Sketch of Alexandria project
Drawing by M. Hamilton Morton, Jr. A.I.A.
Chapter VIII
Preservation Economics
Historic preservation is a very expensive art form. The preservation of a painting, or an antique dresser, does not compare with the cost of preserving a Greek Revival house. And yet, in many ways, it is a more important art form than paintings or furniture. For here is where history has taken place. They "are more than beautiful works of architecture. They are vehicles of culture... and in their evolved states, whole works of art, in whose intangible elements the true value lies, because it is there that we find the signs of life."
If we think of the aesthetic value of preservation, then it also must be seen in terms of its costs. There may be no inexpensive way to preserve an important older building. The costs of simple maintenance alone can be a financial burden for a family or community organization that has the responsibility of care for a historic structure. Costs of full restoration can run even higher, and often require special materials and workmanship.
What can be done to alleviate such financial burdens? Who has the responsibility for paying for preservation? Is there a way to create financial incentives to offset such costs? These questions must be confronted in order to make preservation acceptable to society in general.
The federal government has tried to give financial assistance
for preservation, especially through the provisions of the National
Historic Preservation Act of 1966, including grants and loans.
But even at its zenith in 1979, the national appropriation was
only $60 million, (roughly the cost of twelve miles of interstate
highway). As a result, the grant program never got off the ground,
and the loan program had only a limited scope. To provide financial
aid for preservation, federal programs instead have relied on
incentives to encourage the private sector to provide the funding
that wasn't available through the public sector. Remarkably,
these incentive programs have worked, to a degree no one thought
possible.
Rehabilitation can seem an expensive option for a commercial developer. There are drawbacks to rehabbing older structures-spaces not easily adapted to current needs, problems of deterioration not apparent at the beginning of work, difficulty in finding apporopriate construction materials.
Yet rehab can also pay. Studies have shown that rehab can save money compared to new construction, as shown in the following report.
Rehabilitation costs per square foot are often significantly less than the costs of new construction. Case studies presented at the National Trust for Historic Preservation conference on the "Economic Benefits of Preserving Old Buildings" demonstrated that the cost of rehabilitating old structures generally runs 25-33 percent less than comparable new construction. In those cases where the costs are equivalent, the preservation project provided greater amenities-time saved in construction, more space in either height or volume, or the right location. These amenities frequently produced other economic benefits to a developer through higher occupancy rates and rents. In addition, rehabilitation oftentimes bypasses lengthy development review processes, local neighborhood opposition, and zoning delays.
The costs of rehabilitation can be seen in other ways as well. A government study found that rehabilitation construction uses 23 percent less energy than new construction; the primary reason being that the work is more labor intensive than material intensive, depleting fewer natural resources.
A report on the "Conservation of the Urban Environment," prepared by the Office of Archaeology and Historic Preservation in the Department of the Interior, explained this in more detail. The reliance on labor intensive work "is important not only in terms of the employment potential of historic preservation, but also in terms of an individual project's multiplier impact on a local economy. Dependent on the size and sophistication of a locality, a higher proportion of construction materials will come from outside the area than will construction labor. For funds that are spent in a local economy, a higher percentage of funds remains as a stimulant in that locality from projects that are labor intensive. Thus, funds utilized in historic preservation projects have greater impact on employment than funds used in the construction of new buildings such as hospitals, schools, and office buildings because of (1) the greater labor intensity of preservation projects, and (2) through this labor intensity the higher multiplier."
Testimony by the General Service Administration
indicated that rehabilitation creates two to five times as many
jobs as new construction for a given expenditure of money, and
that this was especially important since older buildings tend
to be found in areas of the city that have the highest rates of
unemployment and underemployment.
Owners of designated historic properties often complain that they are taxed unfairly. Local tax assessors may evaluate a historic property in a downtown area based on the property's potential for development. Thus an owner who restores a two-story residence in a prime area may have to pay a property tax rate comparable to that of a newer and larger commercial building. This is patently unfair to the owner of the historic property, who in some cases is severely penalized for maintaining a historic property rather than replacing it with a building that would allow more intensive use.
