Value based REO investing

Real Estate Investing is more than just locating a nice looking property in a good location for what you perceive as a good price.

It is all about finding the best value for your money and then exploiting that investment for the highest possible return.

Locating good buys in today's market is not so difficult with all the resources now available for both experienced & novice investors.

But once you find the property, you still need to determine what you have and whether the "good buy" represents the "best value."

The 4 components of ROI (return on investment), as they apply to real estate investments, are:

1. Cash-flow
2. Loan reduction
3. Appreciation
4. Tax benefits

Cash-flow is simply gross annual income less all expenses less loan payments & maintenance. For example, let's say you found a property for $220,000 with a 20% down payment with a 6% mortgage that yields market rents of $1,350. With a total monthly outflow not including vacancy or maintenance of $1,260 the property is netting $90 per month.

$90 x 12 = $1,080 / down payment of $44,000 = 2.45% return

The second component of ROI is loan reduction:

80% loan = $176,000

Total yearly payments of $12,662 with $10,501 per year interest

= $2,161 loan reduction

$2,161 / down payment of $44,000 = 4.91% return

The third component of ROI is appreciation:

This is without doubt the "X" factor in today's real estate market. Appreciation is affected by these four factors:

1. Scarcity of undeveloped land
2. Transferability or ease in selling & buying.
3. Usability of the property
4. Demand for property in a given marketplace

Of these factors, the buyers ability to get a loan in today's tightening credit market believe it or not affects your properties future value. As financing guidelines tighten, it makes the pool of potential buyers shrink which may drive down home prices.

However with inventory levels at approximately 9-11 mos supply most experts believe the bottom is very close and as such we could see normal appreciation rates of say 2% starting in 2009.

So assuming a 2% appreciation rate, $220,000 x 2% = $4,400

$4,400 / down payment of $44,000 = 10% return

The fourth and final component is tax benefits:

MACRS (modified accelerated cost recovery system) is part of the 1986 tax reform act and works as follows:

Your depreciable improvements can be deducted in the form of depreciation over 27.5 years. & that depreciation allowance less any cash-flow & loan reduction results in a tax sheltered benefit which applied to your tax rate results in a true dollar return.

For example: County assessor shows our $220,000 property above as: $100,000 improvements & $150,000 total assessed value. Value of improvements = $100,000 improvements / $150,000 assessed value or 66.67%. This figure multiplied by the new sales price = $146,674.

$146,674 / 27.5 years = $5,333.60 annual depreciation allowance

$5,333.60 less $1,080 cash-flow & $2,161 loan reduction = $2,092.60 tax sheltered benefit. Assuming a 25% Federal and 8.3% state income tax bracket, the tax savings would be $2,092.60 x 33.30% = $696.83

Putting it all together:

1. Cash-flow: $1,080
2. Loan reduction: $2,161
3. Appreciation: $4,400
4. Tax benefits: $696.83

Total return = $8,337.83 / $44,000 down payment = 18.94 ROI

Assuming home prices don't increase but have at least bottomed out your adjusted ROI would simply be: $8,337.83 - $4,400 = $3,937.83 / $44,000 down payment = $8.94%.

Assuming the property looks in fairly good shape with no maket deficiencies, and calculating a worst case return of 8.94%, this would be one example of a best value as mentioned above.