not necessarily dangerous areas. The units in Class C buildings are smaller than those in Class A and B buildings and the projects have fewer amenities. The occupancy rates are typically higher than Class A 0r B because they are more affordable. Individuals usually own Class C properties, which as of this writing (July 2008) can be bought at cap rates of 10%. These properties will have decent cash flow but little opportunity for appreciation.

Class D Apartments

These buildings are older, in declining and even dangerous areas and as a result may have high vacancy rates, deferred maintenance, functional obsolescence and demand a high level of hands-on management from their individual owners. As of this writing, they can typically be purchased for cap rates of 12% but may generate less income than other properties despite their higher cap rates because of higher maintenance and management demands.

Rules of Thumb:

1. Class A & Class B properties are purchased for appreciation potential.

2. Class B & Class C properties are purchased for cash flow

3. Unless you are an experienced investor, don’t buy Class D properties.

The goal is to buy a particular class of property in the same area class. In other words, buy a Class B property in a class B area.

Alternatively, buy a lower class property in a higher class area. In other words, buy a Class C property in a class A area or one in the path of progress. The reasoning is so that you can possibly change the Class B property bought at higher cap rates (lower in price) into a Class A property which can be sold for lower cap rates (higher prices). This “infill opportunity” is typically only possible if the area is better than the property.

After location, zoning is probably the most important characteristic of any type of real estate. It is the obvious starting point for evaluating a parcel’s potential for development because it spells out what you can do with the property. Zoning is a critical piece of the puzzle particularly if you want to be a land developer, an investor or work with a builder in some way. Save yourself much time, energy and frustration by checking out the zoning first, not last.

Local governments enact zoning ordinances and adopt the maps that show the physical boundaries of the zoning districts, and these are modified periodically. To determine the current zoning of a particular property, you would first look at the zoning map to see what district it falls in and then consult the current zoning ordinance. Both of these documents are available for review or purchase at the municipal building. What will you find in the ordinance?

It tells you what land uses are permitted in each district or classification. These classifications generally include residential, mixed residential, mobile home, commercial, shopping center industrial, office, and conservation. The ordinance also lays out other standards and requirements, such as the minimum lot size, minimum lot width, dimension of setbacks, height restrictions and building coverage. It contains definitions that help you understand the terminology used throughout the ordinance. There are general provisions that apply to every zoning district, and these deal with issues like non-conforming properties and uses, accessory structures and uses, flag lots, fencing, signage and minimum lot frontage requirements.

Provisions for a specific zoning district can often include both “by right” and “conditional” uses. For example, single-family detached dwellings, agricultural uses and governmental recreation areas may be permitted in a district. A privately-owned riding academy, stable for horses, public or private day schools, 18 hole golf courses, places of worship and day care facilities are permitted in that district only when authorized by the municipal Zoning Hearing Board as a special exception. This latter group of uses is not permitted automatically, and to get a special exception, you would have to demonstrate that your use falls within those defined in the ordinance and also complies with any requirements, such as minimum site area, building and paving coverage, and buffering, specific to that conditional use.

It would be helpful to remember some key points about zoning. Land use and regulation laws vary from state to state. Terminology and nomenclature vary from municipality to municipality, even within the same county in the same state. For instance, the “R-2” zoning classification in one municipality may mean that single-family detached housing is permitted on a minimum lot area of 35,000 sq. ft., with a lot width of at least 125 feet, and front, side and rear setbacks (yards measured from the parcel boundaries to define the area where a structure can be built) of 60, 20 and 80 feet, respectively. Go to another municipality, and you could find that the R-2 District permits single-family detached housing on 43,560 sq. ft. lots 150 ft. wide with front, side and rear setbacks of 60, 25 and 80 feet. You should not assume that the same name used for a classification in different municipalties means the same thing and when marketing land to potential buyers, be sure to include information on the permitted use and requirements for minimum lot size and width. Describing the zoning of the property only as “R-5”, “MR-1” or “C-2” is meaningless.

Finally, some words of caution. Zoning and other types of ordinances are available online. Do not, I repeat, do not rely exclusively on online ordinance information. Go to the primary source (the municipality that enacted the ordinance) and check it out to be sure you have the most current and accurate information. Always page through the entire ordinance because municipalities often enact amendments that can be printed in the back of the original ordinance (without cross-referencing the original provisions that have been amended). If the provision is somewhere in the ordinance, it applied. Just because you didn’t see it doesn’t mean that it doesn’t apply.

People often ask me how I got started in commercial real estate, and I tell them that it was a conscious decision for me. Most people who begin investing in real estate start off with single family residential properties because that is what they are most comfortable with. They tell themselves, “All I need to do is a couple of deals a month. I’ll make myself five or ten thousand dollars, then at the end of a very few months most of my problems will be taken care of.”

They do not really understand everything that is involved in getting these properties going. They think they are going to be making big money, but before long, oftentimes they end up with a lot of problems and a lot of headaches. They might have traded in their job for a perceived higher paying job, but find that it is really taking a toll on their lives.

