PSA: Taxes Are the Biggest Cashflow Killer (With Examples)

by | BiggerPockets.com

We don’t have TV service in the main house. We do have one in the casita for our guests — but not in the main house. We do, however, enjoy some Netflix at home. In the evening, once the kids are down for the night, Patrisha and I spend about 45 minutes watching something funny or interesting.

Lately we’ve been on a documentary kick. The last one we watched was about the great American band the Eagles. The documentary is called History of the Eagles.

There were many takeaways for me, but one thing in specific caught my interest. Toward the end of the movie, when all of the narrative’s Ts are being crossed Is are being dotted, Don Henley reminds us of a line in “Hey Hey My My” by Neil Young: “It’s better to burn out than it is to rust”

As I heard these words, I thought I knew where he was going. But then Don Henley comes back with this: “…but, I don’t see rust as a bad thing. I have an old 1962 John Deer tractor that’s covered with rust, but it runs like a top. You know, the inner workings are just fine.”

Does anyone else find this interesting? This intro doesn’t specifically have to do with the subject matter I’ll be touching on in the following paragraphs. It’s just that I, seemingly unlike so many people on BP, see real estate as a part of life — but not life itself. I hope you’d forgive my transgression in saying something of value not just in your real estate endeavors but in your life as a whole.

And now, let’s teach you something about real estate.

The Basics

On your way to figuring out how much to pay for an income-producing property, the first order of business is to figure out the  net operating income (NOI). The application of this NOI varies from one investor to the next, but in one way or another, we all start there.

Now, it’s important to understand that while we do look at the trailing data, what’s most important to us is not how the building has performed in the past, but how we think it’s going to perform in the future. And with this in mind, we are forced to make certain assumptions about both the income and the operating expenses. It is when making these future-looking assumptions that I see people running into trouble.

The Biggest Killer of Cashflow

There is one item in specific which seems to represent the biggest pitfall for people, and it is property taxes. I am going to tell you about five of the properties I came in contact with over the past 30 days. Two we put offers in on, and two others we did in-depth underwriting on, trying to compete. These properties ranged from 52 units to 174. In addition, one of the clients I consulted was underwriting a 20-unit property.

All of these were on-market properties. In all cases we had access to both the trailing financials and the offering memorandum (OM).

Related: 7 Common Myths About Rental Property Taxation—Dispelled

The Offering Memorandum

You know what they say about contractors: If they show up, they are in the top 10 percent. Sad but true. The bar is very low. Well, as it relates to broker underwriting, the bar is similarly low: If an underwriter makes an attempt to look honest, they are in the top 10 percent.

Brokers are in a tight spot, and I respect that. They have to paint the best possible picture. They have to make a pig look like a milk cow that produces chocolate milk. Let that sink in. Those who are better educated manage to do this while maintaining some sort of semblance of appearance of propriety. Most don’t even bother with that.

As it relates to the underwriting of property taxes, if a broker acknowledges the reality that your tax bill will go up post close, that’s about as much as can be expected. But hardly anyone is honest about this, for obvious reasons.

In the case of the five properties I mentioned above (the four that we underwrote for ourselves and the one I helped a client with), some of the offering memorandums flat out made no attempt to underwrite future taxes, while others made feeble attempts at being “honest.”

Here’s what we were comfortable underwriting having researched applicable information:

52-unit: current $43,000; projected $68,000

152-unit: current $57,000; projected $100,000

163-unit: current $122,000; projected $175,000

174-unit: current $162,000; projected $308,000

And the 20-unit I consulted on: current $6,500 – $31,000

Related: THIS Major Tax Benefit Convinced Me to Put My Money Into Large Multifamilies

Conclusion

uirtye numbers above were arrived at after detailed conversations with localities. These are guesses, but they are educated guesses. Could our estimates be high? Sure. But I don’t find the thought of calling my partners, who brought $5 million to the deal, to tell them that I underestimated the taxes appealing. I underwrite as per municipal guidelines.

None of the offering memorandums offered guidance anywhere near real numbers.

Be careful out there, boys and girls!

What about you?

Have property taxes affected your deals in the past? Share your experiences below!

About Author

Ben Leybovich

Ben Leybovich has been investing in multifamily real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben the author of the Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

15 Comments

  1. Lawrence L.

    Great article Ben thank you. How do you come to your calculations for taxes or do you use a rule of thumb if you are doing a quick calculations to see if you are going to look further into the property.

  2. James Gorman IV

    With our IRS today, my suggestion is get a good CPA & TAX Lawyer to help you when selling depreciated low cost basis Commercial Income Property; and do not exclude amalgamation opportunities – especially if the true amount of cash out is important to you.

