Posts by Master Multifamily
Multifamily real estate is an IDEAL investment. IDEAL is a simple acronym for these five important investment components:
- Income
- Depreciation
- Equity
- Appreciation
- Leverage
We’ll examine each and see how real estate satisfies all. We’ll then explore how multifamily investments satisfy an additional, often overlooked criteria – Scale. Lastly, we’ll go through examples of several investment vehicles to see how they stack up to the IDEAL formula. Let’s get started.
Components of IDEAL Investments
Income – money produced by the investment that can be spent, saved, or reinvested. Income is often referred to as cash-flow, which represents cash remaining after all the expenses are paid. Real estate produces income when the tenants pay rent. Great real estate investments cover all the expenses and have a healthy amount of money left over after. A great part of real estate investments is that it can be largely passive, requiring little effort on your part.
Depreciation – a tax benefit that lets you discount the value of the property over time against your earned income. The IRS lets you use the value of your property to offset your income over a period of time. You may hear this referred to as phantom cash flow or a paper loss. It acts like cash flow from a tax perspective allowing you to reduce the amount of taxed income.
The IRS tax code allows for depreciating an apartment building over 27.5 years, and associated assets over shorter periods using component depreciation concepts. The Code allows only real estate investments to be exchanged to defer taxation under Section 1031.
Equity – the ownership amount of an investment. Over time, as the mortgage is paid off, the amount of equity you have in a property increases. Equity affects your net worth and, as you build equity, you build your wealth. Having more equity also helps you when you apply for loans. The equity comes back to you when you either sell or refinance the property.
Appreciation – the growth of the value of an investment. There are two types of appreciation. The first is the natural increase of the property value over time. This is influenced by the surrounding market as well as inflation. The second type of appreciation is forced-appreciation. This happens when you purchase a property and increase its value through improvements – such as raising rents, decreasing expenses, or fixing up a property.
Leverage – using someone else’s time or money to do more with less. Often you purchase real estate using other people’s money (OPM) in the form of a loan. By leveraging, you can grow your investment at a faster pace. You also leverage your tenant’s time as they work hard to earn the money needed to pay rent.
You leverage the expertise of others, such as a qualified property manager, legal resources, lenders and the syndicator. They help you find the right properties to buy, manage them effectively and arrange for financing. You do not have to use up your own credit rating and valuable time.
Scale – the improvement gains you get as you grow to larger-sized investments. This is the additional criteria found in multifamily real estate. With multifamily, you can more easily purchase many units in one transaction. This separates apartment buildings from single family houses. Compare the effort it would take to buy 100 houses to one apartment building with 100 units. You also gain economic advantages having all of your units on one property.
Now that we have gone over the components of an IDEAL investment, let’s compare several types of investments to see how they stand up. We’ll compare multifamily apartments, businesses, stocks, and bonds.
Comparison of Common Investment Vehicles
Multifamily Apartments
Do apartments have passive income? Yes, in the form of rent and with the use of a management company.
Can apartments be depreciated over time? Yes, the IRS tax code allows for depreciating an apartment over a 27.5-year period.
What about equity? The equity of apartments is the difference between the value and any loans on the property. It grows when the mortgage is paid down or the value of the property increases.
How does appreciation apply to apartments? Apartment buildings typically appreciate at a rate of 2-3%, depending on many factors. They can also appreciate much faster in high growth markets or through forced appreciation.
What is forced appreciation? Apartments with 5+ units are valued by the amount of money they produce. Because of this, you can force appreciation by increasing rents or decreasing expenses. Any positive increase in the bottom line will directly increase the value of the multifamily real estate.
In what ways are apartment investments leveraged? Multifamily properties leverage other people’s money when purchased using loans. They also leverage the time of the tenants who work hard to come up with the needed money to pay for rent.
In what ways are multifamily apartments scaled? Apartments come in all kinds of sizes. It is possible to purchase a small duplex or even thousands of units at once. As the number of units grows, you gain more efficiencies, further allowing you to scale.
In summary, apartments satisfy all the conditions of an IDEAL investment. Additionally, multifamily investments have historically experienced higher returns like stocks and lower risks like bonds, giving you the best of both worlds. Thus, they present some of the highest risk-adjusted returns available in the investing universe.
Multifamily investments have performed relatively well under high risk environments – such as housing crisis of 2008-2009 and the corona virus threat. These are just some of the reasons why we have chosen to focus on multifamily real estate.
Businesses
Can businesses generate passive income? Yes, if the management and operations are handled by employees and not the owner. Often, however, small businesses end up being another form of a job for the owner.
How does depreciation apply to businesses? Businesses can depreciate equipment and property. However, this doesn’t usually account for much unless the business has a large amount of equipment or property.
In what ways do businesses have equity? The equity of a business is the value minus the debts. Determining the value can be tricky unless the business is sold or appraised by a competent appraiser.
Do businesses appreciate? Yes, businesses appreciate over time if their value increases through increased profits. Profits grow through higher sales or increased operational efficiencies.
How do businesses use leverage? Businesses are sometimes purchased using loans and can also use loans to expand. Additionally, they leverage the time of employees to accomplish more.
Can investments in businesses scale well? While it is true that businesses come in all sorts of sizes, usually smaller businesses require more hands-on work from the owner. This makes it difficult to scale.
Overall, businesses can make a lot of money for their owners. However, it can be harder to set them up as an IDEAL investment without delegating the management and operations. This can be a tricky balance, which often results in lack-luster performance of the business or an over involvement of the owner.