If you belong to a real estate investment group, take a look around you. Look at the people who have done twenty-five to fifty houses or more. Are they living the life of their dreams? More importantly, are they living the life of your dreams? They may be better off than you are now, but is this really what you want to work towards? I know so many people who have a large portfolio of properties but really haven’t achieved the type of freedom, success, and wealth that they truly desire.

How can you change this? In my opinion, the answer is commercial real estate. When I decided to start investing in real estate, I stopped and took a look around. I realized that the people who were making the big money in real estate were the people who owned buildings not houses. People who owned the large apartment buildings, the large office buildings, the large warehouse and industrial space - those are the ones who really seemed to be living a lifestyle that I wanted.

They didn’t have to be there tending to their properties; they had property managers who took care of that for them. Yet, they were the ones spending the checks, catching planes to exotic locations and destinations, and living the lifestyle that I desired so much. After looking at this for quite a while, I decided that there must be a way of getting this done. They couldn’t have been much smarter, have learned much more, or have had access to more resources then I could.

Even though I didn’t know how immediately, I knew I could figure out a way to do it. I sat down and took the time to learn how to invest in commercial real estate, which is what I would recommend that you do. I studied and figured out exactly what it would take, and as I learned, commercial real estate became less and less of a mystery to me.

How can you start? First of all, let’s talk about why you would want to do it. What are the benefits of commercial real estate? First of all, one of the biggest benefits is that commercial real estate is valued differently. By “valued differently”, I mean the amount of income that a property produces is directly proportionate to its worth. So if a property produces more income, then it is worth more. It has very little to do with “market comps”.

Second, along the way you are going to get a far greater cash flow. Imagine if you were to buy a $200,000 home. That $200,000 home may rent for somewhere in the neighborhood of $1,500 per month. The underlying mortgage on that home may be somewhere between $1,000 and $1,400 per month. So you end up struggling to gain between $100 and $500 per month in positive cash flow. That’s not a very high number for the amount of work you have to put in, and it certainly is not going to get you on the jet set.

Now, let’s take a look at a similar investment from a commercial standpoint. That same $200,000 investment may end up yielding you an 8-unit apartment complex, based on $25,000 per unit to acquire the property. Let’s say each of those units were two bedrooms, which could rent in most areas of the United States anywhere between $400 and $600 per month. For simplicity’s sake, let’s use an average of $500 per month.

At $500 per month times eight units, you’re bringing in $4,000 per month - more than double the rent that you could expect to get from that same $200,000 single family home. Your underlying mortgage payment would be very similar to what you would expect on a residential property; for this example, let’s use $1,400 per month. Your cash flow on this 8-unit apartment building will be $2,600 per month ($4,000 per month income, minus $1,400 mortgage payment). Now that will make a difference in just about anyone’s life.

Third, and most essentially, you’re now spreading out the risk over eight tenants, as opposed to one. If your single-family home goes vacant, you’re on the hook for the entire mortgage. Every penny of that mortgage, all of the maintenance, and everything that goes along with it is now your responsibility. If the house is vacant for two months, you’d better be planning on spending a minimum of $2,800 to cover that mortgage plus miscellaneous expenses including maintenance, utilities, taxes, and insurance.

Potentially, you’re looking at a very heavy negative cash flow. On the commercial property, however, if one of your eight units goes vacant at $500 per unit, you’re still bringing in $3,500. So you get slightly less positive cash flow but you’re certainly not experiencing negative cash flow. Say three units go vacant - you’re still covering your mortgage and experiencing positive cash flow.

For the fourth and fifth reasons why to invest in commercial real estate, and how you can get started, see Part 2 of this article. Until then, make sure your “pot of gold” is filled with the real stuff!!

What would it be like to have an extra $11,472 a month coming into your life each month. Imagine what you could do with that extra money!

You could buy a bigger house, travel, and/or give more to your church or a struggling loved one.

An investor I know is doing just that because he closed on a deal where he is now pocketing $11,472 in positive cash flow each and every month for the rest of his life (actually it will get higher and higher) or for as long as he holds on to the property.

He did this by taking over an apartment complex using a Master Lease Option. Does that mean he has to deal with a lot of tenant hassles? Absolutely not! He pays a management company to do that. The only thing he has to manage is the manager. It sure is easier managing one manager than a bunch of unruly tenants wouldn’t you say?

This investor found this deal in the local classified section of his newspaper. The owner had the apartment complex advertised for a quick sale because he was burnt out (he was managing it himself), had poor cash flow (it was 62% occupied) and he wanted out.

The investor, being a true investor was looking to get into the property with no money down and structured the deal the same way you would structure a lease option for a single family.

He signed a Master Lease for the entire complex and agreed to pay the owner a certain figure each month. He took over all of the income and expenses on the property and anything above what his expenses are and the lease amount is his to pocket.

He also signed an Option To Purchase the property. Anytime with in the next five years, this investor has the right to buy the property for the stated amount in the option.

When the investor took over the property, it was cash flowing but not by much due to the high vacancy. Using a very good management company and a having them spruce up the outside, he was able to get it at 90% occupancy in eight months time!

