JF2431: Cashflow or Equity Gains, Which Strategy is Best? | Actively Passive Show with Theo Hicks & Travis Watts

Today Theo and Travis will be sharing about investing in cash flow vs. equity gain. Theo and Travis discuss the pros and cons, as well as compare the two. 80% of people in the United States are probably in the mindset of investing for equity gains: the “buy low, sell high” mentality. The bigger picture is when your passive income streams exceed your lifestyle expenses, you have financial independence, time freedom. At the end of the day, you have flexibility.

We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening and I will talk to you tomorrow.

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TRANSCRIPTION

Theo Hicks: Hello Best Ever listeners and welcome back to another episode of the Actively Passive Investing Show. As always, I’m your co-host, Theo Hicks, with Travis Watts. Travis, how are you doing today?

Travis Watts: Theo, doing great, man. Let’s rock and roll.

Theo Hicks: Today we are going to be talking about the differences, the pros and cons, the benefits of cash flow versus equity gains. Which is the best passive investing strategy? Should you invest for cash flow or should you invest for equity gains? As always, before we dive into those pros and cons and kind of compare the two, Travis is going to let us know why we are talking about this topic today.

Travis Watts: Sure, Theo. I think we’ve covered this in a multitude of ways, but never directly, and never in depth. I thought we’re a good match to discuss this topic. I’m a full-time passive investor and we’ve both done a lot of equity stuff, so I just kind of want to get two different opinions on it and share other people’s opinions as well… Like Robert Kiyosaki’s opinion on this, things like that; things that initially changed my mindset in the direction that I ended up going. I would say – this is not an official statistic by any means, it’s just my opinion… I would say roughly 80% of people in general, at least in the United States, are probably in the mindset of investing for equity, for gains; the buy low sell high mentality. I’ll get into why that is. But what changed my mindset so many years ago is Robert Kiyosaki pointing out that the wealthy invest for cash flow. That’s why he invented the cash flow board game. That’s why he’s written all the books he’s written, they’re all cash flow themes, and all his advisors are advocates of cash flow. It makes a lot of sense, so I want to dig into why that is. But more importantly, to the point of the topic of this episode, is one better than the other? What are the pros and cons? Which is right for you? We’re not financial advisors, please seek licensed advice there. But we’re going to share some opinions and some education topics with you. So let’s find out. Before I roll into it, do you have anything else to add Theo?

Theo Hicks: No, jump into it. Let’s talk about cash flow investing.

Travis Watts: I’m going to start talking about cash flow, and then I’ll turn it over to you, I guess, for equity. We’ll kind of compare and contrast that way. Being that I’m a full-time cash flow investor myself, I felt like this would be the segment that I would cover.

When you invest for cash flow, what are you really doing? You’re buying income streams, that’s how I look at it. It’s less about the buy low, sell high, it’s more about “If I put this much money here, how much do I get every month in return from that?” The bigger picture here is when your passive income streams exceed your lifestyle expenses, you have financial independence, or financial freedom, or retirement, or time freedom; there’s all these different terms that you could use. But at the end of the day, you have flexibility, let’s call it that; you have more options.

My goal and mission is just to help educate people in this sector. It’s been absolutely revolutionary in my life, for my wife and I, and our family. These are things I just want to put out there to the world and help others with that mission. Here’s the number example. Let’s say that your goal is $100,000 per year in passive income that rolls in without you having to do labor, or physical activity, or whatever; go to a nine-to-five job, etc. How much do you need to invest? Well, if you had a million dollars invested at –just using a simple example purpose numbers– 10% a year return, then that’s $100,000 per year in cash flow. But again, what if your real estate only cash flows 8%? Well just do the math, 1.25 million invested at 8% is 100,000 per year.

So you kind of get to choose your own yield, what makes sense to you with your own portfolio and your own risk tolerance, and that’s kind of how you run the numbers. But at the end of the day, why does Robert Kiyosaki say the wealthy invest for cash flow? Well, it’s simply because the wealthy have capital, they have money. So at the point where you have a million dollars plus to go invest, then wouldn’t $100,000 a year be pretty life-changing? Or if you had 2 million, wouldn’t 200,000 a year, or 300, or 400, etc, you get the point. It’s kind of the lifeblood of big business, true wealth, legacy wealth, generational wealth, and all these kinds of things.

So why is it then that 80% of people, in my personal opinion, are investing for equity? Well, I want to get into the pros and the cons of that first, and then I’ll answer that question here in a bit. So I’ll turn it over to you, Theo.

Theo Hicks: Exactly. The equity gain is the opposite of cash flow. As opposed to investing your capital and then making a return on that capital, you’re making an ongoing return on that capital; you’re investing the money into something, and then it kind of just sits there, and the hope is that the value of that increases over time, and then at some point, a year later, five years later, when you cash out, you pull out a larger amount of money than you put in.

Examples of this in real estate would be flipping a house; you buy the house, you invest capital into it, and then the goal is that what you make when you sell is more than the amount of money it costs to buy the house and fix the house up. Stocks are an example of this, like trading stocks; you buy a stock at $1 and want to sell it at $1.10, or whatever. Cryptocurrency is kind of like stocks, the same thing. It’s this the buy low, sell high, either by doing nothing and just waiting or by doing something and forcing that value up.

Overall, the focus here is on growing the capital and your nest egg. And since it’s more focused on growing the value, and you’re kind of waiting for it to happen, and it’s not necessarily fully in your control, there’s a lot more risk associated with this strategy. But like most investments, the more risk involved, then the higher potential reward, but also a downside as well.

Sometimes, when you’re investing in equity gains, there’s more risk, so hopefully, the return you get is going to be significantly higher than what you would get if you were investing at a lower-risk cash flow type of investment. Here’s an example – and I’ll follow with an example of a rental property or a real estate example. If you buy a home for $100,000, and you put down 20%, so you’ve got $20,000 invested into the deal so far. Keep in mind, they’re going to be very simple numbers, because there are more expenses involved, so this is the best-case scenario. So you’re putting down $20,000, and then let’s say you plan to improve the property. You end up improving it and you sell the property for $175,000.

After calculating all the repair costs, all of the closing costs associated with selling the deal, then you profit at the end at $20,000. So you invested 20 grand, you profit 20 grand; that’s a 100% return on your money. Let’s say you do this in one year, and one day to pay capital gains tax, you’ll pay a really high tax on it. It’s not 100%, but still, a high double-digit return on your money, which sounds amazing. People will do fix and flips, these type of strategies. But there’s a lot of risks involved in this strategy. A little bit less risk, since it’s a rental home in this scenario, because since it’s a rental home, you could rent it out and get that cash flow at the same time… But if it was a fix and flip and there was no opportunity to rent it, say this is not an area where people rent and your only chance is to sell it to someone to own, a lot can happen in a year. The most common horror story you hear from 2008 is people who were fix and flipping homes, things are going great until all those homes they had that they were in the process of flipping, maybe they were three to six months into that strategy, and then the market collapsed. They were stuck holding all of these properties and they couldn’t sell them for the price that they needed to.

So when you’re investing for equity, as I mentioned before, higher risk, higher reward, also higher downside. If you aren’t able to sell it for that higher number, then you’re going to lose money, and you’re going to make less money than you would have made when you are investing for cash flow.

Going back to what Travis said, and he might go into it a little bit more, but what happens if you don’t have a million dollars to passively invest? That could be your end goal. So you could have an active business and then you can use that to grow your equity, hopefully also having some cash flow as well by doing rental properties or some sort. Growing your equity until you have enough properties where you have either enough properties that you can sell them all and have a million dollars, or even better, having enough properties that through refinances and cash flow you have that million dollars or so, and then do both at the same time depending on what your goals are.

Maybe I’m getting ahead of myself, but overall, that’s an example of what it means to invest for equity. You’re investing capital into something, and then you’re either waiting and doing nothing, or you’re waiting and doing a little something, with the hope of that equity growing so that when you cash out, you get your nest egg back a little bit bigger than the last time.

Break: [00:09:58][00:12:00]

Travis Watts: I was just recently on YouTube, I was listening to Warren Buffett and Charlie Munger talk at the Berkshire Hathaway meeting. I don’t know how many years ago it was or if it was the most recent, I can’t remember. Warren obviously got started very young, very early; I think it was like in the 30s or something, and he was talking about what he was doing through the 40s and 50s in the stock market, and he was saying to the point of he was doing these kinds of crazy returns back then not because the market was booming, but there’s a lot of possibilities with little amounts of capital. For example, could I 5x my money overnight with $1? Probably. I could go to a garage sale and buy a coffee mug and then go sell it on eBay for five bucks. So I 5x my capital, that’s amazing. But that’s because I was only using $1, or $5, or $10. The point he was making is he was making these 20, 30, 40% annualized returns back then, but it’s because he was working with, in most cases, under $1 million of capital. So he had a lot of possibilities and strategies he could implement.

Now as he sits on billions and billions of dollars, you can’t just 5x your money overnight. There’s a drastic drop off in the curve of possibilities with that amount of capital. That’s why I think a lot of these wealthy individuals eventually turn to cash flow, as he has done. If anyone’s familiar with how he bought Coca-Cola stock on Black Monday in the 80’s as it fell apart – that’s a dividend-paying blue-chip stock – he’s never sold it. So his cash flow today off his basis of when he bought is 40 or 50% cash flow; it’s incredible. So he turned into a cash flow guy, but he wasn’t always that way. Neither was Charlie Munger, his partner. He used to do real estate stuff as well. Anyway, I digress, that was just a thought I had.

The second thought I had – I rarely share this kind of stuff, but I was raised by two very frugal parents that taught me a lot about shopping in the clearance section, using coupons, buying the off-brand, etc. And I’m thinking about myself back when… If you don’t have a lot of capital to get started, sometimes your lifestyle choices make the biggest impact on your portfolio. What I mean is if you can trim off – and we’ve done an episode on this before on frugality among the wealthy, or building wealth through frugality, I forget what the topic was… But let’s say I could shave off $300 a month out of my budget by not going to as many restaurants, or spending frivolously on Starbucks and coffee, and things like this. Well, $300 a month is $3,600 by the end of the year. But on the flip side, let’s talk about passive investing and cash flow. Let’s say I invested –I don’t know, I’m making up a number– $5,000 at a 10% return; I’m only going to get $500, and probably a lot of that’s going to be taxed on top of that.

So sometimes, early on, if you’re young or you just absolutely don’t have capital, it’s going to be frugality, it’s going to be your budget, it’s going to be your choices of how you spend money that’s going to have the greatest impact.  As you start making a lot of wealth, all that stuff kind of goes out the window. Why have to use coupons and shop clearance racks when you’re a multimillionaire? You certainly don’t have to anyway. You might choose to, I think even Warren Buffett does still. He’s been known to use some coupons at McDonald’s, or something like that. I thought that was kind of funny.

But anyway, so the last thought before I get into the next section, I’m going to answer the question I alluded to earlier, why so many people are into equity investing versus cash flow. The Federal Reserve conducts a survey, it’s called the survey of consumer finances. If you look at that data, you’ll see that the median –not the average, but the median, that’s a more realistic number–  household net worth in the United States is around $121,000. That’s among all age groups. If you bump to the highest end of that, meaning the oldest age, which notoriously those are folks that have the most wealth, so say 75 years of age, it only bounces up to $255,000 as far as the household net worth.

Again, that’s not going to bring a substantial amount of passive income into your life. Therefore, that’s my opinion of why so many people are focused instead on buy low and sell high; it’s a quicker way to turn over capital and smaller amounts. And if the median household net worth was millions and millions of dollars, more people would be into cash flow, because it would give you more flexibility over lifestyle, things like that. Just a few thoughts there on Buffett, frugality, and why folks mostly are into the equity play.

But something you said earlier, Theo, stood out to me – when I talked to investors, whether they’re active or passive, most of them are doing something right now in life actively in hopes of generating enough wealth to then become passive. That’s usually the story that I hear. Whether that’s a doctor, a dentist, or an attorney that’s working their practice, “Yeah, one day when I retire and sell my practice, then I’ll have enough equity to where I’ll just become an investor, basically, and live off the passive income.” That’s the path that most people in my experience are striving for.

With that, here’s the Holy Grail. The thing I really wanted to share on this episode is it doesn’t have to be so black and white. It doesn’t have to be “Are you a cash flow guy? Are you an equity guy/gal?” Could you have both? Yes, you can have both. That’s the beautiful thing. It’s the holy grail of investing, at least to me. What makes me so passionate is I invest in deals that have both cash flow and equity components to them.

You take real estate, for example – I’m investing in something that’s stabilized and occupied where I’m getting monthly income off of that as we go along. Hopefully, I’m –not me personally, but the general partnership, let’s say– is improving the property, the units, the clubhouse, the branding, and the marketing to where the rents are going up, so we’re forcing some appreciation there. On top of that, hopefully, the market is lifting it up and inflation is lifting it up. So if we buy a property at –whatever, I’m making up numbers– 50 million bucks, hopefully, we later sell it at 60 or 70 million in the future. So there’s your equity, there’s your buy low, sell high, but then also, I’ve got cash flow the whole time.

That’s how I like to invest. If you’re not into real estate or that’s not where you’re at right now, think about the stock market in terms of when it corrects. About a year ago, we had a nasty correction in the markets, that it on average sold off about 30%. Some of these real estate investment trusts that pay monthly dividends – they fell 40 or 50%, so I was scooping that stuff up a year ago. Not enough, but I was putting in what I could at the time. So you’re buying at a depressed price point, and then they’re still paying out dividends, even if they had to cut their dividends a little bit and less than them. Well mow most of those, if not all of them in my portfolio, have not only recovered from pre-pandemic levels, but they’re exceeding those levels and they’re bringing their distributions back. So I got a nice equity boost there and cash flow throughout the whole period. That’s how I invest.

Something I want to share is awesome, by John Bogle. This just blows my mind to think about. I’ll maybe say this a couple of times… Over the past 81 years, reinvested dividend income, accounted for approximately 95% of the compound long-term return earned by companies in the S&P 500. We used to not have the S&P 500 by the way, it used to be called something else, with fewer stocks in it, but more or less the index as a whole. In other words, reinvestment of dividends accounted for almost all of the stock’s long-term gains. This is about cash flow; this is totally about reinvesting, as we’ve talked about over and over on the show. Re-invest your cash flow; that’s how compounding works, that’s the wonder of the world, whoever coined that, Einstein or whatnot. That’s why Warren Buffett does this kind of stuff.

Again, over the past 81 years – I have to say this again, it’s just crazy – reinvested dividend income accounted for approximately 95% of the compound long-term return earned by companies in the S&P 500. That’s just crazy to me. So it’s just my opinion that cash flow is king. This is really the focus that we should all be at least striving for one day. If you’re not there today because of things we talked about earlier, that’s fine. But the goal should be, hopefully, do a little buy low, sell high stuff and work your highest and best, and save, save, save, and then get to a point where you can start generating cash flow. That’s all I got. That was my little passion point. I’ll get off my stool.

Break: [00:21:03][00:21:45]

Theo Hicks: I feel like, for a lot of these episodes, we have these questions, which strategy is the best? The answer at the end is always “Well, it depends,” or “Both are great.” But it’s true. Something when we first started talking, you led off with the fact that a lot of the people you speak with are currently working some sort of full-time job that’s not related to investing or real estate at all, and their goal is to eventually create enough wealth or save enough money through that so that they could eventually exit that and then become a passive investor. The whole idea here is that if you want to be a passive investor, you can either pick it from the point of “I’m going to be active in something and then I’ll become a passive investor eventually, once I’m done…” You can do it while you’re a doctor and passive-invest your gains…

There’s really a lot of different strategies when it comes to being a passive investor, active investor, investing for cash flow, investing for gains. It really depends on what your goals are. For someone who’s just starting out and has no money, you’re going to have a hard time being a cash flow passive investor. But like that Charlie Munger example you gave, when you do have a little amount of money, like a couple $1,000, you can multiply that money a lot easier than you can when you’ve got millions of dollars. The best example of this –we talked about in the show before– is the house hack. We talked about frugality, saving 30 bucks a month by just not spending money on certain things; at the end of the year you’ll have $3,600. That’s almost enough to get the ball rolling on a house hack by just cutting back your spending for a year.

Again, the equity is really good for when you’re first starting out and want to get that nest egg rolling. But I think the strategy here is to eventually transition to cash flow, maybe at the same time, and then transition fully to the cash flow. Those are my final thoughts on this topic. Travis, anything else you would want to mention before we sign off?

Travis Watts: Yeah. Just always keep in mind like I pointed out earlier, a million bucks invested at 10% a year is 100k. You can run your own math, you can disagree with the 10% figure and say, “How about 5%? 2 million bucks at 5%?” Whatever, but just realize that once you get to these capital levels is when passive investing can really kick off and take a journey of its own. It’s not too enticing — I’m asked all the time “If you were to start over from scratch day one again with no money or whatever, would you be a full-time passive investor?” Probably not. Because that means that the first money I put out there, to the point of that $5,000 example, I’m going to be getting 500 bucks a year or whatever that breaks down to; 83 bucks a month or something. That’s not very exciting. Just to be able to cover your cell phone bill isn’t life-changing per se. So no, I would probably go back to equity plays and I would be trying to hit doubles and stuff like that as quick as I could. And then again, frugality and whatnot.

There’s no right or wrong, good or bad. It’s what’s right for you given your unique circumstances, your goals, your risk tolerance, your self-discipline, your frugality, things like that. So it does depend, but that was the approach I took in full transparency – worked a high-paying job that was in the oil field, did a lot of buy low sell high, did fix and flips, had some vacation rental single-family stuff, side businesses that I would try to run, and all of this… And I was very frugal to where I built up a nest egg. I sold everything, I took that nest egg and I put it passively to work, but it’s because of frugality that I was able to pull that off at an early age. If I had had lush lifestyle preferences or if I wanted to spend a million bucks a year, I couldn’t have pulled that off. Everybody is different, but hopefully, some of that was helpful and encouraging to listeners on their journey… And I’ll quit talking.

Theo Hicks: Perfect. Travis, thank you again for joining us today. I always love hearing about your experiences. You’ve got a lot to bring to the table here. Best Ever listeners, as always, thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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JF2424: What Can Go Wrong Investing in Syndications? | Actively Passive Show with Theo Hicks & Travis Watts

Today Theo and Travis will be sharing experiences and stories about investing in syndications. They want to ensure no one ever wants to invest in syndications. It’s good to give the alternative perspective because things aren’t just black and white, or good or bad in terms of investing. There are people that make money doing a lot of different things. There’s no perfect investment — there are always risks. There is definitely a risk in communication and reporting of financials.

We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening and I will talk to you tomorrow.

Click here to know more about our sponsors

RealEstateAccounting.co

thinkmultifamily.com/coaching 


TRANSCRIPTION

Theo Hicks: Hello, Best Ever listeners, and welcome back to the Actively Passive Investing Show. As always, Theo Hicks and Travis Watts.

Travis, how are you doing today?

Travis Watts: Theo, I’m doing great, thrilled to be here.

Theo Hicks:  So today we are going to provide you with another contrarian perspective. Last week we went through some of the reasons why someone might elect not to passively invest and decide to actively invest instead. And today, we are going to talk about some of the things that can go wrong when investing in syndications. So as always, before we hop into these reasons, Travis is going to give a little bit of background on why we’re talking about this today.

Travis Watts: Sure. I think the main goal here is to scare everybody off and make sure no one ever wants to invest in syndications. [laughter] And secondarily, it’s good to give the alternative perspective, right? Because things aren’t just black and white, right or wrong, good or bad; in terms of investing, anyway. There’s people as we said many times, that make money doing a lot of different things. So we just kind of want to give the other side of the coin here and share some experiences, some stories that I have specifically, as a limited partner, where things didn’t quite go as planned. And I just want to paint that picture of what that might look like and how that works.

So again, there’s no perfect investment and there’s risks in everything. That’s why we’re doing these shows, and hopefully, the next show will do a little more positive spin on something. But to your point Theo, the back to backs of having this contrarian point of view. So happy to jump into our first topic here. Did you have anything you wanted to add before we get rolling?

Theo Hicks: Yeah, I’m not actually sure we’ve talked about this before, but I know we’ve talked about qualifying the sponsor, the GP before passive investing, and one of the questions that we’re going to want to ask is about a time something went wrong or something bad happened, a deal didn’t go the way they thought it was going to happen, and how they handled that situation.  It’s a really good question, because it can indicate experience and transparency/trust; so if they say nothing’s ever gone wrong, then they might not have you done that many deals, or they’re lying to you.

So some of the things are more scenario-based, other ones are just high-level, what can go wrong at syndications, but it’s just keeping in mind that when you’re speaking with sponsors, as Travis said, it’s kind of good to get an understanding of if they’re going to be able to handle if something were to go wrong.

Travis Watts: Exactly. Great point. Something we talk about all the time on the show are the three primary areas of risk, which would be the deal, the market and the team. So that’s kind of going to be the theme for what I go through here and what you go through as well. I also want to point out a few things we’ve never talked about before, Theo – I’ll let you handle that after I start this first segment – and just some alternative points of view on a couple things.

So what I want to start with is just first and foremost, and just the blunt, right to the point, and that’s just losing money. Everybody’s fear, right? We don’t want to lose money. How do I not lose money? Warren Buffett’s number one rule “Don’t lose money.”

So yes, it’s possible to lose money when you’re investing; it doesn’t matter what you’re investing in, there’s always a risk to that. So maybe unlikely, but it is certainly something to put in your mind as you go through the process. So first and foremost, this is the best thing I’ve come up with myself – diversification. So that means diversify among different operators that you work with, different general partners, that means diversify among different asset types. You’ve got multi-family and self-storage and industrial and office and hospitality… So lots to choose from; maybe choose a few there that you could kind of trickle some money into as you go along.

You could also diversify in terms of active – you do a couple deals actively, but then you do a couple of limited partnerships passively. And then also geographic areas. You can imagine if you had your entire portfolio, like I used to have, in one little 30-mile radius. Well, imagine that 30-mile radius being Miami and a hurricane comes through. There’s obvious risks to having all your eggs in one basket in one geographic location.

So that is a beautiful thing about being a passive investor.  One of the primary reasons I shifted gears to go that direction, is I could place capital in multiple states nationwide with very experienced, reputable operators. And I’m just so grateful that this stuff exists, because I was getting so anxious and paranoid having all my net worth, all my assets in one asset class, one geographic area, and it was freaking me out. This was back in 2013/2014/2015, before I shifted gears.

So the other thing I want to address is some folks bring up just fraud, or Ponzi schemes. We all know the Bernie Madoffs, or the Enron scandals and things like this. My best solution to that is always, always, always do your due diligence; you can only do what you can do. The crazy part about stuff like that is if you’d invested with Bernie Madoff before that whole scandal unfolded in the Great Recession, you could have ran a background check and it would have come up clean. He had a positive reputation in the industry. He was a board member or whatever he was, a chairman of the NASDAQ; this was a very reputable firm, reputable guy, no criminal history, et cetera. And he was running mostly a legitimate business, up until he decided to do this one particular fund that ended up being this massive Ponzi scheme.

But read the PPM’s, leverage attorneys, leverage other people in your network to get second and third opinions. Ask for investor referrals, network with other people, ask people who they invest with and what their experience has been. This is all parts of due diligence, and everybody does it a little bit differently.

And then last but not least, again, diversify. There were folks that put nearly everything they owned and had with Bernie Madoff. And then there were folks that allocated 100k that direction, but also had $10 million over here. Well, those people did just fine, relatively speaking. So diversification, I can’t say it enough. And then as far as the deal itself, that was about the team, and we talked a little bit about markets and geographic stuff. But as far as the deal, ask for stress tasks or a sensitivity analysis. Again, to your point, Theo, ask the operators what could go wrong, what has gone wrong. And really get into the deal. You don’t have to get into analysis paralysis, but know what the breakeven occupancy is, know what kind of debt terms are going on this; know if it’s conservatively underwritten. If you’re buying it at a five cap – we’ve talked about this before – hopefully, the projected exit cap is a higher number. That’s not because you want that to happen, that’s because that’s a conservative underwriting best practice. So things like these. Do you have floating interest rates? Do you have lock fixed interest rates? If they’re floating, is the GP buying a cap for them?

There’s so many things, I can go on and on, but do your due diligence on the deal itself, obviously. But if you get a reputable general partner or sponsorship team with a track record and experience, they’re probably going to be doing, hopefully, a good deal. But you still want to know about the deal. There could just be something that was missed or overlooked are something that you personally don’t agree with as part of your own criteria. So I would advise everyone to pass if you’re not feeling good about the deal itself, even with a good operator. There’ll be other deals, just pass. So those are some thoughts on just losing money.

A lot of questions that come up, especially for new investors in this space about Ponzi schemes and fraud… And I’ll be the first to admit, I was very skeptical in 2015 when I started investing in these asset types, because I just didn’t know. What is fear all about? It’s fear of the unknown. And so that’s why we’re here to educate and share some ideas on that. So I’ll stop my rant there. I’ll turn it over to you, Theo, for your segment here.

Theo Hicks: Yeah, before I go into my segment, as Travis mentioned, there’s a lot that goes into addressing the risk points of the deal, the team and the market. We’re going to go into the team and the market a little more detail in this episode, but Travis and I did three separate episodes, one each focusing on those risk points. So how to vet the deal, how to vet the market, how to vet the sponsor, on Actively Passive here. I think one of them was almost 15 minutes long. So all those different questions that you want to ask to determine how risky the team is, how risky the deal is, how risky the market is; we went to a lot of detail in those episodes, so definitely check those out.

So in addition to losing money, it is also possible to lose your passive investor protection. So again, we’re not securities attorneys or real estate attorneys, but generally speaking, when you’re looking at the liability for these types of deals, the LPs have limited liability, which means that if something were to happen, a lawsuit or fraud or whatever, then a resident or another investor or the bank can’t pursue your personal assets, they can only go so far as to take the money that you had invested in the deal, but they can’t go further than that. Whereas for being on the GP side, they can go further than that. So when you think about passive investing, it’s technically possible to be more of a hybrid version, where you’re bringing money to the deal, but you have some other role in the deal; maybe you’re signing in a loan, maybe you’re responsible for certain aspects of the business plan, and then you’re on the actual general partnership, and you don’t have that same level of protection as the limited partners.

So the solution to that, which is making sure that you are actually the limited partner, so that if something were to happen, as Travis mentioned, that you lose money, you’re just losing the money you had in that deal, and your other assets aren’t exposed in that lawsuit.

Travis Watts: Exactly. Now, those are great points. And again, that’s one of the huge selling points, to me anyway – perhaps it’s a little more sophisticated conversation, but liability is huge; it’s so huge. And I won’t mention his name, but there’s a very well-known syndicator out there in the space that started first in single-family homes and moved into multi-family after the Great Recession. Why did he do that? He lost everything, and then some; he was personally liable for more than what he had invested in those properties. All the banks and creditors were coming after this guy individually after that.

And for those that know it from a real estate perspective, the Donald Trump story back when he was whatever it was, an incredible amount of money – I want to say over $100 million in debt at one point – underwater; no equity in the properties, plus him personally being responsible for that level of debt.

So as a limited partner, say I go put $50,000 into a deal, and everything in the world goes wrong and lawsuits fly and the world just ends – the max loss I’m looking at is 50k, and I don’t have to worry about someone’s coming after my personal bank accounts, my car, my wife, et cetera. It’s all sheltered there. So anyway, not to go too long on that, but that’s a big deal. Hopefully that makes sense to everybody listening.

Break: [12:43] to [14:45]

Travis Watts: The other thing I want to talk about, that not a lot of people talk about, is transparency and communication risk. There is definitely risk in communication and reporting of financials. That’s something that, again, isn’t talked about very much. But think about it like this – as a limited partner, I’m essentially trusting a general partner to manage my money, in most cases in an unlicensed capacity, meaning they don’t hold any kind of financial licenses for the most part. So that’s a big risk, and I have to trust that they’re going to be communicating with me on a monthly or quarterly or semi-annually basis, so they’re going to be sending me financial reports that are accurate and valid, and there’s a lot of trust. And as you operate, most of these syndications are operated in the 506(b) and 506(c) lens, so you’re not held to the same reporting requirements as publicly traded companies are that are on the stock market. So again, you have to trust that audits are being completed, the numbers you’re looking at are real, and things like that.

So what you want to do, the solution here is, again, back to due diligence, back to reputation and track record and background checks, and all these kinds of things… But additionally, you want to ask, what kind of reporting do you give to your investors? What kind of frequency is that on? Can you send me an example of a monthly update that you recently sent out? Can you send me an example of the quarterly financials that you send to your investors? Things like this. And every operator should be able to accommodate to that.

But do recognize too, that I partnered with a group years ago – and I didn’t realize this, because I didn’t ask the questions as part of my due diligence – they didn’t do financial reporting. It was like the craziest thing. They just didn’t feel an obligation to do so. And there was a few investors that kind of got on them about this, and they just wouldn’t disclose.

Now, I’m not saying that they’re fraudulent or anything like that… I was an investor for years with them, I got out of the deal successfully, unscathed and all that, but it was kind of a worrisome point to kind of think about sometimes. Why is this happening? Why can’t I get the financials? And they had their reasons, and I don’t remember all the details; it wasn’t a huge thing… But just recognize that it may not be standard for the group you’re working with to do this in the first place. So make sure if that’s important to you, that you ask the questions upfront. So that’s all I wanted to make on that. I’ll turn it over to you, Theo.

Theo Hicks: Yeah, I would say, just to add to that – another reason why this communication is a risk is that if something were to go wrong and they aren’t transparent, even though you’re a passive investor, you can’t really control how they react to what goes wrong… But the best sponsors, if something were to happen, they will let you know in that next email update and then they’ll have a solution in place for what they’re doing to fix that problem. But what happens if something goes wrong and you only get quarterly updates or something’s happening to the financials and they aren’t sending you the financials, or something weird is going on with the returns; I think you might go into that in a second… But something might go wrong and you don’t know that that’s happening until months later or maybe a year later, and maybe you’ve already reinvested in a couple more deals, right? So the sooner you know something is wrong and that they’re addressing a problem, the better. Because I think the big risk here is that you invest with them again, or just the unknown of not necessarily knowing why you aren’t getting your distribution, or why aren’t they sending financials for the first four quarters, and then all of a sudden, this next quarter they stop sending financials or stop sending updates.

I’ve heard stories of communication just completely stopping and not being able to get in touch with the people again.

So there’s a lot of horror stories that can go wrong if they’re not communicating properly, which kind of brings me to the next risk of something that can go wrong is that you invest with a bad sponsor, that you either didn’t know how to qualify initially, or they misrepresented themselves to you. So we already did a really long show about the questions to ask to analyze their track record, but basically, you want to know that they are an expert in what they’re doing, and you also want to know – which is really big – what their role actually is in the deal. Sure, they could be a GP, but are they the main GP? Are they the person who’s responsible for the asset management, buying the deal, investor relations? Or is it a co-GP situation where they just raise money and then maybe have other smaller role in the deal, but there’s someone else that’s more in control? Because it’s bad to invest with someone like that, but you want to know who you’re investing with. Someone might say that they control $1 billion in real estate or $100 million in real estate, but it’s not actually their company that controls it.

A couple other questions to think about is do they actually specialize in that particular niche, or are they kind of just all over the place, and focus on multiple asset classes, as Travis mentioned earlier? Better to focus on one than multiple. How many deals has their business done in the past? …taken full cycle, which is also important. So not just bought and then held, but have they actually sold a deal and then returned your initial capital, plus their returns. So they have true full cycle return projections, full-cycle actuals, and you can compare those two and see how accurate their underwriting was, how accurate their assumptions were.

Something else that you want to know too, that could indicate that you’re investing with a strong team, is if their company is vertically integrated… Which means that in addition to the GP, they have brought as much as possible in-house, as possible – asset management, acquisition, underwriting analysts, property management companies, in-house compliance people… Basically, a full-fledged company, where everything is in-house, as opposed to working with third-parties. Again, nothing objectively wrong with working with third parties, but there’s an extra level of alignment of interests when it’s in-house and it’s actually your company who’s managing the property, as opposed to another company who’s managing thousands of properties for other people and they get paid based off of a very small percentage of the rent, and they really just make money by managing a bunch of properties, and if they lose you or the revenue drops by 20%, it’s not really affecting their company at all. Whereas if you’re a property management company that works for you, if it’s not doing what you want them to do, there’s obviously a much bigger problem there.

So I guess there’s a lot more that goes into this, but one of the things as well that I thought of – are they guaranteeing a return? That’s another pretty big red flag, because as Travis mentioned in his first point, it’s possible to lose money, there’s no guaranteed anything in investing at all. So if you’ve got a GP who’s guaranteeing you, say a 12% return on your investment, year after year, that is an indication that something’s probably going to go wrong. It’s possible that they get 12% and that’s great, but eventually, they’re probably not going to hit that 12% number. And then what are you going to do? Are you going to accept the lower number, and maybe people start suing this GP, and then your capital is at risk…

So overall, just make sure you’re investing with someone who’s experienced. The more experienced they are, the better track record they have, the less likely there is something to go wrong.

Travis Watts: Exactly. I’ve shared the story before and I won’t go into the details here, but basically, I partnered — actually, it was a couple groups that didn’t have the track record or experience. One, I knew that for sure, the other was interesting, we’ll say that. But the risk ended up being that – no, I didn’t lose money, and no, they weren’t a fraud or anything like this, but what the pro forma had projected was about a 12% cash flow, and we ended up with near half of that, and near half the total IRR when it all came said and done; and there was a lot of hiccups and road bumps along the way.