The over involvement of the owner can present severe life style-degrading characteristics. Typically, an effective business investment requires special expertise from the owner.
Stocks
Do stocks generate passive income? Yes, stocks can generate passive income in the form of dividends. Not all stocks pay a dividend and the rate and timing varies widely.
Can you claim depreciation from stocks? No, as a shareholder you don’t get any of the benefits of depreciation.
How about equity? Yes, the value of the stock is the amount of equity you have in the investment.
Do stocks appreciate? Yes, stocks can appreciate if the value goes up. However, the value can be up one day and down the next without much rhyme or reason.
How can you use leverage with stocks? Stocks can be leveraged when traded as options. Options give you the right to buy or sell a number of shares at a given price. What you initially invest in is the option and not the stock. Usually the option allows you to purchase or sell a larger number of shares than you could otherwise if purchased directly. However, options carry extra risk and require specialized skills. Another way to leverage stocks is to borrow against their value. This is called margin loans and can be used to purchase more stock, futures, or options.
Can you scale well using stocks? There aren’t many additional benefits to purchasing a larger number of shares. You still earn the same return per share regardless of the number of shares you own. That is unless you purchase a controlling number of shares in a company.
While stocks do have a lot of the components of an IDEAL investment, they don’t have all the benefits. Also, with stocks, you have little control over the performance of the investment and the returns can vary widely for no apparent reason.
Bonds
Is it possible for bonds to generate passive income? Yes, bonds are essentially loans to businesses or governments that generate income as they are paid back over time.
Can bonds be depreciated over time? No, bonds can’t be depreciated.
Do bonds have equity? Yes, the equity amount for a bond is typically the amount you initially invested.
Do bonds appreciate? Yes, the value of a bond can appreciate if the interest rate drops. When you hold a bond with a higher interest rate, the value increases once you can no longer buy bonds at that higher rate.
Can you use leverage with bonds? No, you normally can’t leverage bonds.
Can you scale your bond investments? Like stocks, purchasing a larger or smaller number of bonds doesn’t have any added benefit. The return per bond will be the same regardless.
Bonds do have some aspects of an IDEAL investment but don’t satisfy all. Like stocks, there is little you can do to improve the performance of your investment and you are at the mercy of the market.
Summary Table
Here is a summary of the different types of investments and at what level they can be considered IDEAL.
| Apartments | Businesses | Stocks | Bonds | |
|---|---|---|---|---|
| Income | ✔ | ✔ | Some | ✔ |
| Depreciation | ✔ | |||
| Equity | ✔ | ✔ | ✔ | ✔ |
| Appreciation | ✔ | ✔ | ✔ | Some |
| Leverage | ✔ | ✔ | ✔ | |
| Scale | ✔ |
What is your net worth? Do you know? Why is it important? What steps can you take to increase your net worth? In this article we will go over these questions and put you on the path to financial freedom.
Net Worth Definition
Net worth is the difference between the value of your assets, minus your debts. If your net worth is positive, you are said to be solvent. If your net worth is negative (debts are larger than assets), you are insolvent.
Assets – Debts = Net Worth
To understand this definition, you have to first know what is an asset and what is a debt (liability). In simple terms, an asset is something of value. Assets can be things like: houses, cars, retirement accounts, real estate investments, stocks, bonds, gold, silver, land, furniture, clothing, jewelry, and electronics.
The best kinds of assets are ones that continue to put money into your pocket – some would even argue that it isn’t an asset unless this criteria is met. We tend to agree.
A debt or liability is anything owed. People’s most common debts include: mortgages, student loans, car loans, and credit card balances. It is best to avoid debts that you have to personally pay for out of your own pocket. If you take on large debts, make sure someone else (ex. tenant) pays for them.
If you have a large positive net worth of, say, over $1,000,000, people will say that you are a millionaire. Many people want to become millionaires prior to retirement. Though this financial statistic seems very simple, let’s throw in a few observations.
Not All Assets and Debts Are Created Equal
How Assets Can Vary
Not all assets are equally valuable. Some retirement assets are pretax accounts. This means that you don’t pay tax on the money at the time you put it into the retirement account. Regular IRA and 401-K assets fall into this category. They aren’t easily liquidated prior to age 59 ½ without having to pay taxes and penalties.
Even later in life, withdrawing those assets means that you will have to pay income taxes. For example, let’s say that you are in the 25% Federal tax bracket and your state tax rate is 5%. If you withdraw the assets, you will pay at least 30% in income taxes. In this case, the assets might be worth only 70% of their stated current value. While this isn’t always calculated into your net worth, it should at least be understood.
Some assets (stock equities, real estate) tend to appreciate over time, while others almost always depreciate (automobiles). An appreciating asset goes up in value over time while a depreciating asset goes down over time. When calculating net worth, you have to consider the current value of these types of assets.
Some assets are useful to you but have little market value (many collectibles and personal items). These types of assets will add to your net worth number but don’t really affect your wealth. This is because it is very difficult to sell them for what they are worth on paper.
How Debts Can Vary
Debts also come in various shades. Personal credit card debt is often viewed very negatively. This is due to the high interest rates that can make the debt difficult to repay.
If you want to own your own home, personal mortgage debt is almost always a necessity. It often comes with favorable interest rates and long repayment terms.
Business debt can be the best kind of debt. For example, if you buy rental real estate, the debt allows you to leverage your returns higher. This is because you control 100% of the property but maybe invested only 25% of the cost.
When you buy positive cash flowing real estate investments, other people fund the debt payments. How does this work? The tenants are paying the debt off each month as part of their rent payments. These debt pay downs by others can increase your personal net worth while requiring no real financial sacrifices from you.