Now remember, every month he owned the complex he had positive cash flow. As the management company put more and more tenants into the building his cash flow grew bigger and bigger, to the point where it is now over $11,000 per month.

A lot of investors don’t realize that you can buy apartment buildings the same way you buy single family houses. You can do “subject to”, lease option, wholesale, and pre-foreclosure just as easily and the best part is…the paydays are much, much bigger!

The true goal of every investor should be to create as much massive passive income as soon as possible.

Passive income means just that, money that comes into your house month in/ month out without you having to do a thing to get it. How can you accumulate massive passive income quickly?

Well, if you went out and bought a couple dozen single family houses and kept them, you would create a decent income. Good but not great.

Its’ going to take you a little time to find all of these deals and then you would have to manage all of those tenants.

What If You Put a Couple Dozen Units in the Same Property?

Then you would only have to find one deal and then a few more to create a great passive income.

I know what you’re thinking. Oh no, not apartments! I don’t want to deal with the tenant hassles! And I agree with you, you shouldn’t be dealing with any tenants, wouldn’t it be better if you could just sit back and collect checks while someone else deals with all of the management headaches?

Those people are called management companies and they make a living shielding investors from the day to day management of their properties so you can go out and continue to do what you do best, find more property and create more cash flow!

But Aren’t They Expensive?

It’s true that management companies are paid a percentage of the gross collected rents, somewhere between 6% and 10%, though if you factor this cost into the deal, as long as the property cash flows with these fees, you’ve got yourself a winner!

Not only have you found a property that will get you one step closer to true freedom, you don’t have to hassle with a single tenant.

But Don’t the Management Companies Nickel and Dime All of Your Profits Away?

While it’s true that there are some bad management companies out there, you can be assured to find a good one if you follow these simple steps.

Go to www.irem.com. That’s the Institute For Real Estate Management, a great resource. When there, go into the search box and search for a Certified Property Manager (CPM).

These are owners and managers who have taken time out of their busy schedule and taken a series of required courses to improve their management knowledge and skills. Upon the completion of these courses, they take a big test and then they are awarded the CPM designation.

These managers are the cream of the crop and these are the ones that you want to have managing your properties. They will send you a summary report each month, telling you how the property is performing and the only thing you have left to do is to go cash you’re checks while you’re out finding more properties for your portfolio!

Having rehabbed over 470 properties in the last seven years and collected over 600 apartment units I’m often asked, how can I become wealthier faster investing in real estate?

While most investors concentrate on some aspect of single family houses, I was always interested in apartment houses first, and then single family homes as a means of getting more apartment houses.

From the very beginning of my investing in real estate, I liked the idea that a group of people (the tenants in a building) would get together and pool their money to pay down the mortgage on a property, and I liked the idea that they would also pool their money together to pay for all of the maintenance work for a building.

I especially liked the idea that they would give an owner so much money that the owner would have a bunch of money left over at the end of every month that could be used to either re-invest, save or to go out and have a good time with.

Essentially, I like the idea that other people were willing to help make me wealthy.

The first property I purchased was a three family apartment house. I used credit cards to fund the down payment. When I began to purchase my third three family, I realized that there were a lot of good deals out there and I needed a system to come up with down payments.

That’s how I developed my “Chunker Strategy”. What I do is buy a single family house with little or no money down (through private money or partners), flip it and use a chunk of money to live today and use the other chunk for another apartment house.

I became an expert at flipping single family houses. I learned to wholesale, retail, pre-foreclosure, rehab, subject to and lease option single family houses. I became a transaction engineer because I didn’t want to lose any potential deal that might be available to me.

I soon came to realize that I could also wholesale, retail, pre-foreclosure, rehab, subject to and lease option apartment houses as well.

You see, when I throw out my marketing dragnet for single family houses, I find that I was also attract motivated sellers of smaller apartment houses. If for some reason I wasn’t interested in holding an apartment house for cash flow, I could make a chunk of money flipping it using one of the methods that I described above.

Learning how to invest in apartment houses is like adding another tool to your tool box. You might not need it every day, but when you get the chance to use it, it pays for itself over and over again.

Every once in a while, you come across a great deal on an apartment house. A deal that is going to bring you in a great monthly cash flow of eight hundred dollars a month or more. These deals are actually more common than you think, you just haven’t trained your mind to recognize them.

Imagine for a minute, as you are buying and selling your single family houses, you start “collecting” apartment houses with cash flows of at least eight hundred dollars a month (if you are buying 3+ units, you will want at least a net positive cash flow of eight hundred dollars a month, unless you are in a first half of a rising market, and then and only then should you get less).

You will find these deals by dealing with motivated sellers. These deals do not commonly come through real estate agents. There are many good marketing courses available that teach you how to attract motivated sellers, get one and prosper!

Let’s say that you collect just four apartment houses a year, one every 3 months. At the end of the first year you will have a net positive cash flow of $3,200 per month. That would equal $38,400 per year.

Now let’s say that you continue to flip single family houses, get chunks of cash, and when the opportunity arises you continue your shrewd method of investing and continue to collect four apartment houses the next year. You have just increased your monthly income to $6,400 per month and your total yearly net positive cash flow from your apartments to $76,800.