So it was a risk nonetheless, and that’s how that resulted. And I would say, just to be realistic, in this industry, I would say that’s probably the most common type of scenario that you’re going to encounter, is you’re going to look at a pro forma and it’s going to look shiny and bright and amazing and double your money in five years and whatever, that kind of stuff… And the reality is, it’s going to be maybe 20% or 30% less than that that you end up with. I wouldn’t really complain about that because it’s still a solid return, but it may not be what you hoped for.

So doing all these things we’re talking about puts you in the best position to work with the best operators, to have the best chance of actually achieving or overachieving what those pro formas are all about.

Break: [23:26] to [24:08]

Travis Watts: Last thing I want to talk about really in terms of this episode is the distribution frequency risk. So I just talked a few minutes ago about communication frequency, and now I’m talking about distribution frequency. This is something I’ve highlighted on previous episodes real lightly, but I wanted to paint the picture with actual numbers to explain the concept really quick.

So distributions should be part of your criteria as an investor; do you want monthly distributions? That’s payouts from your investments; quarterly, semi-annually? Or maybe you’re doing new development and you say, “I don’t really care about distributions. It gets built when it gets built, it sells when it sells, it’s in my IRA, and whether that’s in two years or 10 years, I could care less.” Everybody’s different, but just know your comfort level and your risk tolerance here.

And what I want to share is monthly distributions are part of my personal criteria. That doesn’t mean every single deal that I’ve ever done is monthly;  80% are,  20% are not. But it allows me to turn over my capital more quickly.

For anyone that’s ever listened to Robert Kiyosaki actually talk in-depth about investing, his whole thing is “How soon do I get my capital back?” It’s the velocity of capital; he puts money in a project, and then he’s trying to get it back, either through refinancing or through cash flow, as quickly as possible, so that he limits his risk in the deal. Because if you put 100k in and you get 100k back, but you’re still holding the asset, you then have what he calls an infinite return, or you can now take that 100k and put it somewhere else in another deal and do the same thing again.

So here’s the example – let’s say I had $250,000 to invest, and let’s say I parked it into a deal that achieves a 10% annualized return, just to use some simple example purpose numbers. That means I’m getting $25,000 each year in cash flow. So the way I look at that is I can then take $25,000 each year and I could potentially go do another deal with that money. A, I got the money back, in a sense, right? It wasn’t my initial capital, but still, I put in 250k, and I got 25k back in one year. So if you fast forward 4 years, that’s $100,000, right? 25k a year coming back to me and I keep parking that into new deals and now I have 4 other deals that I’m invested in, for example purposes. Well, that means at the end of 4 years, I only have $150,000 at risk in that initial deal, because I had put in 250k, and I got 100k back over a 4 year period. So I’ve now reduced my amount of risk in that particular deal. That’s why I like monthly distributions and cash-flowing assets.

So let’s say I did a new development deal where it’s going to take four years to build, develop, sell, convert, whatever, till I get my money back. Well, I put 250k in, but I still have $250,000 at risk for the entire period of 4 years. Because I didn’t get any cash flow off of that, I didn’t have any kind of refinance or return of capital or anything like that. So that’s one reason why, among many, that new development entails a higher amount of risk; at least in my opinion, it does.

So it’s something to think about in terms of your distribution frequency; some people could care less about monthly versus quarterly, that’s not as big of a deal. But if you’re talking about no distributions in an investment, where it’s all on the backend, versus monthly or quarterly, that can be a huge game-changer in terms of risk. So just something I wanted to point out in a little more detail. I know, I’m a very visual guy, so hopefully that made sense audibly, if that’s a word. But anyway, just wanted to share that.

Theo Hicks: I think that’s an app, Audible.

Travis Watts: Okay, there you go, whatever.

Theo Hicks: That’s a really good point, you need your capital to work for you sooner. So the last point, and I’m not going to spent a lot of time on this, because Travis has already mentioned this, and we’ve got a very long show diving deep on how to vet the market… But another way a syndication could go wrong is by investing in a bad market. So some of the factors that you want to look at to make sure that you are investing in a good market would be the diversified employment, so making sure that no one job industry dominates the market. A good number is 20% to 25% for that top industry. So if you’re investing in a market and 90% of the jobs are automotive or something, and that industry were to take a hit, well, then that entire market’s unemployment rate is going to go up, and it’s going to affect your rental rates for whatever you’re investing in.

Population growth – obviously, you want to invest in a market that’s growing, because the population or the customers of the apartment or whatever you’re investing in. Looking at big Fortune 500 companies or even smaller companies relocating to the area; you’ve got these massive billion-dollar companies that have these arms that are doing all this massive research determining where to move next. And so if they’re deciding to move to a market, that’s because they see something, whether it’s something that’s happening now or in the future.

And something else too that isn’t really stressed a lot, but the political environment in that particular market. So you’ve got some places that are very landlord-friendly, and other places that are very tenant-friendly, which means that it’s kind of based on the amount of rights that the tenant has when it comes to how long it takes to do evictions and late payments and things like that.

Obviously, the more tenant-friendly a market, the more risk there is. And then also, taxes is a big thing too. It can be just one neighborhood over and the tax rate could be much higher, even though the rents might be pretty close if you’re in one county or the other. I live in Chicago, so right when you leave Cook County, the taxes drop by 50%.

Now, one thing that you kind of want to keep in mind when you are analyzing new deals when it comes to the market, particularly rental growth, for example – so if you want to invest in a market that has experienced rent growth and is projected or forecast to experience rent growth, but you also don’t want the GPs to assume that whatever the historical rent growth has been or the forecasted rent growth is going to be is what is going to happen at their property.

Right now is a really good example, because when you look at year over year rent growth for some cities, it went down 10—I think in San Francisco might have been 23% or something crazy like that.

So imagine if you were investing in San Francisco and they’re projecting 5% rent growth because that’s what’s happening every single year, and they actually assumed the 5% and it went down by 23%. Or On the flip side, places like Boise – it’s like, why you want to have this conservative underwriting is because let’s say you’re investing in Boise, they forecasted rents going up by 3%, you assume 2%, but then rents go up by 10 plus percent. So the rent growth assumption, as well as other assumptions you’re making based off of forecasts – keep in mind that they’re important, but it shouldn’t be the only reason why you invest in a deal. Or you shouldn’t only invest in a deal because the population is expected to double in the next 10 years, because who knows if that’s actually going to happen. It’s just kind of a cherry on top.

Whereas other things like being tenant-friendly and landlord-friendly or making these insane rent growth projections are a little bit more important and could potentially be a deal-breaker, because it’s a sign that something is probably going to go wrong in the future.

Travis Watts: Great thoughts, Theo. Let’s bring it home; I’ve got a final thought here… From a high level, there’s no perfect investment type; there’s pros, there’s cons, there’s risks in everything, as we’ve talked about over and over. So it’s just my personal opinion, my personal experience that I prefer mostly investing in these private placement syndications; a lot of multi-family. But again, that’s just based off my own self-study, my own experience, people I’ve networked with, just what’s happened in my life.

So what’s really important is what’s right for you, and this could be a tiny segment in your portfolio for diversification purposes, taking a little out of the stock market to put elsewhere, or it could be like me, where it’s your primary focus. So always do your highest and best, always enjoy what you do, always understand what you’re investing in, and of course, always seek your licensed advice from attorneys, CPAs and other. So that’s all I got.

Theo Hicks: Yeah, I’d say my final advice is that you as the passive investor have a lot of control over what you invest in. So that means that you also have a lot of control over making sure you’re not investing in something that can go wrong.

So we gave a lot of examples of ways that can go wrong outside of the Ponzi scheme example that Travis gave in the beginning, which would have been very difficult to identify… Do your research and have a strong understanding of how what you’re investing in works, right? If you don’t understand, if you’re unclear, then maybe wait and invest in what you do know, so that you understand how to identify if the sponsor is not properly addressing those three risk points. So it’s not saying that you should only invest in one particular thing, right? Diversification is important. But make sure you understand what it is you’re going to invest in. If you transition to self-storage, learn and understand how self-storage works, rather than just jumping in because of a nice investment summary that told you that you’re going to double your money in, say, 5 years.

Those are my final thoughts. Travis, as always, thank you for joining us today. Best Ever listeners, thank you for listening, have a best ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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JF2417 - When You Should Passively Invest _ Actively Passive Investing Show

JF2417: When You Should Not Passively Invest | Actively Passive Investing Show With Theo Hicks & Travis Watts

TIn this Episode of Actively Passive Investing show, we will talk about when we should not passively invest. We are here Travis as well to share his thoughts as well.  They will go through the pros and cons on Passively Investing based on your goals and where you are at. They will discuss the general overview of the differences between active investing and passive investing. And then some of the potential pros and cons for each

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TRANSCRIPTION

Theo Hicks: Hello Best Ever listeners and welcome back to another episode of the Actively Passive Investing Show. As always, I am your co-host, along with Travis Watts. Travis, how are you doing today?

Travis Watts: Theo, doing great, man. Rocking and rolling.

Theo Hicks: I’m really looking forward to this topic today. As you can tell by the title – why you should not passively invest in real estate. Obviously, this is the Actively Passive Investing Show, and we talk about the benefits of passively investing, different strategies, and things like that. But I thought it’d be interesting to maybe present a contrarian perspective.

Background for me – we’re writing a passively investing book, and a lot of the stuff is obviously talking about how great passive investing is, but Joe Fairless was talking about a book that he read, and how it’s really, really important that you present the contrarian in perspective as well; and whether you address those issues or not is a different story, but that allows you to get your point across better, as opposed to just looking through rose-colored glasses.

I find myself doing this constantly; whenever Travis and I do like a pros and cons episode, I just go on and on about all the pros… So we’re going to get all of our potential cons or potential reasons why someone would decide not to passively invest in this show. Then next week I’ll go back to having my rose-colored glasses on, so to speak. Before we dive into why people maybe don’t want to passively invest or not passively invest, we’ll let Travis also provide his thoughts on the subject as a whole.

Travis Watts: Yeah, I think that’s a good foundation, Theo. I totally agree. In fact, about three months ago, I was a guest on someone’s podcast, and I’m going into what I do and I’m getting all ramped up and passionate about it, and they’re like “Whoa, whoa, whoa. Stop, stop, stop, stop.” They said “It can’t be all good. It can’t be all rose.” I thought, “Oh, thank you. Thank you.” Because I do — it’s like anything else; for someone that has children, you love your children. But it’s like, why should someone not have kids? It’s hard to step back for a second and say, “Oh, well, I hadn’t really thought about that.” So yeah, we speak, to your point, about the benefits of passive investing on and on and on because it’s our life, it’s our world, it’s what we do. I’m a full-time passive investor, obviously. But I love this and I really want to add some value here to folks, because there are so many active investors out there.  My perspective seems like there’s way more active than passive, which doesn’t really add up in terms of the numbers. But anyway, flawed perception, I guess.

So the fact is that passive investing is not right for everyone, and that’s something that I really ought to start speaking out to more, so people can understand the contrast of it. Something I love about living in America is you can make money doing so many different things. You can be a successful stock investor, a successful single family investor, doing Airbnbs, doing multifamily, running a business, etc, on and on. And I love that, because I get so wrapped up in my specialty and my niche, and I think it’s the best thing in the world. But then you run into people that are just crushing it in other industries, just killing it. It’s like, “Man, I didn’t even know that was a thing.”

You’ve got 18-year-olds running an e-commerce business and making six figures out of high school. It’s like, “Whoa, where was I at that time?” That was clearly better than whatever I was doing at 18. So this show is about why you should not invest passively. So I’ll get on my little soapbox here in a minute, but Theo, did you have anything else before I dive in?

Theo Hicks: Yeah, I would just elaborate on what you said about how people make money doing anything. It’s not necessarily whether passively investing or actively investing and whatever is objectively the best. As we always go back to in most of our episodes, it’s based off of your situation. A lot of the things we talk about aren’t absolutes cons, or absolute pros, or benefits of passive investing. It’s really going to depend on you, where you’re at, what your goals are, and things like that.

A lot of the things we say today we’re going to, of course, caveat it with “This is not the absolute case.” It’s just we kind of give a general overview of the differences between active investing, passive investing, and then some of the potential pros and cons for each.

Travis Watts: Exactly. As everybody probably knows by now who’s a listener, we’re never giving any kind of financial advice or anything like that. We’re not CPAs, attorneys, etc, so do seek out your own financial advisors, financial planners, etc, people who are licensed to do so. This is for educational purposes, our points of view, a little compare and contrast, things like that.

What I’d like to start with is something I’ve been covering more and more in webinars that I do and speaking events that I’ve done. It has a lot to do with investor profiles. The way I break this down is we’ll talk about a passive investor, and again, to Theo’s point, in a general sense, what a lot of passive investors kind of resonate with in terms of characteristics or traits… And then an active investor, and how that’s different, why that’s different.

I’ll just kick it off with being a passive investor. In my experience – again, I’m a full-time LP, I network with thousands of LPs, I’m the director of investor relations, so I talk with tons and tons of passive investors. This generally holds true among the crowd, so to speak… Generally, a limited partner or passive investor lacks the time to frequently monitor investments… Meaning if they have to be involved on a daily basis or even on a weekly basis, quite simply, they don’t have the time to do it. They’re a doctor, a dentist, a lawyer, an attorney, an athlete (we speak about that kind of stuff a lot), a business owner. The reason that they’re choosing to be a passive investor is that they don’t have the time to go do it themselves, so they’re going to partner with somebody else that does have the time to go manage all that themselves, and they’re just going to participate in that kind of offering.

They usually do enjoy though keeping up with financial news. Kind of looking at the macro level. What is the Fed up to? What are interest rates doing? Where are people moving to and moving from? That’s generally on the minds of passive investors. You want to obviously have a foundation and a basis for what you’re investing in, and that stuff’s really important to know.

The other thing is, the way I phrase it, they like to own a little bit of a lot. In other words, more simply put, diversification. You are taking some risk, because you are relinquishing control as a passive investor, but the benefit is you get to participate in a multitude of things. You could live in San Diego, California, you could have investments in Texas, and Florida, and Georgia, Ohio, the Carolinas, you could be in self-storage, in mobile home parks, in multifamily. So it’s kind of cool to be able to diversify. But I think at the end of the day, if people get real, which most are, you’re seeking to match, but not necessarily beat just the overall real estate market. You just want to be involved, you’re just looking to get some cash flow, hopefully some equity upside, and just, in general, a nice, risk-adjusted return. That’s really what you’re after. You’re not trying to hit home runs every time, etc.

I like to draw parallels to the stock market all the time… It’s more like an index fund investor. I’m going to put some money into the S&P 500 index. I’m just going to participate among all these different companies, and hopefully I just get this averaged upward trending return when it’s all said and done. Hopefully, real estate’s perhaps a little better for you, but I don’t know.

In contrast, an active investor – again, lots of conferences, networking, I run into actives all the time, through every outlet. So this is generally the key here – they enjoy being in the business of real estate. It is a business; this is not something that you do passively or on the side, if you’re going to be a general partner in a syndication, or you’re going to be a house flipper or something, it’s very hard to do part-time. I would say it could be done, but you’re just probably not going to be very successful at it… To the point that also diversification, as we talked about with a passive investor, it may not be a top priority to an active investor. The reason would be – say you know a particular market very well, you grew up there, you have a lot of connections there… All of your deals could be in that market; so that’s not very diversified. But at the end of the day, you seek control over your investments, you’re the one finding them, underwriting them, you’re under the impression (and hopefully, it’s true) that you’re doing it best. You’re looking at your peers and the competition, you’re seeing what everyone’s doing, and you’re saying, “You know what? I’ve got a better idea. I think I could do this smarter, I could do it better. I have access to deals these other folks don’t have, etc.” So that’s why you might want to be an active investor and not a passive investor.

And then you also should have, hopefully, a competitive edge in the marketplace, whatever that may be. Your background or skill set, something else you did that maybe transfers over to real estate, or again, deep connections, etc.

Ultimately, the way I see this is in complete contrast… An active investor usually seeks to beat the market; not match and not just passively participate in what’s going on, but say “I can do that better and I’m going to do it better.” That’s most general partners, that’s most house flippers, etc. They’re doing it because they see a potential for a higher return and a higher reward by doing so… And hopefully, they do enjoy being –I’ll say it one more time– BEING in the business of real estate. It’s a business owner versus an investor. That’s a key difference between the two.

So if any of those resonates with you, one side or the other, those are usually some leading indicators to at least consider. That’s the investor profiles, in a nutshell. I go into more detail on things that I do elsewhere… But for sake of this conversation, hopefully, that makes sense and adds some value.

Theo Hicks: That’s a great breakdown of differences between the passive investor and the active investor.

Break: [00:10:43][00:12:45]

Theo Hicks: What I want to do now is I want to go through, not necessarily what Travis just said again, but what things that maybe will make you not want to be a passive investor. If I were to ask someone who was an active investor – maybe they’re a GP, they’re a fix and flipper – like “Hey, why don’t you passively invest in apartments syndications or whatever, either full-time or just a period?” here are some of the things that they might actually say.

The main one would probably be control, which Travis kind of already talked about. When you’re the passive investor, you have some control. Going back to what I said earlier, there are caveats in all this. It’s not like you have no control, but most of the control is on that front end. So you control who you invest with. We’ve talked about before how to evaluate GPs, evaluate their market, evaluate their deals. But once you make that decision to invest in that deal, then all the control is in the hands of the GP or whoever you’re passively investing with. They have a business plan they’re going to do, they have a hold period, they have their pro forma, but you have no control over how quickly that business plan is implemented, you have no control over when that property is sold, when distributions are sent out… A lot of this stuff is up to the GPs.

Of course with that lack of control comes the benefits of less risk and less time. The point is that if control is kind of your main priority, and you want to be very hands-on and involved, and you want to make the decisions in the business plan, then you’re not going to do that when you’re a passive investor. That’s probably one of the biggest differences between active and passive. The reason why maybe active investors don’t passively invest is that they don’t want to give up control of their capital.

Another one would be liquidity. Again, this one really depends on what you’re actively investing in. When you passively invest in a deal and you put your money in there, they’ll have a projected hold period, and you’ll get your returns. But depending on the way it’s set up, you can’t just instantaneously hit up the GP and say “Hey, I want my money back,” and then they say “Okay, yeah, I’ll give it to you tomorrow or next week.” That’s not necessarily how it works. Again, depending on what you’re passively investing in – there are things you can passively invest in that are more liquid than not… But as an active investor, if I want to sell, I can sell the property, get my money back, and if I wanna refinance, I can refinance and pull capital out; I get to make those decisions.

Another one would be fulfillment. The fulfillment of running a business, scaling a business, maintaining a business, all of that self-fulfillment that comes with growing and realizing your potential through active investing is there, more so than passive investing, which is more of a hands-off, I invest, I make my money… Which I’m sure is fulfilling to a degree, but maybe not as fulfilling as putting your effort into the business and then seeing it continuously grow and grow and grow.

Something else that Travis hit on too would be the returns. This is a potential return, so every single active investment is not going to return more money than every single passive investment. But in general, you’re likely not going to, say, double your money in a year passively investing in a deal. Sure, it’s possible, but it’s a lot more possible to do that when you’re actively investing. I know Travis has an example that he will give in a second about that.

Also, when it comes to higher returns, you’ve got to keep in mind that the return is not just an absolute dollar amount, but also based off of how much money you have invested. When we’re talking about maybe on the small-time level active investing with house hacks, where you can do these really low downpayment loans, after a year you move out and make a 50% return on your money. A lot of creative financing, where you do seller financing, or lease to owns where you can put lower to no down payments, BRRRR methods where you can pull your capital out and kind of make an infinite return… Even [unintelligible [00:16:37].11] a GP, who usually will invest their own money in the deals, but don’t have to do that. Technically, they could have 30% ownership of a massive apartment community with little money down, which again, has a high return.

Then the last one, which maybe kind of relates to control as well, but that would be the competitive edge. Again, I’m sure it’s possible to have a competitive edge when you’re passively investing, but it’s really all frontend. It’s finding that GP, finding that market, that deal, and then investing the money, and then waiting. Whereas when you’re actively investing, you can have some unique creative strategy when you’re actually implementing the business plan that allows you to collect more rent or sell faster. Something as small as implementing some technology tweak to increase your NOI by 15%. There’s a lot more you can do when you’re in control of the business plan.

So that’s some of the reasons why people might not passively invest. Again, not all of these are absolute. It’s not like every single passive investment is illiquid and every single active investment is completely liquid. But if you ask someone why they aren’t passive investing, those are the things that they might say.

Travis Watts: Exactly. I couldn’t agree more. And on that last point that you made about having a competitive edge, I think there’s kind of two ways to look at that… Just a quick little side note. If you’re an LP, like I’m a full-time limited partner, I would say if I have any competitive edge at all, it’s that I have a network with a lot of different people and a lot of different operators. So I get to look at a ton of deals, look at a lot of underwriting, and I’ve got some mentors in my network that are decades ahead of where I’m at, doing exactly what I do. That would be my competitive edge, is having resources to connect with to say, “Hey, it’s not a good deal or a bad deal? What are your thoughts? This is my kind of analysis of it. What do you think?” That’s a competitive edge.

But more importantly, when you’re an LP… Because again, most aren’t like me, a full-time LP; they’re doctors, dentists, etc. So they’re looking for a team that has the competitive edge, whatever that may be in their sector. Usually, each general partnership has something that’s kind of unique to what they do specifically. That’s really what you’re trying to distinguish and find out. So great points.

What I wanted to do is elaborate on my investor profiles, but in story format. I thought it might be useful that I share a couple active success stories, because I was active for six years in real estate, and I’ve been passive for six years. So I’m exactly at that halfway point. So I get to [unintelligible [00:19:14].23] on both sides of the pros and cons. I certainly had some successes in the active space, so I want to share those with you.

The first was a house hack that I did. By the way, the term house hack did not exist in 2009, at least not that I had ever heard of. It was called renting a spare bedroom then, which is what I did. But man, that was such an eye-opener, and I’m going to put that in the active category, because you still have to creatively think about your strategy, you still have to advertise. I took a room, I fully furnished it, I did professional photos… It was active, at the end of the day. Of course, depending on your roommate, it could be very active or it could be passive. It depends on how much work that person has to deal with. I chose a pretty laid-back college student, that mainly just kind of hung out in their rooms, so it was actually pretty passive.

Anyway, from an active perspective, I had this house, the first house I ever bought, I was living in it; mortgage about $650. A furnished room that I did very cheaply – just Craigslist, garage sale stuff I already had, things that were donated to me, whatever. I made it look as good as I could on a budget, and I rented that thing out for $600 per month. So the mortgage is 650, the income coming in at 600 a month… And to your point, Theo, there’s a very low basis; I put very little down to buy the house in the first place. The government was handing out money for first-time homebuyers, I got a benefit from that… And then here I’m getting basically my mortgage paid for right out of the gate, post-college. I thought that was a really sweet gig.

So certainly, one way to start or just something to think about if you have like a guest house or a basement that could be rented, or whatever – everybody’s situation is different… But to me, that was a huge success. I was very young and that was my first eye-opener to real estate and passive and active investing, just kind of a hybrid.

The second story is I bought this house several years later, out in Colorado, for $97,500. I remember the exact amount. I was so happy about it, because it was a foreclosure. I had been begging my realtor to send me these types of deals, and unfortunately, that didn’t come through… So I actually found this deal, and bought it for $97,500. It needed virtually nothing. I did not do the carpets, I did not do the paint, I did not do caulking, I did not do blinds… It was in great shape.

So I bought this thing, and I rented it out… So I had about an $800 a month payment approximately – I think that may have included the HOA. I can’t remember exactly. But I was renting it at $1,200 per month, so I had a nice little margin of cash flow. I was lucky in my tenant selection; I was doing all that myself, kind of on a whim, in an inexperienced way. But I got lucky. I rented that out for about two years, and then I asked my realtor, “What do you think this house is worth?”  You’ve got to remember the time in this market cycle, especially out in Colorado. It was 2012 to 2013, somewhere in there. It’s when the market started turning around and going back up. So we did an analysis, I got a comp, and  $215,000 were the comps; and I was like “Oh my god, I only paid $97,500.” So I said, “Do you really think we can get that?” And she’s like, “Yeah, I really do.”

And that thing was on the market a week, and 215k we’re under contract. It was just incredible; exactly what the comps were. And I sold it. So there’s double your money in two years. It was incredible. I was very, very fortunate on that deal. Probably the best single-family deal I ever had.

So yes, there are pros and cons. Those are two obvious and huge pros to potentially being an active investor, things that are possible. It’s really hard, especially in 2021, to go find a 400-unit apartment building and go double your money in two years; that’s not easy. Good luck doing that. So just some thoughts there.

I also want to share two other things, too. These are my not-so-successful stories, I guess. Just to compare and contrast here. I was doing a flip in Brighton, Colorado; it was kind of like a little oil town about 45 minutes outside Denver. A lot of the oil companies and service companies were parked along this road that I bought this house in, an attached neighborhood to the highway… I put an oilfield worker in there — actually, I’m jumping ahead; this was supposed to be a flip. What I was going to do is it had an unfinished basement, and I had kind of “amateurly” –if that’s a word– put together my budget… I said, “Okay, it’s going to cost this much to finish the basement, this much to repair the outside”, this house actually did need quite a bit of work… But I bought it on the MLS; that was probably a pretty big mistake, because I wasn’t leaving myself a whole lot of margin in this deal. And as I really crunched numbers and sales proceeds, etc., when I thought about selling this property when I was done, the numbers quit making sense, and unfortunately, too late. I had already bought this property and I’m thinking “Oh no, the basement’s going to cost twice what I thought it was going to cost.” All these different things were popping up as red flags and I’m like “Oh, man, I am screwed.” The only thing I could really do – because I wasn’t going to live in this house myself; it was way too far from what I was doing – I decided to rent it out.

So I put an oilfield worker in it, and they worked for the same oil company I worked for. So I thought, “Oh, we’re best buds, right? We work together.” Well, I failed to screen the tenant, I failed to do the background check, all this kind of stuff. So long story short, they paid the first month’s rent, they didn’t pay the second, then they were delayed on third and fourth, and it got really, really ugly. I put a brand new carpet and paint in this place, brand new curtain… I made this place look great, because I was going to flip it… And they only stayed one year. And I was doing that for tax reasons, so I wanted to have a long-term capital gain, hopefully, associated… And man, they snuck a cat in there, and that cat destroyed by carpets, they put holes in my walls upstairs, down, and throughout the staircase, they stole all my curtains and my curtain rods, they destroyed my patio, my deck… They just trashed the place and they left some bugs that I had to deal with.

Theo Hicks: Bedbugs?

Travis Watts: No. I can’t even think of the name right now. I don’t know why I’m blanking on it. But anyway, it was a mess. These people were dirty, they were nasty, they didn’t pay, and then they destroyed my whole house. So then I have those rehab costs again, all over again, a year later. It was a disaster.

I barely got out of that deal with a profit, only because the market saved me and it was going up, that I was able to get a tiny squeak out, a tiny margin. That’s when I stopped doing flips, actually; that was the last flip.

So it has a lot to do with your experience. I’m sure some people have the opposite story, like my other single-family home – I double the money or whatever, and that’s great. I had that too, but it all kind of comes out in the wash. So that really did me in.

The last one is I had an Airbnb – kind of a hybrid between a house hack and an Airbnb. My wife and I bought a house, a 1930s home out in Colorado, very, very cool, old school Tudor home; it had a separate outdoor entrance to the basement, so it was like a complete split level with privacy and all of that, so we put it on Airbnb. It’s kind of a hybrid; it’s our own house, but it was a short-term rental, whatever.

And these folks rent it, and they request a late checkout. We always accommodate that; we didn’t charge anybody for late checkouts. But the problem is, we only have this few hour window between the next people coming in the following day. So I was like sitting there ready to go and clean this place as soon as I saw him leave… And of course, they were late on top of the late checkout.

So we go down there and the whole place is filled with pot smoke; dense, heavy, thick, nasty, nasty marijuana smell. It was bad, it was so bad. We had an older couple in a couple of hours, so we were running all over, throwing all our fans downstairs, opening all the windows… I’m like running to Ace Hardware, trying to get some sprays and stuff, and we’re trying to mask all this stuff… It was very dicey and very, very sketchy. Oh man, the Airbnb stories in general, I could go on and on.

The point is, it was not a pleasant experience. All of this stuff added up over six years, all these different pros and cons, for me anyway, resulted in “I ought to leave all this stuff to the experts and just be a passive investor.”

More important than that – I know the shows about why you wouldn’t passively invest. Here’s the thing – love what you do… Because of something you said earlier, Theo – man, it’s so important. Happiness and fulfillment –I think fulfillment is the word that you used– is so important. You don’t get fulfillment by forcing yourself to do things you hate doing. For me, it became something I hated doing, this active real estate stuff.

So whether you’re active or passive, just love what you do, enjoy being in the business of real estate if you want to be in the business of real estate… And maybe before becoming a big general partner in a syndication, do some smaller active stuff, perhaps, and just make sure that that process is something that really resonates with you.

There’s a quote, and I forget who said it, but it’s something to the effect of “One of the biggest tragedies is when you get really good at the wrong thing.” So many people do that in the corporate world. It’s called the golden handcuffs. You just start working, promoting, making more and more money, and all sudden, one day, you’re making 200K a year but the fact is you hate your job. That’s just such a tragedy, it really is.

So if you’re not really loving what you’re doing or being fulfilled, then maybe switch gears. That’s what I did in 2015, to become a passive investor. Those are just some experiences and stories I thought I would share with the listeners. But my story doesn’t mean it’s right or wrong, or good or bad. That’s just been my experience, and hopefully, that was helpful. I think that’s all I really have on this topic.

Theo Hicks: Wow, it’s some crazy story, and I’m glad you shared those. While you were saying that, going back to one of the reasons why someone might not necessarily passively invest, kind of how you ended that, would be that fulfillment aspect. Maybe some people get fulfillment out of having these crazy situations where the underwriting seems to not work anymore, or they have these crazy tenant situations; maybe they enjoy overcoming those challenges. And once they overcome those challenges, maybe they also realized that in the future they won’t have to deal with that anymore. They’re getting started, and once they’ve scaled, they can pass it off to a team member.

I really liked that we brought up fulfillment, because maybe — I don’t know if we’ve talked about this on the show yet, or maybe it’s been a while… But if you like being an active investor, then that’s a pretty big reason to actually invest. If you like being a passive investor and you don’t like those stories Travis just talked about, then passively investing is fine. Just because you get more control, more of a competitive edge, or the potential for higher returns – none of that doesn’t really means anything if you don’t like it. So I’m sure you’d much rather get that lower, more stable return and enjoy what you do, as opposed to, as Travis mentioned, get really good at something that you don’t like or at the wrong thing. So I’m glad you brought that up. I don’t have anything else to add. Travis, anything else you want to mention about why people shouldn’t passively invest before we sign off?

Travis Watts: No, I do think that’s the most important key – like what you do. I know sometimes you have to maybe experiment with stuff, I totally get it. A lot of what you decide to do ultimately long term is going to be based off that experience.

A lot of folks who are passive investors, limited partners in syndication, for example – they’re also active investors, too. I’ve shared the story, my dad’s in that boat, too. He owns several single-family homes that he enjoys working with his tenants. They’re really good people in a local community kind of sense, and he gets fulfillment out of that.

At the same time, he knows that if he were to have three or 4X that amount of property, that becomes a job now, and the risk of things going sideways, or bad, or not being able to take a vacation anymore because this is your job – he doesn’t want that. So he kind of is in between the two, and that’s totally cool too. I guarantee if he had had a bad experience in those single families, he would be 0% active. But he’s had a very positive experience, so it really depends. But yeah, if you’re new, experiment. And you can be a passive investor, in a sense, in different ways. We’ve talked about buying a publicly-traded REIT, a real estate investment trust, for as little as $10. You can try this stuff out on a small scale, or maybe you could buy a home with an FHA loan or a VA loan for 3% down or something like that… If those programs still exist; I don’t know. But just experiment, I think, but don’t track too far in the wrong direction, I guess is the best advice I could give.

Theo Hicks: Great. Well, Travis, thank you again, as always, for joining us and sharing those stories. Hopefully, you don’t have PTSD from talking about those crazy experiences.  I can see you getting riled up talking about it, and I can totally relate to that.

Best Ever listeners, thank you for tuning in. If you have any questions for us, we do the Actively Passive Show that you’re listening to right now, so we might answer on that. We also do a 60-second segment show that we post to YouTube and our other social media sites where we answer questions a little bit faster. So any questions, submit those to me, theo@joefairless.com and we will add that to our list.

We’re building up quite the library of the shows now, so if you go to our YouTube channel and go to Joe Fairless, The Best Real Estate Investing Advice Ever, we have a playlist of all the Actively Passive Investing Shows we’ve done so far. So make sure you check that out as well. Travis, thanks for joining me. Best Ever listeners, as always, thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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JF2410: The 15 Best Ways to Generate Passive Income | Actively Passive Investing Show with Theo Hicks & Travis Watts

JF2410: The 15 Best Ways to Generate Passive Income | Actively Passive Investing Show with Theo Hicks & Travis Watts

Today, Theo will talk with Travis about the 15 different types of passive income streams that he is somehow involved in.  They’ll share insights about investment opportunities, private placement investing, the concept of being a passive investor, and the effective ways to generate passive income.

If you have questions for us or have a topic you want to discuss, you can email that to me at theo@joefairless.com, and we’ll cover it on the Actively Passive Investing Show.

We also have a Syndication School series about the “How To’s” of apartment syndications, and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening, and I will talk to you tomorrow.