Why is Net Worth Important?
First, if you have a large positive net worth and a high enough store of liquid assets, you will have the financial capacity to acquire more assets. When you purchase more assets, you continue to increase your net worth. This is part of why the rich continue to get richer – they have high net worth and the liquidity necessary to acquire more assets.
Second, if you have been a wise steward over your debts, then your credit rating will be strong. That demonstration of your responsible behavior will make it much easier to enter into new financial transactions. Being able to acquire new debt to purchase cash-flowing assets accelerates the growth of your net worth.
Ultimately a high net worth will enable you to achieve your life goals. These goals could include a wonderful retirement, travel to exotic locations, helping your family and others, or being able to pursue other dreams.
What Steps Can You Take to Increase Your Net Worth?
Improving your net worth takes time, discipline, and savvy. We all have heard stories of athletes and movie stars that have made it big only to lose everything. This can almost always be attributed to a lack of discipline and knowledge. How can you avoid the same pitfalls?
First, create a net worth statement to see where you are now. Sort the information into categories of the various kind of assets and debts that you have. Determine the difference between your assets and liabilities. Monitor that difference over time to see whether you are making progress.
Some steps are very important such as: budgeting, controlling your spending, avoiding bad debt, and paying all your debt obligations on time. Enhance your financial knowledge. Work to understand the impact of tax laws on you and your activities. Reducing your taxes can be very helpful to improving your net worth. Seek to achieve high rates of return on your investments.
A Client Example
A client who is new to real estate investing called me recently. She is a new investor and wanted to know how to proceed. My recommendations included joining her local real estate investing club and reading books about real state investing (to increase her knowledge). From there, she could work to purchase a duplex or fourplex property. A great part of this is that others can help her to reduce her housing costs so she will have more money to invest.
Real estate will provide an opportunity to convert some of her otherwise personal expenses into tax deductions. These deductions are associated with the business, thereby also providing more cash flow to invest to increase her net worth.
As you progress in your financial knowledge, you likely will decide to start a business or begin to invest. For both activities, having a source of financial capital is essential. Work to gain an understanding of what will attract money to your projects.
You should also know how to model business opportunities, analyze financial information, and calculate key financial statistics. Those include more advanced concepts such as: debt coverage ratios, net operating income, internal rates of return, and net present value. A variety of good books are available to help you gain that knowledge.
Summary
To master and grow your net worth, you must first know your net worth. If you don’t already, gather a list of your assets and liabilities and calculate how much you are currently worth. Analyze each asset and debt to understand their true value. Once you have this understanding, work to further your financial education and grow your net worth.
If you run into problems, we’re here to help. If you decide to invest in real estate to grow your net worth, let’s talk.
You may have heard that you should have a mix of stocks and bonds in your portfolio to reduce risks. An economist that teaches at a top university on the West Coast tipped us off to a different approach. In this approach, you use real estate, instead of bonds, to reduce the risk of heavy swings in the stock market. Let us explain why.
How Stocks and Bonds Are Related
A rule of thumb is that the value of both stocks and bonds rises and falls together. However, there are situations where this breaks down. Under these circumstances, stocks and bonds will move in opposite directions.
When you see bonds fall but stocks rise, it is a likely indication that the economy is doing well or beginning to improve. As profits increase, stock prices usually increase. However, this leads to higher inflation. The inflation is kept in check by the Federal Reserve raising interest rates. Because bond prices are tied to interest rates, rising rates makes it more expensive for companies to borrow money. These new bonds push down the rates of existing bonds causing the bond market as a whole to go down.
When you see stocks fall but bonds rise, it is often an indication that the economy isn’t doing well. As people become worried about the economy, they will pull their money out of stocks, causing stock prices to go down. To seek a safe haven for their money, people start buying bonds – which are seen as a more stable asset. This leads to drops in the interest rates as bond prices increase. Interest rates can also be artificially lowered by the Federal Reserve – which leads to rising bond prices.
Balancing High and Low Volatility Assets
To reduce risk, general wisdom says you should have a healthy mix of stocks and bonds. Also, as the market changes, you should adjust the concentrations in this mix up or down to get the perfect balance between stocks, bonds, and the market.
This general wisdom is driven by solid reasoning. When you have high volatility (risky) assets like stocks, you need to balance them with low volatility assets. By doing this, you dampen the damage caused when the risky assets are hit hard by changes in the market. Most people choose to hold bonds as the low volatility asset.
A Better Way
There are several problems with using bonds to counter balance stocks. First, bonds have been producing low returns year after year. Bonds had their heyday in the late 1970s and early 1980s but have been in decline since.
Bonds have an inverse relationship between yield and value. As the yields from a bond trend downward, you have to pay more for the bond – even though the yields are lower. Unfortunately, the higher the price of a bond, the lower the yield. Conversely, as the yields rise, the investor will suffer a loss of principal. Thomas Kenny, from The Balance, explains the basics of bonds well in his article Why Bond Prices and Yields Move in Opposite Directions.
We feel there is a better way.
…the reality is that investment portfolios focused on the “Big Two Traditionals,” bonds and equities (stocks), are forcing investors to compromise – either by sacrificing return for lower volatility or enhancing return at the expense of higher risk. Real estate may offer a way out. This is why we believe real estate is increasingly being viewed, not as an alternative, but as an essential portfolio component.
