Real Estate Returns

From 2004 through 2007 I was securities licensed and participated in Tenant in Common (TIC) market. TIC’s were classified as securities and were essentially sold as a security backed by a  fractional interest in real property. The attraction to the TIC product was it’s qualification for the IRC Sec. 1031 Tax Deferred Exchange and was considered the investment of choice for property investors planning to retire from active management of their investment property. TIC’s just like any investment in real estate in the 2004 – 2007 era are having varying results but the supply of capital they generated for commercial investment market was robust.

TIC investments in apartments are generally doing OK or better than the market and the same can be said of Health Care Properties. The areas of concern and hurt are Office Buildings, Retail Centers including Auto Facilities, Student Housing and Hospitality. There has been some total losses in these property types and there would be a lot more if there were not some form of loan modifications or cooperation from lenders. Don’t get me wrong! Lenders are not accommodating because they’re good guy’s,. They’re doing it because they’ve discovered being a landlord usually costs them a lot more money, headaches and liability. They don’t like that last one!

I decided to not renew my securities a couple of years ago to focus on real estate only. There were several reasons for this but the main one was the amount of mark-up or load by securities folks was getting outrageous and next would be the limitations on available product through securities sponsors. Another was the restrictions placed on me by the Securities license. A lot of the time a successful real estate investor is a Mom & Pop. They invest in real estate because they believe in it. They can go see it everyday. They can look at the history of the country and the history and return of investment in real estate and see a correlation. They don’t care that they’re over weighted in one investment… that’s the way they want it, and they get real peeved at any “Wall Street Type” who tries to tell them different.

Real Estate sales and 1031 tax deferred exchanges are still our main focus. In sales we’ve found a niche liquidating estates for administrators and trustees. For exchanges, it’s not in the best interest of most of the folks I consult with to trade what they have for whats available, which must be the first consideration of an exchange transaction. At times we find exceptions which turn into good and profitable transactions that fits into the investors plans. These are mostly local real estate deal where properties have to be sold to liquidate a probate or trust estate. In terms of TIC’s they’re still around and there are a couple of good sponsors out there in the TIC arena. Likewise TIC sponsors are getting good deals in this market although they’re usually secondary markets and the transaction markup is still over and above the regular real estate. Nevertheless, a good TIC representative can produce a deal that will provide a landlord with a terrific retirement investment.

If you’re an investor looking for an exit strategy from active property management or you’re just tired of tenants, it would be better to focus on finding NNN investments that will give you the same or better returns as a TIC where you’re the only investor and you have almost total control. Lots of these investments exist in properties where ground leases are used. A good example would be a fast food restaurant on a high profile corner. You own the land and the franchise or tenant leases the land on a 20-30 year lease and takes responsibility for paying  the bills on everything. You enjoy the cash flow from the real estate which can be sold, traded, exchanged or borrowed against. Control!

In terms of what is going to happen in the next couple of years… It will depend on the labor market. If we begin to create real jobs, not minimum wage or slightly better middle-man type employment, then things will improve. Also the further away we get from the 2008 collapse the  better chance we have for a new normal. Unlikely we’ll ever get the returns we got in 2004-2007. If you see that happening again, it would be a good time to start shorting the stock of the lenders involved.

The bottom line on sustainable return on investments is controlled by the supply of capital. There is an abundant supply of affordable capital for banks which will is available for qualified real estate investments in the 60-75% Loan to Value ratio. If we return to the days of sensible real estate investment principals, then we look to the lenders rate and add a risk margin for the return on our higher risk down payment. A hypothetical example would be; a lender loan rate of 5% then an investor should be looking at 6-6.25% to compensate for the added risk.

That was a long way to say we won’t have the crazy 2004-2007 market in real estate again for a long time.

Who Gets Your Vote?

The cast of characters—sounds like a Hollywood type of deal. Some of these characters actually think they are in Hollywood, or they are Hollywood material. This is an area where a lot of people screw up, and I don’t want you to be one of them.