Because downtown preservation (where this type of inequity is most commonly found) is a relatively recent phenomenon, there have been few legal precedents to deal with such cases, and it remains unclear whether special provision could be made in assessments for certified historic properties. One case decided that the assessment could not be raised based on "highest and best use" of the property as long as the property was either designated or application for designation had been officially filed. This emphasizes the importance of designation as a way to give protection to owners of historic properties.
Various steps can be taken by local governments to mitigate the
disincentive of higher assessments. Some cities are empowered
to defer tax increases for a number of years, and this power can
be invoked when the restoration of a historic property is completed.
Some preservation ordinances allow for a reduction in property
taxes for designated historic properties. These tax rebates compensate
owners by recognizing the potential inequity of owning a historic
property; they typically are tied to ordinances that regulate
the owners' right to demolish or alter the exterior of a property.
In some communities local lending institutions have agreed to
join together to offer a program of below-market-rate or guaranteed
loans to owners of historic commercial properties who wish to
restore or rehabilitate their buildings. Through such programs
historic districts are able to withstand the pressures for demolition.
The ownership of a historic building can sometimes be a financial burden due to the expense of proper restoration or rehabilitation. A method of easing this burden available to owners of both commercial and non-commercial properties is the use of easements. An easement is a donation to another party of part of a property. The owner agrees to relinquish part of his or her "bundle of rights" inherent with property ownership in return for favorable tax treatment.
An example best describes how easements may be used for historic
properties. The sketch below shows an actual property in Alexandria,
Virginia, a community with high property
values located near Washington, D.C. with high property values.
The property includes a significant historic house and carriage
house (shown in black). The two structures and land had a total
market value of $200,000. However, a developer was offering $1
million for the property, subject to approval to build 18 townhouses
as shown. The owner, recognizing this much greater value, wanted
to sell, but the local historic district commission would not
approve such intensive development of the property.
The owner felt he was treated unfairly, and that he should be compensated by the city for the $800,000 loss of potential profit resulting solely from the historic district commission's designation. The courts, however, have consistently upheld a community's right to deny inappropriate development of historic properties, as long as owners continue to get a reasonable return on their property, even if it isn't the highest and best return. In this case, however, the owner was able to recoup some of that loss in potential income by claiming an easement on the historic property. An agreement in perpetuity was made, and attached to the property title, that as long as the property remained as it was he could claim a personal tax deduction for the $800,000 difference. Depending on the owner's tax bracket, this could be a large proportion of the amount, and would serve as considerable compensation for denying development.
Easements, then, are potentially a valuable means to both protect a historic building and compensate an owner. Using a facade easement an owner of a property with a historic facade agrees to give up the right to change the facade "in perpetuity." The current owner and all future owners are bound to the easement provisions, whatever they may include. In return, the current owner can claim as a donation for tax purposes the value of the easement.
Questions regarding the procedure immediately arise, however. First, who determines the value of the easement? A well qualified appraiser who has had experience with similar appraisals should determine the fair market value of the easement. Second, who checks over the years to insure that the facade, or other easement component remains unaltered? A not-for-profit organization (known by tax law as a 501c3) must inspect the condition of the easement at least once a year, both to see that it has not been altered and to insure that it is being properly maintained. The organization may be chosen from a local or statewide preservation group, a local historical society or the State Historic Preservation OfficeState Historic Preservation Office.
