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.
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.
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
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 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 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.
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 ÷ i
V = 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.
Average annual returns in long-term real estate investing vary by the area of concentration in the sector. Average 20-year returns in commercial real estate slightly outperform the S&P 500 Index, running at around 9.5%. Residential and diversified real estate investments do a bit better, averaging 10.6%. Real estate investment trusts (REITS) perform best, with an average annual return of 11.8%.
The S&P 500 Index’s average annual return over the past 20 years is approximately 8.6%. By any measurement, the real estate sector has outperformed the overall market, even factoring in the drastic collapse in housing prices during the 2008 financial crisis.
The real estate sector is divided into two main categories: residential and commercial real estate. Within either category, there are vast and varied opportunities for investors, such as raw land, individual homes, apartment buildings, and large commercial office buildings or shopping complexes. Investors can choose to invest directly in residential or commercial real estate or invest in real estate company stocks or bonds. There are also mutual funds and exchange-traded funds (ETFs) available that track the real estate sector.
Reasons Why Real Estate Is Better Than Stocks
- You Are in Control: Real estate is an investing business that you can manage or delegate management to professionals. You may assess where and how to invest, make asset improvements, cut costs, deduct owner expenses (travel and home office), raise rents and market your services. You directly make your own wealth-building choices. You can also create a property legacy and leave it to your family.
- Leverage Other People’s Money: The benefits of real estate price appreciation are magnified due to the use of bank funds for about 3/4ths of the investment. You can earn a return on your own investment and a cash flow margin on the debt-financed portion of the investment. Your renters pay down or pay off the debt for you. Over time, the value of debt declines due to inflation (you pay off the liability with cheaper dollars) while the asset appreciates.
- Tax Advantages: You can deduct all operating costs, and deduct interest paid to banks, and some otherwise personal expenses through proper planning. You can deduct a non-cash item called depreciation of the entire investment. You may accelerate this depreciation benefit by segregating the costs of the investment into components. You can also indefinitely defer tax on the sale of your investments through Section 1031 exchanges. Cash you actually receive from the investment during the operating period will likely be shielded from all taxation. Upon sale of the investment (if an exchange is not used) you will pay taxes at favorable capital gains rates. If you are a real estate professional, you may offset other types of income with real estate losses each year. If you refinance the property, you may receive cash from the investment without having a tax bill. Your heirs may receive your real estate investments at a stepped-up market value that they then may also depreciate and manage.
- Asset You Can Touch: Real estate is an asset you can see, touch, improve and evaluate. You can insure your title rights. Real estate is very difficult to steal due to the legal environment that surrounds it. Real estate exists in limited quantities; and there are barriers to entry. Since real estate is not a commoditized asset, you can potentially benefit from its imperfect economic pricing characteristics.
- Multiple Sources of Return: Real estate investors benefit from cash flows, price appreciation, debt leverage, tax advantages and operational opportunities.
- Control the Investing Market Place: With real estate you may choose the most favorable markets and specific properties that are available in the marketplace. You can evaluate the expected risks and rewards, rather than leaving those choices to others.
- Favorable Downside Protection: Your bank can’t force you to come up with cash or move out of your property as long as you are paying the mortgage. You may have optionality and inflation protection if financial conditions get difficult. Your real estate may insulate you against adverse economic events that may occur on the world stage or in regions around the country. Remember that housing is an economic necessity to your tenants.
Reasons Why Stocks are Better Than Real Estate
- Stocks are more liquid than real estate. They may be turned into cash within a few days.
- While volatile, U. S. stock markets over the long haul have a good return track record.
- Stocks have lower transaction costs than real estate. Real estate marketers still expect commissions of about 6 percent (or less, depending on the type of asset).
- Stock investments do not require management attention by investors.
- Stock investments come in a wide variety of styles, colors and results and are available from national and international markets.
- Stock investments may result in favorable tax rates on dividends and capital gains.
You May be Well Suited to Multi-Family Real Estate Investments if:
- You believe wealth is concentrated in real assets not paper investment products.
- You have been uncomfortable with stock market volatility and investment scandals.
- You do not trust big business.
- You tend to buy and sell your investments too often. High transaction costs would discourage this behavior if you owned real estate.
- You would enjoy interacting with others about and have pride in your properties.
- You like to feel in control of your own life and investments.
- You are willing to plan for real estate to be a part of your life.
- You like the feeling of providing necessary housing to others.
You May be Better Suited to Stock Investments if:
- You are happy to give up control to others who should know better.
- You can psychologically handle investment volatility.
- You have discipline not to chase market rallies or to sell during market downturns.
- You like to trade investments.
- You enjoy studying economics, politics and researching investments.
- You have a limited amount of investment capital.
- You must have liquidity and immediate access to your assets.
Having owned both single-family and multifamily investment properties, we have found several advantages of multifamily investing. While money can be made with both property types, one of the main advantages of multifamily is the time saved. Instead of spending limited time on several single-family deals, multifamily properties allow investors to make more efficient use of their time. Multifamily assets also have healthy liquidity upon disposition (good exit options) due to a steady supply of inventory matched by a constant demand.
Additional advantages include reduced transaction costs, a concentration of units within each asset, gains in efficiency for management and maintenance, and easier tax and record keeping. This article examines each of these advantages in detail.