Let’s jump forward to the end of year four. You have now collected a total of 16 apartment houses. Your monthly income from your apartments is $12,800 per month, your yearly net positive cash flow from your apartments is $153,600!

That means that if want to take all of year five off and do nothing, no flipping single family houses, no buying more apartments, no doing nothing, you would still get $153,600 in as a net positive cash flow from your existing apartments.

With $153, 600 you can do a whole lot of nothing!

Now you might be thinking whoa! What about all those tenants! I don’t want to deal with any tenants…you don’t have to. As your purchasing your property, you factor in the cost of a good management company. If the property still cash flows properly, buy it. If it doesn’t…next!

Some people don’t have a problem managing their own buildings. I did it for my first two and one half years in business but I soon realized that dealing with my tenants took time out of me going out and finding more deals, so I systemized the management of my buildings and hired a girl to work in my office and manage them for me.

I haven’t talked to or taken a call from a tenant in over four years and yet I happily deposit those cash flow checks in my bank account every month!

When I buy properties out of state, I hire local management companies to manage them for us. The rule of thumb is to pay them 8 –10% of the gross collected rents for buildings with 20 units or less and 5 – 8% for buildings with 20 units or more.

Let’s get back to the cash flow because cash flow is the real reason you should consider buying apartment houses while your doing your single family investing.

The cash flow gives you the freedom to do what you want when you want, go where you want when you want, and buy what you want when you want. This is exactly why we are in the real estate game.

What if you don’t decide to invest in apartment houses? It’s now four years later, you’ve been flipping a lot houses and are making some good money, heck, you’ve even got some single family houses that your holding for long term cash flow.

Let’s look at the reality of the situation. If you want another payday, you have to buy and sell another house. The cash flow on your single family keepers average $300 per month, what happens if you lose your tenant for just one month? You’ve probably lost your profits for most of the year.

If you were collecting apartment houses during that same four years while buying those single family houses, you would have a pay day in the tune of $12,800 per month each and every month for doing nothing (your net positive cash flow). The management company does all the work! If you lose a tenant in your three family building, no problemo! The other two tenants still pay enough to cover the expenses and also give you a little cash flow.

Not only that, you are creating more and more equity in those apartment buildings through the pay down of the mortgage and the appreciation that takes place each month that goes by. Your setting yourself up for some huge paydays further on down the road.

How do you become wealthier faster investing in real estate? Start collecting some apartment buildings as you buy and sell those single family homes.

The value of commercial real estate is determined in a very different manner than residential property.

In residential real estate, the listing price is determined by the seller and the real estate agent based on the physical characteristics and location of the property. Comparable sales are analyzed for a myriad of variables including price per square foot, number of bedrooms, bathrooms, and garages. In addition, features like a pool or central vacuum and location such as a cul de sac, corner, busy street, or view lot are important to pricing.

Adjustments are made in the suggested price, in an effort to make it equal to the comparable properties. For instance, if the subject property has one more bedroom and 500 more square feet of living space than the comparable properties, the listing price will be increased by an appropriate amount.

In commercial real estate, pricing is driven by the income the property produces. Although physical features are important factors that buyers consider, they are considered primarily to the extent that they enable the property to command higher rent or decrease its operating expenses. Location is also considered to the extent of the ability of the property to command higher rents and appreciate. It is the amount of cash flow and what an investor is willing to pay for these cash flows that will determine the price of the property.

The measure of income the property produces is called Net Operating Income (NOI). It is simply the income generated from operations less the expenses incurred during the operations.

Operating Income
Less
Operating Expenses
Equals
Net Operating Income

Put simply, if the annual NOI from a particular property is $100,000 and an investor is willing to pay $2,000,000 for that NOI, then the property is worth $2,000,000 to that investor. If another investor is only willing to pay $1,000,000 for that NOI, then the property is worth $1,000,000 to that investor.

Investors will consider numerous properties in a given area to determine the standard of how much must be paid for NOI. The “going rate” in area can be considered its Capitalization Rate (Cap Rate), which is simply a percentage rate. While an exact definition and explanation will be detailed in a subsequent article, here is the formula:

Net Operating Income
Divided By
Property Price
Equals
Cap Rate

In this example, the first investor only required a 5% return on investment and was therefore willing to pay $2,000,000 for $100,000 of NOI. The second investor required a 10% return and was therefore only willing to pay $1,000,000 for the same $100,000 of NOI.

This one year return, in commercial lingo sounds like the second investor requires a “10 Cap” and that the first investor only required a “5 Cap”. This is a simplified explanation but you get the gist.

How do investors determine whether they need a 5% return or a 10% return? Commercial investors make that determination based largely on their opportunity costs.

Opportunity costs are the costs associated with not having money invested at all or having it invested in the wrong investment. For instance, if an investor could alternatively invest in a stock, bond, T-bill CD, or other instrument and yield 10% on that same investment, why would he/she buy a property which only yields 5%? In order to attract this investor to the property owner would have to lower the price to give that investor a 10% return or wait until an investor comes along who finds the 5% return attractive, based on other opportunities presented to them.