REAL ESTATE: ALTERNATIVE NO MORE, J.P. MORGAN ASSET MANAGEMENT
When you invest in apartments, you get higher stability like bonds. This is partly due to the longer market cycles of real estate. It is also driven by demographics which help keep housing demand high. Aside from that, apartments have had historically better returns than stocks. In other words, you get stability and higher returns making it a win-win.
You also don’t have the troublesome inverse relationship of bonds. When you increase the yields of an apartment, instead of values going down, you get a multiplying effect. So by increasing yields you also increase the value of the apartment.
If you aren’t including real estate as part of your portfolio, it may be time for a change. Contact us today to get started.
The laws and regulations for rental properties are constantly changing. Each state, county, and city can have their own rules for the handling of security deposits, the ability to increase rents, the warranty of habitability, how evictions are handled, etc.
At Master Multifamily, we look to invest in states that are considered landlord-friendly. This can reduce risk to our investors and make for easier property management. This is only one of many things we consider when choosing where to invest.
While we look for landlord-friendly states, we also want to provide a safe and affordable place for people to live. The following map from RENTCafé shows which states are renter-friendly and which are landlord-friendly.
Real estate provides many different options for investors. We are always amazed, and sometimes perplexed, by the many ways people invest in real estate.
Every method has its set of positive and negative aspects. We would like you to be aware of the most common options out there. Above all, we want you to understand why we like apartments so much.
Single Family Residences (also known as SFR)
When people think of real estate investing, buying a house to live in is usually what comes to mind. They make up the neighborhoods throughout most of America. Many people buy a house and consider it their largest investment. However, single family homes should be lived in, not invested in.
It is common to think that a house is an investment when, more often than not, they are a liability. Houses have become a way for banks to make money and come with risks and expenses that have to be paid for by the owner.
Homeownership is not a way to build wealth. It may be a place to save money – not make money
CNBC Study
When you consider upkeep, insurance, property taxes, roof repairs, heating and cooling repairs, real estate fees, landscaping, etc. a single-family home is a terrible investment.
Flipping or Wholesaling
Flipping has become a craze seen on many reality TV shows. It involves taking a single-family home, fixing it up, and then reselling the property either before or after the closing. What most people don’t realize is that this isn’t real estate investing. Flipping is speculating and usually turns out to be more of a job.
One family member decided to flip homes in their spare time. They started right before the real estate bubble burst in 2008/2009. Having many projects in the works, they were left holding onto properties that could not sell. Luckily they were able to turn the properties into rentals but they were left with many years of unanticipated problems.
Wholesaling is pretty much flipping a property but usually doesn’t involve any improvements. The wholesaler will get a property under contract and then sell the contract to a buyer or another investor.
Ultimately flippers and wholesalers discover that it is better to own the properties than to flip them. They will usually flip a few homes and then want out of flipping because of the amount of work involved with only short-term gains.
Single-Family Home Rentals
Owning single-family homes and renting them out is what most people think of when investing in real estate. It is a common misconception that you have to start buying single-family homes and then somehow graduate into larger properties.
One big problem with single-family homes is that they are either 100% rented or 100% vacant. When a tenant leaves and destroys the place, there aren’t other renters paying to help cover the expenses.
Single-family homes don’t scale like multi-family investments. The investor has to buy one at a time, run around town maintaining houses everywhere, or hire someone to manage them. When they want to sell the properties, they have to close on each one individually.
Duplexes, Triplexes, & Fourplexes
Within any given city, rentals with one to four units are the most common multifamily properties. Anything less than five units isn’t considered commercial real estate.
These properties are easier to find and low priced. At times, people that buy these rentals plan on living in one of the units and renting out the others.
While you can buy these properties with less money, they often require more time and effort to maintain. They can produce very little income and come with some of the same problems as single-family rentals.
Many people start here because they can be easier to find and finance. However, when the economy takes a dive, non-commercial real estate is usually the first to be lost to foreclosure. This is because the properties tend to not produce enough income to support the expenses – especially when rents have to be reduced and it becomes harder to improve the property.
Commercial Rental Properties (5+ units)
Properties with five or more units are considered commercial real estate. The larger they get the more they scale. Once they are large enough (around 60 units) they are able to have their own on-site staff, including maintenance.
Commercial real estate can be anywhere from 5 units to more than a 1,000. With more doors, it becomes easier to make money and weather economic downturns. This is due to the economies of scale and efficiencies you gain.
Unlike smaller properties, commercial real estate is valued based on the money left over after expenses. This left over money is known as the Net Operating Income (NOI). The better you operate the property by reducing expenses or increasing income, the higher the value.
Other Types of Commercial Real Estate
Retail Properties
Retail real estate includes stores, malls, and other shopping centers. The owners of this real estate rent out the space to other businesses. These businesses can include restaurants, clothing stores, law offices, thrift stores, home goods, grocery, etc. The success of retail properties is closely tied to the economy, location, and businesses leasing the space.
Triple Net Leases
Most of the big retail businesses, fast food chains, large pharmacies, and other franchises don’t actually own the real estate their businesses are built on. They prefer not to own the real estate and will instead rent it. However, they will want to build out the property to suit their needs.
These businesses take care of the maintenance, taxes, insurance, and other expenses associated with the property but don’t own the real estate. Instead they pay rent to the owner according to the lease. These are known as Triple Net Leases (NNN) with the three parts being taxes, insurance, and maintenance.
These properties suffer from the same risks as the retail properties. They can also be affected by changing technologies and societal shifts.
Office Buildings
Office space can be rented out to either a single tenant or multiple tenants. In this case, the business prefers to rent the space instead of own real estate. The tenants usually sign for longer leases (7-10+ years). At the start of the lease, there can be large capital expenses associated with making the space ready for the tenant.