One can appreciate why easements are not often used for historic structures, and why their use often leads to complications. The program is good in theory, but not so good in actual practice. The Government Accounting Office conducted a study that found that easements were typically overvalued by appraisers, often at 200% or more of their actual value. It was in the owner's interest to have a high appraisal, and very few appraisers are experienced in evaluating easements and therefore don't have other "comparables" from which to extrapolate values.Government Accounting Office conducted a conducted a study that found that easements were typically overvalued by appraisers, often at 200% or more of their actual value. It was in the owner's interest to have a high appraisal, and very few appraise
Owners also find it difficult to identify not-for-profit associations willing to oversee an easement, typically without compensation. This responsibility has great potential for problems, but little in the way of reward. Finally, owners are discouraged by the fact that easements must be given in perpetuity, which decreases the overall value of their property because some rights of ownership are denied to potential new owners.
When properly set up and administered, however, easements are
a good way to maintain a property's historic integrity. They
permit a community to hold onto important elements of its architectural
heritage, and they benefit owners, who earn tax breaks while ensuring
that the integrity of a historic building has been protected for
posterity.
In densely developed urban areas, historic buildings can be threatened by economic forces that encourage a property's "highest and best use." In these cases-for instance, a historic church building or museum located in the downtown commercial area-owners are limited by historic designation, which can prohibit them from realizing potential profits from selling their property for development. A "Transfer of Development Rights" provision can help rectify this financial inequity.
A Transfer of Development Rights (TDR) program allows
owners of buildings in zoning districts where more intense development
is permitted to sell that development potential to the owner of
another site. As shown in the diagram below, air rights are literally
purchased by another owner for use on a second site.
The city of Philadelphia provides an example of a Transfer of Development Rights program. The TDR came about when an ordinance was passed to prevent the demolition of a landmark downtown building. At the same time an old "gentlemen's agreement" was broken not to build a downtown building higher that the hat on the sculpture of William Penn on the City Hall. It was recognized that development should be encouraged while the historic character of the downtown district was preserved.
The Philadelphia TDR program allowed for this, and had three goals when it was established in 1991;
More than 200 owners of historic structures were eligible to sell development rights through the TDR option. This incentive was combined with two other development programs-an enhanced tax abatement program that included historic properties, and a large revolving loan fund.
San Francisco considered the use of a TDR program as a way to encourage preservation, described in A Preservation Strategy for Downtown San Francisco. The study proposed the following recommendations for the use of TDRs:
Although the federal government laid much of the groundwork for preservation efforts through the National Historic Preservation Act of 1966, little had been done up to that time to give financial incentives for preservation. Without financial incentives, preservation would remain an idealistic issue removed from the mainstream of development. Indeed, until the 1970s developers were given tax deductions for expenses incurred in demolishing older buildings. This was without prior determination whether such buildings had historic significance and should be protected from demolition. These types of tax deductions encouraged the wholesale demolition of many older urban neighborhoods, which were destroyed one after another under the guise of "urban renewal" programs. Many sites were destroyed to make way for new development which did not materialize, leaving behind the eyesore of vacant lots. Those areas that were "developed' often fared no better. Urban renewal often generated the construction of new limited-access highways into the downtown core, allowing suburbanites to have speedy access to downtown offices. "Superblocks" sprung up which replaced the traditional urban neighborhood scale of small blocks of two- and three-story row houses and walkups with a new order of high-rise apartments.
When the horrors of 1960s and 70s urban renewal projects became apparent, the federal government responded in a limited way. In 1976 the Tax Reform Act was a first step in recognizing the inadequacies in protecting existing neighborhoods and historic structures. The Act stated that developers could no longer consider the cost of demolition as a deductible business expense; previously developers had essentially been reimbursed by the federal government to wreck cities. The Act also permitted accelerated depreciation for substantial rehabilitation of historic structures, which allowed owners to take greater tax deductions in the early years.
A 1978 Act went further by establishing an incentive program for rehabilitating older buildings. The Rehabilitation Investment Tax Credits Program allowed developers a 10% tax credit for the costs of rehabilitating a historic structure. The 10% credit was a considerable incentive, for unlike a "tax deduction," which is a reduction from gross income claimed on the tax form, a "tax credit" is subtracted directly from the amount of tax owed, and represented a much greater amount.