Thanks to our sponsors


TRANSCRIPTION

Theo Hicks: Hello, Best Ever listeners and welcome back to another edition of the Actively Passive Investing Show. As always, I’m Theo Hicks, here today with Travis Watts. Travis, how are you doing today?

Travis Watts: Doing great, Theo. Thrilled to be here.

Theo Hicks: Today we’re going to talk about the 15 different types of passive income streams that Travis has somehow been involved in. Travis is going to go over the purpose of why we’re talking about this topic today. It’s something that I was very interested in, because I know a lot about multifamily, and I guess real estate in general, but I know that there’s a lot of other different types of passive investments out there… And just understanding what other opportunities there are, how they compare and contrast to multifamily, I thought, would be a very interesting topic for our Actively Passive Investing Show. Before we jump into those 15 different passive investments, Travis, why are we talking about this today?

Travis Watts: Thank you, again, for bringing this topic up. We were talking about this before the show. Sometimes I just run out of ideas ,and I think this is a good one, because we’re always saying terms like passive investing, passive investor, or LP (limited partner), but we’re not really honing in on what each of these really is. What does it mean to be a passive investor, which – we have covered that topic. But more importantly, what are you talking about? What are you actually putting your money into? So that’s what this show is. I just chose 15, give or take – it might be a little more than 15 examples. Most of these I have done, not all. I just want to throw some additional examples in there in case whatever I’m doing isn’t up your alley – well, there are some more ideas for you.

So that’s kind of what it is, I want to turn the theoretical into reality. It’s really what this show is all about. So I’m excited to talk about it… We’ve never done this on the show, I’ve never done this on any podcast, so I think this would be really beneficial for anybody looking to diversify, or wonder what investment options are out there. Of course, a lot of people know me as the multifamily guy, the apartment investor cash flow guy, but there’s so much more to it. I’m always about the concept of being a passive investor more than I am an actual asset class specifically… Though I love multifamily, and we’re going to talk about it.

The last thing before I dive in is a couple of disclaimers – as always, not financial advice at all. Theo, nor I, are licensed CPAs or attorneys, or financial planners, or anything like that. So please seek licensed advice. This is not to advocate that you should do anything, it’s just an educational platform here that we’re sharing some ideas, and I’m sharing some things that I’ve done personally, on a personal note. That’s what this is all about. So with that out of the way, Theo, did you have anything before we dive in?

Theo Hicks: Yeah, I wouldn’t be curious, because you mentioned that you’ve not necessarily invested in all of these things. We’ve got a pretty long list, I don’t want to have you say 25 different things for each point, but maybe let us know if you’ve invested in this, and then very quickly, why you chose to invest in this. For the ones you haven’t invested in, obviously, just say “I haven’t invested in this, but I know that this is a passive investment opportunity.”

Travis Watts: Sure, absolutely. I’d say 90% I have, so I’ll cover that on each thing. At the tail end of these bullet points I will go into a few that I have not. So – good stuff. Alright, let’s kick it off.

The first thing we’ll just get right to it is what we talked about most on the show, it’s private placement investing. This could mean multifamily, this could mean self-storage, this could be mobile home parks, this could be industrial… A private placement is just a private offering, with private investors. There’s no publicly traded market for these securities and these types of investments. You’ve got, say, some general partners, or a general partner, you’ve got limited partners like myself, people that are just kind of silent partners or passive investors… The general partners go out there and they find a deal. They find that 400-unit apartment building, they put it under contract, they get legal docs with their attorneys, they put it together, they send it out, and they raise capital from investors. That’s what makes the deal happen. Again, we’re going to talk about next is the publicly traded stuff, but this is just a little more stable, consistent, less volatile, things like that. This is what I mostly invest in, are private placements.

We’ve covered that numerous amount of times on this, I’m not going to go too much more detail on it, but that’s one broad category where I’m not an active participant in the business model. I am a passive investor, I am the person saying “I like your business plan. I like that deal. I want to take part in it. Here’s $50,000. Send me the checks.” And that’s kind of how that works.

Now to contrast that with publicly traded REITs, real estate investment trusts, or high dividend-paying stocks, things like that – these are on the stock market. They hold similar assets. You could invest, for example, in a publicly traded REIT that owns multifamily nationwide. They have a whole bunch of apartment buildings inside of a REIT structure. By the way, REITs can be private as well, or they could be public.

When they’re public, this is kind of how I view it. By the way, yes, I invested in private placements, yes, I invested in publicly traded REITs, high dividend-paying stocks… Pros and cons. The thing I like about publicly traded is the liquidity. I can go put 10,000, 50,000 or whatever into it, and if I decide tomorrow, because the market went way up all of a sudden, I can just sell and I can just get my profit out and be done with it and be back in cash. That’s a pretty beautiful thing you can’t do, in most cases, with private placements. The cons are it’s subject to the volatility of the market. Sometimes the market’s sky-high and quite frankly, you’re just overpaying for what it is this REIT is holding. Other times the market crashes; that could be an opportunity.

About a year ago, in April 2020 and March 2020, the stock market collapsed, basically. Not as bad as 2008 or 2009 but with COVID, lockdowns, everyone was scared, sell, sell, sell, panic mode… Some of these REITs were down 40%, but I knew that the underlying portfolio wasn’t being heavily affected, because I have so many investments in the private space, which at the end of the day, these are all the same types of asset that we all hold. I knew collections were still coming in, and nobody knew the future. But I did know one thing – that was 40% off, and the private placement was not. So I got into some of that stuff… Buy the dip, I guess.

I can’t predict the market for the life of me, but that’s not what this is. This is just – you flip on the news, and you see the facts… There’s a big sale today, stocks are on sale. I just chose to buy in. That’s all it was. I had a little bit of liquidity. Unfortunately, not enough, because most of that stuff recovered 100% now. I could have doubled the money in a year, that’s pretty crazy. But anyway, that’s REITs and dividend stocks and kind of the pros and cons, and a little bit of what I d,o but not heavy, because I don’t like volatility.

Theo Hicks: That’s interesting about syndications versus REITs… I was talking to a neighbor, and really whenever I explain to people the company that I work, for they always think it’s a REIT. It’s just interesting how still not that many people know about private placements and investing in syndication. They understand they can invest in a fix and flip or a one-off single-family house, or they think that need to be a massive company that owns thousands and thousands of doors… There’s also that in-between of investing in syndications, plus other asset classes, too. So it happens — literally, everyone I talk to thinks that I work for a REIT.

Travis Watts: Well, our training, so to speak, as Americans in the world of investing is all stock market-based. What are the billboards that you see down the highways? Your Fidelitys and your Schwabs… What are the TV commercials? You’re not seeing private placement syndication on Nightly News or whatever. You’re seeing all the Wall Street stuff. So yeah, a lot of people are familiar with REITs. That’s still a level of sophistication above just a 401K plan and some mutual funds and whatnot. But, a great point.

While we’re on the topic of publicly-traded stuff and stocks, there’s one thing I want to cover, and that is selling covered calls. This is kind of an interesting strategy. I’m in no way, shape or form an expert on this; I have done it, but – basically, it works like this, if you’re not familiar. Let’s say I like a company in the stock market and I just want to hold that company long-term. I’m just bullish on the future of that company, whatever it may be, XYZ Corporation. You have to own increments of 100 shares to do this strategy. So I buy 100 shares and I say, “Quite frankly, I don’t care what the market does, up, down, sideways. I like this company. I’m a 10, 20, 30-year hold or whatever.” You’ve got to love the fundamentals of this company, you’ve got to do your due diligence, like with any of these investments. So I buy this company, and what I can do is sell essentially a contract for somebody else to buy my shares from me at a higher price and at a future date if the stock goes up to that price, at that future date. The way it works is, I’m essentially forcing cash flow off of my holding, because I’m going to get paid for this premium, is what it’s called. It’s like a contract premium.

So somebody else – the benefit to them is they don’t have to fork up the money for all the stocks right now, nor do they have to take any risk that the stocks fall down and plummet, because they’re not actually holding them. They’re buying my contract to potentially be able to buy my stock in the future at a higher price, and they only fork up a small amount of money for that premium. But for me, that’s almost like a dividend. When I sell this contract, maybe I make –I’m just making up numbers here… 200 bucks. But I like the stock anyway, I’m holding the stock anyway. So my risk is essentially that, let’s say, I own the stocks at $10 per share and I sell a covered call option at 12, meaning if it goes up to 12, I might have to give away or sell my shares. The risk is if they go to 15, someone’s going to call me out on that option and they’re going to get to buy my stock at 12. I’m going to lose out on that upside potential. But the way I see it, it’s still a profit. I still bought some shares at 10, I sold at 12, and I collected a cash flow premium from the option.

It may be complicated. I hope that makes a little bit of sense to folks; go research it on your own. I’m not an expert in it. But I put it under the passive category because, the truth is, you just have to do a little research; like with any investment, you have to make a decision. But literally, to do this in action could take you two minutes. You could do it once a month, you could do it once a year, you could do it every few months, one time… So it’s not very active. It’s not day trading. You’re not logging into your brokerage every day and looking at the ups and the downs. You’re owning what you own because you want to own it, and then you’re getting some premiums off that. So that’s covered calls, perhaps a little less risky, in fact, than just holding the stock. So many people just buy a stock; it’s like why not make some premiums off of it too?

Break: [00:12:06][00:13:12]

Travis Watts: I want to move on to note lending, or being a hard money lender, we’ll say. Let’s say I have a buddy and he says “Hey, man, there’s an opportunity for me to go flip this house. I don’t have any cash though”, or “I only have 20,000 bucks, and it’s going to take me 100,000 bucks to do it.” Well, that friend could come to me and say, “Can I borrow that 100,000 from you and let me pay you 10% interest on it. I’ll pay you back in six months.” That’s being a hard money lender, essentially. But that’s not how I do it, personally. I do it through investing in, again, private placement funds, sometimes publicly-traded, where they are the professionals out there in the industry loaning to new construction projects, loaning to fix and flippers, loaning to businesses, hard money, short-term, at a higher interest rate, and then of course, they clip a little fee for themselves for putting this whole thing together and then they give the investors, like myself, what’s leftover. Sometimes that can be 8% a year, 10% a year; it just kind of depends on the structure. But it’s a way to get some monthly passive income. Really no equity upside there, you’re just loaning out money. But I like the diversification in a fund model, rather than just saying, “Hey, Joe Schmoe, here’s 100 grand.” And then he says “Oh, I made a mistake and your money’s gone.” A little more risk in that, but people do it both ways.

Additionally, on hard money loans, something to point out – there are all these crowdfunding platforms now, there are all these different services popping up all the time… Peer-to-peer lending has become a popular thing. There are these platforms that people need money for different reasons and they’re willing to pay different interest rates for it, and then you go in there and for very small increments of cash, you can diversify yourself and say “Well, I’m going to loan this person $2,000, and this person $4,000, and this person $10,000.” Then you create your own fund, and hopefully, you’re not getting more defaults than you are actual production out of that. But there are different ways to approach it. The point is, it’s high-interest loans that are short-term, that’s all it is.

Now I’ll move on to a rent-to-own model. This was kind of an interesting private placement to piggyback off what I said earlier with private placements. It can be mobile homes, self-storage, multifamily, etc, hospitality, hotel, office, or industrial. But this one that I did was kind of interesting. This group, their niche is they buy distressed assets, which are single-family homes, off the books of banks in inexpensive markets. So say, in Indiana or Ohio, for example; not coastal markets, not San Francisco.

So they are essentially buying a house –I’m making up these numbers again– for let’s say $40,000 in a market like that. They’re putting about $10,000 into the house to make it meet code and make it livable, and all these things. So their basis is about 50,000. By the way, they’ve done all this 100% cash, so there’s no loans, or debt, or mortgages. Then they’re acting as the bank for folks that otherwise couldn’t qualify for a mortgage through the big banks – through Wells Fargo, Bank of America, JP Morgan Chase, things like that. So maybe they have lower credit, or they don’t have quite the down payment…

What they’re doing is like a rent-to-own business model, which is really interesting, because when you do a lease-to-own or rent to own, you’re not only paying the rent, but you’re paying a portion of the principal, usually, towards being able to actually purchase this home. You’re forcing yourself to save for a down payment, essentially. And if you decide down the road you’re not going to execute on the deal, you’re not going to buy the house and you’re going to walk away from it – well, for the investors anyway, that’s a pretty high yield. You’re getting rent plus principal the whole time, so it’s a nice cash flow on a low basis home, with no debt. And if the tenant does decide, “Yeah, I do want to buy this house”,  then this group is usually selling that same house for like $80,000, for example.

So there’s a nice equity upside to it as well. I’m sure other groups do stuff like that. But it’s just the idea that you can form a business of any type really, and make it a private placement for people to invest in. That’s one that I just thought was particularly interesting.

Theo Hicks: There’s a guy that I interviewed, he doesn’t rent to own, but t was something kind of similar. So basically, he would go and he’d find a big multifamily building, let’s say like a 200-unit multifamily building, and he’d rent a unit, and then he would get money from someone, and they’d buy the furniture for that unit. They’d cover the rent, the security deposit, and the first down payment (as a passive investor) and then they’d get the rent each month. The guy would charge a management fee and some other fee, or something. So it’s like a rent-to-rent model, or something. I don’t know what that is, because there’s no equity upside. I guess it’s more of a cash flow, but definitely passive. I invest with this guy and then I get to collect the monthly rent. But then obviously, there’s no sale or big equity upside. It’s just all 100% cash flow.

Travis Watts: Yep, exactly. That’s a great situation to think about. It’s a different model than what I just described, but it’s still a passive opportunity; it’s a different business model. There are endless amounts of this stuff out there.

Theo Hicks: There really is.

Travis Watts: You really see it when you start sinking into this… And you’ve got a cool role in that you get to interview so many people like this. You get to rapidly learn these different models like that. That’s very cool. Alright, so – distressed debt, I’m going to touch on. This is one that I actually lost money in, but it’s kind of an interesting concept… Similar to what I talked about before. This company was essentially going to banks, and what happens — let’s say a bank issues a credit card to someone; well, that’s uncollateralized most of the time. So they’re giving you a line of credit in hopes that you’re going to pay it, but if you don’t, there’s not a whole lot they can do. They can send you to collections, but there’s no collateral; they’re not coming after your house or what have you.

So that happens sometimes – someone gets a new credit card, they put 5k on it and they quit making the payment. Well, the bank doesn’t have the time or the resources, in most cases, to go chasing after these people, so they’ll sell that debt at a significant discount to a third party, like a collection agency, for example, and then they’ll try to collect on it through the person who owes the money, and try to work a deal with them… Say, “Look, you took out $5,000 and you quit making your payments.” Let’s say this group bought that for $2,000, just to use a simple example. They’d say, “Hey, could you maybe pay us 3,000 bucks then, and then we’ll call it good? Or instead of paying 500 a month for payment, could you do 350?” They’re going to try to work a scenario that’s kind of a win-win. And because they bought that debt at a lower basis, that’s a nice cash flow and potential equity upside. So there was a fund doing that. That’s another way, it’s a private placement offering.

Theo Hicks: Another person I interviewed – something similar but for houses. The same thing, they were doing a foreclosure. For this particular person, the house was always vacant, so they knew they were going to get the house… But I’ve interviewed people who have different approaches to it. They’ll buy the debt or buy the note, and then instead of foreclosing, they’ll kind of restructure the loan with them, so they make cash flow that way. Or they’ll just straight up get the house, then flip it, and sell it, and make money that way. But there’s people out there that will do this on a massive scale and then raise money from passive investors to buy these notes. Again, it’s kind of similar, but on the real estate side.

Travis Watts: Exactly. I’ve seen different business models with transaction fees where you’re getting that transaction fee in some kind of syndication model. To that point, similar, is ATM machines. I’m sure you’ve interviewed some folks that have mentioned ATM investing. It used to be, years ago, it was either a kind of a Wall Street thing, or it was a mom-and-pop operation. So it was either you or I, kind of like a vending machine business, we’d go buy new or used ATM machines, we would be responsible for finding a place to put that, maybe working with a local bar, diner, restaurant, or gas station, and then we would have to maintain it, restock it, and all these things. There’s a little more to it, I’m simplifying it. So we could either do it that way and that becomes kind of an active business, or kind of a Wall Street controlled type of thing.

Nowadays, they’ve taken tranches of that Wall Street model and made it available to accredited investors to participate in. There are a few operators in the space doing this that I know of. One in particular that’s pretty huge, and most people, if you’ve ever talked to someone that said “I do ATM investing”, they’ve probably done it through this group, but I don’t know.

So how it works is, again, it’s a fund, so it’s diversified. There are regions and markets and locations that are historically proven to perform at certain metrics. A couple thousand ATM machines in this fund, I’m a passive investor, I say, “Here’s my $100,000” or whatever; that actually buys ATMs physically, like actual new ATM machines, and then the operator goes and they place them in the existing location. So he’ll take out an old one that has been there for a long time, like five to seven years, it’s outdated, whatever, it needs maintenance – they pull it out, they put mine in there. And then I’m getting a cumulative return based on the performance of the portfolio.

In this case, it’s kind of interesting because the operator is quite involved. They’re very busy, it’s a very active business on that side of the coin. They’re constantly maintenancing, outfitting, putting new ones in, taking old ones out, restocking, all these things. So they’re actually taking the majority of those transaction fees. When you go to use an ATM machine and you pay three bucks to pull money out, they’re actually taking say $2 of that for their fee, and then the passives are getting $1. But when you add it all up it makes, to me anyway, financial sense to partner on something like that for the cash flow.

So that’s ATM investing in a nutshell. I guess I can cover at this point – the vending machine business is very similar. All the little snack machines when you go and get your oil changed, or wherever. That’s a business that can be active or passive as well. There’s buying a vending machine, making sure it’s stocked, and then getting ridiculous prices for stuff you don’t need. [laughs] That’s another kind of business model.

Alright, oil and gas royalties. I’ve only played in this space very minorly. Sometimes it’s a master-limited partnership… It’s kind of a high-risk/high-reward. Commodities bounce up and down, and you just look at the historic charts on oil, and it’s 120 a barrel, it’s 20 a barrel… It’s so volatile. But if I invest in oil and gas, there’s a) some great tax advantages to doing. That’s why most people invest, in sometimes dry hole production, stuff like that. What do they call it? Oh, gosh, I can’t think of the term. But anyway, you’re speculating on where oil and gas is going to be. Wildcats, I think. That’s the most risky form of this investing.

But you can also invest, again, in a pooled fund, private or public, of existing and currently producing oil wells. So you’re eliminating the risk that is there actually going to be any oil there? Well, you already know. There is oil, and it’s producing, and it’s cash-flowing right now. Of course, you’re going to have a lower return because of that certainty. But it’s a whole sector in itself. I mean, that could be an hour-long conversation. But basically, you have royalty, or interest, or whatever, in the actual production of oil and gas wells. That’s something that you can do as well.

Theo Hicks: I have a neighbor, that’s what he does. He works for a big fund that trades energy and then I think he’s setting up his own little fund as well. I’m not sure if it’s oil and gas or what type of energy it is, but he does the same thing, and they bring in big passive investors, use their money to create that stock, or however it works.

Travis Watts: Yeah, it’s interesting when you do — I know as Robert Kiyosaki has talked about, he does some oil and gas exploration investing and stuff like that. It’s on the tail end of what he does. He’s making money through his Corporation, the Rich Dad Company, and then through real estate, and then… It’s like the tail end. It’s like after he, you know, net cash flows and all this, and then he’s speculating a little bit. But the thing is, when you do dry hole stuff, when you’re speculating, you’re trying to get a producing well from complete scratch, most of the time – and again, I’m not a CPA or a tax advisor… Most of the time you can write off the majority of all those costs, from drilling and whatnot, so you get these huge tax write-offs. And if it does produce, even better. But even if it doesn’t and you’re in a high bracket, it’s almost like the government’s your partner there. They’re going to give you a 30% risk-adjusted tax incentive to do so.

And the last thing I’ll say – I worked in the oil industry for a number of years. It’s good when it’s good, and when it’s bad, it sucks. It’s a boom and bust industry.

Renting cars, or RVs, or boats… Speaking of Robert Kiyosaki, he’s the one that actually, years and years and years ago, I heard him talking about how — he’s from Hawaii, and he and his wife wanted a sailboat; almost like a mini yacht kind of thing. I don’t know if [unintelligible [00:25:56].23] But anyway, expensive, and a liability. Robert’s famous for talking about assets and liabilities. Well, he didn’t want a liability on his books, so what he did is he found a charter service, a boat or excursion or tour service, or what have you, that rents out boats and does these things.

So they bought the boat, and then they put it in a pool to be used for that particular company, and that company basically pays them rent on having the boat there that’s accessible to them. So he turned a liability into a cash flow-positive asset… Which I thought was really cool, because he owns the boat; he gets to use the boat anytime he wants for free, it’s his, but then he also makes cash flow off of it when he’s not in Hawaii, which is most of the time. I thought that was really cool.

Fast forward years down the road, this is what my wife and I do with one of our cars. We have a couple of places that we live, and at one of them, we have our car. We’re not there a whole lot using that car, so when we’re not there, we hooked it up to a platform that takes care of everything on our car, from car washes, refueling, the oil, whatever, and then they rent it out to other people while we’re not there, and then wget just passive cash flow. We’re not actively involved in the business, but then anytime we’re going to come to use it, we just go into this app and we just say, “Alright, we’re going to be here for two weeks, we want the car” and then it’s ours. It’s our car. It’s kind of a cool concept. Again, a car is a liability; you’re paying for parking, insurance, maintenance, and upkeep, so we found a way to convert that into an asset for us, which is pretty cool. You could do that with anything.

I just saw an ad the other day on Instagram, and it says, “Do you have an RV? Make 1,500 bucks a week renting out your RV.” That’s the same thing. Most people that have RVs, it sits there three quarters of the year doing nothing, and then they use it a little bit, and then over time, you probably use it even less. It depends. But why not turn that into some cash flow? A lot of people aren’t willing to go buy an RV, they don’t have a place to store an RV, they don’t know anything about RVs; they just want to rent one for the weekend. It makes a lot of sense.

Theo Hicks: Something very similar. It’s not necessarily exactly passive, but it kind of reminds me of that boat story, that RV story. A neighbor back where I grew up, they bought this big semi-truck, the one that pulls the big trailers. But it’s like the living area is massive. So whenever they travel all the time or they go on vacations, rather than flying to their location, they’ll just take a job, hook up a trailer, they’re driving there anyway, they’ll bring the trailer there, you get paid for that, going on their vacation, hook up a trailer, and bring it back. That’s kind of an interesting strategy.

Travis Watts: It’s a hot-shotting business. So if you have the right equipment, again, yeah; if you’re going to have a truck and trailer anyway, that’s half the equation. The rest is just sign up for some platform that you can go pick up jobs. Again, back to the oilfield days – man, some of those guys… I’m out there swinging hammers, working 14 hours a day, sweating my butt off, and here comes some hotshot showing up in his little hoodie with his truck and trailer making more money than I’m making, just because he picked up a [unintelligible [00:29:02].28] or something, and got paid a thousand bucks to bring it out to us. It was crazy. That’d be an active business, of course. But there are ways to make money off that, or turn a liability into an asset.

Alright, cool. This one’s fun. Theo, I know you’ll probably have a few things to add here. So house hacking – Theo and I both got started with house hacking in the real estate space. My story goes that 2009, two-bed/one-bath house; it was the first property that I ever purchased. The government was doing a first-time homebuyer credit at the time because of the recession… And all I knew was this particular house sold for 168,000 a couple of years back, and now it was on the market for 95k, and it didn’t have any major issues; it was quite frankly in good shape, and just needed some paint on the inside. That was my first purchase.

My mortgage, if I remember right, was about $650 a month. I had a spare bedroom in a college town, and I was raised by very frugal parents that taught me about garage sales, and Craigslist, and this kind of stuff… So I went out and I furnished this bedroom in the house, for that matter, so cheaply you wouldn’t believe it. I don’t even know, I spent like 1,500 bucks and furnished the whole house. It was insane.

But anyway, I ended up charging 600 a month for the spare bedroom, so I was essentially living for free. It was an incredible, mind-boggling moment in my life to think real estate is powerful, cash flow is powerful, I want to keep doing this; I want to do this on a much bigger scale. That was when the seeds got planted. That’s how I got started with it. Did you have anything you want to add to that?

Theo Hicks: Yeah. House hacking, just like any other thing – there are so many different ways to go about doing it. If you already live in a house, you can rent out a spare bedroom. I’ve heard people convert a shed – a big shed obviously – their garage into a unit, renting out their basement, you can do more of an Airbnb type of thing if you travel a lot… If you travel to say four or five different locations, you’ve got a place in each of those spots, you’re there for a month, while you’re not there, you Airbnb it. [unintelligible [00:31:01].13] have 12 houses, do it that way.

What I really like about the house-hacking though in particular is that it’s very repeatable. You can house-hack, say a duplex or a triplex or a quadplex, it might be a little bit more active that way, but depending on how you set the lease up, they could take care of everything and you just mostly collect rent and then pay for things as they come up. But then after a year you can move out, and then because of that low downpayment, you can rent out that entire place, or both units, three units, four units, you have a really, really high cash on cash return, and then just do it again; buy another house, house hack again. Slightly more active; it’s not going to be completely passive, like renting out your bedroom… But this is again, the Actively Passive Investing Show, so… It’s not the same as running a full-time business. I suppose you could put the right team in place…

I really like this house hacking strategy. Really, anyone who I ever talked to that talks about getting into investing in real estate, this is really one of the best ways, because it’s a really low down payment, you’re managing a property that you’re there, so you don’t have to travel around everywhere… And once you leave, you can rent it out and have a really high cash on cash return. But I love this strategy for really anyone who’s planning to get into active investing, but there are also ways to make it more and more passive.

Travis Watts: Yeah, I think a lot of these things that we’re talking about, Theo – it requires a decent amount of capital in order to achieve the kind of results that maybe you’re looking for, if you want to be solely 100% passive. So house hacking, the way I see it – there are two things. If your net worth is, let’s say under $100,000, this would be a great way to start. If you want to get started in real estate, it’s cash flow, it’s real estate, it’s home buying… There’s so much flexibility with single-family or small multifamily that you can do, different loans you can qualify for… It’s really a great way. I think that’s why you and I both started that way. It just seemed like the most logical step in the door, at least to me it did.

So that’s how I look at it, when you’re at that kind of level. And you could certainly do it beyond that, but yeah, maybe then at some point, you’re thinking maybe a guest house in the backyard, or maybe the basement with a separate entrance or something. Maybe you don’t want a roommate per se your whole life, but there are ways to make it work, to your point. Or a detached garage or something.

Alright, cool. I want to cover a few low-yield things, but certainly passive opportunities that some people are very into. Certificates of deposit from a bank, a CD, annuities, a common insurance kind of product for retirees mostly… Money markets, which are usually short-term Treasuries and things like that, and bonds, whether we’re talking US bonds or corporate bonds.

Right now, in today’s world, in 2021, these don’t yield very much, but they are passive. You could certainly walk down to your bank and say, “Here’s 100k, I want to buy a CD.” It’s pretty streamlined. So those are some options for you. I’ve done most of those – not all of those – at one point or another, with small amounts of money. Not annuities though.

And then here’s one – it’s kind of a stretch, but I want to throw it in here because it’s interesting. Years ago, like 2016 or 2015, I got a credit card that is straight-up 2% cashback, no matter what, unlimited all the time, on everything. I know it’s not passive income, and I know it’s not an investment, but every single thing I buy in my license then, 2% back.

So you end up getting these rewards that I redeem for cash, and it’s kind of nice. We all have to spend money, you know what I mean? So why not just get a little cash flow stream built off of it? I know a lot of the travel hackers and whatnot online – they do the airline rewards and they end up flying first class for free to Asia, or something. There are different things you can do, depending on what’s up your alley for you. But something to consider if you don’t have a good credit card or cashback kind of thing, that’s certainly an option.

And then I just want to hit real quick some alternative alternatives that I have not done, I don’t think, mostly… Let me take a look. Yeah, no, I haven’t done any of these. But they could be cash flow. There’s a lot of programs out there for dropshipping where you can put some time in upfront, build this e-commerce business, so to speak, and then make it sort of turnkey, to where you’re not actually storing inventory, you’re not actually having to do customer relations and returns, and stuff. You’re arbitraging; you’ve set up a system where you’re buying things for a cheap price, you’re selling them at a higher price, and you’ve made that automated to where you’re just getting cash flow off that business. So that’s certainly something that you can do.

Affiliate marketing – again, let’s say you’re a YouTuber and you’re using a microphone and you’re doing a review on it or whatnot, so you get all these views, and you say “Links in the description” – well, that’s an affiliate link most of the time. These folks are getting a kickback when someone clicks that link, places the order; they’ll get like five bucks or something. Sometimes more, it depends on the price point. So it’s not really passive, but one day it is passive, you know what I mean? You put in some time upfront, and then you just let it roll, and then you have 100 videos, and then you’re just collecting these commissions off all these things that sell, without you having to do any further work.

Car washes could be independently owned. I’ve also seen funds that own car washes. We all know about that, the self-serve thing, or the automated roll through. You can just own those things. They’re sometimes some cash flow kings, they’re pretty crazy.

We talked about vending machines. You can do advertising on your car; we’ve talking about that before the show, Theo. You can put these big banners down the side of your car and some companies will pay you, per month, per week, whatever, depending on how much you drive, what your car is, all these different factors… But certainly, it’s something to think about. I joke that you could get a tattoo across your forehead, or just get a tattoo in general, and some companies would pay you for that, because that’s long-term marketing. I don’t know that that would really be worth it, but to me…

Theo Hicks: Definitely passive.

Travis Watts: But certainly passive, right? That’s just kind of a joke. But there are all kinds of things… To me, to wrap all this up, the bottom line is you’re an active investor if you have an active participation in the business. Not just upfront, but ongoing. When you own single-family homes and you self-manage, that means you’re always looking for properties, you’re always working with relatives, you’re always showing up at the closings, you are always turning over units, you’re always calling your contractors… This is active participation. You are not a passive investor if you own single-family homes. And even if they’re turnkey and you have professional property management, if you’re still dealing in the business all the time, on an ongoing basis, having to make decisions, “Am I going to replace the roof? Am I going to patch it? Am I going to do a new air conditioning unit? What color am I going to paint this?”, that is active participation. That’s how I define active and passive. Passive is all the things that we just described, mostly though, like the private placement example where you’re investing in a private fund, or in a stock situation…

We spoke on the last episode about owning a stock like Apple. Well, I don’t work for Apple; I’m not a CEO of Apple, I’m not an engineer at Apple. I have no active participation in the business of Apple. So if I go and buy a share, I am a passive investor in Apple, or in that business. That’s a quick refresher on how to look at it.

That’s my list. There are probably more than 15 ideas, and I know we went a little bit long, but hopefully food for thought. Everybody listening, you can always reach out to us for more clarification on any of that. Hopefully, it all made sense. But that’s what I wanted to share with everyone, is some of that stuff I’ve played around with.

Theo Hicks: I really appreciate that list. The way I would think of this – again, we’re talking about passive investing, so maybe right now you’re focused a lot on one of these or a couple of these. But as time goes on, the goal of all this, at least for some people, might be to have this passive income replace their full-time job income, so they can become full-time passive investors. Maybe right now renting cars, RVs, and boats, and turning a liability into an asset, or a rent-to-own model, or some of these more complicated/complex models – it might not be something you’re interested in now because you don’t know much about it. But once you retire, you want to diversify, expand, spend your time passively investing even more, and now you’ve got a whole massive list of ideas of things to investigate. You can maybe go from one to two, or two to three, or do all 15+… It’s really up to you.

Ultimately, I think it makes sense to focus on what you know first, get really good at that, and then decide what to expand in next based off of this list went over, or where you’re at, what you’re interested in, things like that. That’s all I have to say. Anything else, Travis, before we sign off?

Travis Watts: I think just at the end of the day, one more thing – as a full-time cash flow investor, if you will, I’m just looking for a risk-adjusted return that makes logical sense to me in something that produces positive cash flow. That’s what I’m always looking for. There’s plenty of things that can produce cash flow, but you’re taking an awful lot of risk for it, so that’s not something I’m going to be involved with.

I’m always trying to learn as much as I can, ask around, network, and just try to figure out what makes the most sense for me. We’re all different, to your point. House-hacking could be right up your alley today, but for me at this stage in life, that isn’t a strategy that I’m actively doing, nor do I intend to really ever do again. So nothing against it; it was great when it was great, but I’ve moved on to some other things. So that’s it.

Theo Hicks: Perfect. Well, Travis, thank you for joining us and providing us with a very detailed list of 15 or so different passive investment opportunities. Best Ever listeners, as always, thank you for tuning in. If you have any questions for us or you have a topic you want to discuss, you can email that to me at theo@joefairless.com and we’ll cover it on the longer-form show Actively Passive Investing Show, or our 60-second segment on YouTube. Again, Travis, thanks for joining me. Best Ever listeners, have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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SELF DIRECTED IRAS Posdcast

JF2403: Self Directed IRA’s | Actively Passive Investing Show with Theo Hicks & Travis Watts

Today, Theo and Travis are going to be talking about self-directed IRAs. What is a self-directed IRA? How does that differ from IRA or 401k you may currently have? Many investors use self-directed IRAs and there’s almost $20 trillion of IRA money in the United States. The purpose of this episode is to provide insights obtained by one of our contributors.

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TRANSCRIPTION

Theo Hicks: Hello Best Ever listeners and welcome back to another episode of the Actively Passive Investing Show. As always, I’m Theo Hicks, here today with Travis Watts. Travis, how are you doing?

Travis Watts: Hey, doing great, Theo. Good to be here.

