By Karla Dennis, E.A.
With the real estate market being better than it has been in a long time, many of you may be considering selling your real estate, doing a 1031 exchange or converting a rental to a primary residence. Whichever decision you make, here is an outline of some of the key considerations to think about when pondering the idea. Buying , operating and selling a rental property can have profound tax ramifications.
By Dwight Kay | www.kpi1031.com
There are a number of potential benefits of exchanging into a Delaware Statutory Trust (DST) 1031 property. It is important to note that these should be carefully weighed with the potential risks that we have outlined at the end of this article. You should also read the risk section of each DST 1031 property’s offering materials in detail prior to investing.
Eliminating the day-to-day headaches of property management
Many of our clients are at or near retirement, and they are tired of the hassles that real estate ownership and management often bring. They are tired of the tenants, toilets and trash and are wanting to move away from actively managing properties. The DST 1031 property provides a passive ownership structure, allowing them to enjoy retirement, grandkids, travel and leisure, as well as to focus on other things that they are more passionate about instead of property management headaches.
Tax deferral using the 1031 exchange
Many of our clients have wanted to sell their apartments, rentals and commercial properties for years but haven’t been able to find a property to exchange into and just can’t stomach the tax bill after adding up federal capital gains tax, state capital gains tax, depreciation recapture tax and the Medicare surtax. The DST 1031 property solution provides investors an ability to move from an active to a passive role of real estate ownership on a tax-deferred basis.
Increased cash flow potential
Many investors are receiving a lower amount of cash flow on their current properties than they could be, due to their properties having under-market rents, properties that have multiple vacancies and/or that are raw or vacant land sitting idle. DST 1031 exchange properties provide an opportunity for investors to potentially increase their cash flow on their real estate holdings via a tax deferred 1031 exchange.
Portfolio diversification by geography and property types
Often times, 1031 investors are selling a property that comprises a substantial amount of their net worth. They want to reduce their potential risk and instead of buying one property (such as another apartment building) or one NNN building (such as a Walgreens pharmacy or Taco Bell restaurant) they decide that investing into a diversified portfolio of DST 1031 properties with multiple locations, asset classes (property types) and tenants is a better fit for their goals and objectives.
This is similar to how investors tend to invest retirement funds in mutual funds and Exchange Traded Funds (ETFs), as opposed to placing their entire retirement savings into the stock of one particular company. However, it is important to note that there are no assurances that diversification will produce profits or guarantee against loss.
Long-term non-recourse financing locked and in place to satisfy debt replacement requirements of the 1031 exchange
One of the requirements for a 1031 exchange is to take on “equal or greater debt” in the replacement property to what you had in the relinquished property (the property you are selling). In today’s lending environment, it is often hard for investors to obtain non-recourse financing at an acceptable interest rate and terms. Due to the DST 1031 properties’ sponsors typically having strong lending relationships, they are able to secure non-recourse financing at some of the best terms available in the marketplace. The DST 1031 investors are the direct recipient of these financing terms that they would otherwise often not be able to obtain on their own.
Access to Institutional Grade Real Estate
DST 1031 properties provide access to large, institutional-grade real estate that is often otherwise outside of an individual investor’s price point. With the typical minimum investment of $100,000, investors are still able to purchase an ownership interest in large $20 million-plus apartment communities, $5 million-plus pharmacies or $15 million grocery stores, for example. This allows investors access to a level of real estate that they just would not have been able to exchange into before.
That being said, we also have had many clients with very large 1031 exchanges opt to invest in DST 1031 properties because they did not want to place “all their eggs into one basket” by purchasing one single, large investment property.
Unlocking trapped equity
For those investors that have a substantial amount of equity in raw or unimproved land (as well as investors with vacant properties that are not producing any cash flow), the DST 1031 property allows them the opportunity to sell, defer taxes via a 1031 exchange and unlock the trapped equity that they have in their properties. Now this trapped equity is free to produce for the investor potential cash flow on a monthly basis.
Ability to typically close on a DST 1031 property typically within three to five business days of completing and returning subscription documents
This is one of the main reasons why investors in their 45-day identification period “time crunch” often turn to DST properties. They are able to close quickly and complete their exchanges due to the properties being pre- packaged, as opposed to waiting 30, 60 or 90 days to purchase another outside property.