Just as in life, the top players in the real estate market get the top dollar. So you pay a little bit extra and you get the best in the class. They usually make the difference up anyhow—they can get you that little bit extra in the sale price or save you that little bit extra in the purchase price that will pay their fee.

Let’s put it this way: if you’re in the bottom of the ninth inning of a baseball game with the game tied and the go ahead run coming to bat… who’d you send to the plate? The 200 hitter or the 340 hitter? That’s right! You’d send the guy that has the best chance to win the game for you. You’d look for that pinch hitter that could bring those runs home for you.

Real estate’s similar in so much as there are specialties, or brokers who work in certain specialties. If you have a real estate property that’s in the rental housing market or the 2-4 unit size, the broker that you hire to assist you in that transaction should specialize in the residential investment section of the market. A similar type of property is the 5 residential units and up or the apartment house investment, but has different requirements for financing and disclosures that the former. Completely different still is the broker that specializes in industrial or office property sales, and still they are different than brokers who specialize in representing tenants and landlords in leasing. So it’s a good idea to select a specialist in the type of property and transaction you’re planning to conduct. Oh! Don’t forget to inquire about the 1031 tax deferred exchange experience of your chosen professional as well.

Another rule of thumb when you’re going out there to select an agent is to interview two or three of them. And you’ll also notice that I said brokers, not agents, not sales persons, not vice-presidents. The reason for that is you need a guy or girl that’s at least taken the trouble to go and get a broker’s license to represent you. Somebody that’s been around the real estate market for fifteen or twenty years and hasn’t considered it worth their while to go and get the extra education to get the broker’s license is somebody that you should not have representing you.

If you’re looking for some additional qualifications, a good way to look at those is to find the agent that took the time and patience to go and get specialty real estate designations. In terms of designations, the top one there is for real estate agents in the commercial field is a CCIM, followed by an SIOR. A CCIM is a Certified Commercial Investment Member, they have a very broad range of knowledge. If anyone can handle cross sections of properties, it would be a CCIM. An SIOR is an agent or a broker who specializes in office and industrial property. Both these organizations have a great network of people all across the country, and indeed, across the world. CCIM’s & SIOR’s are both national and international.

The last designation I’m going to discuss is an RECS, and that is a broker that sells property in cyberspace. That is a Real Estate Cyber Society member. In today’s market, people are buying all over the country, so it is to your advantage to hire a broker that is also Internet-savvy.

Knowing this information will help you find the right agent for the job, not some Hollywood wanna-be. Taking this step will save you both time and money in the long run, and give you a smoother transaction all the way around.

City Living With Style

Here’s the biggest advantage of doing a 1031 exchange? By deferring tax, you have more money in hand to invest in another property. In effect, you receive an interest free loan from the Government, in the amount you would have paid in taxes. A wonderful estate builder indeed! In most cases the tax bite on the profits of a real estate deal fall between 30% to 35%  and by doing an exchange the investor get to roll all the profits into the next deal. Consider what a benefit that is over a lifetime of investing.

Despite this generous benefit some folks elect to sell and pay the taxes. This is often done out of ignorance on behalf of the investor of the broker the used to sell the property. Another reason could be the seller decided to finance the deal for the buyer. Depending on what side of the deal you’re on with this seller financing there are advantages. However, the tax still has to be paid but the question now is, when?

It’s also worth noting here that there are several taxes due if the investor decides to cash out or decide against the exchange option. Here in good old Orange or Los Angeles Counties the investor with a profit or Capital Gain will get the privilege of paying, Federal Tax, State Tax, Depreciation Recapture Tax, County Transfer Tax and in the City of Los Angeles a separate City Transfer Tax. Make sure all of these are considered and what they’ll cost you before committing to a deal. You need to have the exchange option included in your purchase and sale agreements.

