Save Big (or not) With 1031 Exchanges

You’ve found a great asset.  You’ve done your due diligence.  It’s in the best market and sub market.  It has strong financials that are poised to give you just the kind of returns that will set you along the path to financial freedom.  You decide to go for it!

Fast forward 10 years.  Fantastic news!  That great asset you found way back when has done wonders for you over the last 10 years.  Not only has the property appreciated exactly the way you had predicted, but it has been spitting cash at you since you closed.  Now you have a grand new plan.  You have decided to aim at a bigger and better piece of commercial real estate.  The question becomes:  what is the best way to handle the sale of your current property and the purchase of your bigger and better property?

You vaguely remember someone telling you about something called a 1031 exchange.  You might even recall something about a reverse 1031 exchange.  Are any of these methods right for you?  In order to answer that question, we first have to define a 1031 exchange and then think about what the processes involved in a property exchange look like.

A 1031 Exchange Definition

A 1031 exchange (also called a ‘like-kind exchange’) is a tax treatment that allows a property owner to postpone taxes owed on any gains made through the sale of his or her property.  If so elected, the owner selling their property selects a like-kind property to purchase within a specified period of time and re-invests any proceeds from the sale of their first property.  This re-investment of proceeds is not taxed at the time of the transaction as would occur normally, but is instead deferred until that time that the owner purchases another property without the use of a 1031 exchange, or until that time that the holder chooses not to re-invest their gains.  A 1031 Exchange can be used serially and in perpetuity, effectively eliminating the tax burden on gains realized from certain real estate investments.

A Reverse 1031 Exchange Definition

Now that you have a firm understanding of the straight-forward 1031 exchange, let’s examine a ‘reverse’ 1031 exchange.  In the straight 1031 exchange scenario, the steps are fairly straight forward:  you sell your property, select a replacement ‘like-kind’ property (within that specified period of time) and purchase the replacement property.  Under a ‘reverse’ 1031 exchange set up, you effectively do the opposite:  you acquire the replacement ‘like-kind’ property first, and then sell your existing property.  The proceeds from the sale in either case are invested into the like-kind, replacement property according to the rules and limits put in place by the IRS.

Here is an excellent infographic of the 1031 exchange process that explains visually what is sometimes difficult to understand with the written word:

http://dailyinfographic.com/1031-exchanges-the-ultimate-guide-infographic

Purpose

My guess is that by now you have a pretty good idea as to why it is sometimes a great idea to enter a 1031 exchange and why the hassle might just be worth it:  deferral of the typical long-term capital gains rate of 20% on your investment gains until you decide otherwise.

Let’s look at the example we used above.  We purchased our piece of commercial real estate for $1M.  Ten years later, we decided to sell our property for a cool $2M.  Excusing all of the associated costs of the transactions, and any alterations to our cost-basis, we have doubled our money!

If we were to sell outright without the expectation of exchanging into our bigger and better property, we would net (approximately) $800k:

Sales Price:  $2M

Purchase Price:  $1M

Difference:  $1M

 

Taxes (@ 20% of $1M):  $200k

Net to You:  $800k

 

If we opted instead to do a 1031 exchange, this example would look like this:

Sales Price:  $2M

Purchase Price:  $1M

Difference:  $1M

 

Taxes (@ 0% of $1M):  $0

Net to You:  $1M

 

It Might Not Make Sense

A 1031 exchange or reverse 1031 exchange may not make sense for you if you have $50k or less in capital gains.  In this case, the processes involved may be too cumbersome, the interface with intermediaries too costly and the tax consequences not damaging enough to justify involvement.

If it does make sense, a 1031 exchange might just be the ticket to advancing your financial goals.  As with all processes, procedures and rules  surrounding your taxes, consultation with the IRS, tax attorneys and/or a 1031 intermediary is imperative to getting the most out of your tax planning and your commercial real estate transactions.

