When is it okay to lose money to make money? Hmmm… depends on how much, I guess. How about this: When is it okay to break even? Now we’re talking.
If a landlord can rent a property for 3 years at $12/sf per year but must spend $30/sf for build out and the cost of ownership is $2/sf per year, should they do it? The answer is: it depends.
- $12/sf x 3 years = $36/SF
- $36/SF – $30/SF = $6/SF
- $6/SF – $6/SF [$2/sf x 3 years] = $0/SF
Based on these simple calculations the landlord nets nothing; making it seem like the deal is not worth doing. Real estate investment is not simple though and requires complex and detailed analysis to guide decision making from acquisition to disposition. An understanding of the overarching principles that guide such decisions is crucial for successful investing because they can turn nothing ($0) into something. This is the foundation of asset management.
Here are some of the factors to consider when making a decision that, at first glance, appears to result in a loss or, at best, a net zero:
Do you know how much you can deduct from your taxable income based on cost recovery/depreciation on improvements? Are you aware of the 20% deduction straight off the top as a result of the new tax code? What’s the difference between a repair and an improvement as it relates to the time period over which the costs can be deducted?
Financial leverage allows investors to do more by using someone else’s money. While there is always risk involved, financing has the power to increase returns by lowering taxable income through the mortgage interest deduction and amortization of loan points as well as through positive leverage (the greater the spread between the cost of funds and the asset’s return the greater the increase).
When are losses good? Answer, when they offset profits elsewhere and can reduce that taxable income for an overall gain. Do you know how to structure your real estate holdings so that you can keep more money from profitable assets while investing in and/or taking losses in others?
I could make at least 10 other bullets if I parsed this out. Here’s the basic concept… if you can buy a property below market, great. If you can buy a property at a good price (market or below) and add value that will produce disproportionate returns, BINGO. You don’t invest in a dog of a property… you invest in a property that has upside potential. There’s a difference.
The tenant is leasing space… the landlord is investing in them. There are the tangibles like financial statements and leasing history that should guide decision making. That being said… when I was working at Lehman Brothers… (just kidding). Landlords MUST make decisions based on a comprehensive risk analysis. The good part is in the upside. I’m sure Microsoft’s financials looked questionable at some point (we all know Apple’s did). The point is that people enter into contracts and we will never get away from the intangible elements that make us trust someone or want to take a chance on them. You do what you can to mitigate your losses, but when you make a good bet and it pays off, everyone wins.
Repositioning/Investing for the Future
Not all acquisitions are class A properties. Oftentimes, the foundation of a good deal is acquiring a property that can benefit from capital improvements and at a price that reflects such a need. Through such repositioning, investors are able to raise rents and attract higher quality tenants, thereby increasing the asset’s market value. Some investors may choose to perform capital improvements prior to leasing the property, but such a large capital outlay may not be an option for everyone.
It is my position that the best course of action is to aggressively lease up the property by listing it at slightly below market rents but only agreeing to short lease terms, i.e. 3 years and agreeing to renewal options at the then market rate. This applies primarily to office space and landlords should only agree to expenditures on improvements that can easily be reused by subsequent tenants. This strategy allows landlords to offset the costs of the necessary capital improvements to reposition the asset within a short timeframe.
Therefore, that “ZERO” from the previous example isn’t actually zero simply based on write-offs, alone. The question is then not “when is it okay to lose money?” but rather “is this a good investment?” Will my actions/decisions/investments yield positive results/returns over the projected holding period? If the answer is “yes,” you do it.