Theo Hicks: Today we’re going to be talking about self-directed IRAs. Now, a disclaimer, I’m not a self-directed IRA expert, Travis is not a self-directed IRA expert. The whole purpose of this episode is to provide some insights that we receive from a blog post from one of our contributors. His name’s Brian Boyd; he is a real estate attorney who specializes in taxes. He wrote a detailed blog post for us entitled How to Invest in Real Estate With a Self-Directed IRA. Travis and I wanted to hop on a show, Travis will talk about his experiences with the self-directed IRA, I can talk about my very limited understanding of the self-directed IRA, but at least extract the best advice from Brian’s blog post. So before we hop in, as always, Travis is going to introduce the topic a little bit more, and why we’re talking about it today.

Travis Watts: Thanks, Theo. I think that this is just a really good topic in general; it’s something we haven’t covered on our show. It certainly pertains to passive investors; it can pertain to active investors as well, it just kind of depends, but probably more of a passive topic. So it’s a very common strategy. A lot of investors use self-directed IRAs; I used to as well, I’ll share a little bit of experience later in this episode on that. Basically, if you prefer to park your money into private real estate, and there are other things you can invest in, too – private businesses, or physical gold, or silver, and oil, and all these different things – then you should have the choice to do that. And you do have the choice to do that. So that’s what we’re going to cover, is what is a self-directed IRA? How does that differ from maybe the IRA or the 401K that you currently have.

The other thing I thought was pretty interesting as I was doing a little bit of research here, is there are almost 20 trillion dollars of IRA money in the United States. That’s T, trillion, a little less than our national debt, I guess. So that’s a tremendous amount of money. A huge pool. So yeah, rightfully so, to my point earlier, that a lot of people use this strategy, there’s a lot of IRA money out there. So folks looking to do syndications, private placements, etc, this can fit well there also. But to Theo’s point, we’re not giving you any kind of financial advice, so please seek your own lawyers, attorneys, CPAs, etc, for this kind of stuff, and financial planners. We’re just going to be sharing what this stuff is and how it functions. So with that, I guess I’ll just go ahead and dive in or do you have anything else to add, Theo?

Theo Hicks: That 20 trillion dollars is interesting. You talked about how it’s close to the national debt; there’s a solution there – just take that money and pay that debt, right Travis?

Travis Watts: Yeah, yeah. That’s what they should do. We’re going to write a letter and propose that. [laughs] So let’s just get started with what is a self-directed IRA. The important thing to distinguish here is that a self-directed IRA is independent of a brokerage firm. So a lot of folks – I’m going to use two examples, because they’re very widely known. Charles Schwab or Fidelity Investments; a lot of people hold 401Ks, IRAs, etc, through brokerage houses like that. Of course, there are way more examples to give, but you get the point. These are not self-directed custodians. I’m going to cover the differences there and how they function.

First, let’s define what a custodian is. It’s basically an entity that specializes in IRA accounts. So for this purpose, we’ll talk about self-directed. So they manage the transactions that are happening – the wire transfers, etc, they manage the paperwork that goes along with doing these types of investments, the title work that you have to do when you close on properties etc, financial reporting… I forget what the tax forms are, as an example; like a 1099, for example – they issue those and they upload those for you. They’re making sure at the end of the day, how I see this – most important element, there making sure that you are staying compliant, that you’re following the rules that have been set forth by the IRS with what you can and can’t do. Theo, you’ll dive into that just a minute here in a little more detail.

Here’s the biggest difference, and it could be a shocker for some folks… But a self-directed custodian charges fees for you to have an account with them. So why did they do that? Well, because if I open an account for free with them, and I just go buy a piece of real estate, and it’s going to be a rental property, well, then how do they make any money? They don’t. So they have to charge you for opening the account, maybe they charge a percentage per year based on how much you have in your account… They have to charge you fees in order to operate their business, and rightfully so.

Then why is it “free” to have a Fidelity or Schwab IRA? It’s because they are making fees in a different way. Most of the time, they’re trying to push their own products to their customers. So if I have my IRA with Fidelity, and I call them up and say, “What do I do with this money?” They’re probably going to persuade me to go with the ABC Fidelity Mutual Fund, which has – what? Fees built into it. That’s how they’re recapturing these costs, that’s how they can offer these free accounts for folks. It’s not that one’s free and one costs, it’s just, you’re going to pay it one way or another, whether that’s more of a slightly hidden cost, versus an out-of-pocket kind of thing. So that’s the difference in structure between your traditional brokerage houses and how they operate and a self-directed custodian.

A couple of more things to point out – when you’re investing with an IRA, this is its own entity. Kind of like if you were using a business or an LLC. If I go purchase a property, I, as in Travis Watts, I’m not on title. My IRA is on the title. So it’s going to say, ABC Trust Company for the benefit of Travis Watts’s Roth IRA, just to give an example. It’s kind of a long handle there, but that’s how that works. So your IRA actually owns the real estate, and therefore it’s not taxed as an individual; they have their own little tax system that they have to follow. It’s completely different than the individual brackets that we all see and know.

I mentioned you can invest in real estate, private real estate, not just publicly-traded REITs, gold, silver, private businesses, on and on. So these are things that if you have an account with a Schwab or Fidelity or brokerage and you say, “Hey, there’s this house in my neighborhood I want to go buy and rent it out”, you can’t do it. Stocks, bonds, and mutual funds. You’re very limited… Well, I shouldn’t say it’s very limited. But you’re limited to stocks, bonds, and mutual funds that are publicly traded. So, Theo, I’ll turn it over to you for just some general either pros and cons, or things to look out for, or things to know beforehand, I guess. Take it away.

Theo Hicks: Yeah, one of the things you said in the beginning was how you’ve got the self-directed IRA, and then it’s also the 401k. I remember I had a buddy who bought a property using his 401K, and used a loan against his 401K, like $50,000 or whatever, and he used that money to buy real estate. From my understanding, I’m pretty sure when you do that, when you get that loan, you’re not really limited on what you can use it for. Whereas for this self-directed IRA, you can’t use it to buy whatever you want. There are certain restrictions; they’re called the qualified or disqualified persons or types of things that you can buy. So I think you mentioned this in the beginning, but you can’t use your self-directed IRA to buy your own personal house, or you can’t use your self-directed IRA to buy a vacation home for yourself in Florida, California, or wherever. It has to be used for purely investment purposes for yourself, also. So the types of things you can buy are restricted, and also who they’re bought for, or who they’re benefiting are also restricted.

The IRS has a list of what they call disqualified persons. This basically means that they can’t have involvement in this investment. So I’m going to steal Travis’s analogy that he gave me before the show, but below you, above you, and next to you. So your parents or grandparents, your children, your grandchildren, your spouse, your siblings, your cousins – you can’t buy a property for them as a gift, you can’t buy a property as an investment, but your mom is living there, or your dad is living there, and they’re paying you money; those people are disqualified. Other things that are disqualified would be any service vendor to your IRA, as well as any entity that owns more than 50% of the property.

And not only can you not buy it for these individuals, but you can’t buy it from these individuals either. You can’t use your self-directed IRA to buy a house from your mom or buy a house from your brother or sister. These people are disqualified, in every sense of the word. You use a self-directed IRA to buy an investment property for yourself, from someone who’s not related to you, or married to you.

A couple of other things that I didn’t realize was a case with the blog post was that it’s not as easy to obtain financing on a property that you’re using a self-directed IRA to purchase, as opposed to you just going out and doing it yourself or having a business that buys real estate. A lot of times you have to buy the investment all cash, or you’re going to have to use it to invest in a private placement, like an apartment syndication. Now, it doesn’t mean it’s impossible to get a mortgage. I’m pretty sure I’ve talked to people out there who specialize in helping you get mortgages when using your self-directed IRA. But as a general rule of thumb, it’s more difficult to obtain financing when you’re using a self-directed IRA to purchase.

When you are using leverage when you’re using a mortgage, there’s a certain portion of the tax code that’s going to apply to [unintelligible [00:12:56].20] unrelated business, taxable income. We’re not going to get to that, talk to your CPA about that, and talk to your CPA about this, in general. We are just giving kind of general advice.

Something else that is interesting, too… When you use your stuff to IRA, you’re investing your earnings after you’ve already been taxed. So when you withdraw that money, it’s not taxed, right, Travis?

Travis Watts: It depends whether you’re doing a Roth IRA, for example, which you’re not getting any tax benefit as you put the money in. You’re earning money paying the tax, then putting it over into a Roth, then you’re kind of compounding tax-free as time goes on. And then yeah, to your point, hopefully withdrawing after 59,5 tax-free withdrawals out of the account. The traditional IRA account is a little bit different. You do get a tax deduction when you transfer money into it in that current year, but then as you pull out the money, you do pay tax on it. It’s kind of an unfavorable tax, which I’ll highlight here in a minute.

Theo Hicks: Perfect. So when you’re using an IRA that you already pay taxes on, and you pull it out tax-free at some point, then you’re not going to get the same tax benefits from your real estate investment. You’re not going to benefit from the depreciation, interest deduction, assuming you get a mortgage on it, the property tax deduction, any other operating expenses, maintenance deductions, things like that, because the self-directed IRA is not taxed like a regular individual person is. The tax code is specifically for the self-directed IRAs, so understanding that and making sure that you’re not taking that into account when you’re making the decision of whether or not to use your self-directed IRA to invest. “Oh, I want to use that because I can get double tax benefits.” That’s not necessarily exactly how it works.

Travis Watts: Yeah, exactly. Again, without being tax advisors and not giving any advice, but the fact is, to your point, Theo, many of us invest in real estate for the tax benefits. Well, if you put it inside of an IRA, you’re losing that ability, because it just doesn’t matter what’s happening inside the IRA as far as you’re investing. What matters is when you pull money out of the IRA, when you do that, how much you do that, and it’s taxed at ordinary levels. So you can pay much higher taxes, realistically, by doing this kind of thing. So it might be an unfavorable situation for you. But again, that’s why everybody is different. That’s why it’s so hard to say, this is good, this is bad, this is right, this is wrong. It’s not black and white. So it really takes some strategy planning with your CPA, etc, and that’s what you should do.

To that point, I just want to share something real quick before I move to my section. You mentioned the up, down, left, and right, and the disqualified persons. The bottom line is, you could probably tell how you can manipulate the system, and that’s why you can’t do these things. You can’t buy your grandma’s $100,000 house for 300k, you can’t move a parent in and have them pay you 50,000 a month in rent when the market rents 2k. There are things that could be manipulated that’s why you have to shy away from the disqualified persons.

The bottom line is there are so many different rules. That’s why you use a qualified self-directed custodian to help you navigate compliance. It’s, quite frankly, very difficult if you’re doing individual purchasing of property using a self-directed, like a single-family home, because you as the individual behind the scenes shouldn’t have any active involvement with that. You should be hiring third-party contractors, third party managers, third party everything; you should never be going in there and saying, “Hey, I’m going to reach in my pocket and upgrade this unit here with 100k in cash, and then sell it for a higher price.” You can’t do this stuff. It’s illegal. So that’s why you want to take the proper measures to that.

I want to share a couple of things. I used to have, as I mentioned at the beginning of our episode, a self-directed IRA, I had a Roth, I had a 401K, I had different things. And generally speaking, to your point earlier, Theo, if you have a 401K it’s usually tied to your current employer. So if you’re still actively working for that employer, it’s probably not going to be a self-directed 401K. You’re going to have to actually end your work relationship with the employer, now have like a rollover IRA, where you’re no longer actively working there, and then you can switch that into a self-directed account. Usually, you can’t; not in all cases, but usually you can’t if you’re currently employed there. What your friend did by taking a loan against it is not really investing inside the IRA; they just gave him a loan based on the balance that’s inside his 401K as collateral. So when you take a loan against something – yeah, you can do whatever you want with that money. That doesn’t fall under these rules that we’re talking about.

I want to talk a little bit about some pros and cons additionally, that I see here. The reason that I liquidated my self-directeds, my 401Ks, and my Roths, early on before I had tremendous amounts of money in there over time, is that really the way the structure is set up is you’re not wanting to pull the money out before 59,5. That’s just the age that the IRS has stated that if you’re pulling your funds out before then, that there could be a penalty. Right now, I think it’s like a 10% early withdrawal penalty. That was one thing. For many of you listening or those who know me, I live on cash flow. So I don’t want to park money into something I can’t touch till I’m 60, because I can’t touch it, and then I don’t have my cash flow. I just lost that ability to do that. And that’s my whole message to the world, is helping folks with financial independence etc. So that didn’t make sense for me.

Number two, something to think about is right now in 2021, we are at historically low income tax brackets. You can go to taxfoundation.org, on the upper left of the website you can click on tax brackets and look at the historic. Get this – this just blows my mind… Back in 1963, we had the highest marginal rate tax bracket at 91%. So you just think about that – people making over 200,000 a year in 1963 we’re paying 91% in tax. So we have just drifted down and down and down and down and down to today. Our top brackets are 37%, or something like that. They could be going up with a new administration, we don’t know. But still, hey, I’ll pay 37 over 91 and day.

So the idea here is, to your point earlier, Theo, if I have a traditional self-directed IRA, I’m getting a tax deduction today for funding it.  Say I go put $5,000 in it, I’m getting to basically deduct 5,000 against my income today and save whatever bracket I’m in, which is historically low, whether I’m in 20, 25, 30, 37 at the top. And then taking a chance that when I’m 60 and I start pulling the money out, that tax brackets are equal or lower at that point. But realistically, could they be higher again? What if they were 91% again? So I’m getting a little deduction today, and I’m going to pay maybe theoretically twice the tax in the future. We don’t know this stuff; I’m not here to predict the future. I’m just saying what if that scenario were to unfold, the likelihood. It’s kind of like saying “Interest rates are really low today. So when I’m 60, I think they’ll be the same.” Well, probably not. The odds are they’ll probably be higher at that point.

So something to think about… Those are the reasons why I decided, for me personally, it wasn’t a good fit. But that’s not to bash these IRAs, by any means. They do allow you to invest in private real estate, and these real estate private placements, which I’m huge on and I invest a lot in. That’s a great thing if you’re not a fan of the volatility of the stock market, or you’re just looking for diversification, or you’re already in retirement, and you’re looking for ways to generate passive income. Maybe apartment yields make a lot more sense than putting your money in bonds or something like that, just for example purposes. What else? Diversification… Then there’s also the QRP plan. This conversation could go way more in-depth; we’re not the professionals here. But to your point about the UBTI tax, unrelated business income tax – solo 401Ks, QRP plans… There are different versions out there that could perhaps potentially avoid that type of tax. But again, we’re not here to tell you what to do or how that works. It’s beyond my scope, I’m just letting you know; talk to the professionals and figure this stuff out for yourself.

We talked a little bit about Roth IRAs, and those perhaps can have different types of advantages with the tax-free compounding, tax-free withdrawals one day. But there are income phase-outs; if you’re a very high-income earner, you may not even be able to open a Roth or to fund it, rather. So that’s why everyone’s different and you need to consult on things like that.

With that said, that’s a whole jumbled mess of my thoughts, and a couple of stories, and a couple of examples, and what this stuff is… So as Theo pointed out, we do have a blog that was written in much more detail and clarity, so click on that blog, get some more information, reach out to the professionals on it. But I think that’s all I got on the topic.

Theo Hicks: Well, thank you for sharing your explanation as to why you liquidated. Like a lot of things that we talked about on this show, should you use your IRA to invest in real estate? Well, it depends. There’s no absolute yes you should, or no you shouldn’t. It really kind of depends on where you’re currently at. If you don’t have an IRA at all, then ask yourself, “Is it better for me to have one to start investing my money into that? Or is it better for me to maybe use that capital for something else?” Or if I’m 59 and a quarter years old and I’ve got $3 million in there, is it worth liquidating all that when you’re going to be able to start pulling capital out in a couple of months? Or should you just keep your self-directed IRA and do nothing? Or use it to invest in real estate? So it kind of depends on where you’re at and what your ultimate goals are. Understanding how it works, I think, is important to help make that decision.

As Travis mentioned, we’re not telling you that you should or shouldn’t do anything; we’re just trying to give you some information on the strategy, how people have used it in the past, and then direct you to the expert or the individual who wrote the blog post, or your own CPA. Travis, anything else want to mention before we close out?

Travis Watts: Yeah, that was a great point. I just want to add one thing to what you just said. A lot of folks that I come across in the investor relations capacity that I’m speaking with, that are using self-directeds, fit a similar bill to what you described. They have been contributing to these types of accounts for many years, sometimes many, many decades. They have perhaps a few million dollars in there. And at this point, it’s like would that make financial sense to take an early withdrawal penalty when you have that much at stake? You’re going to have to decide that for yourself. But I was fortunate enough to make my decision early on, before I had millions of dollars at stake. So my little 10% penalty really didn’t amount to that much, and it was more important for me to have that long-term flexibility over my investing. But yeah, I think I would feel a lot different if I was 50 years old with $3 million in an IRA. I doubt I would go pull $3 million out myself and take that kind of tax hit at that time. But yeah, there are strategies, there are things you can do. We’re not here to tell you what to do. But great points, Theo. That’s all I got.

Theo Hicks: Perfect. So the blog post on our website is How to Invest in Real Estate With a Self-Directed IRA, for more information on the topic we discussed today. To close out, if you want us to answer a question that you have, either on this show or on the 60-second question segment that Travis and I do and we post on social media and YouTube, you can email me –theo@joefairless.com– that question, and then we will add it to our list of questions to answer. So, Travis, as always, thank you for joining us today. Best Ever listeners, as always, thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

Website disclaimer

This website, including the podcasts and other content herein, are made available by Joesta PF LLC solely for informational purposes. The information, statements, comments, views and opinions expressed in this website do not constitute and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action. Neither Joe Fairless nor Joesta PF LLC are providing or undertaking to provide any financial, economic, legal, accounting, tax or other advice in or by virtue of this website. The information, statements, comments, views and opinions provided in this website are general in nature, and such information, statements, comments, views and opinions are not intended to be and should not be construed as the provision of investment advice by Joe Fairless or Joesta PF LLC to that listener or generally, and do not result in any listener being considered a client or customer of Joe Fairless or Joesta PF LLC.

The information, statements, comments, views, and opinions expressed or provided in this website (including by speakers who are not officers, employees, or agents of Joe Fairless or Joesta PF LLC) are not necessarily those of Joe Fairless or Joesta PF LLC, and may not be current. Neither Joe Fairless nor Joesta PF LLC make any representation or warranty as to the accuracy or completeness of any of the information, statements, comments, views or opinions contained in this website, and any liability therefor (including in respect of direct, indirect or consequential loss or damage of any kind whatsoever) is expressly disclaimed. Neither Joe Fairless nor Joesta PF LLC undertake any obligation whatsoever to provide any form of update, amendment, change or correction to any of the information, statements, comments, views or opinions set forth in this podcast.

No part of this podcast may, without Joesta PF LLC’s prior written consent, be reproduced, redistributed, published, copied or duplicated in any form, by any means.

Joe Fairless serves as director of investor relations with Ashcroft Capital, a real estate investment firm. Ashcroft Capital is not affiliated with Joesta PF LLC or this website, and is not responsible for any of the content herein.

Oral Disclaimer

The views and opinions expressed in this podcast are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action. For more information, go to www.bestevershow.com.

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Passive Investing Strategies, Actively Passive Investing

JF2396: Passive Investing Strategies | Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Theo and Travis will be answering their listeners’ questions and sharing their insights on investing in modern real estate development – like how important are entry cap rates versus exit cap rates in underwriting and how important are preferred returns?

Rather than outsmarting the stock market, the best strategy is to mirror it in your portfolio — typically with investments based on market indexes — and afterward, sit back and see what happens.

We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening, and I will talk to you tomorrow.

Click here for more info on groundbreaker.co


TRANSCRIPTION

Theo Hicks: Hello Best Ever listeners and welcome to the Actively Passive Investing Show. As always, I’m your host, Theo Hicks, with Travis Watts. Travis, how are you doing today?

Travis Watts: I’m doing great, Theo. Thanks for asking.

Theo Hicks: Yup, absolutely. Today, we will be answering another question that was submitted by a listener. Thank you for the questions. This week’s question comes from a listener Jay. We’re going to do a little passive investing a 101 course. The question from Jay was asking us about the pros and the cons of passive investing compared to actively investing, so we’re going to go over a list of pros and cons today. But as always, first, Travis is going to mention why we’re talking about this topic in addition to it being a question from the listeners, about why is this relevant to listeners of the Actively Passive Investing Show… And then he is going to start off by defining what passive investing actually is. Take it away Travis.

Travis Watts: Sure. I’m so glad that we got this question. Thank you, Jay, for submitting it… Because I often forget sometimes. After 12 years of self-study, reading all the books, podcasts, and networking with thousands of people– that there’s a ton of folks just getting started in the space. They’re hearing about the word syndication for the very first time, they’re hearing about passive income, perhaps from the wrong sources… So I kind of want to give our take on it and kind of make a passive investing 101 show.

And quite frankly, this isn’t even about multifamily. You could relate it that way, but I really wanted to dive into specifically passive investing, to Jay’s point, versus active investing. We talk a lot about multifamily syndication, market trends, vetting deals, vetting sponsors, but what about the concept, or the strategy, or the philosophy of just passive investing, multifamily aside? So with that, I want to give you guys some practical math, some practical examples, and I want to go through a few definitions with you just to get started. Before I jump in, Theo, did you have anything else to add before we get going?

Theo Hicks: No, I don’t.

Travis Watts: Got you. All right, cool. So with passive investing, the way I look at it is this is the type of investing that doesn’t require your active participation in the business itself. Hopefully, that makes sense. I’ll give you some examples. Investing in stocks, for example – you’re not the CEO of the company, you’re not an engineer at the company, if we’re using an example like buying Apple stock; so in this case, you’re a passive investor. You’re just going to own a fractional portion of that company, and you’re going to let the team handle the business itself. That’s being a passive investor. You could invest in REITs, real estate investment trusts, you could invest like I invest, in real estate private placements, or real estate syndications as some people call them… It’s anything that doesn’t require active participation in the business.

So what is it not? It’s not fix and flipping properties. So many people think of it that way. Or “I’m going to go buy a turnkey property, a single-family home.” These are not passive strategies, because you’re still having to manage some elements of the business. If it’s not putting a tenant in, maybe eventually you’re doing that, or it’s managing the property manager, or it’s out there seeking and driving to find these properties… There are active components. It’s not wholesaling houses, it’s not day trading stocks, it’s not syndicating your own deals and being a general partner… Those are all active strategies that require your personal time, effort, commitment, inside the actual business of generating the income and the returns.

So with that, why passive investing? I would say this generally falls into two categories for people. You’re either in it for what I call time freedom, which is freeing up your time and having flexibility over your time –I’ll explain that a little bit more in a minute– or you’re in it for just general wealth creation. You’re either more money-focused, or more time-focused, or simultaneously the combination of the two.

Think about this – when your passive income, be it dividends, interest, cash flow, etc., from your assets, when that exceeds your lifestyle expenses (your mortgage, rent, insurance, food, etc.) then you become financially free. This is really the sweet spot of why passive investing and why passive income. I like to think of it this way – we all end up, if we’re ever going to “retire”, with passive income. That could be Social Security payments. That’s pretty passive. You’re not actually working for that money as it’s coming to you in retirement; it’s just being sent to you. Same with a pension, if you’re lucky enough to have a pension, or old enough to have a pension, I guess I should say, these days. Or a lot of people park money in things like annuities, which is another form of converting your nest egg into passive income.

My whole message here is, why not start focusing on that cash flow and passive income generation now, instead of later? There’s not a lot of cons to that. At least you’ll be educated, you’ll have the know-how, you’ll have, hopefully, some diversification built-in, you’ll know different strategies… It’s unfortunate that so many folks either never learn it, or they wait till their 60s or 70s to start trying to figure it out. In some cases, that’s really not a good thing. You may be taking an abnormally high amount of risk at that point, etc. So that’s what passive investing is in a nutshell – you’re trying to diversify, get multiple income streams rolling in to offset your lifestyle expenses, so you either have flexibility over your lifestyle and what you want to do with your time, or just to generate wealth and perhaps pass that on to someone else. It’s just building income streams, instead of the buy low/sell high mentality that so many folks have. With that, that’s kind of passive investing in a nutshell. Theo, I’ll turn it over to you on whatever topic you want to cover on that.

Theo Hicks: Yeah, a lot of the things that you just said are going over the main benefits of passive investing. I really liked how you positioned it that, look, you’re going to have some sort of passive income, most likely eventually, or at least the baby boomers and older generations today; maybe not us, but most people are going to have social security pension, some sort of passive income coming in. So why not just do it now instead of later; why just rely on getting Social Security or pension? Why don’t you just also passively invest now so you can kind of have both of those? Just in case one of those happens to go away, especially our younger generation.

So I want to go back over to what Travis just said a little bit and extract a list of the benefits of passive investing. Then I also have a list of cons or drawbacks, but all these are going to be compared to actively investing. Before I even go into that, I’m going to call these potential pros and potential cons, because it’s not like every single passive investment is going to have all these cons or all these pros to the same degree, same with active investing. So it’s going to depend on the three things that Travis talked about all the way at the beginning, which is going to be the market, the deal, and then also the team you’re investing with.

So assuming that you’ve got a passive investor with a team who’s got a level 100 skillset, a level 100 market, a level 100 deal, as opposed to that person who’s actually investing having a level 100 experience, a level 100 deal, a level 100 market, all things being equal – what are the pros and cons of being a passive investor in that amazing active investment or actually being the active investor? I’ve got four categories for the pros and the cons. It’s going to be control, time commitment, risk, and return. So I’ve got benefits for each of those four points, as well as potential drawbacks for each of those four points.

Let’s start with the pros first. This is what Travis talked about, and that’s going to be the time commitment. When you’re passively investing, you have a lot more flexibility over your time. Of course, this is the Actively Passive Investing Show, so passive investing isn’t completely passive, so to speak. It’s not like you do nothing. You still have to look at deals and understand what’s going on, but it’s not going to be as large of an ongoing time commitment as being that active investor who needs to actually work in the business, as Travis said. That’s probably one of the major benefits of passive investing over active.

Also, from a time commitment perspective, you can also look at it from a lower upfront time commitment. Because when you’re actively investing and you’re managing your business, that takes a lot of time; it’s like a full-time job. But it also takes a lot of time to get to that point in the first place where you actually buy your first deal; because you need to have the money, the team, you need to find a lender, you need to raise capital, or have enough money to actually do the deal before you even actually have a deal in the first place, that you have to manage. So the upfront time commitment for you as a passive investor is going to be a lot less, because you’re just finding someone who’s already done all that upfront work and then you are just investing. So you don’t need to have an insane amount of experience or expertise in whatever asset class you’re investing in, because you’re relying on an experienced team member.

Also, from a risk perspective, passive investing, again, all things being equal, has a lower risk than actively investing. Same reason, because you’re plugging into a proven system, a proven business plan, a competent team, in addition to your ability to diversify more easily across multiple asset classes, multiple markets. When you’re actively investing, you’re usually focused on one asset class in one particular market, so you’re not very diversified.

The fourth point would be return. So from a passive investor perspective compared to actively investing, you’re going to most likely see more consistent returns. Passively invest – I’m going to get my monthly distribution or my quarterly distribution. Whereas if I’m an active investor, I might not get paid off at first; I might have to wait until the sale happens actually make money. Also, if you look at it from a time perspective, passive investing has a lot higher return on your time too, because you’re making money without having to actually put forth a lot of time. So before I go into the cons, I want to pause there. Travis, any thoughts on those?

Travis Watts: No, I think that was an excellent job. Thank you for covering those.

Theo Hicks: So the cons – again, they’re gonna be related to the same four points. We’ll start with the point of control. Sure, you have a lower upfront time commitment, a lower ongoing time commitment, don’t need expertise, don’t experience… But the flip side of that is that you have no control over the actual business plan of what you’re investing in.

Using stocks, as an example, you have no control over whether or not the CEO gets fired, or how much money gets invested in R&D; all you can do is just select what you invest in and then let the team do all the work. Same with real estate – you can pick what you want to invest in, what team, what market, but once you invested, you have no say over the business plan. So really no control once you’ve actually invested; your control is exclusive to picking what you invest in.

And then from a time commitment perspective, sure, there’s a lower upfront time limit compared to active investing, as well as a lower ongoing time commitment compared to active investing, but it is possible that you need to have more of a financial foundation before passive investing. For example, if you need to be an accredited investor, you need to meet the liquidity of the net worth requirements. Whereas if I want to actually invest in say, a house hack, I can just bring five grand down, get a 3.5% down  loan and get into actually investing. Or you can do creative financing, 0% down, or you can be a syndicator where you’re not bringing that much money to the deal. Whereas if you’re a passive investor, you may need to be accredited. It is possible to be sophisticated, but you still need to have some level of knowledge of investing before you can passively invest; whereas active, technically you don’t need any experience or money to do a deal.

And the last one would be a return perspective. So you’re going to get more consistent returns, as well as a higher return on your time. But by being an active investor, you’re going to have a higher upside potential by being the active investor, compared to passively investing. When you’re passively investing, you might just get a preferred return, you might participate in some of the upsides, but the return on investment, the ROI percentage is going to be much higher when you’re actually investing, compared to when you are passively investing.

And then I really couldn’t think of any downsides from a risk perspective in passive investing; maybe that can be related to the lack of control. But as long as you’re investing with a competent team that’s implementing a proven business plan in a valid market, then again, all things being equal, a lot less risk when passively investing compared to actively investing. Those are my lists of pros and cons.

Travis Watts: Excellent list. On that last point, I was just thinking out loud here… Yes, to your point, there are really three areas of risk. You have the sponsorship team, the market you’re in, and the deal itself – those are all risk points. So I don’t want to make it sound like there’s no risk in passive investing; absolutely not true. And it has so much to do with the team. It’s just simply their ability to execute the business plan. But then also thinking, there’s a lot of things out of all of our control. What is the Fed going to do? What’s the government going to do? What tornadoes or hurricanes are going to come through? We don’t have a say over this stuff. We can do things to insulate that risk, like have insurance or buy an interest rate cap, etc. But at the end of the day, there are always unforeseen things that can happen. But it’s a lack of control, I would say, when you’re an LP like me. I’m doing my best due diligence ahead of time; that’s my active portion. I’m making that commitment, I’m sending funds, and from there, it’s really not in my hands. So that can be a risk for sure. Great points.

What I want to cover quickly here is just some practical math. Again, this is kind of a passive investing 101 episode, so I want to depict the differences between someone who’s got $10 to start and someone that’s got $100,000 to start. We’ve got people listening from all different types here; someone that may be very young, that wants to start their journey. My nephews are starting their passive journey now, around 18 years old, which is fantastic. I didn’t get started until 20, so they’ve got a little bit of upper hand if they commit to it.

Then you’ve got folks who — maybe they never really intended to be an investor. They started a business, they were successful at what they did, they sold their company, and now they’re sitting on a few million dollars… They don’t know what to do with it. So there could be someone definitely with 100k plus to invest at this point.

So I kind of want to cover both of those really quick – how do you get started with $10? Well, again, we’re talking about passive investing, not necessarily multifamily. So for my nephews, they’re starting with a little bit more than that, but still, they’re buying shares of publicly-traded REITs, real estate investment trusts. You could potentially find a REIT out there that’s publicly traded, that has a $10 per share price attached to it. Let’s run those numbers. So if you bought a $10 share, and it had a seven-cent dividend per month, that’s 84 cents per year, that equates to an 8.4% yield, or cash flow, or dividend, whatever term you want to use. That’s an example; you could literally get started with that. It’s usually free to open a brokerage account these days; it’s no commission trades, etc. So that could be your starting point.

I got started with house hacking. Theo, you mentioned that. I just bought a house that I was going to live in myself at a depressed price in 2009, and I rented out a spare bedroom, and I had a roommate basically paying my mortgage.

So you can start in different ways. I would deem that pretty passive. I didn’t have to work or do any labor there. I just had a spare bedroom, I collected a check every month, and I had to deal with just someone living there. So I would say that still falls under passive.

There’s a lot of barrier of entry sometimes to private placement investing, which is mostly what we talked about on the show. You may have to be an accredited investor and perhaps you’re not, you may have to come up with 50,000 or $100,000 to get started; maybe you don’t have that right now, you’re not a millionaire, etc. So the concept here is that you have to graduate, –you don’t have to, but– I graduated to the level of investing in private placements. I didn’t start there. Everyone’s going to have a different starting point. But to your point earlier, Theo, you have to have a way to earn some income, then perhaps save some money, and then build up that nest egg so that you have more options and more things you can invest in, that may have these higher barriers of entry.

But here’s what I want to compare and contrast. I just used that $10 per share REIT example. It’s the same philosophy and the same concept for private placements. Let’s say you have $100,000 to invest, and you invest in multifamily syndication, you’re getting $700 per month; that’s $8,400 per year, that’s an 8.4% return annualized. So all you’re doing there is you’re adding some zeros, but it’s the same game, it’s the same concept.

So if you’re interested in the passive journey and the passive concept of time, freedom, wealth creation, financial freedom etc, just know, you could start with that 84 cents a year, work it up to 8,400 a year, work it up to 84,000 per year, so on and so forth. You just accumulate, it’s a snowball effect that takes time and commitment. As I often say, it’s simple, it’s not easy. Simple on paper.

So I’ll leave you with this thought… Most people have the investing mentality, as I mentioned earlier, of buy low sell high. Nothing wrong with that, but note that that builds net worth; that builds equity, that builds your nest egg. And that’s important, but that’s what that is focused around. Now, if you invest for cash flow, you build wealth, you build income streams. So it’s vastly different; it’s not highly marketed, it’s not highly talked about, because most stocks aren’t paying a dividend, and if they are, it’s 1%or 2%, it’s very low, so it’s very hard for most people to ever retire on yields like that. It’s kind of how our system is created.