Since the new Rehab Investment Tax Credits (RITCs) could only be taken for rehabilitation work on historic structures, a procedure needed to be instituted for determining what structures qualified as historic. To accommodate this, the 1978 Act utilized the State Historic Preservation Offices (or SHPOs, commonly pronounced "Shpoes") in each state. One of this office's primary responsibilities was to review and approve eligibility for "Certified Historic Structure" status. Such status now made rehabilitation costs eligible for the new tax credits.
With these parameters the new Rehab Investment Tax Credit program became an immediate success. A 1979 study showed that $1.3 million in tax credits had generated $27 million in rehabilitation work. Between 1976 and 1986 nearly 17,000 projects, valued at $11 billion, took advantage of the program. The focus of urban projects had shifted dramatically from demolition to rehabilitation. One prominent preservation consultant, speaking at a preservation forum, concluded, "The tax credits have been enormously successful in cities and towns around the country in encouraging the preservation of historic buildings." Congressman Richard Gephart (D-Mo.), speaking at the 1994 National Trust's conference, referred to the tax credits as "the most important feature for urban redevelopment and urban renewal" in the 1980s. Another concurred, explaining the significance of the credits in revitalizing downtowns; "all kinds of things have been tried to stop the deterioration of downtowns. The first program that ever really worked was the investment tax credit."
Because of its success and increasing public support, the federal government expanded the RITC program in 1981 as part of the Economic Recovery Tax Act (ERTA). Instead of a straight 10% tax credit for Certified Historic Structures, the new Act increased the tax credit to 25% for "significant" structures, truly a substantial return on investment, and also allowed the tax credit to be used for "contributing" buildings in "Certified Historic Districts." It also added two new categories, allowing a 20% credit for any income-producing building over 40 years old and a 15% credit for any over 30 years old. The new Act led to the creation of many new historic districts, for through this device many structures which would not be recognized as historically significant on their own could qualify for the 25% credit as "contributing" structures.
The tax credit program led to the saving and rehabilitation of many, many historic buildings. Its purpose was not to restore "significant" older buildings as museum pieces, but to return them to use to meet current housing, retail, industrial and commercial needs. Even developers with no previous interest in historic preservation wanted to become involved because of the financial opportunities. The National Park Service reported that the largest number of rehabilitation projects under this program (approximately 50%) were for housing, with many more being mixed-use projects, which included housing. This stimulation of private investment in housing through a public program was unparalleled by any other government housing program.
For the years 1982 through 1985 the tax credit program alone stimulated the investment of an estimated $9 billion dollars in over 11,000 structures. An article in Historic Preservation that included a national survey of developers showed that 36% would have not done rehab work to historic properties without the tax credit program, that 39% would have done substantially less, and that only 24% would have done as much as they did with or without the program. Certainly the tax credits provided the engine to make the historic rehab program run.
The program also made some strange bedfellows. Where old-line preservationists had for many years opposed most of the proposals presented by developers, now preservationists and developers both supported the programs, the former because it saved historic buildings and the latter largely because it was profitable. The biggest beneficiaries of the program financially were high tax bracket investors who were looking for a way to decrease their tax burdens. They considered investment possibilities primarily on the basis of whether they qualified for tax credits, and as "passive investors" they were little concerned whether business contained within the structure succeeded or failed, as long as they received the program's tax breaks.
By 1983 there were 3,600 applications for tax incentive projects. In 1984 the Government Accounting Office looked into the impact the program was having on the federal treasury, and became alarmed at the program's success. They calculated that the taxes lost through these credits had increased from $2.5 million annually in 1978 to $210 million in 1984, and an increase was projected to $700 million annually by 1988. In a time of fiscal cutbacks, this kind of largesse could not pass unnoticed.