Let’s face it, we want to be financially secure. We may want a larger home. We may want to send our children to the best colleges. Many of us have dreams of comfortable retirement years spent traveling around the world. Reaching such goals will take money. Yet, we probably don’t relish the idea of giving up more of our precious time to reach those goals.
So how can you build your financial wealth to meet your life goals? How can you secure a better lifestyle without being forced to work even harder? Answer: Invest passively in multifamily real estate
Over the years passive investments in apartments have proven themselves to be wealth building engines. The wealth comes from:
- The “value add” strategy,
- Increasing the velocity of your money, and
- Tax efficient gain harvesting
What is the “Value Add” Strategy?
A Value-add Strategyi increases multifamily real estate values by raising rents, reducing vacancy, and reducing expenses to increase net operating income (NOI). To capture value, apartment complexes are rehabbed in a process sometimes called “flipping” apartment buildings.
How can I increase the velocity of my money?
The value add strategy’s wealth building power can be magnified if you increase the velocity of the movement of your money (i.e. reduce the time it takes to compound your investment returns). We call this the velocity principle.
Understanding the Velocity Principle: The Rule of 72
Background: The Rule of 72 is a commonly understood financial formula that quantifies how long it takes to double your money at a given a rate of return. For example, if you divide 72 by 6 percent, the rule states that it will take 12 years to double your money at a constant 6 percent rate of return.
Cascading Your Wealth Upward: The velocity of your money, or the speed at which value doubles, is critical to rapid wealth creation. We call reducing this time as “cascading your wealth upward.”
At Master Multifamily LLC we seek to double your money over five to six years. In other words, we seek to harvest annual investment returns of between 12 and 15 percent . At the same time, we seek to distribute annual cash returns of between 5 and 7 percent to you. These are our goals, not guarantees.
A wealth building example: Let’s look at an example of the application of the Rule of 72. Say a person has $1 million to invest in apartment buildings. After careful consideration, they decide to do so. Let’s assume they receive a cash-on-cash rate of return of 5 percent. This means that they would receive a (tax shielded) cash distribution return of about $50,000 per year. Let’s also assume that the investment principle amount doubles within five years, and the funds are reinvested in apartment buildings at the end of year 5.
In this scenario, the annual cash distribution return would increase to $100,000 after 5 years, while the principal amount invested would increase to $2 million. Assuming this process is repeated after another 5 years (10 years total), the principal invested grows to $4 million, and the cash distributions would increase to $200,000.
While an investor may not be able to live on $50,000 of tax shielded income at the beginning of the investment process, receiving $200,000 per year after 10 years could provide financial independence. Note: True wealth is best measured by the amount of your reliable spendable income.
How can I ensure wealth building continues?
To continue growing value, harvesting gains in a tax efficient manner is critical. Once the “value add strategy” has worked its magic, your investment should be moved to a different asset so value compounding can continue.
Tax Efficient Gain Harvesting – Three Strategies
- Debt Refinance – This strategy may return all, or a large portion of, the amount invested by you while at the same time preserving cash distributions from the property. No taxes are due because of a refinancing transaction.
The refinancing proceeds can be placed in a new investment, thereby providing a new opportunity to capture value compounding. - Section 1031 Exchange – Once the expected growth in the value of an apartment complex has been realized, the sponsor can sell the property and redeploy the proceeds into a larger asset or multiple assets via a Section 1031 Exchange.The Section 1031 Exchange feature of the tax law is only available for real estate assets. It permits you to defer payment of capital gains taxes. An exchange would not return principal immediately to you; however, the exchange would provide you with higher cash distributions and an opportunity to accelerate principal appreciation.
- Sale Only – A project sponsor may decide to sell an apartment complex when market conditions present an opportunity to harvest gains. A sale will usually result in payment of capital gains taxes by you when the increase in value is distributed. As such, a sale could partly interrupt the compounding of your investment value due to the tax obligation that must be satisfied. An individual investor, however, may seek to redeploy their investment by completing their own Section 1031 exchange.
You can work with the sponsor of your multifamily investment partnership to encourage an exit strategy that best reflects your goals. By applying these strategies and principles, each dollar invested will be put to hard work in accomplishing your goals and thereby improving your life.
i A “value-add” strategy is similar to “flipping” a single home, though the value add terminology applies to apartment buildings. Adding value to an apartment building is accomplished by any action, such as raising rents or reducing expenses, that will increase the property’s net operating income. These “value add” strategies, such as upgrading the interiors of apartments while increasing rents, typically take at least two years to fully implement. Apartment building investments are sold at values determined by dividing net operating income by a market determined capitalization rate. For example, dividing a $100,000 annual improvement in net operating income by an assumed 6% capitalization rate, amounts to a $1.67 million increase in investment value. We call this the multifamily value gain formula. See Multifamily Value Gain Formula
Apartments present investors with 4 ways to capture an equity return:
- Equity appreciation
- Operational cash-on-cash returns
- Debt paydowns funded by renters
- An income tax shield provided by tax depreciation
Cash-on-Cash Return
The cash-on-cash return is the annual cash distribution from the investment divided by the equity investment made by each investor.
Cash-on-Cash Return = Annual Cash Distribution / Investment AmountExample: If a person invested $100,000 and the annual cash distribution received from the investment was $10,000, the cash-on-cash return would be $10,000 / $100,000 or 10%.
Appreciation of value is the largest potential source of gain for equity investors. If you work very long in the multifamily space, you are sure to encounter someone saying that an apartment complex is a “value add” proposition. What does that mean?