  3. Jerome Kaidor

    I do take property tax into account – but it’s nowhere near the most damaging to cash flow. Neither is it hard to figure. Here in California, I just multiply the sales price by 1.2%. Some counties are a bit less. They get to raise it 3% a year – that can break your planning. If they get ahead of the real market value, you protest the valuation. There are legal offices that specialize in that, and they do it for a percentage of what they save you.

    Here’s what I find much more damaging and elusive: Sellers lying about maintenance & repair!

    And here’s another one…. Sellers giving pro-forma numbers on market rents that you will never get – because the property is in a rent controlled jurisdiction.

    • Alexander Bigelow

      Could not agree more with your points. I take every number a seller gives me with not a grain, but a pound of salt. Protect yourself by doing your own research and approximations, not only on the taxes but every other expense as well.

  4. chris schu

    You don’t need to be a CPA to realize that pro formas aren’t worth the paper they’re printed on. Such documents can be as bad as crooked fortune tellers yet still fool otherwise astute investors who love wearing rose-colored glasses.

    At least trailing paper is supposed to reflect reality while providing a STARTING point for investigating the alleged income/expenses of a prospective property yet even audited financials can have blatant misrepresentations sprinkled throughout.

    “They have to make a pig look like a milk cow that produces chocolate milk.”
    And that my friends is – in a nut shell – was what the Great Recession (loose…basically fraudulent…underwriting, MBS, incompetent regulatory oversight, and pure greed) was all about.

    “None of the offering memorandums offered guidance anywhere near real numbers.”
    Why am I not surprised?

    Another poster stated “Almost criminal the pro forma budgets they create.”
    True that!

    “Sellers giving pro-forma numbers on market rents that you will never get…” was yet another post.
    Summary: Pro formas = fantasy land.

    As LEYBOVICH said:
    “Be careful out there boys and girls.”

  5. David Milner

    Property taxes are a state & local tax, so every state, and sometimes jurisdictions within a state, determines their own assessment procedures and tax levies. This can vary widely between states, so it is a good idea to reasearch before entering a new state.

    For example in Arizona, a highly invested market, as of 2014 calendar year, there is no longer a reassessment following a transaction. There is also a taxable value increase cap of 5% per year. This is very investor friendly! As an example, my brother-in-law was looking at properties in Phoenix for lower cost investments than his San Francisco home. He found a 2/2 asking $125,000, with a taxable value of about $40,000. When he purchased, the assessment did not go to purchase price, instead it only increased 5% from the previous owner’s $40,000. So his property tax on a $125,000 purchase is only ~1% effective rate of the old $40,000 plus five percent increase, or $42,000 for taxes of only ~$420 per year, or less than $40/mo. Both Oregon and Nevada, while different processes, have similarly resulting artificially low property taxes, with no reassessment at purchase

    Texas, on the other hand, is a non disclosure state, so purchase price doesn’t have to be revealed, but the local appraisal district does reassess freely from year to year with no increase cap, and about 2% effective rate, or double the Arizona residential effective rate. So, the same $125,000 purchase in TX would likely get assessed much closer to the acquisition price and likely see a tax bill of more like $2,000 per year, or $150/mo vs. the $40/mo in Arizona.

    To complicate matters, most mortgages impound taxes along with insurance, so owners pay a monthly escrow and not the full installment. It definitely makes a difference which state a property is located as to the annual property tax expense load, which can be the difference between cash flow positive and negative.

  6. Erik S.

    You definitely have to research the local jurisdiction as they vary a lot. For example, the same property in NC and a few minutes away in NC can have thousands difference in taxes due to SC taxes being much higher for non owner occupied. It is so easy to calculate. Google “real estate tax rates in _________________”. Make sure to apply and city limit taxes too. Find out how to calculate the tax basis. Example NC does per $100 in assessed value. SC does per $1000….

  7. John Barnette

    For an even deeper analysis of possible taxing scenarios I also consider population demographics and financial situation with local government. I considered exchanging some of my Bay Area low cap rate property that had appreciated a ton to some professionally managed high cap rate turnkey Chicago multi-plexes. I did not. And a significant reason is fear of future excessively high property taxes due to the horrible fiscal state of Chicago and the flat population growth. I personally feel property owners are going to get taxed and taxed and taxed some more.

  8. dennis tierney

    Depending on your location property taxes can also be your friend. Commercial property taxes are high in Iowa, whereas residential property gets around a 50% “roll-back”. Some smart lawyers figured out that if you change an apartment building from commercial to condo or co-op status you can drop property taxes in half. Therefore if you buy a property that is commercial rated and then change to co-op, as we did , the money saved goes immediately to your bottom line. The property we did that with in Council Bluffs has been our best cash flowing one and the legal costs paid for themselves in less than a year.

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