We’ve talked about the 4% rule, I’ll just touch on that – the stocks, bonds, and mutual funds world that we’re all used to suggest to a lot of folks that you live off the 4% rule. So you have a million bucks in your retirement account, you withdraw 4% a year, and you live on it. That’s 40k. And then you’re pulling out of your nest egg every year, and the theory or the logic is that the stock market historically goes up more than 4%, so you’ve got a margin built into that. Not a big fan of that myself, but that’s how our system is built and I think that’s why so many of us think “nest egg.” Save, save, save, or max out your 401k and put it all in under the mattress or whatever, and then one day you have enough money. But really consider passive income in exchange for that philosophy. I think it can be very life-changing. I know it has for me, and it has for so many people. Thank you for listening to this, as we tune into that alternative message, perhaps. Theo, any closing thoughts?

Theo Hicks: Yeah, just to kind of go back to what you just mentioned… I like how you focus on that barrier of entry, because again, one of the pros and the cons would be the upfront time commitment or the upfront investment of needing –at least for my real estate syndication perspective– to have that liquidity, that net worth. Something I didn’t mention that you mentioned, which is that the actual money to invest, that $50,000 or $100,000 minimum investment. But then you said, well, that’s one way you can passively invest. But you can also get started for as little as say $10 by passively investing in a stock or in a REIT.

Of course, there are different pros and cons of passive investing in different types of things. Maybe one day, we’ll do a show on the pros and cons of the various types of passive investments. I know we’ve kind of hit on that before, with talking about REITs and stocks versus syndication. The whole point is that it is kind of a myth that I need to be a millionaire and have $100,000 in order to passively invest. So I need to be an active investor first, become a millionaire, have $100,000 in cash before I can passively invest. Not necessarily the case. You can get into other types of passive investments for a lot less, while you continue to work at your full-time job to save that money. So if you’re young and only have $5,000, you might not be able to invest in a syndication. You may be able to invest in a crowdfunded real estate deal, but there’s other options out there besides the $50,000, $100,000, $500,000 syndication investment.

I don’t have anything else on this topic to mention. Do you want to say anything else, Travis, before we sign off?

Travis Watts: Yeah. And to your point, Theo, there are so many ways that you can be a passive investor. We’ve only really hit on private placements, and stocks, and REITs. But one of the places that my wife and I live, we have our car there that we leave for us, but then we also signed up for this platform where we rent our car out to other residents and we get passive income off of that. That rental income is essentially paying all the expenses for that vehicle being there, and that’s just a creative outlet that you can do. You can invest in ATM machines, you can loan out money at a high-interest rate to people for various purposes, whether that’s a business, whether that’s real estate, note lending, tax liens… There’s so many different things out there. I just wanted to paint the picture of being passive versus active and why you might consider that.

The only thing I’ll end with is a quote from me. A famous, famous Travis quote – “The most important asset that we have is our time. Passive Income can help free up your time so that you can pursue the things that you love.” That’s my philosophy in a nutshell, my mission, and my message to the world.

Theo Hicks: I’m going to start doing that. “A famous man once said…” “Who’s this famous man?” “Me.” Travis, thank you so much for joining us today and providing us with your famous quote and breaking down the pros and cons of passive investing versus active investing, and at the end giving us examples of very creative ways to create passive income, like renting the car out.

So that’s all we have for today, thanks for tuning in. If you want us to answer one of your questions on the show or in our 60-second question segment, you can email me at theo@joefairless.com, and we will add that to the calendar. Again, Travis, thanks for joining me. Best Ever listeners, as always, thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

Website disclaimer

This website, including the podcasts and other content herein, are made available by Joesta PF LLC solely for informational purposes. The information, statements, comments, views and opinions expressed in this website do not constitute and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action. Neither Joe Fairless nor Joesta PF LLC are providing or undertaking to provide any financial, economic, legal, accounting, tax or other advice in or by virtue of this website. The information, statements, comments, views and opinions provided in this website are general in nature, and such information, statements, comments, views and opinions are not intended to be and should not be construed as the provision of investment advice by Joe Fairless or Joesta PF LLC to that listener or generally, and do not result in any listener being considered a client or customer of Joe Fairless or Joesta PF LLC.

The information, statements, comments, views, and opinions expressed or provided in this website (including by speakers who are not officers, employees, or agents of Joe Fairless or Joesta PF LLC) are not necessarily those of Joe Fairless or Joesta PF LLC, and may not be current. Neither Joe Fairless nor Joesta PF LLC make any representation or warranty as to the accuracy or completeness of any of the information, statements, comments, views or opinions contained in this website, and any liability therefor (including in respect of direct, indirect or consequential loss or damage of any kind whatsoever) is expressly disclaimed. Neither Joe Fairless nor Joesta PF LLC undertake any obligation whatsoever to provide any form of update, amendment, change or correction to any of the information, statements, comments, views or opinions set forth in this podcast.

No part of this podcast may, without Joesta PF LLC’s prior written consent, be reproduced, redistributed, published, copied or duplicated in any form, by any means.

Joe Fairless serves as director of investor relations with Ashcroft Capital, a real estate investment firm. Ashcroft Capital is not affiliated with Joesta PF LLC or this website, and is not responsible for any of the content herein.

Oral Disclaimer

The views and opinions expressed in this podcast are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action. For more information, go to www.bestevershow.com.

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JF2389: Is Multifamily in a Bubble? | Actively Passive Investing Show with Theo Hicks & Travis Watts

Today, Theo Hicks and Travis Watts will be answering the question, “Is Multifamily in a Bubble?” and sharing their insights about whether you should be investing right now? Or should we wait for the bubble to pop and take advantage of opportunities? Moreover, what should we be doing? They will also tackle the question, “Is now a good time to get started in Multifamily?” We get to know who we are potentially selling to, what the buying pool and the demand will look like, and the importance of an exit strategy.

Click here for more info on groundbreaker.co

 

We also have a Syndication School series about the “How To’s” of apartment syndications, and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening, and I will talk to you tomorrow.


TRANSCRIPTION

Theo Hicks: Hello Best Ever listeners and welcome back to another episode of the Actively Passive Investing Show. As always, I’m Theo Hicks, and joining me is Travis Watts. Travis, how are you doing today?

Travis Watts: Thrilled to be here Theo. Thanks.

Theo Hicks: Today, as you can tell by the title, we’ll be answering the question “Is multifamily in a bubble?” We’ve talked about something similar in the past, we’ve gone over some market reports, some forecasting reports to see where multifamily has been in the past year or so with the pandemic, where the experts project multifamily going in the future… So we’ll be bringing that information back again and then using it to again answer this question “Are we in a bubble? Should we be investing right now? Should we be waiting for the bubble to pop and then take advantage of opportunities? What should we be doing?” Before we begin, as always, Travis will explain –although I kind of already did– why we’ll be talking about this topic today.

Travis Watts: Sure. Just to add to that, a couple of things came to mind here recently, which is why I felt this was appropriate now… The word bubble gets thrown out constantly, all the news headlines, CNBC, it’s always “The stock market’s in a bubble,” and then tomorrow it collapses, and then you’re unsure at that point. But real estate is a lot more slow-moving. I wrote a blog last year in 2020, “Is now a good time to get started in multifamily?” So that’s what originally kind of prompted this topic, to your point. We’ve discussed it in different ways.

I just had a call the other day with an investor and he’s saying  “It’s just my luck. I’m always late to the game and everything” and he was comparing multifamily to cryptocurrency. I thought, whoa, whoa, whoa, whoa, this is a lot bigger conversation to be had. It’s really not comparable in that type of way. So I really wanted to address why that is; and not to say that things aren’t in a bubble or that they are, but to define what that means, so that you can decide for yourself if you think that anything’s in a bubble. But today’s topic of courses is multifamily.

A lot of concern over the virus, obviously, that’s been the last 12 months in everyone’s focus. Cap rates continuing to compress; that was happening pre-COVID, and that was a big topic about multifamily. Lots of people jumping in the sector, I’ve pointed that out. I got started in 2015 as a limited partner in syndications, a lot more training, boot camps, books, conferences, podcasts… This just really exploded. But does that mean that we’re in a bubble? So that’s what we’re diving into.

I’ll get started with just what I initially brought up, which is “Is 2021 a good time to get started?” Something that I only briefly touched on a couple of episodes ago is what is your exit strategy? I still think this is so important that it bears repeating. What I mean is when you’re buying an asset, I don’t care if we’re talking about a single-family home, a mobile home park, multifamily, who are you potentially selling to? And then what does that buying pool look like? What does that demand look like?

So you really have three broad categories. You have institutional players, REITs, mutual funds, pension funds, and all this kind of stuff. You have syndicators, private groups, usually putting deals together, structuring it that way; then you have individual owners or maybe joint venture partnerships, family offices, things like that.

With institutional, I just want to reiterate this from a couple of episodes ago – you think about, “Hey, you’re a big insurance company, you’re a big pension fund. Okay, what do you need to pay out people their monthly retirement and their pensions?” Well, you need yield, you need cash flow, you need dividends, you need interest, it’s what you need. So when you have deep pockets, there are only so many asset classes to look at where you can go park 100 million dollars in capital and get a consistent type of return. You can’t be trading penny stocks, for example. So the way they’re looking at the landscape is US Treasury yield is around 1%. It might be a little higher today, but it’s hovering around 1%. It was below that recently as well. 2% yield on triple-A bonds, which are the highest-rated bonds. You’ve probably got 3% triple-B bonds; now you’re starting to get a little more risk into the mix. You’ve got an S&P 500 index that has a dividend yield of 1.5%. So you take all that into consideration – it’s all very, very low yield. I think we all know that we’re in a very low yield and low interest rate environment.

Then to speak a little bit about syndicators, JVs, individual buyers, etc. – they’re looking at the same stuff, of course, but additionally, things like certificates of deposit at the bank. I just looked that up the other day – they’re paying half a percent annually to lock up your money for six to 12 months, sometimes longer. Additionally, pretty much we’ll just stay zero in the bank as far as checking, savings accounts, money market accounts. It’s so close to zero, it’s not really worth even mentioning. 2% on annuities for folks looking to retire on a fixed income… So here’s the point that I’m trying to make – we’re all looking for yield; institutional, Main Street, you and I and everyone wants cash flow yield, dividends, and interests. So that makes for a lot of demand on something that is producing that. So what produces that? Well, multifamily does, and we talked about before, cap rates.

The cap rate, again, quickly, if you just paid all cash for a property, paid the operating expenses on it, the cap rate is basically your yield. Nationwide, we have approximately 5% cap rates across the US. So you get approximately a 5% return having no leverage, no debt, no mortgage on the property. So that’s a pretty conservative approach to investing in multifamily, especially for institutions who may have that 100 million dollar to go put to work. Clip a 5% coupon, it sure beats all the alternatives that we just discussed.

To that point, there’s a healthy demand, there’s a necessary demand for yield. So I think that we’ve still got some room to go, as crazy as it may sound… Historically cap rates were more like 8%, and now we’re at five; that seems extreme and chaotic, but the same thing with interest rates. It’s just the environment that we’re in today.

The last thing I’ll say on this intro topic is it really depends on what markets you’re in. We talked a lot about is it a good time to get started? Maybe not in San Francisco, maybe not in Manhattan… Maybe, I don’t know. But you’ve got to look at the macro-level trends, where people are moving to, where taxes are the highest, landlord/tenant laws, etc. So there are definitely markets that are going to be less lucrative right now compared to others, like Albuquerque, New Mexico, for example; cap rates are 6.5%. So it really depends… Compared to a San Francisco, where there’s 2.75 caps, something like that. So it’s pretty extreme. That’s a drastic difference.

So we talk about Texas, Florida, the Carolinas, Georgia, Arizona, Idaho – we did an episode on that, top 10 markets based on a lot of different research, a lot of different metrics. So pay attention to your markets, look at where jobs and people are moving to. It’s a good, I think, intro to this segment. I’ll turn it over to you, Theo. That was kind of long-winded on just kind of your thoughts there and anything that you want to add to that.

Theo Hicks: No, that was all amazing. It kind of brings me back to the point we’ve talked about a few times, which is very key and related to that exit strategy. That’s people are going to invest in something. So when you look at an absolute cap rate of 5%, you say, “Hey, I want to make more than 5% return on my money. Because five years ago, I was making 10% easy.” So that means that real estate isn’t a bubble; I should invest because the return is going to be half what it was before. But you’ve got to look at it relative to everything else. As Travis mentioned, keeping it in the bank is basically zero, no point to even talk about that return percentage is. He gave all other examples; so it’s the institutional players, syndicators, individual owners – if you are going to invest your money in something, your money is going to be somewhere. So just because the return is not going to be as high as it was, say five years ago — now, it might be. But even if it isn’t, it’s more a relative comparison as opposed to absolute numbers. I think that is something that’s also super important, and it definitely relates to the exit strategy.

Something you mentioned in the beginning is a blog post you wrote that we did a show on, about is now the right time to invest in real estate? One of the key things we talked about in that episode would be your risk tolerance. So as you mentioned, it kind of depends on what you want, how much risk you’re willing to take. But at the same time, keeping in mind that you have to put your money somewhere. And so just because you might think that it’s a little bit of a more risky time to invest in real estate, what’s the risk of doing nothing and is living in the bank, as Travis mentioned. Everyone says, “I wish we would have gotten in 5 years ago, 10 years ago.” There is always some time frame where they wish they would have gotten in. So five years from now, people are probably saying the same things about now.

And the third thing, because Travis was talking about the markets to invest in… It depends. You can exceed this 5% cap rate –that is just a national average– in certain places; you gave the New Mexico example.

Something else to keep in mind too is that the person or the group you’re investing with is also super important. Travis and I have a three-part episode on the three major risk points of apartment investment in particular. That would be the team managing the investment, the business plan/deal, and then the market. So you could invest in one of these amazing markets, but the business plan doesn’t fit to that market, or the team doesn’t know what they’re doing, and it’s not going to perform very well. You can invest in a really, really bad market on paper, but if the team knows what they’re doing, they’ve found some very niche business plan that works really well in this “bad market”, and they can perform very well. So it’s kind of balancing all three of those factors and knowing that people have been successful in real estate during all times since real estate has been a thing. So it’s just understanding what works and what doesn’t work depending on what part of the market cycle we’re in.

All these stats are very important, but also at the end of the day, you could be investing in a place that has the lowest vacancy rate, the most rent growth, but then the team doesn’t know what they’re doing, or it’s the wrong business plan, they’re still not going to perform very well.

On that same note, I’ve got a couple of other statistics that we’ll bring in, that I think are very fascinating, when it comes to how multifamily performed during the pandemic. Compared to all the other asset classes – retail, office, hospitality, industrial… Only industrial outperformed multifamily. Multifamily basically outperformed every other asset class, except for industrial, during the pandemic. Obviously, it was doing really well beforehand, but during this past 12 month period, it still performed really well. More specifically, vacancy rates dropped slightly, and now they’re, in a sense, basically back to what they were pre-2019. But we’re still talking about in the 4% range, which is still historically very, very low; the lowest it has ever been. Because for the book we’re working on, I did a very big deep-dive in the last five recessions, starting in the 1980s, and vacancies have just consistently been decreasing and slight little ticks up on the way, but overall going down.

Similarly, rent growth overall was negative over the past 12 months, but again, it dipped and then started of recovering. Loan origination is something else that we’ve talked about on the show before; those slowed down a lot in 2020. Volume is down 20%, but now the projections are that it’s going to rebound and be at just below the 2019 levels. So again, 2019 – a great year for multifamily. If 2021 is supposed to be from a vacancy, rent growth, or loan origination perspective, very similar to 2019, then it seems like we’ve bounced back.

One more thing that I want to mention quickly that maybe Travis had mentioned is that his article that these were based off of, these forecasts and projections, weren’t taking additional economic stimulus into account. It’s just saying if there’s no more economic stimulus, here’s what we think is going to happen. So that’s something else to keep in mind.

Travis Watts: Absolutely. That’s Freddie Mac, by the way. We can put a link somewhere or you can reach out to us for that link. But yes, it’s a Freddie Mac survey; very knowledgeable folks in the space. So just to piggyback off of those topics… In my mind, I’m trying to look at the pros and cons here. I don’t want this to be just a totally bullish “multifamily is the best, yadda yadda.” So let’s look at some of those cons in fairness. The unemployment rate is still high.

So when you’re investing in multifamily, it’s all about your tenants, it’s all about your renters and their ability to pay rent. People losing jobs is not a good thing; the government pulling away unemployment benefits – not a good thing, etc. These eviction moratoriums are still in place. There are still some negative elements to all of this. The unemployment rate, I believe, last I checked is still around 7%, which is still a little bit high. It did spike up drastically in early 2020 when lockdowns first happened, but it kind of flattened the curve, so to speak, at this point.

Rents in a lot of the largest markets are expected to remain depressed during this year. So it’s something to think about as a limited partner. If you’re doing these syndication investments, always look for conservative underwriting. If you’re looking at projections that we’re going to take written from 1,000 to 1,300 overnight, that’s probably not realistic. So just read through the lines there.

And then vacancy rate is expected to increase slightly on a national scale. But to Theo’s point, it really depends on the market that you’re in whether or not that’s going to happen, and that is just a slight increment. To the pros, more markets are expected to see rent increases versus not; that’s just looking forward. That’s through a bunch of different sources, not just Freddie Mac; that’s CBRE, Marcus and Millichap, on and on.

I just did a speaking event at the Best Ever conference and I tried to pull as many sources as I could from all different outlets just to paint the picture of what everybody “is thinking as far as forecasts go.” That would be very true in that case.

So the rolling out of vaccines, additional stimulus… By the time you’re listening to this, that probably would have passed, this 1.9 trillion stimulus package. We’re still kind of in the works on that at the moment. Long-term fundamentals of multifamily are still on solid ground as far as just supply and demand, the amount of renters we have, how expensive it is to build new products, how much time that takes versus what’s available now… All your fundamentals are there.

And yes, cap rates have compressed, but as we talked about, there’s still a margin there that still looks pretty lucrative to a lot of institutional buyers. So think ahead and think of who you’re going to potentially be selling your properties to. Yes, it’s a crowded space. We talked about that. I did mention Albuquerque and other examples. Kansas City, Missouri – they have higher cap rates out there as compared to… Even internationally too, you look at Toronto in Canada. We’ve got a lot of investors that are Canadian that I speak with, and there are like three caps out there in Toronto. So a lot of those folks are shifting over to bordering US to start looking into US multifamily, and single-family for that matter. So just something to keep in mind – London, Singapore, so many examples of lower cap rates than what we’re seeing stateside, especially in certain markets.

With all that, we’ve had a lot of disruption in 2020, we all know that. To your point, Theo, multifamily really held up well, at least thus far; we’re not completely out of the woods. But industrial did outperform, but most other asset classes didn’t. I’m continuing to invest, on a personal note… I did a lot of deals in 2020 myself in the multifamily space. I’m still very bullish, and no, I don’t think that we’re in a bubble per see, but I’ll leave it to you, the listeners, to decide for yourself if that’s a bubble, and perhaps there’s a strategy or an asset class you’re more familiar with that potentially has a higher yield with lower risk, etc. Then maybe that’s the right fit for you. But the way that I look at it from the complete landscape I see, this is still a great asset class, both for Main Street and Wall Street investing.

Theo Hicks: I appreciate you doing the cons as well as the pros, because I get very inspired… [unintelligible [00:15:49].21] “Oh, that’s great. Let’s invest.” So I appreciate you bringing those up.

I do want to bring up one thing I did forget – it was the moratoriums. We’ve got the eviction moratoriums… Because historically, when I did my recession analysis, when the recession hit, more people start to rent, because it’s traditionally cheaper to rent than to own. But I wonder, since the previous recession didn’t have the eviction or the foreclosure moratorium, that did have an impact on why some of the metrics during this time around were different than other recessions. I think that’d be something interesting to look at… Because recession happens, you lose your job, you’re not going to go homeless; you just downgrade to a smaller apartment or something. So the demand for multifamily goes up, and usually rents go up as well. Whereas now it seems [unintelligible [16:31] rents went down, and I wonder if it has to do with the fact that people didn’t have to leave their homes or their apartment. I think they have some sort of declaration.

So it sounds like, as Travis mentioned, when you listen to this, more stimulus is happening. That should continue to hold up and support multifamily, and then hopefully that continues until people can get back to work and pay their rent. Then once it goes away, things go back to normal.

You mentioned something too that I think would be good – people can definitely reach out to us. Email me, theo@joefairless.com, what your thoughts are on what we’re talking about today. This is kind of all speculative, we’re basing it off of different expert reports and forecasts… But again, none of this stuff is going to be perfect. They even say it in the report, these are all just averages and projections based off of certain assumptions and scenarios. So let us know what your thoughts are as well. If you think that a certain asset classes will perform better, if there are specific opportunities you see that you’re focused on, we’d love to hear that. If it’s a lot of info, maybe Travis and I can have a quick talk about it on the show or turn it into a 60-second question segment. Travis, is there anything else you want to mention before we sign off?

Travis Watts: No, I think we covered it. Appreciate it.

Theo Hicks: Perfect. Well, Best Ever listeners, thank you so much for tuning in today. Make sure that, as I mentioned, if you want us to answer a question on the show, we’re going to answer a fast question on our 60-second segment. Email me, theo@joefairless.com, with those question or questions. Thank you so much for listening. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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JF2382: Cap Rates, Waterfalls, And Preferred Returns | Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Theo and Travis will be answering the podcast listeners’ questions. They cover the topics of cap rates and return split structure. Even though some deals may look great on the surface and offer you great returns, you still have to do your due diligence and make sure that you know what you’re getting into. Theo and Travis provide examples showing how easily the numbers can be skewed or manipulated when it comes to projected returns.

We also have a Syndication School series about the “How To’s” of apartment syndications, so be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening.

Click here for more info on groundbreaker.co


TRANSCRIPTION

Theo Hicks: Hello Best Ever listeners. Welcome to another episode of the Actively Passive Investing Show. As always, I’m here with Travis Watts. Travis, how are you doing today?

Travis Watts: Hi Theo, I’m doing great. Thanks.

Theo Hicks: Yep, thanks for being here. Today, we are going to answer your questions. That’s right. We are now accepting questions from the Best Ever listeners. We received a few questions and we’re going to answer questions that were submitted by John this week. John, thank you for submitting those. As you can tell by the title of this episode, we’re going to be talking about cap rates, waterfalls, and preferred returns. Before we answer those questions, Travis, do you want to talk about why we’re talking about these specific topics?

Travis Watts: Yeah, I think you did a good job covering it. I think the bottom line is in the last three, four episodes, or so we’ve been opening up the ability to pre-submit your questions to us. We’ve been doing our best to keep up and try to do those either on a 60-second clip or on our episode. I thought you know, why don’t we just make a full episode of just questions that have come in over the last week. We won’t be able to get to them all, this is only a couple, but I wanted to dive in because I thought these are really great questions. So that’s kind of the backstory. Anyone who wants to submit a question, as always, theo@joefairless.com; submit any questions you have and we’ll do our best to address them or at least to email a reply if we can’t do that. So… Happy to do that.

I’ll just dive into question number one. I thought this was good. I want to paint this picture a little different than anything I’ve ever heard myself on how this is explained. The question is, how important our entry cap rates versus exit cap rates in underwriting? That’s a pretty big question, so I wanna tackle that.

I guess let’s first start with anyone that may not be familiar with what is a cap rate. I’ll give my quick and dirty explanation of it. If you paid all cash for a property, you had no debt, no leverage, no mortgage, that’s your approximate yield or cash flow on the property. If you’re buying a five cap million-dollar property, you pay a million dollars cash. After you pay your operating expenses, you might expect somewhere in the ballpark of $50,000 per year in cash flow. That’s a five cap. I did want to bring up a visual for anyone who’s tuning in on YouTube. Actually, I’ll get to that in just a second.

Let’s take a couple of different parallels. I like to sometimes use stocks as an alternative example, or maybe bonds even. We’ll start with bonds. So if I buy a bond, and I forget what the par values are, if they’re $100 or $1,000. It’s been a long time since stocks, bonds, and mutual funds for me. But let’s say it’s $1,000. I buy this bond and let’s say for example purposes interest rates are at 5% today. I wish they were; they’re not. But if they were. So if the treasury is at 5%, I’m buying a bond at 5%, and then interest rates drop to 4%, for example, the price of my bond is going to go up. I’ll use my arm as that example. So bond prices go up, that means interest rates came down, interest rates go up, that means bond prices went down. So why is that? Well, because I own a bond that has a 5% coupon attached to it, or yield. In today’s environment, if you go shopping for bonds you’re only going to find 4%, for example. Someone is willing to pay more for my bond because it has a higher yield. But ultimately, what’s happening is that’s going to shift it down to the current yield. So if my bond goes to $1,200, for example, someone pays that, they’re ultimately going to have a 4% yield, because that’s how those numbers work.

Now, let’s use stocks if that was a little bit confusing. I like to think of dividend-paying stocks in parallel for this example. So you have a dividend payer stock, $10 per share; the annual dividend is 60 cents. That equates to a 6% annualized yield on the stock.

So let’s say the market rises and we have a really big bull run, now that stock that was $10 a share is trading at $12 per share. But if this happened in a short timeframe, they may still be paying a 60 cent dividend annually. If that’s the case, then your yield just dropped from 6% down to 5%, because if you run the numbers, 60 cents divided by 12, you get a 5% yield. So same type of inverse relationship is all I’m trying to point out.

And then to that point, if you’re joining us on YouTube, this is from the Federal Reserve Bank of St. Louis and CoStar data, just so I’ll get that out of the way. This is US multifamily cap rates and the spread between treasury yield, which is basically interest rates, and then the cap rates on multifamily. You can see from 1981, which is where this chart starts, all the way up until about 2001 and 2002, we hovered around an 8% cap rate on multifamily nationwide as an average. Since 2002 it’s just gone down, down, down, and down, as interest rates have as well. So they are correlated. That’s the point I’m trying to make. We’ve basically halved the cap rates over time over the last 20 years or so.

What point am I making with that? At the end of the day, back to the question, “How important are entry cap rates versus exit cap rates and underwriting?” the way I see it as a limited partner, as an investor, or as an active real estate guy, all I’m trying to do is somewhat be conservative and predict the future. As we all know, things have cycles; the stock market has cycles, the bond market, the debt markets… Listen to Ray Dalio speak to this, he’s an incredible source of knowledge on cycles in general. But the fact is, we’ve been in a downward cycle for a long time. So what is the probability or likelihood –this is what you have to ask yourself– that maybe interest rates start to reverse and come back up? When is that going to be? If that happens, you can clearly see that cap rates are going to be associated with that.

We may go to an environment where today multifamily is at 4% or 5% cap rates, where now we start up-ticking again slowly, probably, hopefully… But to five, then six, then seven, etc. to kind of normalize. This could take decades, just to be clear. However, when you’re underwriting a deal in multifamily, you’re probably going to be in this deal for many years. So to me, it’s important to think ahead. Nobody has a crystal ball, nobody can predict the future, but what you can do is be conservative and say “Yeah, I see this downward trend here, and cap rates are at 4.5% or 5% today, so I’m just going to go along with that and say they’ll be 3% when I sell.” But that’s being awfully aggressive.

Theo and I talked about a story on the last episode of a syndicate group I was watching, I was vetting their deal, and that’s exactly what they were doing. They were saying “We’re buying at a five cap, hopefully, we’re going to sell this thing at a four cap, and these are our numbers.” The numbers looked incredible, and hopefully, they can pull that off. But what happens if it goes the other direction on them? Those returns are going to get halved. It’s going to look very ugly and they’re not going to hit their projections by any means.

So when you’re underwriting –we’ve talked about this a lot– if you’re buying something at a five cap, holding it five years, do a five and a half cap, maybe a six cap upon exit in your underwriting, just to be conservative. That’s the only point I was making with the chart here.

So to that point, yes, they’re very important, but it’s a lot to do with being conservative, and it’s a lot to do with your assumptions and just trying to predict the future as best we can as real estate professionals. So with that, I know it’s a long-winded question number one. Theo, do you have any thoughts on that question?

Theo Hicks: Yeah, super-fascinating. Thanks for sharing all that. Obviously, I agree with you because we talked about this multiple times… Making sure that the exit cap rate assumption is higher than the entry. Another way to look at it as well, at least on the front end, is that when you’re buying a deal, it’s obviously better to buy it at a higher cap rate than the market is. Because if I buy it based off of the current net operating income and the purchase price at say a 6% cap rate, but similar properties in the market are trading at a 5% cap rate, that 1% is basically just free equity I’ve created at purchase. So it’s good to know also what the entry cap rate is based off of the purchase price and the NOI versus the market cap rate.

Obviously, the opposite would be a problem. If the market is at a five, and they’re buying it at a four, that would be an issue. I wish we had a calculation, but if you just take a $500,000 NOI, and you just change the cap rate by like 0.1%, the value of that property changes so much. So if you do that calculation, it’ll show you why these are so important, especially the exit cap rate. Because changing the exit cap rate by a couple of decimal points might make a deal look really, really good… As opposed to just being an okay deal.

So as a passive investor, you don’t need to know every single aspect of the underwriting, but these cap rates, since they have such a dramatic impact on the value of the property, you want to understand how they’re coming up with these numbers.

Travis Watts: And that’s back to that story of that syndicate group, buying at a five, projecting a four. That’s just the simple way as an LP, as a passive investor, something to look for. We talked about red flags, we talked about due diligence, and underwriting, and whatnot… Just keep an eye out for that. Always ask. In that instance I shared on the last episode, they didn’t announce that in their webinar at all. They completely brushed over the entry and exit cap rates completely, and just showing folks “Oh, we’re going to get this 20% return” or whatever it was. It sounded great until I asked the question and I realized what happens. So… Red flag. Something to be aware of.

Theo Hicks: Exactly. So that was question number one. Question number two is how important are preferred returns versus having a straight waterfall split of 70/30. So we’ll define these terms really quickly. A preferred return is basically a threshold return that the GPs offer to the past investors. If they’re offered an 8% preferred return, then they get the first 8% of the ongoing cash flow. Then once the preferred return threshold is achieved, then the remaining money is split based off of the next step in the waterfall.

Whereas the other option which is a straight 70/30 split, there is no threshold return for passive investors. It’s just every dollar that is output as profit is split, in this case, 70/30 or 50/50. Then another term he threw in there was waterfall. Really, a waterfall is just like a written explanation of how the profits are distributed. So the first part of the profits go to the debt, and the next part of the profits go to the preferred return, and the next part might be unpaid preferred return, and then it might be the split, and then once it gets to a certain IRR, the split my change to something else. So these waterfalls can be pretty complicated, or they can be as simple as just “Pay the debt and then 70/30.”

Why is it important to have a preferred return? Well, it’s kind of like a protection for the passive investors and it promotes an alignment of interest between the GPS and the LP. If I’m investing in a deal and I know that I get the first 8% of the profits before the GPS gets paid, then they’re probably going to make sure that deal’s cash flow is 8% so they make their money… As opposed to if they just get paid regardless if it’s 1%, 2%, 3%, 4%, up to 8%, then the alignment of interest is a little bit different and I’m less protected, in a sense. I think it’s really as simple as that. I think it’s as simple as just an extra layer of alignment of protection, an alignment interest for the limited partners, and then knowing that “Hey, if this deal cash-flows 8% or lower, the GP is not going to get a portion of the profits. I’m going to get that.” I think it’s as simple as that. Travis, what are your thoughts?

Travis Watts: Yeah, it is kind of quite that simple. To your point, there are no guarantees with investing. This to me is kind of the next best thing. It’s saying, “Well, hey, look. I’ll give you the first 8% of a deal or whatever. 100% goes to you first, before I even start pulling out of it or splitting anything.” I like that incentive. I’ve done both as a limited partner, I’ve invested in both structures. I’ll tell you, part of my criteria today, 2021, is to always have a preferred return or what some groups call a coupon. The difference is really if it’s a limited partnership structure, an LLC structure, but not to get long-winded with that…

I did partner years ago in a deal, no preferred return, straight split, like exactly this question. I don’t know – call it coincidence or what have you, they stopped distributions for (in my opinion) not a great reason. I felt like it was just because they didn’t have to. There was no obligation, there was no pref, no expectation, whatever. So it baffled me. It’s like, “Why would you do that? You’re obviously going to turn off a lot of your investors by doing that.” But rightfully so, they did it.

For what it’s worth, I just feel like of all the deals I’ve done with preferred returns, I feel like –to your point Theo– it’s the GP saying “We better make sure this deal is performing and we better make sure our investors are getting paid, or we’re going to have some problems on our hands.” I just feel like it’s not even an alignment of interest, it’s putting the LPS first, which maybe seems a little selfish… But hey, you know, we’re the ones taking most of the risk anyway. So for what it’s worth, yeah, that’s the bottom line. It’s an alignment of interest, it’s something I look for. It’s something that everyone listening should put in their criteria, either way. I prefer just a straight split structure, I prefer having a preferred return. So those are my thoughts on it. Pretty straightforward. I think.