Some folks confuse “tax -deferred”  with “tax free”. They are quite different and you don’t want to discover that difference when you’re across the desk from the IRS auditor. Here’s the difference: In a 1031 exchange, you defer paying the capital gains taxes on your relinquished property. Its tax basis is carried over to the replacement property. When you finally sell the replacement property, without doing an exchange, you will pay the tax at that time. However, you may repeat this deferral process over and over again, from property to property over a period of years and under current law your immediate family can inherit the property with a stepped up basis. In other words, the capital gains tax is forgiven. Not Bad!

It’s refreshing to know that there is some break from the IRS in pursuit of capital gains tax.

As you might imagine, there are some rules and regulations to adhere to in a IRC Sec 1031 Tax Deferred Exchange. While the tax deferred exchange has been around since 1921, there have been some modifications in the rules. For this reason, it is very important to use the services of professionals who are familiar with these types of transactions. A mistake here could be very expensive and as everyone’s situation is different a consultation with an expert and some research  of your options is a really good use of your resources.

Now we have established the benefits of investing in multifamily properties or apartment rentals, tomorrow we can now get down to most efficient way to manage them for fun and profit.

Everyone Want's A Beach Community

A few years ago Stephen Covey authored a book titled, The 7 Habits of Highly Effective People® in which he strongly advocated beginning projects with the end in mind. Unfortunately few people took heed of that advice, especially in the multifamily or apartment investment property market.

As a result of ignoring that advice many find themselves in what we metaphorically refer to as the harvesting season for the landlord that’s had enough of tenants, taxes and toilets and would just like to enjoy the fruits of their effort. Shrewd investments and savvy exchange moves for many years combined with careful management, saving and sacrificing to build their retirement nest egg. But even with a plan…would it have prepared anyone for the debauchery of the credit default swaps and the collapse of the funding for the investment property market? It’s no secret the condition of the apartment house market is completely different now than it was in 2007 and that’s not the Landlords fault.

Long gone are the days when lenders were lining up to provide financing, and as I write this post, it has just been announced that Freddy & Fanny have been delisted from the NYSE. It’s too early to tell what effect that will have on their lending programs, but they’re basically the only game in town now for residential investment property loans. It can’t be a good result for the investors of residential income property. As it is we’re looking for buyers with 40-50% down payments to get a deal done. A far cry from the, “tell em a story and get the funds” of the 2004-2007 era.

An argument can be made that Fanny & Freddy’s trouble may bring with it an opportunity to get back to some old-fashioned real estate deal making. The kind of deal that provides security, cash flow and comfort to both sellers and buyers. Eliminate a bunch of “Wall St. Wing Tippers” in the middle to boot. The kind of deals we had before the Wall Street boys got control of the mortgage market. Before franchise real estate companies would only do, or allow their brokers and agents to do only the vanilla cash or cash to new loan transactions. Let’s look at what we have now and what we could do to improve the investor’s security, control and return on investment.

As I see it here are the retiring landlords options and opportunities:

• Sell and pay the Taxes. (Ochs!) 30-35% goes to the taxman.
• Sell a do a 1031 Tax Deferred Exchange. (But I thought you were tired of tenants)
• Donate the property to a Charity for an annuity payment. (Property needs to free & clear and your cash flow is controlled by the Charity and their investments)
• You could do a master lease if the lender allows it. (But you’re still a Landlord)
• Last but not least… In fact it’s the best option of all! Seller Financing. Sometimes referred to as “Owner will Carry.” (Opportunity!)

OK! OK! Lots of seller’s won’t entertain the idea of financing the deal for the buyer’s and in the past I’ve have been in complete agreement with them. But, things have changed in a lot of respects, so please hear me out on this. The last 3 years have shed a lot of light on the security or lack of it, on our investment markets. If you were a believer in the security of real property as an investment, then you’d surely believe in a loan or loans that are properly structured, using cash flowing real estate as security or collateral. Right!?