The GAO also discovered some serious abuses in the program. Some 17% of those owners claiming tax credits did not qualify, and their buildings had not been approved for such status. Also, if a building were sold within five years of its rehabilitation, the owner forfeited his or her credit on a prorated basis, and was liable for a "recapture" tax. But the study found that fully 40% of those owners who sold within five years had not paid this recapture tax. Finally, a serious abuse was found in the use of easements. For properties where an easement had been donated, and the owner was able to take a tax deduction based on its value, it was found that the average easement had been overvalued by more than 200%.
The federal government decided to clamp down, and the tax credit program was in serious jeopardy of termination. It was saved only because of a strong lobbying effort by groups impressed by the incredible success of the program in retaining and refurbishing older buildings and historic districts in cities throughout the country. The 1986 changes in the tax law trimmed down the program, but also removed some of the abuses and inequities.
The 1986 Tax Act limited credits to individuals
who were actively involved in the property. Passive investors
would no longer be able to piggyback onto others only to take
advantage of tax credits. Also, tax credits were scaled back
to 20% for Certified Historic Structures
or contributing buildings in Certified Historic Districts, and
to 10% for any other structure built before 1936. These new values,
although lower, were an improvement in some ways. With the previous
values of 25% for a CHS and 20% for a 40+ year old building
not certified as a historic structure, many owners and developers
had preferred working on the latter property, for the rehabilitation
standards were much less strict, and rehab work didn't require
a delay while state certification was obtained. As a result,
more secondary buildings were rehabbed than significant historic
structures. This distorted the program's goals. The situation
has largely been rectified with the new 20%/10% values, which
gives primary encouragement to the most significant structures.
The Rehab Investment Tax Credit
program has done much, since its inception, to stimulate interest
in rehabilitating older structures. As described above, the program
has changed considerably since its inception. The current program
operates according to the following provisions.
Buildings may qualify for RITCs either as "historic" or "non-historic." To be considered "historic" a building must either be listed on the National Register (a Certified Historic Structure) or be a contributing structure in a historic district recognized by the Secretary of the Interior. Owners can claim a 20% tax credit on the costs of rehab for these buildings. A qualified "non-historic" building is simply one built before 1936, and it is eligible for a 10% credit.
Buildings may earn the 20% credit only if they are income-producing,
or used in a trade. Residential rental units also qualify, but
for the 10% credit a building must be nonresidential.
Expenditures that qualify for RITCs are essentially those connected with the rehabilitation or restoration of the structure. The Secretary of the Interior must certify that the work is consistent with the historic character of the building, and this approval is usually administered through the State Historic Preservation Office.
Examples of qualified expenditures are:
Examples of non-qualified expenditures are:
Consider a commercial building for which the owner paid $100,000 five years ago. The value of the land itself is $45,000. The owner has made $10,000 in improvements and has depreciated the property at $6,000 per year. The adjusted basis would equal:
$100,000 Cost of property
-45,000 Less value of land
$55,000
+10,000 Plus improvements
$65,000
-30,000 Depreciation (5 yr.@ 6,000)
$35,000 Adjusted basis
In this case the rehab expenditures must exceed $35,000 to qualify, since it is the greater of $5,000 or the value of the adjusted basis. Also, the rehab work must be completed within a 24-month period, although prior approval may be given for a phased rehab extending up to 60 months.
Prior Use Requirement: To be eligible, a structure must have been used as a building prior to its rehabilitation, and cannot, for example, be a caboose or grain silo converted to use as a habitable building.
Wall Retention Requirement: If the rehabbed building is nonhistoric (qualified because it was built prior to 1936), it must also meet the wall retention requirement. To satisfy this requirement a certain proportion of the exterior walls and framework must be retained as follows:
The great incentive inherent in the RITC program is that tax credits are given, which provide a dollar-for-dollar reduction in the income tax owed, rather than a deduction. The Rehab Investment Tax Credits may be used to offset up to $25,000 of personal income tax liability. Beyond that they may offset 75% of such liability. Credits not used in one tax year may be carried forward up to 15 years or carried back three years.