 

CRE Value and the CAP Rate Impact

You remember our friend CAP rate? CAP rate is defined as the unlevered return you can expect to receive on a commercial real estate asset investment. CAP rates vary by asset type, asset class and location. CAP rates also vary over time according to supply and demand.

For instance: CAP rates will likely not be the same for an office building situated in a major metropolitan downtown area and a suburban apartment complex. A suburban apartment complex in one part of the country will not have the same CAP rate as an identical suburban apartment complex in another part of the country. The same office building and suburban apartment complexes may have a different CAP rate next quarter or next year or ten years from now. The point is that CAP rates change.

Let’s look at how CAP rates impact the value of our commercial real estate first. You may know that the value of a piece of commercial real estate is typically calculated like this:

Net Operating Income / CAP Rate = Value of the asset

Let’s take an easy example. Suppose your multifamily property has a NOI of $100,000. The going CAP rate for your class of property in your market right now is 10%. This 10% CAP rate says you will earn a 10% return on your invested dollars if you purchased this asset using all of your own cash.

Calculating the value of the asset using the formula above looks like this:

$100,000 / 10% = $1,000,000

So, if you purchased your multifamily building for $1,000,000 using all of your own cash, you would receive $100,000 per year or 10% return on your investment.

Using the formula above, let’s look at the impact of a changing CAP rate on the value of your apartment building.

At a 5 CAP (a CAP rate of 5%), your property would be worth:

$100,000 / 5% = $2,000,000

At an 8 CAP (a CAP rate of 8%), your property would be worth:

$100,000 / 8% = $1,250,000

You get the idea. And you can see that a varying CAP rate can impact your acquisition costs as well as the value of your investment over the life of your hold period. Finally, CAP rate can affect the timing of any financing events during the hold and the price you are able to demand on disposition. Whether it’s an industrial building, a strip mall or an office park, it pays to pay attention to CAP rate.

NOI: The King of CRE Valuation

Now that you have made the decision that commercial real estate is the ticket to a well diversified portfolio, you begin the search for the perfect asset. There are many different assets to choose from in commercial real estate: office buildings, industrial warehouses, strip malls, apartment buildings and even the post office building!

Just as you get your feet wet looking at the vast array of possibilities, you may discover that deciding how much you are willing to offer on each of these assets is becoming a little bit of a challenge. Some of the properties your broker has sent you don’t even have an asking price! The listing broker only says something like: offered at market rate. So now, you not only have to find just the right property for your investment appetite, you also have to determine how much it’s worth.

You aren’t a real estate appraiser you say? That’s okay; we’re going to explore how the majority of commercial real estate brokers, investors, bankers, and maybe even appraisers come up with their estimated value of a commercial real estate asset.

First, let’s remove all traces of residential real estate valuation from that head of yours. Using what you know about residential real estate to help you value commercial real estate is going to really get you off on the wrong foot.

You may recall from previous blog posts that commercial real estate does not have a central ‘For Sale’ repository like residential real estate does. There is no MLS for the commercial side of the house. Next, and perhaps most importantly, in commercial real estate, we do not use comps. You know; comps. Comps are the way we all determine how much our personal residence is worth when we are looking to purchase or refinance. We compare houses with the same number of bedrooms, bathrooms, and square feet to our current or prospective home. We then look at these ‘comparable’ houses within a tight radius, closest to our current date.

Yeah, comps are not really used in a serious way for commercial real estate. At best, you could use this kind of information as a tool to see generally how far away from, or how close, your property’s asking price is from properties that have closed escrow. Be warned, however, that you may or may not find recent sales or sales of very similar property types, and therein lies the limitation in using this method for anything other than as a reasonableness test.

Another method of valuing commercial real estate is replacement cost. This method is not used much anymore, and is not talked about too much. The one place you will see a reference to a replacement cost is in a sales listing where the broker might say something like ‘priced well bellow replacement cost’. Replacement cost is just like it sounds, it’s the cost of re-constructing the commercial real estate asset from the ground up(though not including ‘the ground’). There are a couple of ways to go about this type of calculation, but a typical calculation is based on an average dollar value per square foot. As with comps, the replacement cost calculation can be used for reasonableness testing.