Lifetime Exchange Benefits

Here’s the biggest advantage of doing a 1031 exchange? By deferring tax, you have more money in hand to invest in another property. In effect, you receive an interest free loan from the Government, in the amount you would have paid in taxes. A wonderful estate builder indeed! In most cases the tax bite on the profits of a real estate deal fall between 30% to 35%  and by doing an exchange the investor get to roll all the profits into the next deal. Consider what a benefit that is over a lifetime of investing.

Despite this generous benefit some folks elect to sell and pay the taxes. This is often done out of ignorance on behalf of the investor of the broker the used to sell the property. Another reason could be the seller decided to finance the deal for the buyer. Depending on what side of the deal you’re on with this seller financing there are advantages. However, the tax still has to be paid but the question now is, when?

Before you make a decision one way or the other, it would be prudent to examine the effect of your decision give the choices. In an 1031 Tax deferred exchange you can defer some or all of the taxes. You don’t have to do all or nothing! In a sale where the seller finances the deal, some taxes are paid at the time of sale and the balance are paid as the seller receives them with some exceptions. In an outright sale or “cash out” there’s an assortment of taxes due especially here in Orange & LA Counties. Here’s a list without percentages as they can change depending on your situation, Federal Capital Gains Tax, State of California Income Tax (or your state if the have tax), Federal Depreciation Recapture Tax. There’s also Property Transfer Tax on the entire sale amount even in exchanges. If someone tells you to pay the tax, it’s only 15%… Run! Find a new adviser.

Some folks confuse “tax -deferred”  with “tax free”. They are quite different and you don’t want to discover that difference when you’re across the desk from the IRS auditor. Here’s the difference: In a 1031 exchange, you defer paying the capital gains taxes on your relinquished property. Its tax basis is carried over to the replacement property. When you finally sell the replacement property, without doing an exchange, you will pay the tax at that time. However, you may repeat this deferral process over and over again, from property to property over a period of years and under current law your immediate family can inherit the property with a stepped up basis. In other words, the capital gains tax is forgiven. Not Bad!

It’s refreshing to know that there is some break from the IRS in pursuit of capital gains tax.

As you might imagine, there are some rules and regulations to adhere to in a IRC Sec 1031 Tax Deferred Exchange. While the tax deferred exchange has been around since 1921, there have been some modifications in the rules. For this reason, it is very important to use the services of professionals who are familiar with these types of transactions. A mistake here could be very expensive and as everyone’s situation is different a consultation with an expert and some research  of your options is a really good use of your resources.

Now we have the tax situation established we can examine the benefits of investing in multifamily properties or apartment rentals, and get down to most efficient way to manage them for fun, profit and devise an exit strategy that will work best for you.

Most people I know got into that business by accident! After 18 plus years of dealing with landlords in their day-to-day business, assisting them in buying, selling and exchanging their properties. After many lengthy chats and informal surveys, I have come to the conclusion that most people got into this type of investment property by accident rather than on purpose.

Among the reasons most people finish there was they bought a new home and kept the old one. Some bought a house next door just so they could control who their neighbor would be, others helped a family member or a buddy with a loan and finished up getting the property instead of the loan repayment. There is also a considerable portion of this market who inherited their property and decided to continue in the business of their benefactor.

Another group of investors are those folks who attended a real estate seminar and actually implemented some of what they learned there or in the materials they purchased. Still others invested for the tax benefit and they are mostly large salary or high net worth individuals. Others got started by investing with partners or buddies and some even got started investing in REIT’s and limited partnerships.

And then there are the determined!

The folks with the plan! In my experience over the years, this is the smallest group in number but they’re the investment power in the rental property or multifamily properties.They bought, managed, bought some more, leveraged and exchanged into larger properties,or refinanced the properties they own and bought more. They did whatever it takes to grow their investment portfolio, because these folks recognized that real estate investments are the IDEAL investment for wealth accumulation and cash flow when done right.

