Even with depreciation, this is still a bad deal at $489,000. If your depreciation deduction were $17,781 per year, and you are in the 31% tax bracket (who knows, maybe it’s higher or lower, but work with me here for the sake of example) then the value of that deduction is $17,781 * 0.31 = $5,512.
Your NOI is $37,800. Let’s assume (again for the sake of an easy example) that you paid cash for the property, so your before-tax cash flow is also $37,800 – there’s no debt service.
Your after tax cash flow in the 31% tax bracket would be $37,800 * (0.69) = $26,082. If you add back the tax benefit from depreciation, your after tax cash flow would be $31,594. If you paid $489,000 for the property, your net after-tax cash on cash return would be $31,594/$489,000 or 6.5%. You could get a bank CD that pays that much with no risk at all. It would be silly to take all the risk of owning an apartment building for the same return.
I have been approached to buy a 3 unit rental, asking $489,000, where total rental is $4,500 ($2,220+$1,200+$1,100) a month (seller says $5,000 a month). Prop taxes are $8,400. What do you think? Any analysis would be appreciated as I am not quite clear about the depreciation aspect. I think prop should be depreciated over 27.5 years, so $489,000/27.5 = $17,781. Is this $17,781 simply added to the free cash flow of the property? Thanks… Kim
Posted by ken in sc on March 09, 2001 at 16:00:19:
This deal is overpriced. Unless you put a high downpayment, it would lose money. And noone on this board puts a high downpayment!
As for depreciation, you forgot your land value. Depreciation is price less land value divided by 27.5 yrs. And it has nothing to do with real dollar cash flow. It is just an accounting paper loss that typically offsets rents so that you are not taxed on making all that rent money as income.
Always buy income property for income, mortgage reduction, and appreciation first, and let the tax rules be the icing on the cake, not the reason to buy.
No deal here. You would be substantially overpaying for this property at $489,000.
If rental income is $4,500 per month, that’s $54,000 per year. Assume 30%-40% for expenses. Even at a conservative 30% assumption, your net operating income is $37,800. If you paid $489,000 this would be a 7.7% cap rate. Unless you see some other avenue to create value (rapidly rising rents, rehab opportunity, or something similar), I would advise you not to pay anywhere close to $489,000.
As for depreciation - it’s a non-cash expense, meaning it reduces your taxable income but not your cash flow. So, the answer to your question would be “yes”.
You seem to be looking at them both as money in your pocket…neither one is. Depreciation is a “paper”, tax deductible expense. Nate’s post (below) explains the benefit well. The benefit to you is the income tax savings, which is a fraction of the depreciation itself. (Also, when you eventually sell the house, all of the depreciation that you have taken is, in effect, added to your profit and taxed. The advantage of depreciation is that it reduces your taxes today, but it adds to your taxes later. Most people are happy to trade savings today for expense later.) The details of your example seemed to show you simply adding the depreciation to your cash flow. It doesn’t work that way…you can add the tax savings related to the depreciation, but not the whole depreciation.
As for property taxes, this is real money out of your pocket. You showed it properly as a real expense. However, you later added back to your cash flow. This is similar to depreciation, except that it is a real, out-of-pocket expense. You do get a tax benefit from it, but it is a fraction of what you really spent. (However, unlike depreciation, since this is a real, cash expense today, you do not have to add it back into your profit later.)