The gold standard, if you will, for valuing commercial real estate, however, is Net Operating Income, or NOI. NOI, used in combination with CAP rate, gives you the potential acquirer, the estimated value of an asset and a great starting point for presenting an offer or negotiating a position.

Net operating income is defined simply by the gross operating income of the property, i.e. all rental income plus other income the property generates, minus all of the asset’s operating expenses. Please note that this calculation does NOT include mortgage payments of any type. Once this value is determined, and a CAP rate is known, it is a straight forward calculation to determine an offering price.

What is CAP rate you ask? This is an important question when working the formula we’ll discuss in a moment. The CAP rate, or the capitalization rate is the unleveled return you would expect to find your market or submarket for your particular asset type. For instance; in Dallas, TX, we might expect to find CAP rates in the 6% rage as of this writing for a B-class multi-family asset. The same B-class multi-family asset in San Francisco, CA may currently be fetching 3.5%.

The lower the CAP rate in a particular market, say in San Francisco, CA, the more secure and stable the asset. The higher the CAP rate, the greater the intrinsic risk. Generally speaking, there are CAP rate ranges for each class of assets within each market. Your commercial real estate broker should have the most current CAP rates available for your asset type and class.

The calculation: Once we have a handle on the NOI and know the going CAP rate, the value calculation is fairly straight forward. We divide NOI by our CAP rate, which looks like this:

NOI / CAP Rate = Asset Value

Here is an example. Our NOI is $500,000 and the going CAP rate is 6% or .06. We plug and play:

$500,000 / .06 = $8,333,333

This calculation is easily swapped around to find any of the three variables if we have the other two. This makes this calculation handy for learning more about our market and its expected returns and/or understanding the financial performance of a commercial asset.

As with any calculation; there are some pitfalls, particularly in the NOI derivation. We will explore those limitations in a future blog post. Beyond those pitfalls, NOI/CAP rate valuation calculation and all of its flexibility, makes it stand head and shoulders above any of the alternate calculations out there.

Don’t Lay an Egg When Selecting a Multifamily Property!

Just for the sake of argument, let’s assume you’ve decided that commercial real estate is for you.  You’ve decided that investing in commercial real estate, and particularly multifamily property is the way to go to secure your retirement (and I would agree!).  You’ve decided as well that you are capable enough and educated enough to act as an active investor on your apartment investment, and for now, you’ll forego the passive investing route.  Surely, you think, if you can invest passively, why not invest actively for greater returns? Apartment buildings are, after all, just many little houses put together and that really isn’t that much different from your own house, right?  You’re excited and you can’t wait to get started!

It’s Easter Sunday tomorrow, and in the spirit of the holiday, let’s work on growing your nest egg, not laying a doozy that will crush your dreams of retirement.  Following this one simple guideline will stop you from making perhaps a multi-thousand dollar mistake.  When people get excited to begin a new project, a great many people do what seems logical in this day and age — they go to the internet.  This does seem to make sense.  After all, when you want to begin shopping for a new house, the internet is a great place to start — you can investigate new cities, new neighborhoods, neighborhood schools, local businesses, new houses for sale, resale houses up on the block, comparable prices and more.

When people first launch their search for multifamily apartment buildings (particularly 5 or more units), one website normally attracts most of the attention:  Loopnet.  Now, there is absolutely nothing wrong with Loopnet.  Here is the distinction you must keep in mind as you peruse those seemingly fantastic investments for sale on Loopnet — unlike residential real estate, there is no central listing service like the MLS for commercial real estate.  Let me say that one again:  Loopnet is not an MLS system for commercial real estate.  Not only does this apply to Loopnet, this is also applicable to any other website that lists apartment complexes and commercial real estate for sale.