Increased tax efficiency due to depreciation deductions on replacement property
Investors that have owned their apartments and rental properties for longer than 27.5 years and commercial properties for longer than 39 years have fully depreciated the properties, with no more deductions to help shelter the rental income. By purchasing DST 1031 properties that have a greater amount of financing than their relinquished (sold) properties, those investors are creating for themselves a new basis to shelter rental income through. We encourage all investors to speak with their CPA and tax attorney regarding this prior to investing in DST 1031 properties for details regarding their particular situation.
Increased tax efficiency due to interest write-offs
For investors that have fully paid off their properties, the DST 1031 properties with financing in place provide for interest write-offs to help shelter potential cash flows. Many clients in today’s environment are looking for a way to increase tax efficiency due to the burdensome tax system in place in the United States. The DST 1031 can help to potentially solve some of these tax problems.
Dwight Kay is the Founder and CEO of Kay Properties and Investments, LLC (Kay Properties). Kay Properties is a provider of DST brokerage and advisory services headquartered in Los Angeles, CA with an office in New York, NY. Registered Representatives at Kay Properties and Investments specialize in helping 1031 exchange clients throughout the country purchase DST properties and are securities licensed in all 50 states, Washington D.C. and the U.S. Virgin Islands. Mr. Kay has personally been involved in over $200,000,000 of client purchases of DST properties and other securitized real estate products.
Dwight is a published author with multiple published white papers and articles on 1031 exchanges, Delaware Statutory Trust (DST) properties and real estate securities. He has been interviewed on local and nationally syndicated radio stations on the matters of 1031 exchanges and replacement properties. He also is the author of the published book “Delaware Statutory Trust (DST) Properties: An Introduction to DST Properties for 1031 Exchange Investors.”
Dwight began his career in commercial real estate working for a national commercial real estate brokerage firm focusing on multifamily and commercial real estate. Mr. Kay received his Bachelors in Business Administration from Point Loma Nazarene University in San Diego, California, and successfully obtained his Series 7, 22, and 63 securities licenses as well as a real estate broker’s license.
We all work hard at our J.O.B., don’t we? We work hard each day and hope to retire when we’re 65, that’s the American dream, right?
Many of us are looking for something better, maybe a scenario where we can retire earlier or perhaps enter a state of semi-retirement. The answer: investing in apartment buildings.
Imagine working really hard to find a good building at a fair price, putting the financing together, and hiring a property manager to run the whole thing. Was that a lot of work? Of course. But don’t you work hard anyway? Here’s the difference….
Apartment Ownership – What’s It Really Like?
Imagine the day you close on the building and your property manager takes over. Ask most apartment building owners, and they will say they spend anywhere between 2 and 5 hours per week on their building if it’s managed by a professional management company.
What have you done? You went from a job that took 40-50 hours of your time each week to one that takes a fraction of that. And you replaced part or all of the income of your job with that from the apartment building.
You’re working less while maintaining your income.
What would this mean to you? Maybe you could spend more time with your family. Maybe you want to travel more. Pursue a hobby. Give back. Or maybe do more deals.
How is something like this possible with apartment buildings? The answer is in how apartment buildings are valued.
How Do you Make Money On Apartment Investments?
The value of an apartment building is driven by its net operating income, the amount of income left after all expenses are paid. The more money the building spits out after all expenses, the more it’s worth.
In many parts of the country, a building is worth 10 times its net operating income. This “10 times multiplier” is referred to as the “capitalization” or “cap rate” for short. Don’t worry about this for now – it’s not important to the point I’m trying to make. Let’s just use a cap rate of 10 for our discussion.
Let’s say a building has a net operating income of $100,000, which would make it worth $1M. If you could somehow make the building generate $10,000 more each year, maybe by increasing rents or decreasing expenses, you would have generated $100,000 in value (a cap rate of 10 times the additional income of $10,000 is an additional $100,000 in value).
Let’s look at a more specific example, so that you can start visualizing how this “math” could work for you in real life.