Credits may be used only by individual taxpayers or closely held corporate taxpayers (five or fewer shareholders owning more than 50% of the stock). They do not apply to work done to buildings owned by other types of corporations or non-taxpaying institutions.
If the building is sold, exchanged or converted to personal use within five years after the credit is taken, the tax credit must be repaid at a recapture rate of 20% for every year under the five year minimum. For example, if the building was sold after three years, the owner would need to repay 40% of the credit taken. The new owner would be ineligible for any portion of the credit.
An example will illustrate the important tax advantages of the RITC program to a property investor. First, assume $1 million is invested in the construction of a new building. With straight-line depreciation over 31.5 years (the standard rate) the tax benefits accruing over the years would be $80,638.
For comparison, assume an investor purchases a historic property for $250,000 and spends $750,000 to rehabilitate it. The same total amount of money is spent on this property as on new construction. However, with the resulting 20% credit for rehab and a similar depreciation rate, the tax benefits would total $204,906, yielding more than two and one-half times the benefits.
It is important to realize that the tax credit program is complicated
and subject to change, and the description above is only is a
general overview of the major provisions. Before work is actually
begun on any such project one should get the advice of a reliable
financial advisor.
There are many variables in considering the financial feasibility of rehabbing an older commercial building. How can these variables be accommodated in a systematic way so as to calculate a project's potential?
"Pro forma analysis" is a technique commonly used for
projecting the financial future of a project for a given number
of years. It figures "dollars in" versus "dollars
out"; the bottom-line must always be favorable for any investor
to consider a rehab project. Pro forma analysis begins with a
base-line year, usually the current year, and considers how the
financial status of a project will change over three, five or
even ten years, based on certain assumptions made by the analyst.
Five years is the most common time span, long enough for the
project to "settle in," to cover most start-up costs,
and to develop a normal occupancy rate-yet not so long that projections
are too hypothetical.
To better understand the elements of a pro forma analysis, a case study will be used of a typical two-story, turn-of-the-century, commercial building. The property is for sale at an asking price of $195,000. Located one block from Main Street in downtown, it is in an area with good potential for growth, either for offices, stores or residences. The property has not been improved in more than 40 years.
The following analysis will look at the feasibility of investing in the rehab of this property, and will present, item by item, the factors which need to be considered. A financial datasheet, using a computer spreadsheet program, is presented on the following page that gives a complete overview of the analysis. On the pages following, each item is explained, with some assumptions changed to illustrate its overall impact, until a complete picture of the project is developed.
Final Price - The asking price for the property is $195,000,
but the seller usually will accept 5-10 percent below the asking
price. A final price of $175,000 is assumed here.
Costs of Rehabilitation - There are a number of ways to calculate the costs for the rehab. Initially, a project architect will give a preliminary estimate, based on prices from other projects and cost-estimating books. Contractor's bids provide more accurate estimates, but are difficult to obtain until the project is actually designed and plans and specifications are available, a process that follows rather than precedes the feasibility analysis. Typically, a cost estimate will be developed in the projects's early phase by basing it on a dollar-per-square-foot value. This "quick and easy" approach generalizes many of the project details, but where one factor may be estimated low another will be high; the result for any but the smallest projects should be a reasonable estimate of costs. The square-foot cost figure can be obtained by talking with builders and realtors in the area, who will estimate it based on their experience with other projects similar in scope.
For the case study project the preliminary cost estimate was established at $40/square foot, for 7,200 square feet (SF). This was added to the cost of demolition, which together formed the project's "hard" costs of $298,000.
The "soft" costs for the project included professional fees for the architect, appraiser and attorney, as well as costs of the mortgage during construction (6 months), closing costs, permits and start-up costs. For this project these total $52,756.
