Time Horizon Definition – Rental Property Investment Criteria

Time can  have  a significant  impact  on the growth  rate of your real estate portfolio. Time affects such things as the tax rate  applied  to  your  gain  or  loss. The  long  term  capital gains tax rate has historically been more favorable than the short term tax rate. Time is also the variable  in the rate of inventory  turnover.   Large  retailers  are  willing  to  accept lower   profit   margins   on   items   they   merchandise  in exchange for a higher inventory  turnover  rate. Would  you rather earn twenty percent  on each item, or house, you sell and have a turnover  rate of one, or would  you rather earn eight percent  on each  item you sell and  have  a turnover rate of three? Let’s do the math.

Turnover Ratio = Turnover/Years = 1/1 x 20% =  20% total return

Turnover Ratio = Turnover/Years = 3/1 x 8% = 24% total return

 

This simple  example  clearly  illustrates  that  an  investor can accept  a lower rate of return on each  property  bought and sold and earn a higher overall rate of return, provided that the frequency, or turnover  rate, is increased. I should mention  that  this example  does  not,  of course,  take  into consideration transaction costs. These costs may or may not be significant depending on your specific situation, but they must be factored in when analyzing  a potential  purchase.

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Investment time horizons typically fall into one of three cate- gories: short term, intermediate term, and long term. Short-term investors are defined as those individuals who buy and sell real estate with a shorter duration. They typically hold their investments less than one to two years. This class of investor most often seeks gains by adding value through making improvements to the prop- erty, or by taking advantage of market price inefficiencies, which may be caused by any number of factors, including distress sales from the loss of a job, a family crisis such as divorce, or perhaps a death in the family. The shorter holding period does not allow enough time for gains through natural price appreciation caused by supply and demand issues or inflationary pressures.

The short-term investor may furthermore seek to profit by using the higher-inventory-turnover strategy and, as a result, may be will- ing to accept smaller returns, but with greater frequency, thus realiz- ing an overall rate of return considerably higher than the long-term approach, as demonstrated previously. Since current tax codes penal- ize short-term investors by imposing higher tax rates on short-term capital gains, they must factor this into their analysis before ever pur- chasing a property.

The proper financing mechanism is also a key part of an in- vestor’s analysis. In a short-term strategy, an investor can often take advantage of a loan with a more favorable floating or adjustable rate as opposed to a longer-term fixed-rate loan. In addition, depending on the type of financial instrument procured, principal payments may not be required. This provision allows an investor to minimize his or her outgoing cash flow by making interest-only payments. Cash flow is the name of the game in real estate. Learn to use it to your benefit. Finally, you should be aware of any pre- payment penalties that may be imposed on short-term financing. Banks are especially notorious for assessing this additional type of fee income on a loan. Their decision to do so is based on the prem- ise that since the loan is short term in nature, they must charge addi- tional fees to offset their other costs associated with making the loan, such as administrative costs. That argument, however, is the same one lenders use to justify charging a loan-origination fee, which is typically one point, or 1 percent. If you have a good track record and are an established investment professional, prepayment penalties can usually be negotiated down to a minimum, and often- times will be waived all together.

Intermediate-term investors most often hold their properties for at least two years but no more than five years. This class of investor typically seeks gains through a combination of increases in property values, resulting from price appreciation due to supply and demand constraints in the local market, and by making modest improve- ments to the property. Reducing debt to increase cash flow is not as high a priority for intermediate-term investors as it is for their long- term counterparts. This class of investor also tends to be more highly leveraged than do long-term investors. Finally, since intermediate- term investors hold their investment properties for a minimum of two years, they are able to take advantage of the lower and more favorable long-term capital gains tax rate. As the tax laws are cur- rently written, income derived from the sale of assets with a holding period shorter than 18 months will be treated as ordinary income and therefore subject to a higher tax rate.

Once again, the proper financing mechanism is a key part of an investor’s analysis. In an intermediate-term strategy, an individual can, like the short-term investor, take advantage of a more favorable floating-rate loan. If the time horizon is firmly established as one that will not exceed five years, I recommend using floating-rate instruments in most cases, since they almost always carry lower interest rates than do fixed-rate loans. The exception to this recom- mendation is, however, that if rates are forecast to rise in the near future, it may be better to lock in a fixed rate now than to run the risk of rapidly increasing rates. Similarly to short-term financial instru- ments, you may be able to obtain a loan in which principal payments are not required.

Depending on the needs of the seller, you may even be able to negotiate a deal in which no periodic payments whatsoever are required. This includes both principal and interest. I’ve used this technique myself; as a matter of fact, I very recently closed on a land deal valued at $3.3 million that will not require any periodic princi- pal or interest payments. The seller agreed to carry the note and allow the interest to accrue. The interest will become payable at the time individual lots from the land are released, which occurs when my company, Symphony Homes, builds a house on it (see Appendix B). At that time, a construction loan is obtained to pay both the accrued interest and the principal balance to the seller. Interest-only payments are then made to the bank over the next four months or so until the house is completed and sold.

Long-term investors may purchase real estate properties and keep them in the family for generations. They will typically hold them for a minimum of five years, but oftentimes much longer. Long-term investors seek gains through capital appreciation by simply holding and maintaining their investments while making improvements on an as-needed basis. They sometimes seek to minimize the associated debt and maximize the cash flow generated by the property through an acceleration of both interest and principal payments. Although in the short term, investors adopting this strategy will decrease the property’s cash flow by making larger monthly payments, they will eventually increase its cash flow by eliminating the debt altogether. As a result, long-term investors are usually not fully leveraged. They gen- erally prefer the positive cash flow to being excessively leveraged. Long-term investors are able to take advantage of the more favorable long-term capital gains tax rates when they do eventually decide to sell. In addition, long-term investors may elect to take advantage of deferring the tax liability indefinitely through a provision outlined in the Internal Revenue Code referred to as a 1031 exchange.