Assume you bought a 10-unit building for $540,000, and you had to put 30% down. The building was bought at a “10-cap” based on our formula we’ve used so far. Which means its net operating income (or NOI) is $54,000 per year, times our cap rate of 10 is $540,000. The income per unit is $1,000, and the expenses are 55% of the income. The building is in great shape and has been managed by the owner himself.
So far there is nothing special about this deal.
However, suppose you found out that the average market rent in the area is actually a $200 higher per month. Suppose further that you meet a property manager who manages two similar buildings in the area, and he tells you that his expenses are only 45% of income.
Let’s say it takes us 3 years to get the building to where it should be, i.e. with each unit bringing in $1,200 per month and lowering our expenses to 45% of income. Here’s how this would impact our financials:
By making small improvements each year, we have added $25,000 to our Net Operating Income. What is our value now?
Our new NOI is $79,000, so our value now is about $790,000 ! That is an increase of $250,000 in three years! Isn’t that incredible?
But that’s not all.
You also had between $2,600 and $4,700 in monthly income from this building over those three years.
That’s still not all. You (em, I mean your tenants), paid down $21,500 of your mortgage balance during that time, too.
Here’s what you get if you add everything together:
Your down payment was $160,000, and your total profit if you sold this building in 3 years is $284,000. This means you nearly doubled your investment!
In the meantime you enjoyed an average of $3,500 per month in cash flow.
Maybe you need more than that each month to quit your job. No problem. Buy a bigger building. Or get a second or third one. Three of these buildings will give you $10,000 per month in income and almost a $1M of profit in 3-5 years.
Retirement Possible In 5 Years After Investing In Aparments?
Would it be a lot of work? Absolutely. Do you work pretty hard right now? Probably.
Imagine working just as hard for the next 5 years and being able to retire. Imagine. 5 years.
And then you can do whatever you want. Keep working. Keep finding new deals (why stop?). Travel. Family. Give back. Whatever.
You don’t have all the answers, and you probably feel overwhelmed. That’s to be expected. The point I’m trying to make is, make sure that whatever you’re working hard at gets you to where you want to go.
I always say, “where there’s a will, there’s a way. And where there isn’t a will, there is NO way”. So ask yourself first, how badly do you want it? If you want it badly enough, you will choose to commit to the journey.
Use REIClub.com as a resource to get started – there are tons of articles, blog posts, and videos! I’ll try to do my part to write articles (and maybe publish a few videos) on the subject of investing in apartment buildings with a particular focus on raising money from private individuals (called “syndication”).
For me, and many others, apartment buildings are the single best way to retire early. It might be a good wall to consider climbing. Why not get started today!
Michael Blank’s passion is being an entrepreneur and helping others become (better) entrepreneurs. His focus in real estate investing is buying apartment buildings by raising money from private individuals.
Michael has been investing in residential and multifamily real estate since 2005 and began syndicating deals in 2010. He is the author of the Syndicated Deal Analyzer and the free eBook “The Secret to Raising Money to Buy Your First Apartment Building”.
Pasadena, CA – March 25, 2014
We hope to see everyone back in Pasadena in 2015!
www.IncomePropertyExpo.com
by: Michael Blank
A deal comes in for a 12-unit apartment building from one of your brokers. He faxes you a rent roll and a list of expenses. The asking price is $575,000, and he’s asking for what you want to do. It’s relatively easy to answer the question “is this a deal?” (the answer is usually “no”), the harder question to answer is “what is the most I would pay for this deal and why?”
When I first got started with analyzing apartment building investment deals, it took me about 4 hours to answer this question. This is extremely time consuming, and when you’re looking at a lot of deals, it can be overwhelming.
The trouble is, if it takes you too long to get back to the broker with feedback (or if you don’t get back to him at all), he will stop sending you deals. The same is true if you always respond with “that price is too high, it needs to be X”. Without usable feedback, the broker won’t know what you’re looking for and/or won’t be able to articulate to the seller why his asking price won’t work for you.
In this article I’d like to describe how to answer the question “what is the most I would pay for this deal and why”, and to answer it promptly.