Investors using real estate as a vehicle for retirement cash flow are typically the apartment landlord. In most cases their portfolio enjoys a more favored tax treatment while it remains outside the constraints normally associated with a retirement account. The rules,regulations and constraints like those found in IRA’s, 401(k)s 529′s and other tax favored facilities for investments and methods of wealth accumulation have limited flexibility for borrowing against and there are no withdrawal guidelines with respect to age for the real estate investor and his property.

Most all landlords, especially the determined are fully aware of the benefits outlined in IDEAL. which was adequately covered in a previous post here. The largest obstacle that all these folks have is getting good advise and direction from their paid professional advisers. Here I’m speaking of tax and legal advisers, and why it is necessary to only consult with specialists in that area or specialty.

The other area of concern is the type and caliber of real estate investment advisory or broker they use or choose to do business with. In order to successfully landlord, one needs to treat this business seriously, and that should begin with only working with specialized people in the multifamily property arena, and to use an old cliche in the business, “the day you buy, is the day you sell”. Sometimes the better option is to use the IRC Sec. 1031 or 1033 and defer or roll the Capital gain into the next building or real estate transaction.

Tomorrow we’ll expand on Sec. 1031 Tax Deferred Exchanges and and a brief look at the benefits to the investor starting at the beginning of the investment cycle.

Check back in tomorrow or add us to your RSS feed.

Pride of Ownership Multifamily

Here’s why we think  Apartment House – Multifamily Properties are key to wealth building.

Income

Properties like these are usually referred to as investment property. Apartment Investments, multifamily properties deals, properly structured with enough down payment, will generate a positive cash flow equivalent to, or perhaps better the interest rate of the mortgage on the property. This cash flow will increase in most markets, even a highly leveraged, negative cash flow property can turn into a positive cash flow investment with the passage of time.

Depreciation

Depreciation is the tax deduction one can use against the income real estate produces. Here’s the layman’s version of how this works. The Government in an effort to encourage investors into the multifamily rental property or residential income property allows the value of the improvement (that’s jargon for the buildings) to be written off or depreciated over 27.5 years. (39 years for commercial) This was a solution to the problem of Government providing housing to the poor or low income citizens. Only the improvements are covered under this law, not the land as that is expected not to decline in value during the hold period.

Equity

Growth Build-up – Most folks grow their equity over a period of years because the historic trend in real estate has been upward. However, they also get equity buildup results from the periodic pay down of the principal amount of the loan, usually through monthly payments on an amortized loan. Even if there is no appreciation over the life of the loan, the property owner would end up with a free and clear property at the end of the loan payment period on a fully amortized loan. This is usually a 30 year period on residential property but it is exceedingly rare to find such financing.

Appreciation

While the amount of appreciation varies from market to market, real estate is a growth asset and often the largest part of the return on an investment in real estate is the equity gained through appreciation. Even small amounts of appreciation year after year can be considerable. Usually, the longer you hold on to a property, the better. The effect of appreciation is greatly magnified by the use of leverage. Since the late 1970′s real estate has been a tremendous inflation hedge. Some would claim that is away better than hoarding gold or other precious metals.

Leverage

Through the use of a mortgage or borrowed money along with a small (but increasing recently) amount of money of your own, you can control a real property. The best leverage most of us can obtain in the stock market is 50%. In real estate, it is not unusual to obtain 65%, 70%, and even 75% leverage. If we take the latter, you can control a dollars worth of property for a quarter. With leverage usually comes the risk of lower cash flow after operations costs, but also with that risk comes potential for greater investment return.

Bonus

In addition to the I.D.E.A.L. as stated above, multifamily real estate investments have potential additional tax benefits including the aforementioned IRC 1031 Tax Deferred Exchange and cost segregated treatment by your CPA. There’s always a way to use real estate as a bank or reserve for a college fund for kids or grand kids, additional source of down payments for expanding your holdings or just plain borrowing against. Remember if real estate is part of your retirement savings, there’s no rule against borrowing from it or taking a withdrawal in the form of a loan anytime either. Bonus! No immediate taxes due! But check with your CPA for your particular case.

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