What is Value Add?
The sales prices of apartment complexes are determined via competitive bidding with value determined by the bidders’ estimates of future “net operating income” and the market “capitalization rate”. The net operating income, or NOI, is revenue less operating expenses such as maintenance, insurance, utilities, property taxes, payroll and management fees. The capitalization rate has a direct relationship to value because a property’s capitalization rate is calculated by dividing its annual NOI by the potential sales price of the property. Another way to state this formula is to say that the sales price of the property is determined by dividing NOI by the capitalization rate.
Net Operating Income (NOI) = Revenue (ex. rent, pet fees, storage rental, etc.) – Operating Expenses (ex. landscaping, insurance, taxes, utilities, etc.)Capitalization Rate (Cap Rate) = NOI / Sale Price
Let’s say, for example, that in a sub-market of Dallas-Fort Worth, Texas, properties are trading at a capitalization rate of 6%. Armed with that information we can estimate the “value add” to the equity investment that may be achieved by lowering operating expenses, reducing the vacancy rate, or increasing rents. Let’s say that we can improve one of those operational parameters (or a combination of those factors) by $100,000 per year. Assuming a capitalization rate of 6%, we can increase the value of the property by a huge multiple because the value added is determined by dividing $100,000 by 6%, resulting in an increase in value of $1.67 million.
Multifamily Value Gain Formula
This is the multifamily value gain formula, or value multiple. At a capitalization rate of 6%, the resulting value multiple is 16.67; at a capitalization rate of 7% the value multiple is 14.29; at a capitalization rate of 5%, the value multiple is 20.
This formula or multiple is a major key to understanding why investors benefit from multifamily investments. The value increase does not depend on inflation or on prices at which comparable properties are traded. In the multifamily space value increases can be planned for and managed.
Example
As a real-life example, we recently evaluated an apartment complex that would sell at about $13 million for 136 apartment units, determined using a preliminary capitalization rate of 6.4%. The seller tested upgrading the kitchens in the complex on 6 of those units, spending $4,000 per door. The test showed that rents could be increased by about $150 per month due to this action. If this trend were to hold in upgrading the remaining 130 apartments, for an upgrade cost of $520,000 the annual rent increase would be approximately $234,000. The value of the apartment project could be increased by approximately $3.7 million by making this investment. If the equity raised for the project were 30% of the purchase price, or $3.9 million, the equity investors could capture a return of 94% due to this value add opportunity.
Some ways to increase the equity appreciation of an apartment complex do not require a capital investment. For example, the project sponsor might install yield management software to capture full market rents. The project management might add interesting community activities to reduce vacancy rates. We have a list of over 100 techniques that may be used to improve the operating income of a project.
A Key to Success
One of the most important factors to ensure equity appreciation is to have on site management, supervised by a highly competent property manager. A property manager with extensive “value add” experience can develop a sensible budget for property repairs and upgrades that are important to lowering operating costs and capturing value add returns to investors.
It’s not for everyone, but check this out!
We target to achieve annual cash flow yields of 5-7% or more, and overall returns of 12-15% per year – all while investing in a relatively low risk asset class. Of course, returns are not guaranteed so do your due diligence. You must be an accredited or sophisticated investor (under SEC definitions) to invest. Our minimum investment size is $50,000. You may invest additional amounts in increments of $12,500. We plan to offer somewhat higher rates of return to large investors who serve as a foundation for our business.
What assets can I Invest in?
The investments are made through private partnerships holding multi-family apartment properties, A- to C+ quality grade, sizes in the range of 65-250+ units. We create a separate partnership for each property. We look for non-elevator properties with pitched roofs with full to partial utility separation. We look for A to B locations surrounded by like-kind or better assets, with the same quality of retail, entertainment, hospitality and grocery facilities. The investments are targeted for the best U.S. markets. Our current market focus is Dallas-Ft. Worth, Texas and the Salt Lake City metro area. We currently will not invest in other commercial property classes.
How do I know you can perform?
While we are a new investment company, we have experience investing ourselves in five states: Utah, Arizona, Alabama, Indiana and Georgia. We have worked for the past 7 years in the real estate business, primarily as tax advisors to many successful multi-family real estate investors. We are joint venture partners with a larger investment firm that has an investor pool of over 450 accredited investors and over $100 million in multi-family assets under management. The larger firm is mentoring our business and will be checking our key work products (market selection, financial modeling, property management, contracts, financing, etc.) until we have built a more extensive track record of our own.
When will I be able to invest?
We are targeting to complete our first purchase of a large multi-family property within the next few months. However, we insist on quality results so will be careful not to waste your money. Based on the track record of our investment mentor firm, only about 3% of possible deals will qualify to be acquired under our investment criteria, also due to the competitive investment space we work within. It takes patience and time to find the true wheat amid the chaff.
We plan to develop opportunities for our investors to park money with us pending our next investment, with a guaranteed, but stable, low return thereon.
Why do you invest in A- to C+ quality grade apartments?
We generally will invest only in garden style apartments that have solid current cash flows, and significant appreciation potential. We have found that apartments which are in the age range of 1981-2005 embody the best prospects for improving value. Appreciation potential can be captured by improving rent collections, increasing rents, or lowering financial and operating expenses. Such improvements are hard to achieve in brand new units, and risks multiply in lower grade units because they are harder to manage and require more investment to rehabilitate.