Theo Hicks: There’s one thing that I just thought of that I think confuses some people. I think this is a good spot to talk about. That’s the difference between when you’re reviewing a deal, the difference between the preferred return and the cash on cash return percentage. So you’ll see a deal where, for example, the overall preferred return is say 7% to you as an investor. Then you look at the investment summary and you say “Oh, hey, why are they saying that I’m only getting 5.8%, or 5.5%, or 5% (or whatever) cash on cash return year one? And then why is it at the end of the deal, the cash on cash return is 20%? I don’t get that, what’s the difference between that cash on cash return and the preferred return?” The preferred return is just again, a threshold. It’s not you’re guaranteed to get 7% forever and then that’s it, that’s all you’re going to get, there’s nothing else. That’s just like, “Hey, that’s the threshold. Up to that point, you get the cash flow. Then above that, it gets split. So if the deal cash flows below the preferred return, then you’re going to get whatever that cash flow is.”

Usually that difference between the preferred return that you’re offered, and the cash on cash return that you actually receive, that will typically accrue and be paid out at some point during the deal. It kind of varies from sponsor to sponsor. Let’s say that year two it’s 7%; well, then you get 7%. Let’s say year three it’s 8%, so you’re going to get your 7% plus whatever the split is of that 1%. You might get 0.77% percent, a 70/30 split. Overall, over the lifetime of the deal, all those percentages will be averaged to get you what your overall cash on cash return is.

So kind of overall, the cash on cash return is just based off of what you actually get, and the preferred return is just saying, “Hey, here’s the threshold. If it’s below this, you get all of it. If it’s above this, then you get up to that point, and then a split of what’s left.”

Travis Watts: Exactly. And there are different ways to catch up with a pref, while we’re on this topic. Ideally, how you’re going to catch up on a pref in your example, Theo, is if your property actually produced 5% in a year, but you have a seven pref – well you’re behind; you didn’t get the full pref. Ideally, through the performance of the property, you’re going to be able to catch that up. As rents and cashflow increases, you can eventually catch everyone up. If you can’t do that, you can catch up a pref through a refinance, for example, if there’s some equity to be had. Extract some of that, pay everybody up to their pref, maybe a little more, who knows, return the capital, etc. If you can’t do that, it can come from the sale of the property.

I had this happen – a property really went sideways in terms of the projections, but there was a good amount of equity in it. So when we sold, that pref got caught up first. So all the LPs ended up getting that pref and then we did a split on top of that. But unfortunately, we had to wait. So yeah, a lot of folks that are especially newer, are confused when they see a 7% pref, that “Oh, this thing is just 7% cash-flowing for five years.” That’s really not how it works. It could be below, it could be above, it could be at… It’s going to be all over the place. But pay attention to that in the underwriting when you see these deals, anyone who’s an LP or a passive investor.

What I see a lot of times is a deal will pop up in my email from some sponsor, and it’ll say “Average cash flow 9.5% annually.” I’ll think, “Wow, that’s incredible.” Then I’ll look at the breakdown, it’ll be like 5% year one, 7% year two, and then they’ll bump away high like 13% or something. What they’re doing is they’re projecting a refinance, they’re trying to manipulate the numbers,  and they’re trying to spin this thing off to the illusion that it’s just the 9% cash-flowing asset. It is not, by any means, that. So it’s important to dig a little deeper, ask the questions, do your due diligence, etc.

Theo Hicks: And we’ll do a show, because I like it when I go into more detail. We’ll do a show where we talk about the different returns that are offered. I don’t think we’ve done one yet. Because there are different cash on cash returns, equity multiples, IRRs, all this fun stuff. I think that could be a full show.

So we’ll stop there with answering those two questions. Again, if you want to have us answer your questions, either on the main show or on the 60-second question YouTube videos that we do, you can submit your questions to theo@joefairless.com. You can send one question or a list of questions, whatever you want. So, Travis, is there anything else that you want to mention before we sign off?

Travis Watts: I don’t think so. I think we hit it. So thank you guys for these questions and keep them rolling.

Theo Hicks: Yep. Keep them coming. Travis, thanks again, as always, for joining me today. Best Ever listeners, thanks for tuning in. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everyone.

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JF2375: 3 Immutable Laws Of Real Estate Investment | Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Theo and Travis are talking about three things that allow people to succeed in the real estate business. While many people focus on the markets, demographics, projections, and other specifics of the business plan, some fundamental things should be right about the deal for it to work. Occasionally, real estate investors get lucky and make a decent return even when some of these laws are bypassed. However, those are exceptions, not the rule.

We also have a Syndication School series about the “How To’s” of apartment syndications, and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening. 

Click here for more info on groundbreaker.co


TRANSCRIPTION

Theo Hicks: Hello, Best Ever listeners, and welcome to another episode of the Actively Passive Investing Show. As always,  I am your co-host, with Travis Watts. Travis, how’s it going?

Travis Watts: Hey, thrilled to be here.

Theo Hicks: Yeah, thanks for joining us, again. Thank you also Best Ever listeners for joining us. And today, we are going to talk about the Three Immutable Laws of Real Estate Investing. So Travis just told me beforehand that he just came across this article, and it’s something that’s been up on our website for – gosh, since 2016, probably, in the middle of the economic expansion. And we’ve kind of reiterated these points throughout the past five or so years, after the different elections and after the COVID pandemic hits… But right now, since we’re, I guess, technically, maybe still in a recession, we thought this would be a really good topic to bring up. And we also haven’t talked about it from the perspective of passive investors either; we were mostly focused on it from an active perspective.

So we’re going to go over these three immutable laws of real estate investing are, but first, as always, Travis is going to let us know why we are covering this and then I’ll kind of also go into a quick little myth that people have when they think about investing in real estate.

Travis Watts: Yeah, I appreciate it. Well, I think you did a good job covering why we’re covering it. But yeah, that’s my confession, is that this has been out there for years and years. And I’ve read so many of the blogs, and of course, the books. I’m sure I’ve skimmed across this, but it really just sunk in for some reason this week. I came across it, written years ago, and I thought, “This is really a foundational concept that everybody needs to be aware of, active or passive really”, but it was looking at it through the lens of being a passive investor. I really want to share and reiterate even if you’re listening today and you’ve heard this before in some other fashion, we’re going to dive a little bit deeper into it. I wanted to pick and share a few stories of how this has been true for me in my own experience.

If I’m not mistaken, Theo, you know better than I, but I believe this is really comprised of Joe interviewing thousands of different investors and putting together the most successful three points, basically, to investing in real estate. So for any regard, these are the things I followed myself, these things I firmly believe in, and they’re just laws or rules to follow, if you will, and good for both sides of the coin. So that’s it, what’s the myth that you want to cover?

Theo Hicks: So from the perspective of the active syndicator, one goal is always to make money for you. But the overall goal is at all times is to not lose your money; at the very least to conserve that initial capital, so that if something happens to the deal or to the market, at the very least, you’ll still get your equity back. That’s the number one rule of investing. I think that’s like Warren Buffett’s number one rule for investing, is capital preservation, right?

And so in order to do that, the syndicators focus on the different things that could happen to the investment that will result in you losing your money. So in apartment syndications, the three main risk points are going to be the business plan, the market, and then the team. So the team could mess up and lose your money, it could be a bad market and you could lose your money, or it could be the wrong business plan or the business plan fails and you can lose your money. And so the focus has to be on “Well, what are they doing in order to minimize risks in those three areas?”

Now, when it comes to the market, that is probably the least risky point. When I say market, I mean the  actual location, because you can make money investing in any market… People have invested in New York or in the middle of nowhere in Iowa, and they made money investing in real estate… As long as it obviously has some of the right metrics, and Travis and I have talked about this on the show before, how to evaluate each market, so I’m going to focus on that one as much. Obviously, there’s the team investing with the right GP, we also talked about that, and the other one is going to be the business plan.

So why is it that one apartment syndication deal can do really well in the exact same market, following the exact same business plan, and maybe by the exact same team, and the other one doesn’t do very well?  It comes down to, as Travis said, these three points we’re going to go over it. So these three points are things that Joe has learned from his experience and from interviewing people, that allowed people to be successful regardless of where they invest, regardless of what they invest in, or if they didn’t do well, here are the things that they realized that they should have done differently.

And so at the end of the day, there’s this idea, the myth of it’s all about the location, it’s all about investing in the perfect markets. It’s helpful, it’s beneficial, but at the end of the day, any operator following any business plan is not going to be successful just because they invest in some market that the rents are supposed to grow by 10%. There’s other factors involved, and the one we’re going to focus on today is going to be the actual business plan.

Travis Watts: Exactly. And I’ve shared that story before on our show, Theo, of where I was an LP in a deal with a syndicator early on, bought a really good deal, good price, good market, etc. but unfortunately, this particular operator couldn’t execute their business plan, made a lot of mistakes in regard to that… And it was just one of those situations where, yeah, the market definitely helped boost the rents, helped boost the equity, but it really was to no avail of the operator. So we exited early. It was kind of an unfortunate situation. But yeah, markets are important, location was important, but at the end of the day, none of us got our projected returns or what we hoped to get out of that deal. So – great points.

So the first law that we’re going to cover from Joe is buy for cash flow. This is obviously my biggest message to the world; any podcast, I’m a guest on, any blog I ever do, it’s always about cash flow. That’s my passion. That’s what’s made the biggest impact in life, which is why I resonate so much, especially with this particular law. So it’s the opposite of what most people think of when you say, investing or “I’m an investor.”

In fact, I remember when I worked in the oil industry, there was this guy that came up to me, somehow he found out that I was buying single-family rentals… And he goes, “You’re an investor, right?” A very intense guy. I said, “Well, yeah, I buy real estate, I buy rental.” He goes, “Yeah, I get it.” He goes, “Buy low, sell high. It’s pretty simple.” And he walks away, and I thought, “Well, not exactly.” In my opinion, that’s pretty much just wrong… Because yeah, you can make money doing that, but I wasn’t trying to buy low and sell high. I had buy-and-hold rentals at that time and I was doing vacation rental stuff and things like this.

So it’s just kind of funny that – think of it as the opposite of appreciation. Natural appreciation is going to come from that story I just shared with that LP deal, where people are moving to an area and inflation is growing, expanding employment, wages – that’s going to lift values naturally. But that’s pretty risky, because mostly that’s out of our control. We can’t really control what the Fed’s going to do, when interest rates are going to do. Think about Texas right now; everyone’s moving to Texas, right? Well, what if Texas, this year, comes out and says, “You know what, we’re implementing a 10% state income tax.” Well, that’s pretty much going to change a lot of stuff over there about why people are moving there.

So things can evolve, things can change out of your control. That’s why I’m a big fan of forced appreciation, which is value-add investing, where you’re buying something that’s outdated, that needs fixing up, and you’re forcing the value back into it, therefore, you can justify lifting the rents etc, in terms of that.

So another quick story about cash flow is when I used to buy single-family rentals. I intended to do a flip one time – this was one of my first flips – and I was into the budget initially, and what I thought would cost me maybe 10 grand was already at 16 grand, and I thought, “This isn’t going to work out. The numbers aren’t going to work. By the time I sell, and I pay the commissions, I pay taxes, etc. I’m not even going to make a return.” And the only thing that saved me was cash flow. I pivoted my business plan. I said, “You know what, I’m going to make it a rental. And that’s going to give me time to start collecting money, so that I can build back the cash reserves that I wasn’t going to get.” So that was really a life-saver and a game-changer for me to realize how impactful cash flow really could be.

So at the end of the day, buy for cash flow. As long as you’ve got a supply of people willing to rent, you don’t really have to care too much about what the market is doing; the market’s really hot, the market’s declining, the market’s stagnant… Hey, man, if you got monthly income rolling in, at the end of the day, like we talked about on our last podcast, just to use simple numbers. I take 25K and put it into a deal; that deal produces 25K in cash flow. I take that 25K and do another deal. I’m reducing my risk as I go along that daisy chain, because my real risk is in that first investment. As long as that’s stabilized and cash-flowing, I really have little to worry about. So kind of my long-winded rant there, but that’s law number one, buy for cash flow.

Theo Hicks: Yep. And your last example is the perfect reason why. So if you buy for cash flow, but you can still have a potential value-add play or a potential market-driven appreciation play. But that’s more of like a cherry on top, so to speak. It’s cash-flowing, that’s the cake. And then if you’re able to force appreciation or if the market were to increase the value of the property or the rents naturally, then that’s great, you make even more money. But if it doesn’t happen, you’re still going to hit your projections, you’re still going to make money, and even if the market tanks, you are still not going to lose your money, as long as you’re following law number two.

So all these laws, they all come together. You can’t just do one, you have to do all three, I forgot I mention in the beginning. All three of these come together; because Travis said, “Well, as long as there’s a steady supply of renters”, then you buy for cash flow and it’s okay, because you don’t really care what the markets doing, because you’re not going be forced to sell… As long as you also follow law number two, which is making sure you’re securing long-term debt. So whenever you’re investing in a syndication deal – unless you’re an institution or you’re a hedge fund – you’re going to get financing on the property. You’re going to get Freddie Mac agency debt in order to fund the majority of the project costs. Usually, the syndicators are going to raise 20% to 30% of the project cost from limited partners, and then the rest of the money comes from a bank.

Now, the law here is to secure debt that’s at least twice as long as the business plan. So let’s take a value-add business plan as an example. Let’s say the plan is to renovate 100% of the interiors over a 24 month period, and increase the rents by $100 per unit. So the business plan is two years; it takes two years to renovate all the units. So when the syndicators are going out and securing debt, they’ve got a couple of options.

One option is they can just find a two-year bridge loan that’s going to include all those renovation costs, which allows them to raise less money. But the problem is, well, what happens if they aren’t able to complete the renovations in two years? What happens if they complete the renovations, but they overestimated their rental premiums? What happens if, you know, let’s say a pandemic hits or something, two years in, and they are unable to hit those rental premiums?

Well, if they secure a two-year bridge loan, then they have no choice but to sell or refinance. And if they can’t refinance into agency loan because the deal isn’t stabilized, and they can’t refinance into a bridge loan because of what happened with the COVID pandemic, bridge lenders stopped lending – well, then they have to sell, and well, what if they can’t find a seller? They’re going to sell for a loss and can’t get all their money back, or they’re going to be foreclosed and they’re not going to get any of their money back.

So in order to avoid all those potential situations, the law says secure debt that’s twice as long as whenever the plan is to do any sort of refinance or sell or something. So in that example, you either secure a loan that’s at least four years, so that if something happens in year one or year two and you don’t hit their projections, then they can just wait, keep collecting the cash flow they’re making, make partial payments or no payments, but not be forced to do anything with the property or the loan. As I said, refinance— [unintelligible [00:15:31].16] or get foreclosed on. So at least two years is ideal. Some syndicators you will see that they’ll have a 5 year loan or a 7 year loan or a 10 year loan or a 12 year loan or even a 30 year loan.

And then the other option would be a bridge loan. Well, maybe they have to get a bridge loan for some reason. Well, if that’s the case, then they need to have the ability to extend that loan out to, again, that 2x period. So traditionally, bridge loans are about three years, but you can get multiple one year extensions. So ideally, they have a 3/1.1. So three, with the ability to have two one-year extensions to hit that 5 year mark, and that’s two times the business plan.

Travis Watts: Exactly. And what we’re really talking about, Theo, in all of this. I’m just zooming out, as you were speaking… I’m thinking, all this really is is reducing risk and being conservative. And that’s the foundation to me anyway of investing. Like you pointed out, Warren Buffett’s first rule “Don’t lose money”. Well, yeah, it makes sense, right? It’s pretty obvious. Who wants to lose money? So all of this is helping folks, active or passive, not lose money. That’s all we’re really talking about.

And so to that point, law number three is have adequate cash reserves. Sometimes I like to draw parallels, either to stocks or the stock market. In this case, what I think about is this personal finance. You hear all the time from the Dave Ramseys of the world, or the Suze Ormans or whatever, have six to 12 months of cash reserves on hand in case you lose your job, etc, so you don’t have to lose your house or not make your mortgage or rent, and these types of things.

Same concept here – when you’re underwriting or if you’re buying a property, I don’t care if we’re talking about single-family, multifamily, have cash reserves on-hand to cover the unexpected expenses, which are going to happen. I just used that example of my fix and flip earlier, where I budgeted 10, but it took 16. Well, fortunately, I had the extra six sitting around because I thought, “Yeah, that’s a possibility. I’m going to need some extra cash for something.” I did. What if I hadn’t had it? I could have been in a really bad situation.

So when you can’t cover your unexpected expenses – speaking to syndications, the theme of our show – you’re either going to have to do a capital call, which is collecting more money from your investors; that’s never a good thing. First of all, you don’t want that on your track record as a GP. Second, what investor wants to have to fork up money unexpectedly for a deal that they shouldn’t have had to do that for? That’s not a good thing. Or if you don’t do that, you might have to, to your point earlier, sell that property at a loss. No one wants that either. You don’t want that on your track record, and LPs certainly don’t want that; or you may have to just give the property back to the bank, whether that’s in a short sale, or a foreclosure, whatever. It’s not going to be good. These are not good options. So what saves you? Having adequate cash reserves.

So let’s get specific with it. I think Joe points out a couple things… And maybe this has changed, because this is a 2016 article; I don’t know if he’s got a different view on it. But still, the concept remains the same; have $250 per unit in cash reserves per year. That’s one thing. Additionally, you might want to have an upfront operating account of 1% to 5% of what the purchase price is.

So none of these things have to be exact; you might have a different take, a different opinion, a different percentage, a different dollar amount. The fact is, have adequate cash reserves. Don’t think optimistically, best-case scenario, “We shouldn’t have things pop up, there’s not going to be a kitchen fire, we probably aren’t in a flood zone, so that won’t happen. Tornadoes never come through this area…” Just expect that all of that is going to happen, and have adequate reserves to cover it.

And I’ll share with you one other story… I was actually in a syndication deal that we had to do a capital call unfortunately, for all of these reasons that we’re talking about… And it was unfortunate. It ended up being – I think, it was 10% of what we had originally put in. So you think, okay, I put in 100 grand or whatever—I don’t know what I put into that deal. I can’t remember. But let’s just say for simplicity, that’s what I did.

So all of a sudden, you get this email or this phone call, “We need you to put up 10k ASAP. Can you do it this week?” That’s never a good call. Even if you have the 10k, that’s not what I wanted to do with it. Maybe I had other plans for that money. So it does happen. It really does. So it’s something to think about, and pretty simple in concept; adequate cash reserves, pretty self-explanatory.

Theo Hicks: Yeah. So now, the only real change, at least as we’re recording this, would be that the syndicator is probably going to be on the higher end of the upfront reserves number, towards the 5%, because of the additional reserves that lenders are requiring right now. For some loans, it is up to 18 months of principal and interest, which is a lot. Usually, it’s 3-6 months. So as Travis said – and I like the way you said that – all these rules are to save you and save the syndicator if something happens. So buy for cash flow, making sure that you’re not forced to do anything, and making sure that there’s no capital calls… All the rules are just very, very conservative ways to make sure that you don’t lose your money.

And one last note on the adequate cash reserves is that if you don’t use this stuff, then you get it back. So if it’s not used, it’s not like the money just disappears, or the bank just keeps it. Because a lot of the things are acquired by lenders to be staying in the account for a certain number of months, and then it can be distributed or used for something else.

But yeah, all of these things are just ways to reduce risk. And by risk, I mean, losing your money. So just to quickly summarize – one, buy for cash flow; not market-driven or natural appreciation. Two, secure long-term debts. You are not forced to do anything. And then three is to have those adequate cash reserves, both upfront and then on an ongoing basis.  Travis, is there anything else that you wanted to mention before we sign off?

Travis Watts: Just to iterate how these three points came to be one more time, because I think it’s important and it’s a strategy I’ve used for years and years and years. And Theo, we talked about this – God, like, when we first started this podcast, one of the first episodes.

When I’m learning something new – let me give you an example unrelated to this. Let’s say something I don’t know much about, that I’m certainly not an expert in and that I want to learn. So let’s say interior decorating; it’s not really my thing. So if I were to want to know what to do with a house or a room or something, what I would do is I would hire, not one person and get one opinion, I’d probably hire three people and get three opinions, and I would do my own homework and due diligence and whatnot. I would end up with maybe let’s say 10 different ideas, and then I would find the commonalities. So let’s say out of 10 different opinions on a living room, seven people said, “You really ought of paint this wall a lighter color. Maybe a neutral gray or something.” I’m going to take that and hone in on that. That’s what these three points are, are interviews with thousands of real estate investors and finding the commonalities; how many people say, “Buy for cash flow. Be conservative in your underwriting. Have adequate cash reserves. That’s what these are. This isn’t just one person’s opinion, “Here’s what I think about real estate.” That doesn’t really matter. I think what matters is a survey of many successful people. And that’s something to keep in mind and why we did this show.

Other than that, anyone listening, if you guys have an idea for topics or any questions, please email theo@joefairless.com and we’re happy to implement that onto one of our shows.

Theo Hicks: Yep. And then also kind of on a similar note, we’re doing something even more specific, which is our 60-second question. The same – email us topics or questions you have, and then we’ll kind of decide if it makes sense to do it on this show, or if we’ll do it on a 60-second question episode, which we have on the YouTube channel.

Travis, thanks again for joining us. I’m glad we got to dive deep into the three immutable laws of real estate investing. Best Ever listeners, as always, thank you for listening. Have a best ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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JF2368: The Case For Multifamily Real Estate in 2021 | Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Theo and Travis will be making a case for multifamily real estate as an asset class. This episode builds on previous episodes of the Actively Passive podcast that covered various industry reports and showcased in-depth information about the multifamily market.

This time, Theo and Travis are explaining why multifamily real estate is a great choice for passive investment in 2021. And while there are many nuances for each market and specific deals, some common indicators show how profitable and secure the multifamily asset class investments can currently be.

We also have a Syndication School series about the “How To’s” of apartment syndications, and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening!

Click here for more info on groundbreaker.co


TRANSCRIPTION

Theo Hicks: Hello Best Ever listeners and welcome back to another edition of the Actively Passive Investing Show. As always, I’m your co-host, Theo Hicks, with Travis Watts. Travis, how are you doing?

Travis Watts: Hey, Theo, doing great.

Theo Hicks: Well, thank you again for joining us today. Best Ever listeners, thank you for joining us as well. Today we’re going to give you a Case For Multifamily Real Estate in 2021. There is a question mark in the title, but for me it’s an exclamation point. The Case For Multifamily Real Estate in 2021.

Travis and I have done a few Actively Passive Investing Shows in the past on very detailed, in-depth, well-researched multifamily reports, commercial real estate reports, going over a lot of stats and data on specifically why there is a strong demand for multifamily; some of the forecasts for commercial real estate in general, but also multifamily for 2021 and beyond. So based off of our backgrounds, as well as our reading of those reports, we kind of threw together a list of different points that support investing in multifamily, specifically in 2021 and beyond. A lot of these metrics will kind of give you an idea of what types of metrics indicate a demand for multifamily, what types of metrics show that a certain asset class is going to be strong; how do you know that a certain asset class is going to be strong. So those are the things we’re going to talk about today.  We’re gonna be keeping it pretty high level. If you want to check out some more detailed analysis, again, check out some of our other Active Passive Investing Shows. There are also lots of different really solid real estate reports out there that you can find as well.

Travis Watts: Absolutely, Theo. I think for me anyway, the purpose of this particular show episode is that, to your point, we’re hugely going really in-depth on something very specific. What are the top 10 markets for 2021, or how does a cap rate work, or whatever it is… The way I envisioned this is I’m sitting at a table, I’m introduced to somebody I don’t know, they say, “What do you do?” and I say “I invest in apartments” and they say, “Oh, really? Tell me more. Why would you do that?” So this is just kind of that high level, I’m kind of making the case for why I do what I do. So it’s just kind of some general thoughts.

I’ll kick it off with something that we talked about several episodes back, I can’t remember which one it was, but it’s about cash flow strategies. I’m such a huge advocate for investing in things that produce passive income, or cash flow, or dividends, or interest… And personally, part of my criteria is on a monthly frequency. And the reason is because when I have a whole portfolio stacked up with monthly-paying, cashflow-producing assets, yes, I’m living on a portion of it, but then anything I’m not using, I’m able to quickly reinvest into other assets that produce even more cash flow. Therefore, what’s important about that, that little circle of life right there, is the way I see it, I’m reducing my risk.

So let’s say I have to go out there in the world and I have to earn an income, and I pay my taxes, and I’m left with my net amount of cash. Well, I take that cash and I initially put it into some real estate, let’s say. So that in my mind is where I’m taking the most risk. In fact, all the risk, that first investment. But as that investment starts kicking off more cash flow and more income, and I take that and then buy another asset over here, then I’m taking significantly less risk. Because even if that new investment that I just made over here falls apart or goes to zero, or whatever happens, I still have my initial piece of real estate. So I still, in my mind anyway – I’m sure some people probably don’t agree with this – but it’s almost like I’ve taken no risk on the last investment that I made, because I still have everything that I started with, hopefully, and then some.

So that’s the primary reason. We’re going to get into a lot more in this episode, reasons for multifamily, and apartments, etc. But at the top of my list, it’s all about cash flow and passive income. I’ll leave it at that.

Theo Hicks: Yes. Like all transactions, it’s all about supply and demand. So for real estate, for multifamily, I like looking at supply as two different things – it’s the people, and then the properties. People need to live somewhere, every person needs a place to live, so how many units are there for people to live in? So as the number of people goes up, if the units stay the same, then demand for those units is going to go up. If the people stay the same, but the units go up, then the demand for those units is going to go down. When the demand goes up or down, that impacts the amount of rent that can be charged. It’s kind of a simple calculation.

When it comes to determining where supply is at, there are places you can see the number of units constructed. Those are kind of good to understand compared to the previous year, but I really like the absorption rate, because that basically tells you over a certain period of time, there are this many available units; what percentage of those units have been occupied? That doesn’t really tell you how many years are being constructed, but it kind of shows you what the demand is for the units.

So obviously, an increasing absorption rate indicates that there are less units than there are people. If it’s going down, then there are more units than there are people. [unintelligible [00:08:28].11] real estate reports – you’ve probably heard this before, it’s the affordable housing crisis. There’s a very limited supply of affordable housing because of the costs to make multifamily, and the amount of rents you can get. All the new construction is going to be A class, because it costs a lot to develop the property, so you need to get a lot of rent in order to cover all those costs. So it doesn’t financially make a lot of sense to do new development for C class or B class properties. It’s usually going to be an A class range in really nice markets.

Since the supply of B class, C class, affordable housing isn’t really going up  –it might even be going down, because they’re getting fixed up and brought to a higher level– but the number of people that need that housing, especially now because of the current recession that we’re in, that is a big plus for multifamily, from a supply and demand perspective. This is kind of reflected in the rent growth.

I just did a blog post a few weeks ago about the rent growth forecast. The 10 markets where rents are going to grow the most in 2021. What you realize when you read these things is that these are all, again, forecasts, and it could be higher, it could be lower… But when you look at 2020 rent growth, and then 2021 forecasted rent growth, they’re not in these massive, big markets.

The market that grew the most in 2020 was Boise, Idaho, of all places. So they’re not these A class markets, they’re these secondary and tertiary markets. On the one hand, you can see that okay, there’s a lack of affordable housing, and then in these areas, the rents are going up. So if you are a passive investor, you might want to consider looking at, again, these value-add type plays, where they’re buying the C class, B class properties, in areas that have experienced rent growth, that has beaten the national averages over the past five years, and is projected to continue to beat the national average over the next five to 10 years, and investing in those places. You can still do well investing in new development deals and things like that, but at minimum, you’re always going to have this demand for these affordable housing until something changes where it becomes really cheap to build again.

Travis Watts: Absolutely, Theo, great points. Two other things I was just thinking about is — I want to give a different kind of spin on what everybody’s pretty familiar with, which is the appreciation aspect of real estate, and the depreciation aspect. But I want to take it a step further and paint a different picture.

A lot of people think of appreciation in the sense that, “Oh, I’m going to buy this property – whatever the property is, single-family, multifamily, etc. – and I’m going to sit on it for numerous years. Hopefully, the market is just going to lift the value, and (to your point) supply and demand, and one day, it’s going to be worth more.” As we all know, our grandparents and what they paid for their single-family homes way back when, $20,000 for a house that today is $500,000. Well, that’s certainly one way to look at appreciation. The problem with that is markets don’t always just go straight up. As you know, what about 2008, ’09 and ’10? Sometimes markets go down. So solely relying on just market conditions for appreciation, I think, is a mistake. This is why I invest in value-add properties, because we are forcing the appreciation. We are buying something that’s already at a discount because it has some problems; we’re fixing those problems, we are raising the rents.

The whole name of the game in multifamily is net operating income. We either have to increase revenues and/or cut expenses. And then your NOI (net operating income) goes up, and then your property is more valuable. A lot of single-family investors don’t necessarily think about it that way, because NOI really is almost irrelevant in the single-family space; it’s more based around the comps in your area.

So that’s one thing to think about with appreciation. The good thing about real estate, generally speaking, is that it’s kind of an inflation hedge. So if you believe the Fed and their projections that inflation is 2%, then theoretically your property is going up approximately 2%. Either you can raise your rents 2%, or the cost of materials to build goes up 2% a year… So yeah, in theory, over time, the property’s worth more. But guess what? It’s gotten eaten up too with inflation, so maybe it’s really not worth anything more.

So something to think about there is, think about it like buying a stock. If you could find a really solid company that, for whatever reason, just had a big dip, because the whole market went down, like we saw last year in March and April… If you’re able to pick that stock up at a 30% discount and it recovers, now you have a 30% buffer. So the market could collapse again 30%, but you still wouldn’t be losing any money. You’d be at breakeven at that point. That’s just how I like to invest, and a different way to think about appreciation.

Now for depreciation, this is where we get into taxes, and Theo and I certainly aren’t CPAs or tax professionals, so certainly seek out your own licensed advice on this… But real estate has some tremendous tax advantages with bonus depreciation, with cost segregation studies that you can do, mostly applicable in the multifamily space… But the bottom line is, to the point of my first topic when I was talking about reinvesting cash flow and then lowering risk – well, if I’m not having to pay 35 plus percent in taxes on my cash flow each year, because I have more depreciation than I have cash flow, then I’m able to reinvest that cash flow over and over again, where otherwise I wouldn’t be able to.

If you ever look at these compound interest charts – I’m sure most of us nerds out there, myself definitely included, are always running these calculations of the phenomenon of compounding. But if you ever throw in the equation of, assume that you paid 35% tax, it’s incredible. We’re talking over time, millions and millions of millions of dollars in difference, just because you were paying taxes along the way. It’s certainly a killer of returns, hands down.

So another reason I invest in real estate in general, single-family, multifamily syndications, etc, is the tax advantages and the fact that I can keep rolling that forward, and that they’re tax-favored. If I’m holding a property, let’s say longer than 12 months, now it becomes a long-term capital gain, which is tax-favored, as compared to just getting interest in the bank, for example, something like that, which goes into your ordinary bracket up to 40% plus, that kind of thing. So those are two more high-level thoughts I just thought of.

Theo Hicks: A quick follow-up on the appreciation. I think I brought this up a few times on the show, but I really liked his thought process… It’s from the first webinar that we did for the Best Ever conference. They’re talking about should you buy or should you sell, or should you hold in 2021. It was a tax specialist, and she was saying something changes in the tax code. It’s going to, in a sense, impact all investments very similarly. Some might be impacted, more or less; everyone’s going to be in the same boat. So are you just going to stop investing period, or are you just going to find the best investment for the time being?

I think we’ve talked about this [unintelligible [00:15:41].26] maybe you don’t get 10% returns, but you’ll get 5% returns when everything else is going to be zero or negative. So when you’re talking about appreciation, it kind of triggers my thought process… Because like, look, even if that cap rate part of the equation makes it so that values go down — and it’s not just real estate value is going to go down and everything else is going to be completely [unintelligible [00:15:57].28] The stock market is probably going to go down too, other investments are going to go down too.

So when you have that other metric of the forced appreciation, you can offset and maybe even completely overcome any dips in the market by forcing that appreciation up. And then it’s even better if you’re investing with a company that is very conservative with their underwriting and even assume that in five years from now we’re expecting the market to be worse than it is now, so that if it’s not, then the value is appreciated even more.

We’re talking about the case for multifamily, and when you’re investing in these value-add force appreciation type deals, and the markets doing really well, then you’re going to do even better, if the market is not doing very well, then you’re really better than what you do if you’re investing in something else that was completely reliant on the market that’s not doing very well.

We have other points, too – the back-end buyers. Last week we talked a lot about the exit strategy. Who’s going to buy multifamily? Right now, I know Travis has talked about this a lot, but the returns on other investments are either really low or not very stable. A lot of these big hedge funds are buying real estate, they’re buying stabilized, turnkey, low headache real estate in order to get that 5% consistent return that they can’t really get anywhere else. So when you are investing, again, with value-add, or really investing with anyone who plans on stabilizing the property, which I don’t know why they wouldn’t stabilize the property, then you can have confidence that on the back end an institution is going to buy this property from them.

Travis Watts: I was just going to caveat one thing that you mentioned that’s critical for everybody listening to understand – when you’re saying a 5% return, we’re talking about an unlevered return. We’re talking about institutional capital, buying an apartment community with no debt, no leverage. That’s what a cap rate is, essentially, when you’re buying at a five cap. So these institutional players, just to clarify your point Theo, are looking around and saying, “Treasuries are paying 1%, and bonds are paying 2%. So hey, 5% sounds pretty good.” And if you’re not using any leverage or debt, you’re taking a lot less risk, therefore this may be pretty comparable to buying a bond or a treasury, at least in my opinion. So that’s kind of their perspective from an institutional standpoint. This is a pretty high-yielding asset without taking on a lot of risks, if we’re not going to lever it up with debt.