How to Quickly Analyze an Apartment Building Deal using the 50% Rule
Step # 1: Determine your Investment Criteria
Before you can seriously answer this question, you need to decide what your investment criteria are. If you plan to syndicate the deal, you need to answer the same question for your investors.
What is the minimum cash on cash return and average annual return that you and your investors will be happy with?
For example, you might decide that you won’t touch anything with less than a 10% cash on cash return and an overall average annual return of 20%.
If you’re syndicating the deal, you need to decide what returns you want for your investors. What minimum returns will you need to show to attract capital?
Before you can analyze a deal, you need to determine your investment criteria. Otherwise, how will you know if you have a deal?
Step # 2: Determine Fair Market Value Using the Cap Rate
I’m not going to explain the “cap rate here (Bob Diamond does that in his REIClub article here), but I do want to give you some tips for determining what cap rate you should use in your analysis. The BEST way to determine what similar properties have sold at is to ask you brokers. Hopefully you’re working with a handful of good brokers who are feeding you deals. If they’re worth anything, they’ll tell you what the prevailing cap rates are in the area and will send you comps for the area you’re looking in. From that, you can create valuable information about the cap rate and price per unit.
Let’s assume that the prevailing cap rate for your market is 8% for similar buildings. That just means you have a way to assess “fair market value”, but who’s happy with that? You may decide that you don’t want to get into a building with anything less than a 10 cap, and that is a fine investment criterion.
Knowing the market cap rate is important for estimating the re-sale value and your financial projections later on. Also, it may be unrealistic to look for 10 cap deals in an area where everything else is selling at an 6-cap, make sense?
Step # 3: Assess the Value of the Building Using the 50% Rule
Now you can quickly assess what you want to pay for any deal that comes in. Assume the seller is reporting gross scheduled income of $100,000. In our income projections, we will use an occupancy rate of 90% unless the seller provides a lower number. If the reported expenses are less than 50% of income, then ignore what’s reported and use 50% to calculate the Net Operating Income (NOI).
Apply your desired cap rate to get the current valuation of the building:
If the asking price is above $450,000, you can now quickly get back to the broker and say that the fundamentals aren’t right. You can say that the expenses are clearly under-reported, or the vacancy rate, etc. You might say, “The expenses are way low. Assuming 50% of expenses, and using the reported rental income, in order to get at my desired cap rate, I could spend no more than $425,000” and see how flexible the buyer is.
Using the 50% rule makes it easy to quickly answer the question “what is the most I could pay for this apartment building investment deal and why?”. It will save you tons of timing in phase 1 of the analysis and makes you more responsive when a deal first comes in.
Michael Blank’s passion is being an entrepreneur and helping others become (better) entrepreneurs. His focus in real estate investing is buying apartment buildings by raising money from private individuals.
Michael has been investing in residential and multifamily real estate since 2005 and began syndicating deals in 2010. He is the author of the Syndicated Deal Analyzer and the free eBook “The Secret to Raising Money to Buy Your First Apartment Building”.
This post provided by REIClub.com for creative real estate investors. Copyright 2002-2011 All Rights Reserved. Published with Permission of Author. No part of this publication may be copied or reprinted without the express written permission of the Author and/or REIClub.com
Apartment News Publications Inc. is teaming up with the Income Property Management Expo to provide Apartment Owners/Managers & Commercial Property Management Companies with tools for efficient, cost effective management, operation and maintenance of their communities & facilities!
Southern California Attendee Information:
This expo will host FREE seminars throughout the day addressing CA Energy Efficiency Programs, Landlord Legal Updates, Tax Code & 1031 Exchanges, Property Maintenance and more! The goal of the Expo is to provide attendees with the opportunity to network with other industry professionals while enjoying fine food tastings, the PGA Experience, Luxury Car Display & Test Drives, raffles & giveaways and the expo floor which will have over 100 exhibitors!
To learn more about the Income Property Management Expo, how to attend for FREE, or learn how to reserve a booth for the Expo Floor, visit IncomePropertyExpo.com!
By: Christopher Miller
One of the most important parts of a 1031 exchange seems to be the least understood, so I am devoting this month’s article to one important detail: Debt replacement needed in your exchange.
@IPMExpo