Notice the inverse relationship here. As prices are lowered, the return to the investor or Cap Rate goes up. Conversely, as prices are increased the return to the investor or Cap Rate down.

Cap Rate only takes into account the first year of cash flow and does not account for the second year, third year, etc. Notice I have not even mentioned appreciation. Commercial real estate is primarily considered based on its cash flows while investing in residential real estate is almost totally based on appreciation.

In residential, there is only one way to win. Prices people are willing to pay for houses to live in must go up! In commercial real estate investors are purchasing cash flows. In our example, if the investors paid all cash, they would have been paid back 100% of their initial investment after 10 years and as of the 11th year, they would have $100,000 of annual cash flow from that single property.

Hopefully the property will have appreciated as well and the market will be favorable. But at the very worst case if no appreciation occurred whatsoever, the investor would still enjoy the $100,000 of annual cash flows.

Most investors do not pay all cash for a property but use financing to help them buy the property. This is called using leverage. When you use leverage you can make the mortgage payments with your NOI.

Net Operating Income
Less
Debt Service
Equals
Cash Flow Before Tax

Consider this. Let’s say that the first investor leveraged the property and only put down a 10% deposit or $100,000 to purchase the $1,000,000 property. This amount would be the investor’s Initial Investment. Let’s also consider that the remaining $900,000 was financed at 7% for 25 years which is typical in commercial financing.

With a fully amortizing loan (meaning principal is paid down as well as interest paid), the annual payments would be $63,000. This is called debt service.

The debt service is paid from the $100,000 NOI produced by the property, leaving $36,000 of Cash Flow before Tax. For simplicity sake, I will not account for tax effects on income or yields.

In this case, in Year 1, the investor has earned $36,000 for a $100,000 cash outlay, or a 36% Cash on Cash return. The way to figure a Cash on Cash return is to divide the Cash Flow before Taxes by the Initial Investment.

Cash Flow Before Tax
Divided By
Initial Investment
Equals
Cash On Cash Return

Assuming no change in the NOI, the investor would receive this same amount for 25 years until the debt is paid off. Subsequently, all other things remaining equal, the investor will enjoy the entire $100,000 of NOI.

Notice again, I haven’t even spoken about appreciation which may or may not occur. But even if no appreciation occurs to our example property, this is still an incredible investment!

Now obviously during a 25 year period these cash flows will change as rents will be increased and capital improvements will likely be needed (new roof, etc). But again, I’m keeping it simple for example purposes.

To summarize: In residential real estate there is only one way to win. The strategy is to carry the property and hope that the market goes up and that the property appreciates so that the investor can sell for more money than was paid. Positive cash flows are typically non-existent and if present, negligible relative to the anticipated appreciation the residential investment will bring.

In commercial real estate it’s the other way around. Properties are purchased for their positive cash flows with potential appreciation a secondary consideration.

And, it is for this reason that commercial real estate is more stable and can weather financial storms that residential investments cannot.

There is more to buying raw land than meets the eye and more than a few individuals have wished they’d had a second chance upon finding themselves duped, conned, misled, ill-advised, uninformed, oversold, undereducated and often unprepared. They realize, often too late, that a raw land purchase should be properly investigated, evaluated and negotiated using a logical and rational plan.

Let me start by saying I’m not a geologist, soil analyst, surveyor, engineer or land consultant. I’m a passionate real estate investor, licensed agent, appraisal assistant and landlord who purchased various raw lots, as large as a 15-acre parcel, for investment and building projects. In addition, I have consulted with numerous individuals proficient in real estate, who have contributed to my general awareness of the conditions and merits of raw land. We, as small investors, can further use this information to our advantage in wisely choosing land and utilizing it to it’s highest and best use regarding fulfillment of our needs, wants and desires.

This chapter is not a technical sleeper and as such, it will not go so far as to tell you how much lime to add to your soil to adjust PH levels (7.0 is neutral) but it does try to get you thinking about some of the more general considerations that can lead you to further investigate your options using this material as your starting point.

With that said, the first question I’ll ask you is what exactly do you intend to do with this land once you have it? Why are you buying it? What purpose do you have in mind for land? Are you going to build a home, purchase a lot for retirement or investment? Will you acquire considerable acreage for farming or subdivision? Do you want commercial, residential, recreational or agricultural? Will it be in the north, south, east or west?

So your first question should be, what am I, or we, buying this land for? Will it satisfy my, or our, requirements? To get answers to these questions you would best be served by talking to those who will be most intimately involved with the land, such as your spouse, partner, family members, associated owners, etc. Once you have a clear understanding of what the land is supposed to satisfy, then your search can begin. So often people waste their time and effort because the significant partners have such a wide gap in what each person truly wants from the purchase that they never settle on anything or end up with much less than they could have had.

Land can be said to consist of soil, geology, water and climate. Whether you’re looking at beaches, mountains, deserts, high plains or city lots, they all have some basic components. Some of the basic requirements we most often seek are clean air, water, electricity, sewage disposal and trash removal.

Clean Air might be construed as freedom from dusty roads, smog, foul smells from industry or landfills, free from noise of traffic, airports and/or neighbors.