Theo Hicks: Thanks for clarifying that. So because of a demand from these institutions for that type of real estate, then not only can you benefit from what we talked about already – the cash flow, the appreciation, the tax benefits, the cash and the rent growth, the demand and the supply – we can also have confidence that once they sell this thing, someone’s going to buy it. They might say, “Oh, well, who’s going to buy this thing on the back end if the market is not doing very well, the market takes a dip?” If it’s going to perform better and be a lower risk than other investments, institutions aren’t just going to do nothing and just sit with their money; they’re going to invest in something. And this is going to be one of their better options, especially now.

And then from your perspective, to even reduce your risk even more – because whenever you do research on some of these real estate reports, you’ll see the national average for everything. Some things are better than the national average, some are less than the national average, and then if you get to look at, say, 2019 data forecasts and then what actually happened in 2020, maybe some that were supposed to be the national average didn’t, maybe ones that were not supposed to beat the national average did it… It’s kind of hard to be perfect, especially in 2020, especially. So a good way to minimize risk even more, is to diversify across multiple markets. So possibly invest in some primary markets, but then also do some tertiary markets and some secondary markets. That way, they might not necessarily do as well if you had put all your eggs in one basket and we’re right, but you aren’t going to do as bad if you put all your eggs in one basket and we’re wrong. Diversifying across these different types of markets that have different pros and cons can help you participate in the national average, and hopefully outperform that. But since you’re in multiple places, then if something happens to not perform how it’s opposed to, then the ones that did pull you back up and make sure that you’re keeping your capital, and it’s growing, and you’re making that cash flow.

Travis Watts: As part of the beauty of being a limited partner, I highly value diversification. It’s a lot of the reason why I left doing single-family investing, where I had a portfolio of single-family homes, into multifamily, is so I could pull that equity out and I could redistribute it in smaller amounts nationwide, in markets where I was kind of placing a bet on, with operators who, quite frankly, are doing things a lot better than I was. So I’m huge on that, absolutely. We covered the top 10 markets, as you pointed out, a couple of episodes ago. So in theory I was able to liquidate those single-family homes and go put 25K here, and 50K here, and 75K there, and spread that across those top 10 markets, give or take. So great points, Theo.

Another thing, since we’re talking about single-family and multifamily, is the safety of your capital. So this is something I got really uncomfortable with. Let’s take an example of a single-family house rental and multifamily asset, both leveraged, meaning that we have mortgages or debt on apples to apples that way.

So with a single-family homes, the ones that I used to own, when I had a renter in them, and I was getting the rent payments on time and in full, I may have been a few 100 bucks cashflow-positive every month. But anytime a tenant moved out or didn’t pay me rent, not only did I not get the few 100 bucks, I went severely negative, because I still had property tax, insurance, and HOAs in my mortgage payment. So I might have been $1,000 underwater. So that 300, 300, 300, 300 just goes away if in month number five I don’t collect a rent payment, for whatever reason… In addition to all the maintenance issues that pop up with roofs, and HVAC systems, etc. A lot of times my cash flow was wiped out for the entire year, just because of an unforeseen whatever, that kind of thing.

So I got to thinking about risk, and I thought, “Man, if I had five properties, and even three of those I wasn’t getting rent for whatever reason – maybe a flood, tornado, or just a coincidence – I might be in pretty bad shape.” I don’t have thousands of dollars per month to cover in expenses. and I certainly didn’t have enough cash flow from my other properties to cover that.

So in multifamily, let’s use a 100 unit apartment building just as an example. A lot of times you can find these and underwrite these properties at, let’s call it, a 60% breakeven occupancy, just to use simple numbers again. That means out of my 100 units, I could have 40 tenants not paying rent or not occupying the units, and I’m still at a break-even. I’m not losing money, I’m at break-even on the property in terms of cash flow. So to me, that’s really about safety and risk reduction, and it’s a big reason I really like multifamily, which is obviously the topic that we’re covering here.

In addition to the last thing – I know I already covered it a little bit, but the inflation hedge of “We can bump rents based on what the inflation rate is”, the materials get more expensive to build these types of products, therefore our product becomes more valuable… So it’s a huge topic right now, Theo, and everybody listening, if you haven’t been tuning in, the Fed is just pumping trillions of dollars into the system. We’re going to see inflation. I don’t know what percentage, I’m not that smart, I don’t know how that’s really going to pan out…And hopefully, it doesn’t end up as hyperinflation, like we’ve seen in Venezuela, or back in Germany in the 20s and 30s, or Zimbabwe… But I do think this 2% inflation is perhaps a little bit of a joke, looking forward to the next decade.

So you want to be in something, in my opinion, that’s an inflation hedge. And if you’re leveraging, like we’re talking about, if you have a mortgage and debt, you are locking in today’s dollars in that debt, and then paying them off with cheaper dollars. The more we inflate and the purchasing power goes down, the more money we have to pay off that pre-existing debt. So all in all, big fan of real estate in general, but multifamily, for those reasons.

Theo Hicks: Yes. And then to kind of  close and summarize… The thing to think about here isn’t, “Is me passive investing in multifamily going to help me double my money in a certain amount of years, or get 15% annualized return?” I think the better approach is to compare it to everything else.

I’ve kind of said this multiple times in the show, but unless you’re just going to keep your money in the bank or under your mattress, you’re going to invest it in something. So what is the best vehicle to invest in? What is the ideal vehicle to invest in when the market is doing well, or when the market is not doing really well, or when you think the market is not doing very well, or you think it’s doing very well… The point of all these things is to say “Hey, look. These are all the different things that multifamily has going for it that allow it to obviously perform really well when the markets doing well, but most things do well. But what happens when it’s not performing well?” What happens if there’s a dip, or as we talked about inflation, or a recession, the stock market crashes, or whatever… People are going to need a place to live, and you’re going to need a place to invest your money. So those two things being true, real estate is a very good place to park your money.

We’ve also kind of went specifically why we think that multifamily is one of the best places in real estate to park your money, especially when it comes to single-family, especially if you’re passively investing. Actively investing is a different story. We’re talking about passively investing, what should you passively invest in… And Travis kind of went over specifically his story about single-family homes versus multifamily. There are a lot more advantages to that as well. We do have a couple of blog posts comparing single-family and multifamily at joefairless.com; just type in SFR versus multifamily on there and that will come up. But that’s how I approached this, is “Look, you’ve got to invest in something. What should you invest in? Multifamily, and here’s why.”

Travis Watts: I’m glad that you brought that up. Again, you brought up looking at the surrounding options. I did an episode on our show a few episodes back, just solo, about what kinds of things in our market today are yielding approximately a 2% return, or a four, or a six, or an eight, or a 10. Just giving examples to think about. Not suggesting all of these will always produce this kind of cash flow, but it’s something to think about. I’m still bullish on multifamily, for the reasons we talked about. Mostly because institutional capital is looking around saying, “Well, 1% over here,” “2% over there,” or “Oh, 5% over here.”

So think about this – a lot of people have trouble wrapping their heads around where cap rates are today in real estate in general. Let’s say nationwide they’re around 5%, on average. Let’s say that they go to 2%. Your immediate thought might be “Oh, well, I’m out. If it’s a two cap, that’s crazy. I’m not investing in real estate.” What if you look around and the bank is at negative interest rates, you’re having to pay the bank to store your money, and bonds are negative, and what if there’s no such thing as yield, except for real estate that yields a 2% return? That’s probably going to be your best option then. You’re going to want to make any kind of return whatsoever. You always have to be matching it up against the surrounding options.

In another scenario, let’s say that cap rates are 2% on multifamily, but municipal bonds are 4%, which would be a crazy world. But if that were the case, maybe that’s a better option to place your capital, because you might get a tax-free yield at a higher interest rate, and these kinds of things.

So you always have to be kind of looking at the landscape and understanding what Main Street investors are looking for and chasing, and institutional, and from our last episode, understanding what the exit strategy is, who are you likely going to be selling to. Anyway, with single-family, that’s going to be individuals. That’s going to be Main Street people. With a 500 unit apartment building, that’s probably going to be an institutional buyer more than likely. So things to think about, those are my final thoughts

Theo Hicks: I like that, looking at what are these big institutions doing, and then assuming that they know what they’re doing; they have some information that they’re basing the decisions on when they’re investing hundreds and billions of dollars. It kind of reminded me of something we talked about a while back when we were talking about how to analyze the GPs market; something else that you do as well, like, “Okay, if a Fortune 500 company is moving to this market, they have a big team who’s analyzing the entire country to say where should we move our corporate headquarters, based off of a variety of metrics.” So if you’ve got a bunch of Fortune 500 companies going somewhere, or you’ve got some big Fortune 500 company buying a bunch of real estate somewhere, they’re probably onto something. You can use that as a guide, where to invest market-wise.

Same thing here – what are the institutions doing? Are they investing in multifamily? Are they investing in bonds? Are they investing in the stock market? What are they doing? Then figuring out why they’re making that decision. They’re not just randomly investing in multifamily; they’re doing it for a specific reason. So that’s another way to guide you to where to test things out. Anything else you want to mention, Travis, before we sign off?

Travis Watts: No, I think that’s it. All in all, to conclude, I’m still bullish on multifamily for 2021, and looking forward, I’m still investing. I did more deals personally in 2020 than I’ve ever done in any given year, and we’ll see how this year pans out. That’s my opinion on it, for what that’s worth… That’s all I got.

Theo Hicks: Perfect. Thank you as always, Travis, for joining us today. Best Ever listeners, thank you for tuning in. One last thing to mention before we sign off – we are doing a new shorter segment on YouTube. We’re calling it the 60 Second Question. So you submit your Actively Passive Investing questions if you’re watching on YouTube in the comment section below. If you’re listening to the podcast, you can just email me directly at theo@joefairless.com, and Travis and I will read your question and your name, and then we’ll answer it in 60 seconds or less. We’ve got a couple of videos already up on our YouTube channel, so make sure you check that out. If you want to have your question featured, again, email me at theo@joefairless.com.

Again, thank you for tuning in. Best Ever listeners have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

Website disclaimer

This website, including the podcasts and other content herein, are made available by Joesta PF LLC solely for informational purposes. The information, statements, comments, views and opinions expressed in this website do not constitute and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action. Neither Joe Fairless nor Joesta PF LLC are providing or undertaking to provide any financial, economic, legal, accounting, tax or other advice in or by virtue of this website. The information, statements, comments, views and opinions provided in this website are general in nature, and such information, statements, comments, views and opinions are not intended to be and should not be construed as the provision of investment advice by Joe Fairless or Joesta PF LLC to that listener or generally, and do not result in any listener being considered a client or customer of Joe Fairless or Joesta PF LLC.

The information, statements, comments, views, and opinions expressed or provided in this website (including by speakers who are not officers, employees, or agents of Joe Fairless or Joesta PF LLC) are not necessarily those of Joe Fairless or Joesta PF LLC, and may not be current. Neither Joe Fairless nor Joesta PF LLC make any representation or warranty as to the accuracy or completeness of any of the information, statements, comments, views or opinions contained in this website, and any liability therefor (including in respect of direct, indirect or consequential loss or damage of any kind whatsoever) is expressly disclaimed. Neither Joe Fairless nor Joesta PF LLC undertake any obligation whatsoever to provide any form of update, amendment, change or correction to any of the information, statements, comments, views or opinions set forth in this podcast.

No part of this podcast may, without Joesta PF LLC’s prior written consent, be reproduced, redistributed, published, copied or duplicated in any form, by any means.

Joe Fairless serves as director of investor relations with Ashcroft Capital, a real estate investment firm. Ashcroft Capital is not affiliated with Joesta PF LLC or this website, and is not responsible for any of the content herein.

Oral Disclaimer

The views and opinions expressed in this podcast are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action. For more information, go to www.bestevershow.com.

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JF2361: The Importance Of Having An Exit Strategy At The Start | Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Theo and Travis will discuss the importance of thinking about the exit strategy before entering a deal. In a way, this is not the topic that gets covered often since most investors are not thinking ahead far enough. However, selling the asset is a vital part of the investment process.

Travis gives an example of how something that looks like a great buy at first can turn out to be a lemon if nobody wants to take it off your hands. And just because a property is at a great acquisition point, it doesn’t mean that you should jump into the deal.

We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening!

Click here for more info on groundbreaker.co


TRANSCRIPTION

Theo Hicks: Hello Best Ever listeners and welcome to another edition of the Actively Passive Investing Show. As always, I am your co-host, Theo Hicks, with Travis Watts. Travis, how are you doing today?

Travis Watts: Hey, Theo. Hey, everybody. Happy to be here.

Theo Hicks: Thanks for joining us. Thanks for tuning in, everyone. Today, we’re going to be talking about how to plan for the end. Very ominous, but we’re talking about the exit strategy. A lot of real estate podcasts and content are really focused on the upfront – finding deals, finding GPS from a passive investor perspective, analyzing the deal, understanding the team, and then how to fund the deal, how to get the ongoing evaluations and recaps… But there’s not a lot of focus on the end of the game, what happens at the end of the business plan.

A very common truism in real estate is that you make money on the buy, but in reality, they’re saying is that when you buy it, whatever the price that you buy that is going to impact the amount of money you make at the exit. So really, what we’re talking about is the exit. So what we wanted to do today was go over some of our thoughts based off of a blog post that someone on our team wrote… Our thoughts on how to understand the exit strategy, why it’s important, the different types of an exit strategies, the pros and cons of each… Because if you do make the most money at the exit, that’s probably the most important thing to actually know. And since people don’t talk about it a lot, Travis thought it’d be a good idea to talk about it today. With that said, Travis, do you want to, as usual, introduce in more detail why we’re covering this topic and give some background from your perspective as a passive investor, maybe when you realized that the exit strategy was actually one of the most important aspects of passive investing?

Travis Watts: Absolutely, Theo. I was skimming through joefairless.com the other day, and I just came across this mere coincidence… I just had one of those light bulb, epiphany moments… Being that I’m the director of investor relations, and I talk to investors all the time, I got to thinking of the questions I get asked all the time, and this is certainly not one of them… And I thought, why is that? Everyone’s so concerned with what’s the year one projection, and the cap rate, and the purchase price, and all these things, and analysis paralysis upfront… But what about your ability to sell the asset in general?

I just thought of this just now as you were doing your intro… I remember when I first got started, I was maybe a year into real estate, it was like 2010 or something. I went to this conference and they had an opener, someone that came up before the main act, which was about fix and flips and stuff… And they were trying to sell this tax lien investing software platform or something like that. And I got duped, I bought it. It was a couple grand. It was free information I could have found online. But the funny thing was, I got into this platform they were selling and I started searching for things, and a lot of this stuff was more or less swampland. I’m thinking, “Yeah, it’s cheap. You might be able to acquire this land. It’s very inexpensive. How cool is that? But who wants swampland? Who are you going to sell that to?” So you really could get yourself screwed in something like that, and it was a little bit scary. I did a little bit of a step back, thinking about the bigger picture there and the exit.

When it comes to value add deals – this is why I really want to bring up this topic today. Value add deals, for those that may not be familiar – we talked about this on our last episode, but it’s a strategy where you’re buying a pre-existing asset that’s got some problems of whatever type, you’re going in and fixing those issues, and you’re raising the rents over time. I’m simplifying the strategy, but basically, if I had to put a percentage to it, roughly 50% of your return is coming from cash flow and collected rents as you hold this asset. The other half comes from the equity upside, which is the forced appreciation when you go to sell. So really what we’re talking about is your exit strategy could be 50% of the equation, yet nobody’s talking about this. So I thought we have to bring this up on the show.

I’ll share one more story. I’m in a lot of investor meetup groups and there was this one in particular that I was at… It was kind of this newer syndicator, and he’s up there presenting to the group, and he says, “I tried to chase these 100 unit properties, give or take; anything from 75 units to maybe one and a quarter, somewhere in this sweet spot.” He said “Because I’m above the threshold of a lot of mom and pop operators”, which is true “and I’m below the radar of the institutional buyers.” And I got to thinking, “Then who are you going to sell to?” You’re really limiting your potential and who’s going to buy this asset. Maybe another syndicator, maybe they’re looking for bigger deals, too. So it’s great from the acquisition standpoint, but it might end up biting him later when he goes to sell, and maybe he doesn’t hit the returns, because there’s just not a big buying pool for it. So anyway, it’s certainly something to think about, certainly something to ask a general partner if you’re going to be like me, a limited partner, as to what is your exit game plan? Your strategy? Who have you sold to in the past? You may be able to answer that question yourself, which we’ll get into later. But that’s kind of why we’re covering it. I’ll turn it over to you, Theo, if you’ve got any thoughts so far on that.

Theo Hicks: Yes. I think one important thing to realize as a passive investor, what we’re saying is true – if you’re investing in a deal where value is being forced up, then you’re going your make money via cash flow. That depends on what type of investing you’re doing. Last week or seven episodes before this one, we talked about the four different types of investments. Some of them are more focused on cash flow, and less on the upside. On the other end, it’s development where it’s all upside, no cash flow, and then value-add falls in between there. So if you’re looking at a deal — obviously, when you’re investing you want to make money. So for the value of the property to increase, the value of your investment to increase, so understanding how that calculation is done is important.

There are two metrics that are used to calculate the value of the property. It’s going to be the market cap rate; that’ll be based off of recent sales of similar apartment communities. Then there’s going to be the net operating income. Its net operating income, divided by the market cap rate, equals the value of the property. So those are the two metrics that can be changed in order to increase the value of the property. So when you are investing in a deal, the goal, obviously, is to increase the value, so you want to know which one of those two are they banking on? Are they banking on the cap rates in [unintelligible [00:09:49].01] the lower it gets, the higher the value is… So are they banking on the cap rate going down and they’re just going to keep the net operating income the same or just have it go up with inflation? Do they plan on making the market cap rate the exact same, and increasing the NOI? Or is it going to be a combination of each?

So that’s why on the one hand, the sales comps are going to be important when they’re buying. Ideally, they’re buying below market rates, because when they do that, then that’s just going to be free equity. If the market cap rate is 5% and they’re buying it at 6%, then they have free equity of 1%, based off of the NOI, for free. That’s obviously one thing that’s important. If they buy it at the market rate, that’s fine. But being the highest price, buying a deal at three cap and a five cap market – probably not the best idea; but at or above is better.

And then what’s even more important, which is rarely talked about, is the exit cap rate, because that’s what’s going to determine the value of the property at the exit. So how are they determining the exit cap rate – some call it the reversion cap rate – is very, very important. That’s one of the most important questions you want to know, that’s probably hidden or not thought about. So there are lots of approaches. Some sponsors will just set it equal to what it is today, and some of them will assume that’s going to go lower.

The best approach is to actually assume the market is going to be worse at exit than at buy. So if they buy it and the market cap rate is at 5%, and they plan on selling in five years, the best practice is 0.1% or 100 basis points every year of the hold. So they’ll assume an exit cap rate of 5.5%. That way if the market is the same, then point 5% free equity. If the market gets better and the cap rates go down, then even better. But if the market does worse at sale – maybe a recession happens, something happens that changes a market cap rates in the area – then the return projections are going to be met depending on how far up the cap rate went.

But as Travis said, it is something that is super important and maybe not thought about… Not like hidden knowledge, but it’s something that you wouldn’t really think about; asking about an exit cap rate or reversion cap rate seems like it’s not that big of a deal, but when you’re talking about millions of dollars or hundreds of thousands of dollars in NOI, a 0.1% difference in the cap rate is going to change the value of that property by a lot. So just some of the things to keep in mind. Ultimately, the question here is, are they banking on NOI, cap rate, or both? If they’re banking the cap rate, what evidence do they have to support that this cap rate is going to go where they say it’s going to go, if they’re assuming it’s going to get better?

Travis Watts: Yeah, that’s a great point. All great points. But let’s talk about the hidden knowledge thing that you brought up. I was watching a webinar… I look at a lot of deals, for anyone who’s not aware; I look at a ton of deals. And I was on this crowdfunding platform, because someone asked me a question about it, and I was checking it out… I’m watching this webinar presentation on this deal; it was out in Florida. Everything looks great; projections look great, cash flow looks great, the exit looks great… I’m thinking “Wow, this seems like a pretty solid deal.” Well, the thing they left out was the reversion cap rate. No one talked about it in the presentation, no one asked about it in the Q&A… So I circled back with that sponsor afterwards and I said, “I only have one question, because I didn’t hear it. Maybe I missed it. But what’s your projected exit cap?” They were buying at five cap, basically, and they were projecting a four cap on exit.

Theo Hicks: Oh, no…

Travis Watts: I thought, ” Man, right out, I’m done.” There’s no way. I wouldn’t touch that thing. To your point, if they were buying at a five cap, the answer I was looking for was 5.5, maybe six; some conservative approach, assuming that the market had softened. Then those projected returns I’m looking at would then become a lot more conservative. But instead, they were taking a very aggressive approach, to try to make that deal look good. So this needs to be part of your criteria, anybody listening who’s a limited partner, like I am. I’m such a big advocate for self-awareness, writing down your goals, your criteria on these deals… That has to be one, is to look at cap rates. That’s my little rant on that.

But at the end of the day, Theo, and everybody, all of what we’re talking about, it’s a balancing act of risk. What we’re really talking about is what’s the risk. So you have asset classes, property ties, business plans, leverage, the time horizon… But really, at the end of the day, you’re trying to answer two questions. Is it likely that I’m going to make money? How much money? And am I okay with those projected returns? But more importantly, the feasibility of that. So I’m always trying to stack up when I’m listening to presentations or when I’m on calls with general partners… What I’m trying to figure out is, “Okay, I understand what you’re telling me. I understand that you’re saying it’s going to be this kind of percentage, this kind of return this kind of whatever. But what do I have to go by to give me certainty around that?” That’s why track record and experience are so important. How many times have you done this? Is this your typical business plan and business model? Is this your typical hold period? Typical underwriting structure? All these kinds of things. I like to know about the good, bad, and ugly of past performance. Do you have deals struggling right now? Have you lost money? Have you had capital calls as a company? I could go on and on. All I’m really talking about though is assessing the risk in all of this. So those would be my thoughts on that. I’ll turn it back to you, Theo.

Theo Hicks: Exactly. Assessing the risk and then what you’re comfortable with. As Travis mentioned, there’s a lot of different types of syndications you can invest in, with different types of exit strategies, and there isn’t really one that’s objectively better than the other, always, at all times. It just comes down to what your goals are. Sometimes there are syndicators who will buy a property, and they don’t really have an end date. They’re going to sell at some point, but they don’t really have a set number of years when they’re going to sell the property. It might just be they buy a core asset that’s already fully completed, and they might just hold it for a while. So if your goal is to have a very low-risk investment and make a return, and you’re not necessarily worried about making a large chunk of capital at an exit, then that might be a good strategy for you.

Another long-term hold strategy would be they might do a value-add play, but then rather than selling once they’ve completed the value-add, they might refinance, or do a supplemental loan, and then refinance. That way you might get, maybe not as much money back as you’ve gotten if they would have sold it, but you’ll still get a sizable return, assuming that the GP gives the LPs refinance proceeds. But then they’ll keep holding on to the deal and you’ll keep making cash flow. The cash flow might be the same, it might go down, it might go up, depending on how big the refinance was, and things like that. Other ones might plan to fully reposition and sell after three to five years. When that happens, you get all your money back, plus 50% or so profits. Again, everything depends. These numbers aren’t an exact science.

Then you’ve got a development deal, where there’s no cash flow at all, and then they exit after two or three years, or maybe they refinance and they hold… So there are all these different exit strategies, so you want to kind of ask yourself, what do you want? Do you want to double your money in five years and then get it all back? Do you want to just make a cash flow, and then that’s it? So understanding what the exit is, is going to determine which type of syndication you invest in… Because if you want that equity upside, but you also want to get the equity, you don’t want to sit there and be bigger, then you’re going to want to invest in a deal where they’re going to fix it up, force that value up, and then sell and get you your money back. You’re not going to want to invest in a core turnkey asset that is going to cash flow.

Travis Watts: Exactly. Another one that just came to mind too is a REIT roll-up. Sometimes these syndicators, they’re buying portfolio deals, which means maybe two or three properties, and they’re putting them in one small portfolio, and then they have lots of these portfolios. Then they’re going to find a REIT, maybe a pre-existing, real estate investment trust, or maybe a newly formed REIT, who’s going to acquire all of those properties in one big package. I’m using the term REIT roll-up. Maybe it’s a jargon term in the industry, but basically, you’re wrapping up all of your assets and selling them all off either to Wall Street, or it could be a private REIT. But that’s another exit strategy. But here’s how I look at it… There are really four common exits; I’m not saying this is all-inclusive here, but you could sell, like I just said, to a real estate investment trust, to a REIT, publicly traded or private. That’s one thing. You could sell to institutions, so pension funds, insurance companies, etc. That’s institutional capital, in layman’s terms. Again, not all-inclusive. Syndicator groups, and then individuals, and/or family office, things like that. It just kind of depends.

Let’s talk about that. Institutions and REITs, typically… Again, I have to use a generalization here, and that’s the disclaimer… But typically, they’re investing for cash flow and for yield, and newer properties, or recently renovated properties. I would say they’re mostly in the A class and the B to B plus categories of assets. They’re not in the business, usually, of value-add and doing lots of heavy turnaround and repositioning. They don’t want to buy assets that have leaking roofs and HVACs going out and under-market rents. They just want a turnkey asset; they want to place their capital, and they want to have virtually no worries for 5, 10, 15 years, whatever their business plan is. Now when you’re talking about syndicators and individual buyers – again, as a generalization – they’re typically looking in the B and the C class space for what these institutions are basically offloading… Because now they have problems, they need work, the rents are unable to be pushed anymore, because it’s an older asset that hasn’t really been kept up. Maybe it’s got outdated amenities… All these kinds of things. So typically, they’re looking to go in with a value-add play, and renovate, and bring things back up to the market level, and then sell back oftentimes to REITs and institutional capital and things like that. It’s just different business plans.

To your point, Theo. There isn’t a right and a wrongm and a lot of people, they prefer core assets where they’re looking for just that natural inflation, if you will, to kind of lift the values over time. They’re not looking for that forced appreciation in the deal. So those are the four exits, in my opinion, that are most common. Those are my thoughts on that. If you have any final thoughts, Theo?

Theo Hicks: Yeah. I think we went over a lot of information here. [unintelligible [00:20:46].05] condense it down… So just as a passive investor, what questions do you want to have answered based off of the exit strategy? So the first question, arguably the most important question about the exit strategy is, what is that exit cap rate assumption? What is that reversion cap rate assumption that will determine how conservative or aggressive they are being? And again, the best practice is to have an exit cap rate that is higher than the current cap rate. How higher that is, it depends, but it shouldn’t be lower than. Travis gave the story of the 4% exit cap rate, 5% in-place cap rate – probably not the best idea.

Then the other question based off what Travis just talked about is who do you typically sell to on the back end? Or who do you expect to buy this property on the back end? And then based off of what Travis said, was their answer aligned to what Travis just talked about? So are they planning on buying a B or C asset and doing a value-add play, fully renovating it and then eventually selling it? Then they should say that they plan on selling it to an institution, or if it’s like a fund, a REIT. But if they are going to buy a B property and just kind of hold it and not do anything, and then claim they’re going to sell it to an institution – well, that’s probably not going to happen.

I think those are the two most important questions – what’s the exit cap rate, and their justification for how they came up with that? And then two, who’s your typical buyer? Who do you expect to sell to on the back end?

Travis Watts: Yep. Those are great points. That’s a great way to phrase it, too – who is your typical or ideal buyer in this situation? What type of individual, or institution, or what have you. Because the answer, quite frankly, is that nobody knows. Five years down the road who’s going to buy this deal? I don’t know. Nobody knows. But the point is, you’re looking for competence. You’re looking for “Well, we’ve thought this through”, let’s put it that way. “In the past, we’ve sold to three institutional buyers and one syndicator.” Well, that kind of answers your question there. To your point, Theo, you just want to make sure all this stuff aligns with what you’re wanting. Does that help you accomplish your goals? Are they being realistic with their business plan and approach? That’s it.

Theo Hicks: The competence thing is huge [unintelligible [00:22:55].14] trap them or trick them… But these are important things to think about, and you can kind of gauge the sophistication of the GP by asking them some of these questions that they probably aren’t asked a lot. If they don’t really have an answer… They can say, “I don’t know, I can figure that out for you, and get back to you.” But if they start making things up or sound like they don’t know what they’re talking about, that could save you. Something as simple as that could save you from potentially losing your capital.

Travis, going back to your example, which was perfect – if you didn’t know to ask that question because it wasn’t presented to you, you would have invested in a deal with the return projections based off of a very aggressive cap rate assumption. You’re just asking that question, and they’re getting their honest answer, which we’re assuming the markets going to get way better when they sell, or them saying, “Well, I never thought about that,” or whatever. It just kind of gives you an idea of who you’re working with here. So is there anything else you want to mention, Travis, before we wrap up?

Travis Watts: No, I think we hit it. So for anybody listening, feel free to reach out to us with any additional questions or leave a comment. We’re happy to answer those.

Theo Hicks: Yes, any questions? Just email me at theo@joefairless.com. We’re also doing a new shorter segment called 60 Second Question. So you submit your Actively Passive Investing questions. You can email those to me at theo@joefairless.com. If you’re listening to this on YouTube, you can also leave it in the comments section. Completely up to you. Just leave your name and your question, and we will read the question and we will answer it in 60 seconds or less. 60 Second Question, email theo@joefairless.com, and we post those on our YouTube channel. So as always, Travis, thank you for joining me today. Best Ever listeners, as always, thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

Website disclaimer

This website, including the podcasts and other content herein, are made available by Joesta PF LLC solely for informational purposes. The information, statements, comments, views and opinions expressed in this website do not constitute and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action. Neither Joe Fairless nor Joesta PF LLC are providing or undertaking to provide any financial, economic, legal, accounting, tax or other advice in or by virtue of this website. The information, statements, comments, views and opinions provided in this website are general in nature, and such information, statements, comments, views and opinions are not intended to be and should not be construed as the provision of investment advice by Joe Fairless or Joesta PF LLC to that listener or generally, and do not result in any listener being considered a client or customer of Joe Fairless or Joesta PF LLC.

The information, statements, comments, views, and opinions expressed or provided in this website (including by speakers who are not officers, employees, or agents of Joe Fairless or Joesta PF LLC) are not necessarily those of Joe Fairless or Joesta PF LLC, and may not be current. Neither Joe Fairless nor Joesta PF LLC make any representation or warranty as to the accuracy or completeness of any of the information, statements, comments, views or opinions contained in this website, and any liability therefor (including in respect of direct, indirect or consequential loss or damage of any kind whatsoever) is expressly disclaimed. Neither Joe Fairless nor Joesta PF LLC undertake any obligation whatsoever to provide any form of update, amendment, change or correction to any of the information, statements, comments, views or opinions set forth in this podcast.

No part of this podcast may, without Joesta PF LLC’s prior written consent, be reproduced, redistributed, published, copied or duplicated in any form, by any means.

Joe Fairless serves as director of investor relations with Ashcroft Capital, a real estate investment firm. Ashcroft Capital is not affiliated with Joesta PF LLC or this website, and is not responsible for any of the content herein.

Oral Disclaimer

The views and opinions expressed in this podcast are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action. For more information, go to www.bestevershow.com.

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JF2354: 5 Risk Profiles In Multifamily Real Estate | Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Theo and Travis will be sharing a list of 5 risk profiles in real estate. And while these risk profiles are the same for any real estate, the hosts will be focusing specifically on multifamily properties.

The list ranges from A-list properties located in the country’s top markets that are considered to be cash flow properties to buildings that are considered to be high-risk investments.

And while it’s important to invest within your risk tolerance, having the property be flagged as “high risk” may not mean that it’s a bad investment. Theo and Travis share their thoughts on what can make a risky investment attractive to a limited partner.

We also have a Syndication School series about the “How To’s” of apartment syndications, and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening! 

Click here for more info on groundbreaker.co

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JF2347: Pros and Cons of Passively Investing in a Fund vs Individual Deals | Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Theo and Travis will be talking about being a passive investor in fund deals and individual deals. They’ll be discussing them from a factual point of view. Hopefully, this detailed comparison will help you figure out which deals are right for you and your real estate business. 

We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening and I will talk to you tomorrow. 

Click here for more info on groundbreaker.co


TRANSCRIPTION

Theo Hicks: Hello, Best Ever listeners and welcome to another episode of The Actively Passive Investing Show. As always, I’m your host Theo Hicks, as well with Travis Watts. Travis, how are you doing?

Travis Watts: Hey, Theo. Hey, everybody. Happy to be here.

Theo Hicks: Yeah, thanks again for joining us. And Best Ever listeners, thanks for tuning in. Today, we’re going to be talking about investing in real estate, individual deals versus funds. So as a passive investor and you’re working with a sponsor, is it better to invest in a single deal one at a time, or to invest in a fund? So to learn more about what investing in a fund actually looks like, versus a deal, logistically, we have a blog post on the website you can check out, called Passively Investing in Apartments, Fund, or Individual Deals, where we talk about the different types of funds and things like that. But today we’re going to focus more on the pros and the cons of investing in a fund, versus individual deals. So before we jump into those, Travis, anything you want to mention?

Travis Watts: Well, Theo, I think this is a very relevant topic. I’m asked this all the time. I probably would have had a different take on this five or six years ago. My perspective has even changed throughout the years. It’s something I’m asked all the time. You see a lot of these more maturing companies in the syndication space, a lot of them are going towards the fund structure just because they have the reputation, the connections, the deal flow, the ability to raise more capital… So it’s definitely worth checking into and asking yourself the question whether it’s right for you. We’ll try to hold back on opinions, at least until the end… But this is more of a factual pros and cons conversation.

