by Jeff Brown
There are many universally accepted, hard ‘n fast truisms in real estate investments that are quite simply factually inaccurate. Today let’s take just a few major examples.
1. Buy and hold forever.
2. Always plan to utilize tax deferral to role over gains without taxation.
3. Cash flow is ALWAYS king.
4. Investors should always sell within 2-5 years.
Buy ‘n Hold Forever
To employ one of my favorite phrases from the nomenclature of the professional, “What a crock!” 🙂
Here’s what you have to look forward to if you buy into this belief system. You’ll retire with the following factors in place, embedded in concrete:
All your properties will be 30-100 years old the day you retire. I’m sure that was your goal, right? 🙂 After all, what’s better than being retired reliant on ancient properties with failing systems, obsolete floor plans, operating expenses 20-40% higher than when you first acquired ’em and tenants of deteriorating quality? Yeah, that’s the ticket.
Where do I sign up for that retirement Nirvana?!
But wait, it gets worse. Since at retirement you’ve owned pretty much all your units for a very, very long time, you’ve not received your retirement bonus surprise. This special gift is courtesy of your belief in buy ‘n hold forever. You get to have your units all debt-free with massive cash flow relative to when they still had debt. The special gift? None of that massive cash flow is tax sheltered in the least. No, not a penny forever more.
Welcome to the wonderful world of buy and hold! 🙂
Then there’s our old friend functional obsolescence. Think of the really old rentals in your market these days. I live in San Diego, so it’s much of the inventory. How bad and dysfunctional can a floor plan be? How ’bout having to walk through one bedroom to get to another? Think I’m makin’ that up? I’ve seen it far too many times in older homes and even some multiple unit buildings. See, it wasn’t a big deal when Leave It To Beaver was winning the ratings wars. For the record, The Beav was born in 1948. 🙂
Or how ’bout my personal favorites, the wall/floor heater and wall/window air conditioner? Tenants go outta their way to find units sportin’ those amenities. You know, the tenants who can’t afford the modern and totally functional units a block up and two blocks over. There are a lot more examples of function obsolescence, like kitchens without dishwashers, but you get the point I’m sure.
Although, if you’ll indulge me a bit here, another all-time favorite of mine is the so-called ‘”family” unit braggin’ about three bedrooms with one bath. Gotta believe having extra one bedroom units in the same complex available makes long term sense if you have many 3/1 units. The divorce rate must be off the charts with just one bath for a married couple with two kids. One of ’em will surely end up renting that vacant one bedroom. 🙂
Always Tax Defer — ‘Cuz, You Know, Taxes Are Evil
I love 31 Flavors Jamoca Almond Fudge ice cream. But it’s a freakin’ treat, not a staple of my normal diet, for Heaven’s sake. The avoidance of tax liabilities for the sole purpose of being able to say you never pay taxes on your long term real estate gains is beyond bad thinking. Let’s quickly, but succinctly, explore why that’s true.
Tax deferred exchanges — often called “1031 exchanges” due to their origin in the Internal Revenue Code, Section 1031 — are NOT tax free as many describe them. When was the last time the government gave you a tax break and didn’t get it back later, at least in some form or fashion? And didn’t get more than they let you skate on previously?!
Two things happen when we exchange, using the rules provided in Section 1031 of the IRC. First, the potential tax shelter on your newly acquired property(s) will almost always be reduced from what they woulda been had you simply sold and bought. The reason is that your new depreciable basis will only increase by the amount your newly acquired debt exceeds the debt on the property you relinquished.
Example: You traded into a property for which you borrowed $200,000 to acquire. The relinquished property had a balance of just $125,000 at the time of sale. That means that even though you paid almost $300,000 for the new property, your “new” depreciation on it will be based upon a lousy $75,000, the increase in debt. But wait, it gets worse. You can’t depreciate the whole amount, as you must first subtract the value of the underlying land first, using its percentage of value. So, if the land is worth 20% of the property, you’re left depreciating just $60,000. If you use the same formula 95% of investors use, that amount will be the answer to — $60,000/27.5, which is a mere $2,182/yr. If you’d bought that new rental in a straight sale, eschewing the exchange, your depreciation woulda been somewhere around $8-9,000/yr!
Sure, you’re right when you say the relinquished property’s old adjusted basis goes with ya in the exchange, including it’s, um, less than robust annual depreciation. But even with that added to the new rental’s largely restricted depreciation figure, it’s not even close to the sell/buy approach in the vast majority of cases. This isn’t to say that sometimes the investor should indeed execute an exchange. It does mean that exchanging, tax deferred, shouldn’t be the default strategy.
Cash Flow is ALWAYS King
I think it’s possible that belief has turned more investors’ retirement plans into epic disappointments than just about any other. Besides, it’s about the timing. Is cash flow ever a bad thing? ‘Course not. However, emphasizing cash flow over capital growth at the wrong time can horribly retard what coulda, shoulda, woulda been your much more impressive retirement cash flow.