Well, okay you say.  No big deal.  So you only get a portion of the listings — big whoop.  Here’s why this is important.  Loopnet and all of the other commercial real estate listing websites get these listings generally speaking, at the end of their sales life cycle.  What does that mean?  What it typically means that commercial real estate brokers have shopped this listing to everyone on their buyers list, shopped the listing to other brokers in their firm and their buyers lists, shopped the listing to others in their network and found no takers.  This means that many, many pairs of eyes have reviewed the property, reviewed the offering memorandum (a multi-page marketing brochure on the property), reviewed the actual financial performance and have determined the property doesn’t meet their investment criteria.

Of course you can argue that their investment criteria may be different from your criteria.  You have found a great deal and are perfectly willing to put your hard-earned dollars to work on this project, but consider this:  the number of reviewers on your find may be in the hundreds!  Hundreds.  You may want to consider carefully why each of those reviewers said ‘no’ to your great investment.

Don’t let your hunt for a nest egg investment turn your retirement into scrambled eggs (sorry, I couldn’t resist).  Consider carefully those ‘can’t miss’ multifamily investments you find online.

Happy Easter!

Pop Quiz: What does a 5-plex, your doc’s office and a Hilton hotel have in common?

If you guessed that each of these can be defined as commercial real estate, congrats — you have scored 100% on today’s quiz!  If the answer didn’t quite spring to mind, this blog entry is for you — please continue reading.

There are just a couple of broad categories used in discussing and transacting real estate — residential and commercial real estate.  Residential is the most intuitive, generally describing single-family housing and multifamily housing of 2-4 units (duplex, triplex and quadplex).  Commercial real estate is any property that is used for commercial purposes, and is much broader in scope and encompasses several, perhaps unapparent, property types discussed below.

Commercial real estate is everywhere.  In the course of a day, you can encounter several examples of commercial real estate:  in the morning before work, you stop at the gas station for some gas for your commute into work.  Gas station – check.  You decide that to make it through your morning meetings, you’ll need some coffee, so you take the most convenient drive-thru at Starbucks.  Starbucks – check.  You get on the stop and go freeway, passing a movie house, a shopping mall and your favorite baseball team’s stadium.  You guessed it:  each one of these is considered commercial real estate.  An hour and a half later, you arrive at your office building to begin your day when your secretary tells you that you are scheduled to be in conference at a downtown hotel.  As you have no doubt figured out, the building where you and your co-workers spend vast numbers of hours of your lives and the hotel where you are supposed to be this morning, are both great examples of commercial real estate.

Commercial real estate can be divided into a few categories for ease of discussion and focus:  retail, industrial, land, office, leisure and multifamily.

• Retail property consists of just what you imagine it to be:  property that hosts retail stores.  Examples would be: the Home Depot, Macy’s, Payless Shoe Source, et al.
• Industrial property consists primarily of factory, research and development, manufacturing, warehousing and distribution centers.  Distribution centers, for example, are generally located outside of major metro areas where there is space to house inventory that may be called upon by metro area stores.  You may be familiar with one of the more popular research and development parks in the U.S., The Triangle in North Carolina.
• Land zoned for commercial use is considered commercial property.  Land designated as farm land is considered commercial real estate.  Even land that is raw and undeveloped could be considered commercial real estate.
• Office buildings with no special equipment, but suitable for administrative tasks is commercial real estate.  You may encounter some distinctions within the office category, like medical office space.
• Leisure real estate is really several, and quite varied property types.  Hotels, resorts, golf courses, stadiums, etc. are considered commercial real estate.  In fact, thinking back to the definition of commercial real estate posted above, each of these property types is most assuredly in existence for a “commercial purpose”.
• Multifamily property is shared residential apartment-style or townhouse-style living.  We think of this form of commercial real estate in terms of a 5-plex all of the way up to complexes with more than 500 units!  These buildings can be very old with few amenities, or brand new with state-of-the-art technology and attractions.  Multifamily buildings all can be sub-categorized into garden-style, mid-rise and high-rise depending on the density of apartments built on the parcel of land on which they sit.  They can be situated on many acres with open space and parks, or on a downtown city block.