Water Availability is essential and is often desired for aesthetics as well as drinking, bathing, washing, cooking, cleaning, toilet facilities and watering vegetation. We also enjoy lakes, rivers and streams for recreation. Others enjoy the tranquil sounds that our streams, rivers and oceans can provide. Without a doubt, water availability is a major concern. Note: A 1666 square foot roof can capture 1000 gallons of water for each inch of rainfall; cisterns of all types have existed since the dawn of man.

Electricity is another necessity that we often take for granted. Is a power plant within a reasonable distance from the land or will it cost you thousands of your own dollars to run cables across public lands to get your electricity hooked up? How far are gas and oil suppliers?

Sewage Disposal - 25% of our country is on a well and septic system. If you don’t have access to public utilities, will your land support a septic system as well as the water to operate it?

Solid Waste Disposal - how far is the landfill? Is there a collection service? You can’t burn everything; how will you get rid of it?

Those are the major necessities for modern, everyday living…things that we really need, but can often overlook until after the contract is signed. Others essentials are a telephone, mail delivery, shopping, police, fire station, hospital/emergency services, schools, churches, recreation facilities and access by good roads and highways.

You‘ll want answers to questions like those above and county officials such as planning and zoning, community development and building departments are a good place to start. I would also call utility companies about water, sewer, electric and phone, and talk to neighbors, contractors, developers, real estate agents, appraisers and a local surveyor to have some of the more important questions addressed at the beginning of my search. I wouldn’t rely on the sellers to be all-knowing, either.

Again, planning and zoning departments can offer the following: Maps of existing uses, forecasts of future development, lists of planned new roads, utility extensions, locations of planned waste disposal facilities, details on environmental areas and future land uses. They also regulate building codes, curb-cut permits, historic preservation, housing codes, subdivision regulations, tree cutting and zoning laws. They usually have aerial photographs and plat maps that can help you to better identify and evaluate the land in question.

Do you already have your location identified? Will it be in the east where the weather is often wet and humid or out west where it is predominantly arid and dry? Will you be living in cold weather in the north or gravitating towards the southern hemisphere? Concerning location, what are you least comfortable with: Avalanches, landslides, earthquakes, flooding, hurricanes, tornados, tsunamis, volcanoes and/or wildfires? You may want to investigate areas of interest by going to websites like http://www.officialcitysites. You will get a better picture of what awaits you concerning it’s economy, environment, population, recreation, educational, medical and employment facilities to name a few.

Let’s assume you know where you want to buy this land, why you want to buy it, and how and when you will use it once you have it. The following general observations, ideas and information may help you to further investigate the alternatives that are available to you in your endeavor to find the land of your dreams.

Raw Land is unimproved property; it has no utilities, sewers, streets or structures and usually must be cleared.

Here Are a Few Drawbacks That Are Sometimes Associated with Raw Land

1. Negative cash flow; usually the land does not generate any income while you pay the principle, interest, taxes and costs of development.

2. Tax advantages are scanty as land cannot be depreciated.

3. Generally, raw land is considered a long-term ill-liquid investment that often takes time before gains can be realized.

4. Risk of loss on resale can occur if you choose poorly, fail to evaluate and negotiate properly, the economy slips or various other unforeseen events occur.

5. It is difficult to obtain traditional financing on or borrow against accrued equity.

Here Are Some Possible Benefits to Raw Land

1. Land has the potential to experience tremendous appreciation if bought in the way of growth, or if a higher and better use can be achieved.

2. Owner financing can often be obtained through the seller at below-market rates.

3. Subdividing can create added value and provide for immediate returns.

4. Privacy and pride of ownership can provide a secure feeling to the holder.

What is Considered Good and Bad Land?

The worst you can buy is swamp or marshland. Most often flat land is the least expensive to develop and the most desired for building purposes. Land with barren rock will increase costs and virtually eliminate a basement just the same as a high water table.

You will most often be contacting many of these sources by writing to them. Don’t get discouraged when you don’t get immediate replies, as the average response rate is one reply for every eight letters that you send. The pros will get on lists and pay services to
monitor many of these potential sources, however, good old-fashioned detective work does pay off. When researching in this manner, secrecy is one key and fast action using all cash is the other.

A special consideration to note when hunting legally challenged property is to have a sand and some organic matter, appears rich and dark in color and is considered ideal for most purposes. As opposed to good soil, you don’t want hard cracking ground when dry and sticky soil when wet. Warning! Check with your state offices for the presence of expansive soils; this stuff cracks foundations in the most insidious ways, leading many to ruin.

Many people are literally being driven to the hills. Granted the views can be spectacular but roads, utilities, water, sewer, and foundations, such as pilings, can add 25-30% to building costs alone, further adding to this already expensive proposition. When considering going vertical, an 8-degree slope is about the limit when concerning building economically on hillsides.
Plots with trees, a view, rectangular in shape, a gentle slope or none and a good location are most often preferred, and streams can boost values by 100% in some cases.

How to Determine the Value of Raw Land

Using the appraisers standard view of estimating value can give us some clues, so let’s look at what appraisers do!