To fully appreciate the cascading upward potential of multi-family units, please consider the following: Multi-unit apartments are priced in the market based on the ratio of indicated net operating income divided by a market-based capitalization rate. Net operating income means effective rental and other income less operating expenses, but excluding non-operating items (depreciation, loan payments and the capital improvement reserve allowance). As an example, if net operating income were $350,000 per year for a 100-unit complex, and the capitalization rate were 7%, the indicated purchase price is $5,000,000, or a cost of $50,000 per unit. If 30% of the project cost were put down on a financing loan for the project, the required raise of capital to purchase would be in the neighborhood of $2,000,000. This project would require 20 investors to purchase, assuming the average investment were $100,000.
Why are cash flows from each project and appreciation of my money likely?
We extensively model our expected results, looking carefully at break-even assumptions and debt service coverage ratios, using a wide variety of key documents. Those documents include audited tax returns, three years of financial history, rental agreements and rent rolls, copies of all utility and service contracts and ad valorem tax data. We personally tour each property.
We perform extensive due diligence before acquiring any property.
We will select only the best qualified property managers for our projects to ensure effective management.
Rent price growth nationally over the past year has been about 5%, and we believe will continue at least at the underlying inflation rate over time. If rents for the hypothetical project mentioned above start at $650,000 annually and then grow by 5% the first year, the value of the project would increase by $464,000 ($650,000 times 5% divided by 7%). If operating expenses were reduced by 10%, or $35,000, then the value of the project would increase by about a further $500,000. We look for projects where these value increases are likely to occur.
What are some steps you take to protect investors?
We screen our projects against an extensive list of criteria to select from among only the best U. S. statistical metropolitan areas and sub markets. Those criteria include cap rates, homeowner vacancies, housing affordability, multifamily permits, state and local political and tax environment, population size, number of multi-family projects in the area, population components, in-migration population growth, employment distribution, unemployment rates, environmental stability and predictability, income growth, unemployment rates, rental vacancy rates, and apartment building absorption rates.
Within those MSAs we look extensively at micro market criteria relevant to each housing project, such as employers, proximity to attractive services and shopping for tenants, the existence of universities and hospitals in the area, low crime, attractive school districts, the location of transportation in relation to the project, growth paths, proximity to other favorable housing projects, local government volatility and other factors.
We always remember that it is very hard to manage yourself out of a bad project location!
How will you finance your projects?
Financing options are varied, including new loans, money from Section 1031 exchanges, and loan assumptions. We will look to government sources (Fannie, Freddie, HUD), commercial mortgage backed security financing, regional banks, insurance and specialty acquisition lending, depending on the deal. Our lenders will look at customary factors, such as occupancy, debt service coverage ratios, loan to value, etc. Since these are large loans, the lenders are tough to satisfy which is one reason the default rates on these multi-family loans are very low.
What are your criteria for selecting multifamily asset property managers?
We seek property managers with at least five years of experience managing 10+ assets and/or 2,000 plus assets. The assets must be 80+ units with on-site management. We look to the ability of the manager to achieve economies of scale across multiple assets, and use of professional grade property management software. A qualified manager will have on-site personnel that can service all building components and work to effectively resolve issues with tenants.
How liquid is my investment?
You will be investing in a real estate business. The investment will not be as liquid as a common stock or bond that is traded on the security exchanges. We will distribute cash from liquidity events (refinancing transactions and asset sales) when it makes business sense to do so for the benefit of the majority of our investors. However, we will strive to provide opportunities to exchange your investment into another asset or for you to withdraw from the business in financial emergencies through offering your investment to another investor. We will seek to provide you with stable quarterly cash flows unless we are temporarily consolidating resources from cash flow to improve a property.
Real estate can be valued or appraised using three different methods:
1. The Cost Approach – The cost to replace or reproduce the improvements plus land cost. This method is typically used for valuing new construction.
2. The Sales Comparison Approach – Comparison of other recently sold properties that are comparable in size, quality, and location to the subject property.
3. The Income Approach – An objective estimate of what a prudent investor would pay for the property based upon the net operating income the property produces.
The Income Approach is used most in estimating the value of multi-family real estate investments because they are income-producing assets owned by investors seeking financial returns on their investments.
The Income Approach is driven by the formula:
V = NOI ÷ iV = Value
NOI = Net Operating Income
i = Capitalization Rate or “Cap Rate” (Return on Investment)
Net Operating Income (NOI) is the net income (before mortgage payments) derived from operating the property.
It is important to note that Annual Debt Service (Principle and Interest) is not an operating expense. It is a debt or financial expense paid from the property’s net operating income. Depending upon an investor’s risk tolerance level, properties can have varying levels of debt – or no debt at all. (Depreciation expense is also not an operating expense, and the same is true of a capital replacement allowance.)
The Capitalization Rate or “Cap Rate” is the percent annual return given a specific investment or property value. It is the net operating income of the property divided by its value. Technically, it is the weighted average cost of capital, both debt and equity, invested in an income producing asset. (However, market expected Cap Rates affect values in competitive markets.)
Knowing any two of the three components of the formula V = NOI ÷ i will allow you to solve for the third. Following are variations of the formula:
NOI = Value x i
i = NOI ÷ Value
V = NOI ÷ i
Source: A Real Estate Investor’s Guide To Valuing Multi-Family Real Estate Using Cap Rates By: Dennis J. Noneman, CCIM
As you consider how real estate investing may help you to reduce or defer your income taxes, please consult your legal and tax advisors about your own situation. Tax advice should be customized. (The comments provided here do not constitute specific legal or tax advice.)