This is a short list with just a few examples.  I’m sure that if you sit down and think about it, you could come up with many, many more examples of commercial real estate on your own.  Commercial real estate touches our lives everyday.  We will explore in much more detail how we, as investors with an eye on securing our financial future, can help our friends and neighbors live more comfortably, derive more convenience in their neighborhoods and enjoy more fully their hard-earned time off through our commercial real estate investments.

 

Do You Contribute $69.5k a Year to Your Retirement Plan? Now You Can!

Yesterday, I had the pleasure of attending for the first time Realty411’s Masters of Real Estate Conference & Expo in San Jose, CA. There wasn’t much discussion about commercial real estate or apartment investing, but there is always something to learn, and learn I did.

Did You Know?

One of the speakers gave a talk on self-directed retirement plans.  I will blog a lot more on that topic, but if you don’t know what a self-directed IRA or 401(k) is, put it in a search engine — you won’t be disappointed.  In any event, one thing the speaker introduced me to is the Individual 401(k).  The Individual 401(k) is a program that is nothing short of stupendous, fantastic and life changing!  Honestly, what is the difference you ask?

Well, here’s the difference.  If you are a W-2 employee, you are very likely used to the employer-sponsored 401(k), or even IRA.  In the W-2 401(k) program in 2014, your contribution limit as an employee is a not so high at  $17,500, or $23,000 if you are playing catch-up — see the official language of the IRS right here:  http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics—401(k)-and-Profit-Sharing-Plan-Contribution-Limits.

The amazing part of the Individual 401(k), or the “indi (k)” as the speaker called it, is that even as a sole proprietor (not that I recommend this business structure) you will have the ability to contribute some serious dough to your retirement plan.  One of the best parts of this plan is that you need have only the intent to make money.  Huh?  That’s right, you as the owner of a business with the intent to make money, you may offer yourself a super way to contribute way more than your W-2 401(k) could ever hope to offer.

Being self-employed and offering an Individual 401(k) to yourself (and to your spouse or partners), you are entitled to not only contribute the “employee” contribution limit of $17,500, but also the “employer” contribution amount which is $52,000 (in 2014) or 25% of your compensation, whichever is less! Incredible.  And this is only if you are younger than 50.  If you are 50 years and older, the limits are even higher!  Here is the link to the IRS page that talks specifically about this program and how it should be implemented:  http://www.irs.gov/Retirement-Plans/One-Participant-401(k)-Plans.

So, by my simple calculations, here how this could work for you (age 38):

You start a business that compensates you $208,000 for all of your hard work.

You decide to contribute the maximum amount allowed by the program at $17,500 in 2014.

Your employer (you) decides that they will contribute 25% of your salary, or $208,000 X 25%, or $52,000.

That means your total retirement contribution amount equals $52,000 plus $17,500, or $69,500!  Voilà!

If you use the Individual 401(k) for yourself, please share your story.  Before hearing this yesterday, I hadn’t even considered this retirement strategy, and now I’m banking on it.

 

Hello!

Thanks for visiting and welcome!  I decided to start this blog to chronicle my exploration into investment alternatives as I continue planning and investing for retirement.  Maybe a little dull for some, but seriously important and something I hope myself and others can present in an interesting way.  Of course, suggestions are always welcome!

Over my W-2 career, the choices in investment paths has been limited, if not down right scuttled by not just my employers, but many other employers across the nation.  You might have experienced just what I’m talking about and early on, these limitations played out in how much money I was able to save and invest, and how much money was put into investments on my behalf and slated for retirement.  I knew that in order to recoup those “losses”, I would have to develop more creative ways to reach retirement in a financially whole way, i.e. get to retirement age with enough money to survive and thrive until I leave this world — hopefully many years hence!

This is a journal and a retrospective of my thought processes, my education and my experiences as I’ve tackled saving for retirement as a Gen-Xer.  I hope you’ll visit often, and I hope I’ll pass along information that you will find useful.  Enjoy!