A final cost of rehab was "rent-up" costs, or the costs
of advertising, marketing and office expenses in finding initial
tenants, in this case $10,820.
Total Project Costs - The price paid for the property plus
the costs of the rehabilitation are added together to form the
total project cost, which must eventually be recouped if the investment
is to be profitable. In this example the total is $536,576.
Loan to Value (LTV) Ratio - To raise the total of $536,576, two sources were used, investors and lenders. Investors are individuals who are willing to put up their own money, either in the hopes of a significant return or for tax advantages. Lenders are simply institutions, such as banks, who lend money as a business.
Banks and other lenders are unwilling to put up all the money for a real estate project, but insist that some funds be developed through other resources. Thus, if the project fails, they will recoup enough in value to cover their portion of the investment. The percentage of total costs a lender is willing to risk is established as the "Loan to Value" ratio. Typically this ratio is between .75 and .80, meaning that the bank is willing to make a loan for 75-80 percent of the project's value if it is determined that a project has a sound financial basis; this in large part is determined on the basis of a thorough feasibility analysis, such as this one. Based on an LTV ratio of .80, the case study project could expect a mortgage from the bank of $429,261, requiring $107,315 in cash from investors.
______________
The initial total cost of the project has now been determined.
To the analysis must now be added calculations of ongoing income
and expenditures, and their impact must be determined on an annual
basis (referred to as "annualizing")-i.e., converting
all information into an income or expenditure over a one-year
time span.
Total Gross Rent - A projection is made of the annual rental
income derived from the project, based on market data figures
for the local area. The project's downtown area currently has
a typical rate for ground floor commercial space of $10-18 per
square foot per year. Because this property borders a main shopping
street, a rate of $14/SF was assumed for ground floor rental.
The second floor could be leased for offices at $10/SF (the basement
is assumed to have no rental value). Based on the square footages
for each floor as shown, a total gross rent (annualized) of $86,400
is anticipated.
Projected Vacancy Rate - Not all of a project's space can
be leased all the time, even in a very good market. Initially
it takes a period of months or years to come up to full occupancy
at full market rates. An average vacancy rate
of 30% of 10% was assumed.
Gross Effective Income - By reducing the Gross Rent figures
by the projected vacancy rate, the expected annual income, called
the Gross Effective Income, can be calculated. This is shown
to be $77,760.
Operating Expenses - Balanced against the Gross Effective
Income are ongoing project expenses. These include taxes, insurance,
project management costs, legal and accounting fees and normal
repair and maintenance. The cost of utilities may either be included
as a project expense, or may be passed along to the tenants if
the lease so specifies. The case study assumes the tenant pays
for utilities. These annual expenses are projected at $27,638
for a typical year.
Debt Service - The annual debt service
is based on the total mortgage amount (in this case, $429,261),
the mortgage interest rate and the number of years of payments.
The case study uses an interest percentage rate of 8.5% paid
over 20 years, or 240 months. From this a monthly payment is
derived, using an amortization calculation. Such calculations
can be done quickly by a bank loan officer or by using one of
many simple computer programs now available.
The whole purpose of a pro forma analysis is to determine how much an investor can expect to get as return of his or her initial investment. Will it be as much as could be expected from other types of investments, such as the stock market or a money market bank account? Is the return high enough to be worth the extra risk involved and the fact that the money may be tied up for an extended period of time? What are the local market conditions, and how are they likely to change over the course of two, five or ten years? It is apparent that changes in some of these factors can impact dramatically on the financial outlook of a project, while others will have surprisingly little impact on the total return.
A rewarding aspect of investing in real estate is the fact that
there are three ways to make a return on an initial investment.
Added together, these three types of Return on Investment (ROI)
can add up to a significant total return-one that justifies the
greater risk and involvement. The three types of return of investment
(ROI) found with real estate are Cash Flow, Return on Taxes,
and Appreciation.