* Site size and shape, represented by frontage, width and depth.

* Corner influence equals visibility for commercial, or privacy for residential

* Plottage, has assembly or combining of parcels been accomplished

* How much land is excess or surplus; surplus has less value than what is required

* Topography: Land’s contour, grading, natural drainage, soil, view and usefulness

* Utilities: Sewers, drinking water, natural gas, electric, telephone, cable, etc.

* Site improvements: Landscaping, fences, gutters, walks, drives and irrigation

* Accessibility: Parking, location, streets, alleys, connecting roads and highways

* Environment: Climate, adequate water supply, air quality, rivers, lakes, oceans and the absence of any hazardous materials

An old timer once gave me this advice: He said, “Dan, always try to buy land that is located as close to those amenities that an area is famous for, as that is often the reason people come to certain areas. He lived in Florida and had plenty of beachfront property located in tourist areas, which clearly illustrated his point.

Who Has This Raw Land and How Do We Find It?

You may start your search by contacting farmers, investors, real estate agents, state and federal agencies, cities with odd lots they need to put back on their tax rolls, bureaus of land management, federal marshals, tax sales, bank foreclosures, developers, property heirs, the elderly, and family and friends. Use your networks and birddogs while driving areas of interest looking for further opportunities to buy.

Property is often advertised through newspaper ads, real estate brokers, For Sale by Owner signs, flyers, bulletin boards, the Internet, etc. A quick note on how not to buy is in order here. I would not recommend buying land from a glossy brochure or big development company as it is almost always overpriced to cover large overhead costs, advertising and profit. Also remember when a building boom is on, land prices rise. You will do much better buying when demand is low. Another caveat is to stay away from land that is advertised outside of its normal market as it is often overpriced or has problems; otherwise, a local buyer would have bought it!

If you want to find the deals, then most often you are going to have to dig for them. A few successful methods may include visiting the county clerk/recorder’s office to search the public records for the following:

* New probate filings, use them to contact heirs
*

* Eviction proceedings to contact out of state landowners

* Arrests - these people may need money and may also be going away for a while

* Bail bondsman who may have forfeited collateral in the form of land

* Divorces filed, leading to a division of assets

* New guardianships to contact disinterested heirs

* Deeds in lieu of foreclosure, private sellers may in turn sell it to you

* Lis pendens means litigation pending, often signaling foreclosure

* title company in addition to the regular search of mortgage

* Tax and easement liens

* also check files for I.R.S. liens, bankruptcy filings and judgment liens

Quick Review

Up to this point we have talked about not getting conned when starting out. We also noted that it pays to understand what everyone wants from the land to start. You are aware that utilities and basic necessities are very important considerations. You know whom to contact to get further in-depth information on properties of interest. You know flat land with natural amenities is the most desirable and economical to develop. You are more familiar with the risks involved with this type of real estate and you also know that rock, marshes and hillsides can be expensive to develop. You have a better idea of how an appraiser begins to determine value and you may have a few ideas on how to find land and the people who own it.

With that said, we are ready to get down to the business of evaluating, negotiating and financing our well-sought piece of terra firma. What follows is a basic checklist. There is more to consider but this will get you off to a running start.

Basic Raw Land Checklist

* Get the most recent and valid information available: A copy of the deed containing the legal description with any covenants and/or restrictions

* Get the street address, a plot plan indicating the specific property location, a survey, a preliminary title report, a recent map and any aerial or land based photographs to help you locate fence lines, trails, roads, streams, ponds, building locations, etc. Walk the land to verify, evaluate and correlate what is indicated, also looking for any signs of hazardous waste dumping, burying or burning

* Determine present use in zoning, according to what planning and zoning tells you. Symbols are used to designate uses - here are a few:

A1 - Agricultural with single family home
C - Commercial business
CO - Commercial office
FP - Flood plain
M - Industrial
R1 - Residential single family
R1H - Residential hillside
R2 - Residential multifamily
RT - Recreational tourist/ Residential transitional

General categories include:

Farm, Ranch and Timberland
Recreational or Resort
Industrial
Commercial/Business
Residential
Mixed use

* Confirm who owns it, their full name, address and phone number

* Find out what they do; are they a dealer in real estate?

* Ask if anyone else is on the title or has authority to act

* What are the annual taxes and assessed values?

* Ask why they are selling and how long they have owned it

* If the owner doesn’t want to sell, ask if they would consider selling a parcel of it

The preceding is an abbreviated checklist. It is meant to get you started off on the right foot. Many people will research buying a new car more thoroughly than they would when buying raw land; there are many good books that are devoted solely to the subject of raw land. This type of investment is generally not the best choice for the new investor but often times people look to build they’re dream homes away from developed areas and for that reason I have included my two cents here.

Finance Considerations $$$

Raw land as opposed to improved property is much more difficult to finance through traditional lenders. The main reasons are that it generates very little income, development costs can be expensive, there are no buildings or improvements that can be used as collateral and it is often considered speculative.