The United States income tax laws and regulations contain provisions that are beneficial to real estate investors. The most important and common aspects of these rules are as follows:
1. The Potential for Non-cash Losses to Offset Ordinary Income
For investors with adjusted gross incomes (AGI) of up to $150,000, operating losses from real estate caused by favorable depreciation rules may allow a full or partial deduction of up to $25,000 in real estate losses annually against ordinary income. This benefit phases out as AGI levels exceed $100,000 annually. This is one scenario where it may be possible to have cash flow positive real estate investment results, while also potentially reduce ordinary income taxes. Your specific result will depend on the annual facts pertinent to your income sources and portfolio.
For high income investors, real estate non-cash losses may be required to be suspended and deferred until the time of a taxable sale of the real estate investment. This is a feature of the IRS Code’s passive activity rules. However, this should be understood as favorable tax treatment since the investor may receive positive cash flows while paying no income tax (due to the depreciation deductions). The deferred real estate income treatment is similar to the deferral of taxation on cash returns within an IRA; however, in this case the investor may both receive and spend cash without paying current income taxes. Compare this to dividends and interest paid by most other investments (i.e. stocks and bonds), which are taxable to the extent of the cash received by the investor.
If you actively work in real estate businesses, you might qualify as a Real Estate Professional (REP). REPs must work actively at least 750 hours per year in real estate businesses, and more in real estate than in any other business, among other requirements. For such investors, they may offset real estate losses against ordinary income when calculating their tax liability, regardless of how large their AGI is in the year. The REP test must be met each year to qualify for this benefit, but only one spouse needs to qualify.
2. Favorable Depreciation Rules
Real estate investors in residential housing may deduct the costs of housing assets, except for the cost of land, over 27.5 years, or a shorter life. Buildings are depreciated over 27.5 years. Short-life equipment may be deducted over 5 years, while other types of real estate asset components have other depreciable lives. To maximize depreciation deductions (and tax deferrals or reductions), investors may perform a cost segregation study to identify the component assets of each investment.
3. Tax Rate Benefits
When an investment in residential property ultimately is sold, investors are generally taxed at a capital gains tax rate for the portion of the gain that exceeds their original cost. Additionally, the depreciation which was taken during the life of an asset is generally taxed on sale at a tax rate (28%) between ordinary tax rates and the capital gain tax rates. Deferred real estate losses are recognized at the time of the sale and serve to reduce these taxable gains.
4. Other Tax Deferral or non-Recognition Benefits
Real estate investors who sell properties, but who also meet complex like-kind exchange rules under Section 1031 of the Internal Revenue Code, may defer recognition of all or portions of their gains. This means that investors can redeploy profits into larger, or more profitable, investments while not paying taxes on the intermediary transactions. The successful completion of these transactions requires competent transaction facilitators, intermediaries and professional advice. The “tax basis” of the old property is transferred to the new property so the gain on the exchange sale is deferred into the future.
This exchange strategy is limited to structures where a fund does the 1031 Exchange or ownership structures where the investor has direct title in the asset. A limited partner or LLC member cannot trade the proceeds from a sales distribution from a real estate partnership or LLC under these rules.
Real estate properties may be refinanced in “cash out” transactions with no recognition of tax on the cash proceeds since a refinance is not a “sale” event under the Internal Revenue Code. Second mortgages used to finance real estate investments create tax deductible interest expense (as long as the aggregate proceeds are $100,000 or less).
Investors who leave their heirs real estate may permanently create non-recognition of inherent gains in the properties because the tax basis is “stepped-up” to fair value at the time of death. Furthermore, the heirs can depreciate the real estate assets based on the stepped-up basis.
Investing in real estate ventures through LLCs and limited partnerships presents gifting and estate tax benefits. Unlike stocks, when an investor gives an LLC interest of a real estate investment to a family member, an investor will likely be able to reduce the value of the gift by about 30% for gift and estate tax rules. The value is discounted under the theory that the investor has limited control over the LLC interest under IRS rules.
Gains from the sale of a taxpayer’s primary personal residence are excluded from capital gains taxation of up to $500,000 for married couples and $250,000 for single individuals if the taxpayer has lived in the home for two of the last five years. In addition, should the gains from the sale of a taxpayer’s primary residence be greater than those exclusions, the taxpayer may also invest that portion through a 1031 exchange. (See http://www.investopedia.com/articles/tax/08/real-estate-reduce-tax.asp).
The investor’s home may be a strong engine of personal wealth creation in markets where home prices are appreciating since such non-taxable gains may be invested in another home or into other investments.
5. Business Tax Deductions
Real estate investors may create favorable business structures to facilitate liability protection while creating tax-advantaged reporting structures. These business structures include partnerships, C and S corporations and LLCs. (Note: it is not recommended to hold real estate investments in corporations.)
As a part of these activities, real estate investors may create business enterprises and conduct business in a way that seeks to maximize available tax deductions. Yes, investing in real estate may be structured as a business! Just a few of the types of ordinary and necessary business deductions that may be available include the home office deduction, employing a spouse or children, meals and entertainment, vehicle deductions, travel expenses, office expenses, small capital improvement deductions and telephone expenses. Following the IRS rules for deductibility of each type of cost can result in increasing business deductions while offsetting some otherwise personal expenses. In addition, using the appropriate tax structure may reduce the marginal tax rates paid on the investor’s income.
6. Other Tax Points
Real estate investing income is generally not subject to self-employment tax (FICA and Medicare) unless you are conducting an “active” real estate business. Active real estate businesses include activities such as real estate sales and brokerages, flipping houses, real estate construction and development, renting hotel space or short-term trading of properties. Consideration should be given in some of these activities to takes steps to avoid the “active” business label.