Acquisition Time and Efficiency
We all are limited in the amount of time we have. By consolidating the purchase of multiple units into fewer transactions, a lot of time can be saved. This is exactly what takes place through multifamily investing. Instead of purchasing each investment one unit at a time, all the units may be acquired in a single transaction.
Imagine you want to purchase 24 units within a year. In order to do that with single-family properties, you would need to purchase an average of 2 units per month. For this to work, you likely would need to review more than 10 units for every one purchased. If this were the case, you would be reviewing around 20 units per month and more than 240 for the year. For most people, the time required to evaluate all these properties simply isn’t feasible. Even if such reviews are possible, it wouldn’t be a good use of your time because it would pull you away from other high value goals.
Instead of purchasing 24 units as single-family properties, consider what it would take to purchase 24 multifamily units. You could purchase units in a variety of ways by purchasing them all at once in a 24 unit complex or by mixing two 12-unit assets, several 8-unit buildings, multiple fourplexes, etc. Let’s say you end up locating one 12-unit building, and three fourplexes over the course of the year. Under the same circumstances as before, you would be reviewing around 40 properties instead of 240. If you chose to focus on one 24-unit property and spent the year locating and acquiring it, you would still be saving a lot of time in your effort.
There is a big difference between the number of multifamily vs. single-family properties that will be available at any given time. The number can be influenced by many different factors including population, economic factors, current supply and demand, etc. No matter the circumstances, the number of single-family units available will far exceed multifamily investment properties.
This may seem like a disadvantage at first. However, the larger supply of single family properties is also paired with a larger demand. There will be thousands of people looking for a place to live as well as investors trying to find places to rent. Competition exists for multifamily investments, but can be more favorable because fewer people have the resources and expertise to acquire and manage multifamily properties.
Reduced Transaction Costs
With each property closing, there are transaction costs such as lender and attorney fees, appraisals, surveys, inspections, title fees, environmental surveys, engineering inspections, etc. By investing in multifamily properties, you incur these expenses more efficiently. Consider the example above: if you were to purchase 24 single-family units, you would have a separate closing on each of the 24 units. Each closing would have its own set of time deadlines, financing applications, legal documents, and acquisition expenses. Imagine the time and expense it would take to prepare and review all the loan documents, inspections, and other reports.
With multifamily investing, the costs may be higher in some cases because fees often are based on the value of the loan or property. This can work in your favor since those involved in putting together the deal will tend to need to be more competitive to secure the higher value business – helping you get the best price.
Early on in our investment careers, we sat down with a commercial banker to discuss buying several single-family properties under one loan. He told us that it would be as much work for him to put together this small deal as it would be for a big deal. We learned an important lesson that day and our focus shifted to multifamily.
Unit Concentration Fosters Management Efficiency
It’s much easier to visit all of your units if they are under the same roof or on the same plot of land. Imagine the effort in visiting all 24 of the single family units from the example before. Most likely they would be spread out all over town. You would find yourself constantly going back and forth through traffic and possibly bad weather. Instead of using your time on the important task of growing your portfolio, you would be spending it on visiting your units.
By putting a larger number of units within one asset, you can much more efficiently manage your time. Even if you have two apartment complexes on opposite ends of town, you will still only be visiting two properties instead of 24. Another great benefit is that the larger assets often tend to have their own set of on-site staff to help you manage the property.
Even if you elect to have a property manager do the work for you, with smaller properties you will be faced with the disadvantages of negotiating management agreements with several parties, seeking to manage your properties through third parties, and will be unable to ensure consistent quality in the management of your units.
The Benefits of Efficient Management and Maintenance Labor
With a larger unit count, you are able to make better use of property management and any additional part-time or full-time staff. At a lower unit count, it is harder to justify the costs of on site labor resources. It is a classical economies of scale situation in which a larger unit count generally results in bigger profits per unit, which makes the labor and management proportionally more affordable.
Multifamily labor and management are not only more affordable but they are more efficient because the units are physically concentrated. In medium to large apartment complexes the staff will often be on-site and dedicated to each property. If you have several properties within one area, this same staff can be shared between the properties as efficiency demands.
Improved Tax and Record Keeping
It is easier to keep records for one 24 unit property than for 24 single-family houses. It can be very time consuming to prepare and file all the necessary paperwork required by the IRS and the states for each property. Banking time is more extensive with the small property approach, With 24 single-family houses, you will need to keep track of everything separately for each property including expenses, depreciation, interest expenses, etc. With a large multifamily property, the record keeping becomes less tedious because the preparation is done for a smaller number of properties. Better quality software and record keeping becomes justifiable.
Divestiture of the Property
When it comes time to sell your properties, there are advantages and disadvantages to both single-family and multifamily investment properties. Single-family units can be more flexible in that you don’t have to sell the entire portfolio at once. You can choose to sell off a few houses at a time and also choose which ones would be best to sell at any given time. However, there will be additional effort to divest the properties due to the extra paperwork and time.
Multifamily investments on the other hand can be easier to sell. There usually is a good supply of buyers interested in purchasing. Instead of working through multiple transactions, you can sell much of your portfolio properties at once, including dispositions through Section 1031 exchange transactions.
Considering all the benefits of multifamily real estate investing, we hope you see why we have chosen it over single-family property ownership. A limiting factor for new investors may be the amount of capital required to invest in multifamily properties. To help people overcome these barriers, we team up with investors and other partners to make multifamily investing in reach of a wider audience. We look forward to working with you on our next project.