For those reasons mentioned we find that sellers are often our first choice regarding financing. It is typical for a seller of raw land to accept 10% down and the rest to be paid over time at a specified (below market) interest rate. This would be an example of an installment land contract. Other forms are contract for deed, mortgage and note and purchase money mortgages. In these cases, a real estate attorney usually drafts these contracts and a bank will act as an escrow agent to facilitate verifiable records of payments received. The seller often retains the deed until the property is paid for in full.

If you want to investigate bank financing, then you may start out by offering 30% down with a seven-year mortgage, with the bank getting an extra percentage point over and above the current interest rates for standard loans. This may not be accepted but it does give you a starting point to see just what they may be willing to do.

If you plan on building on your land, then having a development plan with an appraised set of blue prints for the project will help the lender in justifying your loan. If you can use equity from other property, then paying substantial down payments may also be an option.

My final words of caution here would be to know values and don’t overpay. Always offer less when possible and research recent sales of comparable properties. The larger a parcel is, the cheaper it tends to get per acre. Ask an agent what an acre of land tends to go for in the area that you are considering; try to buy more than one acre.

When buying residential lots, builders try to keep raw land costs down to 10% of the overall value of the project. If streets and utilities are already in place, then they will use 25% as their guideline. If you can combine or assemble parcels or achieve zoning changes with property, you have a good chance of immediately increasing its value. Always physically inspect the property and do your research before obligating yourself to buy it. Try using contracts with contingencies put in to protect yourself. In essence, these are really options that let you control the deal while you investigate and research the land’s potential to satisfy your objectives. Happy Hunting and buy the high grounds!

These terms are important for you to understand as they are the ones most commonly used by the professionals with whom you will be working. This is not intended to be a glossary, but an explanation of the terms through an example.

Net Operating Income (NOI)

The Net Operating Income (NOI) of a property is calculated by determining the property’s first year Gross Operating Income and then subtracting the Operating Expenses for the first year.

Gross Operating Income
Less
Operating Expenses
Equals
Net Operating Income

The Gross Operating Income of property is the total income a property can expect to receive from all sources over a one year period. The Operating Expenses are the expenditures needed to keep the property operating during the same period. (See the article Cash Flow Model for a more thorough explanation.

Sample Calculation:

$500,000 Gross Operating Income
Less
$300,000 Operating Expenses
Equals
$200,000 Net Operating Income

The NOI of a property comes directly from the operations of a property and disregards mortgage payments or other additional expenditures the property owner may make, such as tenant improvements or leasing commissions.

Capitalization Rate (Cap Rate)

Many investors start their financial analysis of a property by calculating the NOI in order to be able to calculate a Capitalization Rate (Cap Rate) according to the following formula:

Net Operating Income
Divided By
Property Price
Equals
Cap Rate

The Cap Rate is expressed as a percentage rate. Cap Rate is typically calculated based on the first year of operations of the property and an all cash purchase of the property.

Sample Calculation:

$200,000 Net Operating Income
Divided By
$2,000,000 Property Price
Equals
10%

A Cap Rate can be looked at as a first year return to the investor comparing how much the investor would receive from operations with the price that would be paid in an all cash purchase of the property. It is a measure of performance the investor can look at to compare how their money is working for them in one property compared to another property or investment.

Many institutional investors purchase their properties for all cash, not using any financing. For them, the Cap Rate is a valuable method of comparing properties. Individual investors often use financing and it may be more appropriate for them to use additional methods of comparing first year returns.

Cash On Cash

Many investors who use financing to acquire properties use the Cash on Cash method to compare first year performance of competing properties. Cash on Cash takes into consideration the fact that the investor does not have to have all cash to purchase the property, but also will not keep all of the NOI because they must make their mortgage payments from their NOI.

First, the investor must determine the amount they must invest to purchase the property or their Initial Investment.

Total Purchase Price Plus Costs
Less
Amount Financed
Equals
Initial Investment

Sample Calculation:

$2,050,000 Price + Costs
Less
$1,550,000 Loan
Equals
$500,000 Initial Investment

Next, the investor must determine the first year Cash Flow from operations, including the payments due on the financing.

Net Operating Income
Less
Payments on Financing
Equals
Cash Flow

Sample Calculation:

$200,000 Net Operating Income
Less
$140,000 Payments
Equals
$60,000 Cash Flow

With the calculation of the Cash Flow and the Initial Investment, the investor can make another comparison of how their money performs in this property compared to other properties. By calculating Cash on Cash the investor can calculate a first year percentage return on their investment in the property.

Cash Flow
Divided By
Initial Investment
Equals
Cash on Cash

Sample Calculation:

$60,000 Cash Flow
Divided by
$500,000 Initial Investment
Equals
12% Cash on Cash

The Cash on Cash percentage can be looked at as a first year return to the investor comparing how much the investor would receive in cash flow from the property when the property is purchased using financing. It is a measure of performance the investor can look at to compare how their money is working for them in one property compared to another property or investment, when financing is used.

Many investors use the Cash on Cash percentage in their investment decisions as more accurately reflects their results than does the Cap Rate which ignores the financing used to purchase the property and the payments that must be made on that financing from the NOI of the property.