What Are You About?

That’s what I was asked recently by an investor. In determining if and why he should invest in any of my deals, this question stuck in my mind as we talked through things. “You’re all over the place” he said.

I was taken aback. That’s something I’ve never been of accused of. People throughout my life have often said I need to lighten up, enjoy the journey, or have more empathy for why some aren’t as committed to the cause as I am. Now, this investor and I know each other outside of the investment world, so maybe that contributed to the confusion some.

The feedback, though, sparked the idea for this Real Estate Journal Entry. If I’m not clear on what I’m about in regards to real estate, then why would anyone on my investor list ever invest with me?

To put it simply, I’m about adding value, creating infinite returns, and not paying taxes.

Adding Value

What Is It?

This is certainly the core of my real estate philosophy. As the name implies, the “Value Add” strategy adds value to the property. This strategy is perfectly suited for commercial property since commercial property is valued based on its income. Here’s how that value is calculated:

Total Income - Total Operating Expenses = Net Operating Income (NOI)

Net Operating Income / Capitalization Rate = Value of Property

A full article about capitalization rates can be viewed here. By just observing the formula above, you can easily tell that a lower capitalization rate (smaller divisor) OR a higher NOI (bigger dividend) will result in a higher property value. While capitalization rates are out of the operators control, the NOI is completely within the the operators control. By increasing income as much as possible, and lowering operating expenses as much as possible, the NOI is maximized thus maximizing the value of the property.

How To Do It

There are a few keys to successfully implementing this strategy.

Buying

The first one is buying at the right price. In today’s market, it may not be possible to buy a property based on how it’s actually performing at the moment. Sellers expect some premium due to the high competition in the market. But a buyer can’t pay so much of a premium that they give away the profit of the value add. So, it takes a disciplined approach.

Understanding population trends in the market, median income trends in the area, the desirability of the submarket where the property is located, selecting rent comps, being realistic about vacancy and bad debt, and properly preparing for a multitude of economic conditions all play a factor in what price can be paid for a property.

To be clear, when evaluating a deal, I’m always aiming for the following metrics:

• 13-17% IRR

• 1.8-2.0 Equity Multiple

• 6-7% Avg Cash-on-Cash Return

IRR means the Internal Rate of Return. It’s a complex idea (one that I’m considering writing a full article about), but for the time being, it essentially levels out the time factor of returns. In other words, $10k returned today would result in a higher IRR than a $10k return in 5 years, because in those 5 years the purchasing power of $10k will have decreased.

Equity multiple is simply the total return. $100k invested into a project with a 1.8 equity multiple means at the end of the project, the investor will have $180k.

Average cash-on-cash return can be misleading. Cash-on-cash return is the yearly return on money invested. $100k invested with $6k/yr in distributions is a 6% cash-on-cash return. The average is what can mislead - especially with a value add project. During the first few years of stabilization, the renovations and tenant turnover can result in lower cash-on-cash returns. However, after stabilization, when renovations are done, the returns can jump significantly.

Managing

Managing a property is a full book on its own. But the essence of managing a property well is being proactive rather than reactive and measuring key performance indicators on the property. Monitoring things like physical vacancy, economic vacancy, and budget allocation is critical in making sure the property is being run as efficiently as it could be. Surprise onsite visits to check up on renovations, secret shopping your own leasing office, and holding the property manager accountable for what they say they are doing are also critical.

Flexibility is another key piece to management. Regarding renovation budgets, if achieving the desired rents proves to be possible without doing the full planned renovation, then a good operator will see that, standardize the renovation needed to achieve the target rents, and reallocate the new excess of capital to a better and higher use for better returns (or maybe even just hand it back to the investors if it makes sense to do so).

Infinite Returns

Admittedly, this section is a fusion of what I personally believe about and want out of real estate investing and what many passive investors want.

On a personal level, I’m always, always, always aiming for infinite returns. What’s that you ask? An infinite return is returns from a property with no investor money in the deal. Look again at the above explanation of cash-on-cash returns. $10k/yr in returns divided by $100k invested means a 10% return.

10k returned / 100k invested = 10% return

But what if you have $10k in returns with $0 invested? That’s an infinite return!

10k returned / 0k invested = Infinite return

This pairs well with commercial real estate, because once an operator has executed the business plan and added value to the property, a cash-out refinance could recover all the invested capital. And certain commercial loans are non-recourse, meaning the borrower is not personally responsible for the loan. So, at that point, there is no investor capital in the deal, the loan would be non-recourse, and the property still produces positive cash flow i.e. risk free returns!

There’s a host of other benefits of implementing this strategy as well. The longer a property is held and managed well, the higher the value goes. Which means you could do multiple cash-out refinances over time and harvest “free” money out of that property.

In addition, this gives the investors a chance to increase the velocity of their money. Velocity of money is simply how many times a particular dollar is used in transactions. In all of my examples, I talk about an investor with $100k invested. In a infinite return situation, that investor gets their $100k back from property 1, still receives cash flow, and can re-invest that $100k into property 2. Implement the same strategy again, and then the investor can invest in property 3 with the same $100k. Carry that forward and a stack of passive income streams is compiled all using the “same” money.

However, many passive investors do want to sell - they value the idea of fully exiting from an investment. Usually, this is because they value the equity multiple over cash flow - which is a completely valid way of approaching real estate investing as well. And certainly, on a deal that I’m operating, when we get to the targeted equity multiple and IRR numbers, if the overwhelming desire by everyone is to sell, then I’d do that. In either case, an infinite return or a sell, we can make sure the IRS keeps their hands out of our pockets…

Pay No Taxes

One of the best parts of real estate investing is the favorable treatment of real estate by the IRS tax code. And I believe, fundamentally, this is the proper way it should be. Any value created in real estate was done so by the operator, not the government. Therefore, the government shouldn’t be sticking its hands in the investor’s pockets.

To be blunt: if an individual invests in real estate, they can (legally) never pay taxes unless they want to. Any positive cash flow (i.e. profit) can be offset by depreciation on the property, expenses associated with the property, and the like. As of the time of writing, bonus depreciation allows investors to possibly accelerate the normal 39 years of depreciation into year 1. These are all great tools. But relevant to the point of this journal entry is the Section 1031 Like-Kind Exchange.

Even if I am part of an investment where we sell the property, I then always look to do a 1031 exchange. The 1031 allows the deferral of capital gains tax on the sell of a property. Continually doing 1031s from one deal to the next allows an investor to legally avoid taxes their entire life, if they choose. Even better, at death, as of the time of this writing, the heirs get a step-up in cost basis of the property. The cost basis is reset to the value of the property at the time of death (or up to 6 months after the death) - meaning that if the heirs sold the property at that time, they would pay $0 in taxes. It’s called the “Buy-Borrow-Die” strategy. If I can’t hold a property and get tax free money out of the property by layering on more debt via cash-out refinances, then you can be sure I will be doing a 1031.

Conclusion

So, what am I about as a multifamily syndicator, operator, and investor? I’m about adding value, creating infinite returns, and not paying taxes. Worth an entire article on its own, but I’ll briefly mention here, is the team needed to do this. I am not a one-man shop. Any multifamily deal I ever bring to my investor list will have a team of expert operators on it. Some of those experts are in the links provided throughout the article.

The other part of the team on a multifamily deal is the passive investors. Without them, no deal would ever get done. If you’re interested in passively investing in multifamily real estate, feel free to schedule a call with me at https://swiftcitycapital.com/invest/.

Hopefully, after reading this, it’s very clear what I’m about. If not, post a comment, send an email, or DM on the social media platform of your choice!