Before Tax Cash Flow (ROI #1) - Cash Flow is the amount that is returned to an investor annually as cash. This represents the most immediate type of return, although it will typically be the lowest in the early years of a project, and may initially even be negative, meaning additional cash will need to be put into the project over the short term.
Cash FlowCash Flow is determined by
deducting the annual amounts for Operating Expenses and Debt Service
from the annual Gross Effective Income. For the case study, the
annual Cash Flow is $5,571. To determine this as a percentage
return on investment, the Cash Flow amount can be divided by the
amount of the original Cash Investment, which is $107,315. This
represents a return of 5.2%. A rule of thumb is that the Before
Tax Cash Return should be at least double the percent that could
be earned in a bank savings account.
Return on Taxes (ROI #2) - Many investors, especially those in higher tax brackets, are less concerned with cash return than they are with the tax advantages of real estate investment, and historic building rehabs provide some of the best tax opportunities available. The calculation of the Return on Taxes is shown on the datasheet in Box E, "Return on Taxes." Return on Taxes is shown on the datasheet in Box E, "Return on Taxes."
Annual tax return is based on the depreciable value of a property. The depreciable value is the total value of the property less the value of the land (a basic assumption of tax law is that a building will depreciate in value over time, but the land it is on will not). With the land having a market value of $30,000 (established through local appraisal), the case study example has a depreciable base value of $506,576.
A building's value can currently be depreciated over 39 years. This allows an annual depreciation of $12, 989 in our example. To calculate the actual Return on Taxes for an investor, this amount is multiplied by the individual's tax bracket. Assuming he or she is a high tax bracket investor, the total state and federal tax bracket percentage may be around 39%, giving an annual tax return of $5,066. As with ROI #1, this amount is compared against the initial cash investment of $107,315, for a Return on Investment (ROI #2) of 4.7% annually.
In addition, the rehabilitation costs of "certified historic
structures (CHS)" can be partially recovered through the
Rehab Investment Tax Credit provisions. Many of these advantages
were described previously in the section on "Tax Incentives,"
where it was explained how the rehabilitation of such a building
could make investors eligible for a tax credit totalling 20% of
the costs of rehab. If the case study building is assumed to
be a certified historic structure, an additional total credit
of $72,315 (20% of the rehabilitation cost of $361,576) can be
applied (shown in the box, "With Rehab Tax Credit").
This calculation assumes the investor spreads this credit over
5 years, giving a tax credit of $14,463 per year, which is in
addition to the already described tax return based on depreciation.
For ROI #2, the annual return is now 17.5%, instead of the previously
calculated 4.7% return without the historic tax credit. One can
easily see the direct and significant financial gain possible
through the use of the rehab tax credit.
Appreciation (ROI #3) - The greatest Return on Investment is typically from the continuing appreciation in the value of a property. If properly maintained and regularly updated, properties will increase significantly in value over time. This assumption may initially seem contradictory, for it has just been explained that tax law assumes a decrease in the value of property over time, but such depreciation is a theoretical assumption, while the true market instead shows appreciation over time.the true market instead shows appreciation over time.
The amount of increase based on appreciation varies with local and regional market conditions. The case study example has assumed an annual increase in the total value of the property of 3%. Thus, if the project was worth $536,576 upon completion, its value one year later would be $552,673, or an increase of $16,097. Although the appreciation increase is based on the total value of the property, the Return on Investment (ROI #3) compares this increase in value against only the cash investment made by the investor ($16,097/$107,315), showing ROI #3 to be 15.0% annually.
This relatively high ROI due to appreciation represents one of
the primary reasons for investing in real estate. However, this
return is realized only on the sale of the property, and is dependent
on an investor being able to tie up his or her money for an extended
period of time. Real estate investing is not for those who need
a regular, predictable return on their investment, but can be
very rewarding for those who can invest relatively large amounts
and wait for favorable market conditions.