Here’s the Captain Obvious simple reason why:
To the extent we go for cash flow, we hinder capital growth. The reverse is also equally true. Both can be easily seen when doing spreadsheets. It’s much easier to detect when it’s too late, which is what I run into all the time with investors lookin’ for help. Once we buy into the myth that cash flow is king — always and without exception — the die is cast. There are several ways to inflict this on ourselves. Let’s talk about two.
- We buy one property with a huge down payment instead of two properties with reasonable down payments. In my world, “reasonable” starts with 20% minimum, just so ya know. 🙂 People do this for a few reasons, most of which is they must have a “bar” for lowest cash flow allowed. In average “plus” to “oh my God” bluechip locations, this means higher down payments. On the one hand, we get blue chip locations, while on the other hand, we’re poisoning our ultimate retirement cash flow to the max. Am I implying we should eschew top notch quality locations? No way. I’m saying there are those level locations not requiring your firstborn as down payment just to get them to pay for themselves.
- We buy inferior locations with “high” cap rates. The spreadsheets on these properties are indeed impressive, though most should be nominated for best script in a science fiction short story. Am I spoiling your fantasy that the 15% cap rate you bought is really far less than that? Are the vacancy rates double what you were told? I’m both shocked and chagrined. 🙂 Are the tenants not what you expected?
Here’s a solid piece to read on this narrowly defined topic of cash flow vs capital growth.
Understand that all cash flow, when the smoke clears, is a yield on a pile of gold. The bigger the pile, and/or the more piles you have, the more cash flow you will enjoy — when the cash flow matters, which is (wait for it…) our freakin’ retirement! 🙂
The investor with $3 million makes the same yield, more or less as the guy down the street with $1 million. It’s just that his retirement income is triple what his neighbor’s is. That poor neighbor will forever be trying to figure out how cash flow wasn’t always “king.” 🙂
Real Estate Investors Should Always Sell in 2-5 Years
(Or some other nonsensical time period.)
Man, I’ve heard this rubbish since Nixon was in office, and it’s as dumb now as it was then. Please tell me about your crystal ball’s record, will ya? Besides, with precious few exceptions, one of which I practice often for clients, having a set timetable to sell simply makes no sense whatsoever. Yet I read and hear about it all the time. When folks espousing this gibberish are asked to explain why, the whole ambiguous “maximize” investment yields malarkey we’ve all heard ad nauseum pops up.
Even a well thought out plan like the cost segregation strategy is subject to changes in many factors that could derail the end game, and most of ’em are out of the control of the investor. Let’s take a phenomenally rising market like the one we experienced nationwide, especially in markets like San Diego, in the mid-late 1980s. It was crazy cool if you’d just bought income property back then. Prices were increasing double digits annually.
So many times back then, I’d hear someone suggest we buy and sell every couple years. It was a very reliable and profitable “formula” for the first two moves. Notwithstanding all their predictions of massive wealth creation, the S&L Crisis hit like a red hot sledge hammer to the back of the head. Vacancy rates vaulted to double digits from virtually 0%. Rents tumbled 10-25% simultaneously.
See, most formulas work perfectly ’til the day they don’t.
From around 1976 through May of 2003, when I left my hometown market of San Diego permanently, the holding periods were all over the map. From ’76 through fall of ’79 some local investors bought and cashed out or exchanged three different times, using the same investment “lineage” of the original investment property! From the fall of ’79 to around the end of 1983, ’84 there wasn’t much goin’ on at all. As in, a whole buncha nothin’. We were back to the races in full stride by the end of 1985. From then ’til around the middle of 1990, it was game on in a huge way. If you’d managed to acquire property in my neck of the woods sometime in early ’85, you were trading into bigger stuff no later than late ’86, early ’87 — and doin’ pretty well. As likely as not, you did it again in ’89 with the same or even better results.
After that, though? From the last of 1990 to the beginning/middle of 1997, you either held or got clobbered. If you traded in 1989, that’s a holding period of eight years, planned or not. Thing is, we hold ’til it makes Captain Obvious sense to stop holding. Simple principle, isn’t it?
BawldGuy Axiom: We don’t decide the holding period, the market does. Period. End of sentence. Regardless of what some may think, we DO NOT control the market.
The same type scenario played out at the turn of the century. I personally know many, many investors who had no choice but to make use of tax deferred exchanges three separate times in the five year period spanning 2001-2005. They made tons of money.
The principle in a nutshell is to take what the market gives us. Take it the way it gives it to us. Take it WHEN it gives it to us. Then smile. 🙂
There are many more of these “known truths” that are nothin’ but wishful thinking. In the end, what we must always do is look at the picture as it is, in real time, with a complete analysis. Objectivity is our friend. Always has been, and always will be.
Investors: Do you agree with this assessment? What would you add to the list?
Leave a comment, and let’s have a conversation!
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