Theo Hicks: Perfect. So let’s jump into the first pro, or con, or advantage, or difference between the two, and that would be the time commitment. So here we’re talking exclusively upfront. So when you’re investing in a fund, you invest your money, and then that fund will be used to purchase more than just one property… Whereas when you’re obviously investing in individual deals, you’re investing in one property at a time. So if you were to invest in, say, ten deals — or let’s use five deals, you can invest in one fund and invest in five deals without, having to continuously qualify multiple deals, qualify multiple sponsors, search around for deal flow, hope for deal flow. You’re going to say, “Okay, this sponsor is a fund, they’re going buy five deals. I’m going to invest in this fund.” And depending on how it’s structured it might be a one-time investment that goes into all five deals. Each deal comes in, you invest an additional amount of money to increase your investment. But overall, it’s more of a, “Hey, here’s a sponsor. He’s doing the fund. I’m going to invest.” As opposed to, “Oh, here’s the sponsor. Here’s one deal. I’m going to invest now. Oh, here’s another sponsor, I’m going to invest in their deal. And this deal, and this deal…” And having to do all that due diligence, which is not the same level of due diligence as a sponsor is doing, but still, it’s a bunch of [unintelligible [00:06:05].13] you need to read. So it’s going to be some ongoing time commitments as well, which we’ll hear about in a second or later on in this episode. But I think that’s one of the major advantages of the fund, is that from your perspective, it’s a lot less of a time commitment to invest in the same number of deals.

Travis Watts: Absolutely. Great points. I think what I want to cover first is the element of diversification. One of my favorite topics, one of the biggest reasons I became a full-time LP investor – and I’ll share with you a quick story of why that is. A couple of things happened in my life in my 20s. One was, I had this overly ambitious goal that I bought the single-family home that I was living in as an owner-occupied residence, and I wanted to pay it off. It was a pretty good deal, so I had a pretty low basis in this property, and I thought, “Man, I’m just going to go hard with this.” And I was hell-bent on just paying that thing off.

So when I finally did that and accomplished that, I had my little moment of celebration, and then two days later, I thought, “What if a tornado hits this house? What if a flood happens? What if this thing starts having foundation problems?” It was a 1932 house, it was very old, out in Denver. And I thought, “I don’t want to have this much equity tied up in one thing.” And I got to thinking about the opportunity cost of having that much capital in one place that I couldn’t otherwise go invest. So long story short, I went out and I got a HELOC, a home equity line of credit, I ended up just doing investments instead. And I essentially just remortgaged the house. So diversification played a big role in that regard.

The other thing was, for those that know my background, I had a lot of single-family rentals out in Colorado, and I had a lot of equity in each one, as that market was driving up rapidly at that point from 2010, 11, 12, 13, 14 etc. And I just got uncomfortable with having that much equity in one location in a 30-mile radius, all in the same asset type. So that led me to discover what the syndication stuff was all about, and the ability to diversify, not only your capital, where you’re putting 25k here and 50k there, and this kind of thing, but in different regions, different demographics, different sectors, different sponsorship groups. So it sits well with me. That doesn’t make it right for everyone. Not everyone is of the mindset of valuing diversification, and rightfully so. Some folks have made multi-millions just focusing on one little niche and putting all their money there. So that’s just my take on it.

So the first topic here within diversification would be, as I mentioned, your capital diversification. The ability to spread out your risk in terms of your dollars and putting them in different deals. The way I look at funds in the syndication space versus individual deals is – I guess you could draw a parallel to index fund investing in the stock market, where you’re buying the index where you have a bunch of stocks in it, versus picking your own stocks. And for anyone that’s really read through statistics, very few people are successful at picking their own stocks and outperforming the overall market sector. So that’s kind of how I look at this, too. And I mentioned earlier that if you’d asked me about six years ago about funds versus individual deals, I probably would have said I prefer individual deals, because I want to choose which one I want to put money into. But in my experience, some are winners and some are losers. I didn’t always pick the best deals. When a sponsor has five deals a year to choose from and I choose one or two, sometimes you get a home run and sometimes you get half the return you were expecting. So a fund allows more of a blend there.

But here’s another thought too, in terms of a minimum investment. Anyone who’s been an investor in the private placement sector knows that a common minimum investment could be 50,000, it might be 100,000. And you’re talking about one deal. So if you go do 10 deals, you might be having to put up a million dollars just to get in the 10 deals that way. In a fund, the minimums often are the same; it might be 50k, it might be 100k, but there might be 10 deals within that fund. So you can spread your risk with a lot less dollars. If you do the math there, you might be putting $10,000 into 10 deals, for example. So it’s just another way to spread risk. It really comes down to you, how much money you’re looking to put to work. If you have 10 million dollars to put the work. Yeah, different story, right? But if all you have is 100k, this might be an advantage, to you to partner in a fund, potentially.

And the last thing I’ll mention here… Well, two quick notes. Geographic diversification I alluded to; there isn’t one perfect market. And markets are changing all the time, right? Businesses are moving around, people are migrating to different places, the political scenes are changing… So it’s nice to be able to place bets on several different markets that you’re a fan of, instead of like I was years ago, all up and down the front range of Colorado, between Fort Collins and Denver. If anything politically had changed there, or they said taxes are going to double, I would have been kind of screwed, right? So it’s nice to place your bets elsewhere.

And then sector diversification. What I mean by that is, depending on the fund and depending on the sponsorship group, there are different sectors, right? So you could be in mobile home parks, you could be in self-storage, you could be in multi-family, you could be in office and retail, in all these different sectors, which is really nice too, for the same reasons that I just pointed out – things change, things evolve, and maybe one day one of those sectors looks a lot better than the other. So it’s nice to be able to diversify that way. So that’s really all I got on diversification. But that’s the meat of it for me in terms of funds, is being able to diversify.

Theo Hicks: Yup, that’s definitely one of the main advantages. And kind of going back to what you’re saying about if you have $100,000 as a minimum, and you want to invest in 10 deals. That’s a million dollars in 10 deals. And kind of going back to the time commitment thing, right? You have to find all 10 deals, and hope you pick the right ones. Whereas you can still invest a million dollars in 10 deals, it’s just now you can do it one time, and then invest $100,000 and see what comes in, increase the amount without having to find the new deal, do a bunch of due diligence. So yeah, that kind of plays into the time commitment part.

And then obviously, the reduction of risks is also huge as well, because you’re diversified, as you mentioned, across multiple deals. So if you said a sponsor has five deals, some are home runs, and if I pick the strikeout, then I’m in a bad spot. So if you invest in those same five deals, all of them in one fund, then the home runs could offset the strikeouts or will outperform the average, which is good. But it also comes down to, [unintelligible [00:13:00].11] but a potential advantage (keyword being “potential advantage”) that investing in individual deals has is the upside potential.

So if an investor has 10 deals and two of them perform really, really well, and you happen to pick that deal, then you’re going to have a higher return than if you invested in all those 10 deals in the fund, and two of them are home runs, maybe two of them were strikeouts, and the rest were average, right? Then you would get the average return. So the really good ones will average out, the really bad ones and get an average return. So again, this is kind of pretty standard though for investments. The less risk involved the less the potential upside is going to be. But again, it depends upon the fund. Because if you’re investing in a fund where you do participate in the upside on sale, then is still going to get upside. It’s just if one deal does amazing, you’re not going to have an amazing return, because it’s going to be offset by the other returns.

As Travis mentioned, it kind of depends on your level of risk. So if you only have 100 grand to invest, there’s much less risk to invest in a fund than to do hoping you’re selecting the right deal. If you got $10 million, you’re trying to double that money, then taking a portion of that and investing in individual deals might be fine.

Something else we have in this list is reporting, too. So I’m sure Travis knows this as well, but when you’re investing in five, 10, 20 deals, especially if they’re spread across multiple sponsors, you’re getting emails constantly with updates on these deals. The format obviously is different, the information included is different, when you’re getting the reporting, the financials for each sponsor might be different, for each deal might be different… Whereas when you’re investing in a fund, most of the time the sponsor is going to have just one email for however many deals are in that fund. The format is going to be the exact same every month, every quarter. The reporting is the exact same every month, every quarter. And that kind of goes back to what I was mentioning earlier about the ongoing time commitment, where you’re not having to balance 20 different emails, 20 different investor reports… It’s just one email with the performance of the fund, any extra information that the sponsor decides to include about maybe the individual deals… But it’s still going to be in one location, which is definitely going to save you a lot of time and headache.

Travis Watts: One thing I’ll add to that as well – you’re absolutely right on the emails. Hence the Actively Passive Show, right? You get in this thinking, “Oh, I’m a passive investor” and then all of a sudden, you’re reading reports and T12s all the time. And one other thing is K1’s. This is the tax form you get in a real estate partnership most of the time. And when you’re doing individual deals, you’re going to get one K1 tax form per deal. So for me, I have a ton of K1’s. And every year my CPA just looks at me and hands me a higher quote, because it’s a beast. You’ve got to keep track of all your bases, and your carry forward losses, and all this stuff. I have so many K1’s.

When you’re in a fund, depending on how it’s structured, you might just have one K1 statement, even though there may be 10 different properties inside the fund. That can be a huge time-saver and a cost-saver too. So just a side note on that.

Theo Hicks: Yeah, and kind of on that same note, the paperwork upfront as well, right? When you’re investing in a fund that’s going to buy 10 deals, 20 deals, assuming some of you are going to invest one time and then not add extra investments later, it’s just one set of paperwork, right? You fill out one PPM, you get qualified as an accredited investor one time. Usually, it might vary. I’m not an attorney, I don’t work for the SEC, but just generally speaking, the paperwork is a lot less, as opposed to having to sign and fund 20 different pieces of paperwork.

Travis Watts: Yeah, and with that also is the accreditation stuff. If the group’s doing the 506(c) stuff, you have to be third-party verified. And every 90 days those letters are expiring. So as you’re going throughout the year, it’s like a quarterly thing. “Oh, I’ve got to go get another letter of accreditation again to go do this deal.” And it’s a headache. It is active, and it does take several hours of your time. So it’s just something to think about.

Theo Hicks: And then I’m going to do the natural transition to the next thing we’ll talk about, I guess the last thing we’re gonna talk about, which is why do sponsors do funds? What are the benefits to the GPs, general partners, and managers of the fund? And one of them — I’ve just mentioned paperwork, right? And so instead of having to create an LLC for every single deal, and multiple PPMs, and all that paperwork, they can just do it one time. One PPM for the fund, and then that’s used to buy individual deals, as opposed to having them do that each time. I’m sure there’s definitely going to be paperwork for each individual deal, but it’s much less for each deal when you do it upfront for the fund.

And then something else that is a benefit to the sponsor is the fact that since it’s a fund, they have a much better understanding of the amount of capital they’re going to have to invest.

So behind the scenes, whenever the sponsors are negotiating deals, one of the things that the sellers want to know, the lenders want to know, the brokers want to know is how are you going to buy this thing? How are you going to raise the capital? So obviously, having a track record of closing on deals is important. Being able to show them that you qualify for the net worth and liquidity requirements is important; but the actual downpayment, where’s that coming from? You’re not going to have passive investors giving you money on an individual deal until it’s under contract, until they’ve reviewed the investment summary, seen the conference call… And then they’re going to send you the money. Whereas the fund, you start raising capital sometimes before you even have a deal. You might start the fund with a deal, it all depends… But you need to have commitments. So when you’re talking to brokers, lenders, sellers, you can say, “Hey, I’ve got this much money in commitments already.” All you need to do is do the capital call. Or if they funded it already… It kind of depends on how it’s structured.

Much more confidence from a seller’s perspective if the buyer is doing a fund, as opposed to having to raise capital… Because what happens if they can’t do it? What happens if something happens and investors don’t want to fund the deal anymore? Whereas with the fund, they’ve already signed the paperwork. So they might not have actually put the money in there, but they’re legally obligated to — from my understanding — to invest. And there’s also the advantage that comes from the revenue coming in to pay the people involved with the fund. So since they’re getting the money sooner, they can use the fees that they collect… Because usually there are fees collected based off of the amount of money that’s invested. These fees can be used to pay themselves, to pay the people on the team that is involved in making sure the fund is maintained.

And one last thing I want to mention, because we have talked a lot about how great the fund is and you did talk about the benefit of the individual deal for upside… Something else that’s important too is that you’re not going to be a newbie sponsor doing a fund. You need to have a track record. So funds are good for sponsors who are already established, whereas — why doesn’t everyone do a fund? Well, they can’t. When you’re just starting out, you’re not going to be able to create a 10 million dollar fund. It’s more of a grind on each deal to raise that capital. But once you’re established, once you have a track record, once you have a large database of passive investors who trust you, then you can be confident that you can hit that funding goal, so that you can buy those deals. So I think that’s key, because — that’s why every single GP isn’t doing a fund… It’s because they can’t.

Travis Watts: That’s a great point. And that’s kind of one of those observations, right? As an LP investor, you see a company that’s doing funds, or a fund, and maybe that suggests that okay, you have the reputation, the track record, the experience to pull this off… Especially if it’s fund two, three, four, five etc. I’m always trying to catch the wave with these groups, so to speak, before they get so big that they’re not taking investors anymore, they’re relying on their returning investors, or they’re going to go public, or whatever they’re going to do; take institutional capital, whatever. So I’m trying to hit that threshold where these companies are getting big enough to do a fund, but they’re not so big that they don’t really need you at this point. So that’s kind of a strategy side note.

So I think overall, I’ll bring this up one more time, because I think it’s important to draw the parallel between the mutual fund, the ETF, the index fund stock investor wanting the diversification, wanting to participate in the overall returns of the market, versus the individual that says, “No, I’m going to pick my own stocks. I know best, and whatever.” And rightfully so, maybe. And that’s kind of what this comes down to is who are you as an individual, and what is your risk tolerance? If you’re looking for only choosing the home runs because you think you can identify that, then individual deals make a lot of sense in that regard, as you pointed out.

And a lot of people too, by the way, a lot of people investing in syndications are just busy professionals. We’ve mentioned this over and over – the doctor, the dentist, the lawyer, attorney, pro athlete, entrepreneur. They’re busy. So if you don’t want to take up 12 months of your time working with all these operators and trying to cherry-pick the best deals that you can find in all of this, if you just want to say, “Look, here’s 100k, you go do the work for me, and update me monthly, or whatever”, then funds can also make a lot of sense; as you pointed out, the time commitment element to it.

And another great thing you pointed out Theo, is that maybe a hybrid of the two strategies makes sense. Maybe there’s that one, two, or three deals that are out there that you think “Oh, man, that just seems so great. I want to be part of that deal.” But then, generally speaking, I’ll just invest in various funds, maybe in different sectors as well. So you’re participating in a lot of different ways.

So think of those parallels… I think there’s a lot of advantages to funds. The more we go through this real estate cycle that we’re in now, the more we’re in COVID, with all the unknowns, the more I personally like the idea of a fund structure myself. But that doesn’t mean that that’s right for everybody. That’s just my take. And as you know, at this point, I really value diversifying. So that’s my biggest takeaway.

And one last thing I didn’t mention earlier about markets, just real quick, is that markets – they’re changing all the time. Right now you’re seeing Tesla, and Oracle, and HP – they’re leaving California, they’re moving to Texas. Everyone seems to be moving to Texas. Well, that’s great right now and for the foreseeable future. But what about in 20 years? What if in Texas they say, “Well, we’ve never really had a state income tax, but now we are going to have one and it’s going to be 10%.” A lot of people are going to be exiting Texas. So one thing to kind of drive that point home, one thing I always look at is the lifecycle of the business plan. And five years to me is kind of a sweet spot. It’s much easier to predict what may happen in a particular market over the next five years than it is to go into a deal indefinitely, where you might be holding it for 20 years. Who knows what the world looks like in 20 years. So something else that’s part of your own criteria that I always talk about – know your criteria, know your risk tolerance. But in a nutshell, that’s kind of my take on funds versus individual deals.

Theo Hicks: I highly recommend checking out that blog post we have at joefairless.com, Passive Investing in Apartment Fund or Individual Deals, because there are different types of funds. And the funds can be structured in any number of ways. So it’s important to understand not only the high-level overall, what are the differences between individual deals and funds, but getting more detail on what are the differences between the different types of funds, right? The evergreen funds versus the closed-ended funds. We go in that in that blog post. We kept it high-level here. If you want to go into more details, check out that blog post we have at joefairless.com.

And then we also at the end give a breakdown of the funds and individual deals to kind of try to summarize what’s ideal for you, and not what’s absolutely universally better, but based off of what your risk tolerance is, where you’re at in your investment career, what’s the better investment for you. And I also liked how you said, “Or you just do both.” You can just diversify across — there’s diversification in funds, but it also diversification between funds, between funds, and individual deals… So there are multiple ways to get diversification, so I’m glad you added that.

So that’s what we have today for funds versus individual deals. Travis, anything else you want to mention before we close out the show?

Travis Watts: No, I think we hit it pretty good.

Theo Hicks: One thing I want to mention… Travis and I are going to start doing a new 60-segment that we’re going to post to the Actively Passive Investing Show on YouTube. And we’re going to answer your questions. So if you’ve got any questions about what we talked about today, what we’ve talked about in the past, or anything related to passively investing in apartment syndications, the best way would be to email me, theo@joefairless.com or in the comment section of however you’re listening to this. Submit those questions and we will read your name aloud on the show and we will answer that question for you.

Travis Watts: Alright, very good. Thanks, Theo. Thank you, everybody.

Theo Hicks: Yeah, so everyone, thanks for tuning in, as always. Travis, it’s always great to get your wisdom on these topics. Best Ever listeners, have a Best Ever day and we’ll talk to you tomorrow.

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JF2340: Top 10 Markets To Buy Multifamily in 2021 | Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Theo and Travis are talking about the current Top 10 markets for investment in multifamily property. This list is based on the annual “Emerging Trends in Real Estate” report prepared by PwC and Urban Land Institute. Travis and Theo also highlight additional takeaways from the report. This information will be helpful for both passive and active investors looking to expand their portfolio in 2021.

https://joefairless.com/top-10-markets-to-buy-multifamily-in-2021/

We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening and I will talk to you tomorrow.

Click here for more info on groundbreaker.co


TRANSCRIPTION

Theo Hicks: Hello Best Ever listeners and welcome to another edition of the Actively Passive Investing Show. As always, I am your co-host, along with Travis Watts. Travis, how are you doing today?

Travis Watts: Theo, doing great. Thrilled to be here.

Theo Hicks: Yeah, thanks for joining me, as always. And we’re going to talk about markets today. So we’re going to talk about, as you can see by the title, we’re going to talk about a blog post that we wrote called the Top 10 Markets To Buy Multifamily In In 2021. And if you’re watching this on YouTube, we’ve got Vanna White over there giving us a presentation of a beautiful map, the infographic we have that highlights those top 10 markets.

So this is going to be based off of a PwC and Urban Land Institute report. We’ll have a link to that in the blog post we’re referencing and also in the show notes of this episode. And we’re going to highlight some of the other takeaways from this report today. So before we dive into that, Travis, do you have anything else you want to say about why what we’re going to talk about is relevant to someone who’s a passive investor?

Travis Watts: Yeah. I think this topic is relevant to active and passive investors. It is titled Top 10 Multifamily Markets, but real estate markets are real estate markets, right? No matter what asset type you’re in, or whether you’re active or passive, it all goes hand in hand. And as we talked about a couple of episodes ago, a lot of these episodes that we do, especially this year in 2021, come from questions that I get asked frequently by investors when I’m on calls week after week as part of my investor relations role. Which market should I be looking at? Which reports are good? Which ones are bad? That’s why we’re showing you guys this; it’s a very popular and common topic that I think everyone can benefit from.

Theo Hicks: Yeah. So in that blog post – and if you’re watching this on YouTube, which we highly recommend – Travis has an image behind him that shows the top 10 markets. We’re not necessarily going to list those out today in full. As I mentioned, this is a very long report. We’re going to go into some of the takeaways from this report. And obviously, this has been a show focus on passive investing, and we’re going to talk about why each of these takeaways are relevant to you as a passive investor. So Travis, you could start off by talking about some of the issues that were highlighted in this report.

Travis Watts: Yeah. And one thing before I get rolling here… As you pointed out, Theo, this is like a hundred-page report, again.

Theo Hicks: A big one.

Travis Watts: PwC and the Urban Land Institute, it’s kind of a combination of the two. Very, very much in-depth, in detail. We could literally talk for hours on this report. We’re just going to skim it, hit some high-level topics and things to think about. Check out the blog post, because there’s a link to the actual PDF that I’m referencing, and I’ll point out what pages I’m on too if you want to kind of follow along and if that blog post is something that you want to take a look at.

So to your point, let’s get started. So what these are, are the issues that could potentially arise this year, and then how much importance is weighted on those particular issues. So I’m on pages four and five of this report. And I’ll just kind of start from the top; I’m not going to go over all of them, there’s 10 in every category. But as far as economic and financial issues that could potentially have an impact on multifamily and real estate in general, at the very top is job and income growth. As we all know, we’re in the midst of COVID, everyone’s concern is jobs and unemployment. And you get into these deals as an investor, and you’re looking at these projections of ‘We’re going to be raising rents $200 a door per month over a few years”, well, it’s really dependent on your renters and the fact that they have a job, number one, and then number two, that their income can support those rent hikes. So you’re trying to kind of read between the lines, and we need an economy that’s stabilized to support that. It’s a one to five scale, if you’re not following along, on the chart. So they ranked that as number five, meaning the most important.

And I’ll scale quickly to the bottom. They’ve got inflation and currency strength as still very important in the top 10, but the least of the top 10 of importance. There’s a lot of talk with all this money printing that we’re doing, with the Fed coming out with this proposed $2 trillion stimulus package possibly around the corner… My gosh, it’s crazy. So you’ll see a lot of headlines about inflation, and are we going to see it, and is it going to go into hyperinflation, or are we going to collapse the value of the US dollar? I personally would rank those a little higher on the list myself. That’s a concern to me. But they’ve got them there at the bottom, so take it as you will. Those are the economic and financial potential issues.

Moving on to social and political at the top of the list of most importance. They’ve got epidemics and pandemics in a category; obviously, in the midst of COVID. That makes a lot of sense. That’s still a concern of most people, especially this year. The political landscape – as Theo and I pointed out several episodes ago on the proposed Biden tax plan… If you haven’t checked out that episode, I would. It’s getting more outdated by the day, so stay up with the news. But the political landscape – we just had the inauguration, but now what Biden’s essentially proposed is to repeal the Trump tax reform that was set forth in 2017, which was the Tax Cuts and Jobs Act of 2017. And it’s not a political statement, whether you’re pro Biden or Trump, it’s just that that particular policy was really to the advantage of real estate investors. So if that gets repealed, that’s obviously of most importance.

At the bottom of this list on social and political is terrorism and rising education costs. So obviously, terrorism is hard to predict and determine. That’s kind of an unknown factor that’s always there. And then rising education costs – yeah, obviously, of importance, but may not affect the majority of our tenants and our renters. So it’s up there, but at the bottom of the list.

Last but not least, real estate and development. This is more about new construction in multi-family. The top two being the labor costs and the cost of materials being of utmost importance. At the bottom of the list being the risk of extreme weather, which is global warming and climate change and things like this, and environmental sustainability requirements. A lot of talk about this Green New Deal, and everyone’s going solar, and electric cars… Well, what if some policies come forth that says, “All multifamily units have to be solar by 2030” or something crazy like that. It could happen; perhaps unlikely, but who knows? So that’s why it’s at the bottom of the list, but it could happen as we go into this new change of hands here under the Biden administration.

So I’ll cut it there; take a look on page four and five of the report if you have it. There’s a lot more detail, I just highlighted and skimmed that. But those are some of the issues that could potentially have factors here in 2021.

Theo Hicks: And the key to keep in mind here is that these are based off of surveys of people who are real estate investors. So they’re asking them how do they think these things are going to affect real estate in particular. So these aren’t what they think high-level, but just specifically to real estate, right? And these are based off of surveys. So yeah, all of these different things we’re going to be talking about, you can see how these active real estate professionals replied. So they are people who are actually doing it, and what they think is going to happen based off of their experience and their research.

The next thing that we’re going to talk about is going to be the statistics for working from home. So don’t need to spend much time here; it’s pretty obvious that a lot more people are working from home now. So the question is, as it relates to real estate, is this going to continue? Or is this going to end? And when it does end, is it going to go back to normal, or are more people going to work from home? And so the question that was asked was, in the future, more companies will choose to allow employees to work remotely, at least part of the time. Do you agree, strongly agree, or disagree? The majority of people strongly agree, and then another 42% agree. So basically, every single person either agrees or strongly agrees that this trend of working from home is going to continue in the future. So as a passive investor, that’s obviously going to impact the locations where multi-family is going to be in demand, which I’ll talk about in just a second… But also the type of multifamily that’s going to be in demand. If people are working from home, they’re going to want a different type of experience than if they’re not working from home.

So we actually have a blog post on our website about the top amenities for multi-family for 2020 or 2021 as it relates to COVID. We kind of go through, okay, if people continue to work from home, what types of things are going to be in demand? What size of units? What are the opportunities in the units? What type of amenities at the property are going to be in demand? So definitely check that out. And then the second thing is going to be the locations that are in demand, right? So U-Haul has a really good report…  We actually have a blog post that posted — it’ll be live when this goes live; it’s called 10 States With The Most Net Migration in 2020. So U-Haul tracks all their one-way trips to see where people are renting vehicles and going one-way, with the assumption that they did it to move to that location. So they rank the markets with the greatest positive net migration, and then the markets that have the most people leaving them.

So the South, in general — there are obviously exceptions, but the South, in general, are full of in-migration markets. You’ve got Texas, Florida, Georgia, the Carolinas, and Tennessee. And then you’ve also got some of the mountain areas, so Idaho, Utah, and Arizona. Whereas you’ve got the coasts, specifically the West Coast is in general, as well as the Northeast, people are moving out of those places. So this report is just based off of the states. But in addition to this, you’ve got to keep in mind that within each of these states it doesn’t mean that every single investment you see in Florida and Texas is going to be great. Or every single market in Texas and Florida is going to be great. Again, because of this move, which Travis is going to talk about here in a second, there has been a large movement out of the large urban areas to suburban and even rural areas, which is kind of what Travis will be talking about next. So a natural transition.

Travis Watts: Yeah, that’s a great point, Theo. Actually, I probably should have brought that up at the beginning of this. Just because we’re showing you this map, just because PwC and the Urban Land Institute have come out with this data and this particular survey, there’s going to be differing opinions, whether you tune into CBRE, Marcus & Millichap, CoStar… There are different data sources out there, there are different economists, there are different opinions. Just because you live in Ada, Oklahoma, it doesn’t mean you shouldn’t do a deal there. If your neighbor is short selling their home or there’s a foreclosure in your town, maybe that’s a good opportunity for you. So it’s not to suggest these are the only markets to look at. And again, it’s titled Top 10 Multi-family Markets, but it’s just real estate in general, right? We’re really talking about migration trends, which is what we talk about a lot on this show.

So to your point Theo, my topic here is the age migration and what’s happening. I thought this was really interesting. I’m on page 10 of the report, anybody following along… And what they’re looking at is the forecast from 2020 to 2030. So they’re looking at a full decade of all different age groups and what’s likely going to happen as a progression here. So start out with folks in their 20s – this demographic is shrinking in size, number one, and these groups tend to live a more urban lifestyle. So obviously your studios, your one-bedrooms, your downtown stuff, the city life. Keep in mind, as they point out, this is a shrinking group. So urban will be shrinking, basically, is what they’re saying.

So groups in the family formation years, maybe your latter half of the millennials, folks in their 30s, and maybe up to age 40 – I don’t know exactly where the cutoff is there… But these groups are tending to look for a more suburban lifestyle. And this is a growing group. So this is going to be a big migration here that’s happening to support the suburban lifestyle.

The next one over is empty nesters. So parents where their kids have gone off to school and kind of moved [unintelligible [00:15:39].29] from the house. They’re actually – this was a surprise to me – looking at going more urban. But again, this is a group that is shrinking in size. So it’s not going to be a huge migration here. But that one kind of surprised me, that empty nesters are looking for a more urban setting and lifestyle.

And last but not least, as we all know, the retirement age groups are going to surge. We all know about the silver tsunami. I hope that’s not offensive to anybody. But they’re looking for more of the suburban lifestyle, which kind of surprises me in a sense… But yet, I really think about reality, and folks in my family and just my own parents, and that’s true. They really like the suburban lifestyle, at least in my bubble of the world. So I guess, overall, in general, to your point, Theo, it’s looking like suburban is likely going to take a wind here for the next 10 years as far as the forecast goes, as far as this source of data suggests, and the urban perhaps could be shrinking in popularity. So that’s that on page 10 of the report.

Theo Hicks: Yeah. And it is definitely tied to the working from home statistics too, right? Because most of the people that live in the city live there because it’s so hard to get to work. For example, my wife works in a big company and a lot of people that live in the city have moved out to their parents or moved back home out of the country because they don’t need to be downtown. And so if you don’t need to be downtown and it’s cheaper to live further out in the suburbs… It’s cheaper, it’s safer, you get more space… So all these things are definitely connected.

I remember reading an article right when COVID started, about how many people left New York City for the suburbs and also places like Connecticut, and stuff. It was a crazy amount of people. In addition to people have been leaving these urban areas for a while now, and so it has only been expedited. So again, the point here is that if you’re looking at deals in the large urban areas, take a look at what the explanation is for why they’re doing it. Are they getting a really, really good deal? Or are they claiming that making predictions about “Oh, well, this is not going to last forever. Eventually, they’ll come back.” Sure, maybe that’s the case. But again, there’s additional risk when it comes to that.

So the next thing which I think is really fascinating is going to be about the debt and equity underwriting standards. So as a passive investor, most likely you’re not going to have a highly custom multi-tab Excel underwriting calculator where you pull the P&Ls, and you make all these predictions yourself, underwrite the deal, right? You’re gonna be relying a lot on the information that’s provided by the sponsor who did their own underwriting.

Now, obviously, it’s important to trust that person. We’ve talked about that before, how to qualify the GP. But another really good way to gauge how aggressive or conservative their underwriting is is how banks and then these large equity firms are also underwriting deals. So when we talk about debt, we’re talking about Fannie and Freddie Mac, their traditional fancy banks, commercial banks, insurance companies, debt funds, things like that. When it comes to equity, we’re talking about, obviously, private investors, but these big public equity REITs, hedge funds, private REITs, pension funds, things like that.

So how are they underwriting deals right now, compared to previous years? There’s actually a huge difference. So this is 2021 data, and they asked them – so for debt and equity, how do you expect the underwriting standards to be? And the options were less rigorous, or remain the same as the previous year, or more rigorous. And so historically, since 2014, basically most people said it would remain the same, especially from 2017 and on. A very small percentage of people said that it would be less rigorous or more rigorous. But bring us  to 2021 and 73% of the respondents think that the debt underwriting standards are going to get more rigorous. The previous high was 47% in 2017, and then last year was 34%. So double, basically. And it’s the same trend for equity – 67% said that the underwriting standards are getting more rigorous, and again, the previous high was in 2017, at 34%.  I’m assuming that’s because that was after the election, but still double what has been every year since 2014, with this graph.

So if you’re coming across deals that are underwriting the exact same as they did in the past few years, then that’s something to think about. That is definitely a red flag. And Travis kind of already mentioned this – the rent growth assumptions, we’re talking about just the revenue growth assumptions in general, maybe how quickly they’re going to accomplish these value-add renovations or the renovations they’re doing… Essentially, anything that’s changing from how it’s currently being operated to how it’s going to be operated after them should be very conservative, and not be super aggressive.

Travis Watts: Yup. 100%. This next section really piggybacks off of that, which is great. This is the one I was actually most excited to share with folks, because I would say probably – let me put it in top three category of questions that I get asked by investors always… Is it the right time to start investing in multifamily or continue investing in multifamily? Something to this nature. So I think this kind of sums it up. And this is a great graph I’m going to be sharing with people, because this is a great data to have, as far as a survey goes.

So what this is, is the availability of capital for real estate, 2020 versus 2021. So there are two categories – there’s lending, so getting financing for your deals, and then there’s the equity, which is people wanting to buy and own equity in this real estate. So on the lending, to your point Theo, about more rigorous underwriting and lending… So naturally, there’s a slight pullback; it’s not a major shift, but there is a slight negative impact on lending from non-bank financial institutions, government-sponsored enterprises, debt funds, insurance companies, REITs, banks, collateralized mortgage-backed securities, all that good stuff, has a slight pullback. So a little more conservative approach. But this is the part that really paints the picture. There’s a massive increase in demand from publicly-traded REITs, from private local investors like myself, private equity, hedge funds, pension funds, REITs, foreign investors… Actually, foreign investors has a slight pullback. But everything else has a large margin of more demand through 2021. And I think that really says a lot.

And here are my final thoughts on this, as a conclusion to wrap that up. I’ve talked about this before, maybe on this show, maybe on other podcasts, but right now there is a huge demand for yield. We’re not finding yield, cash flow, and interest and dividends in bonds, and CDs, and money markets, and treasuries. So both Main Street investors and Wall Street are needing and wanting yield. And the biggest margin here is REITs that are increasing exposure here. Obviously real estate investment trust. But this is huge. I hear this all the time about “Well, what do you think about cap rates?” Or “I don’t know about buying something out in Texas at a five cap. That seems crazy.” Well, think about it like this, if an institution’s coming in to buy that asset, and they’re going to pay all cash, they’re not even going to use lending or debt, they’re still getting a five cap, a 5% yield off that property. Well, how much risk are they really taking with no debt and no leverage, compared to bonds and other things that are paying 2% or 1%? So that’s still a very healthy yield for an institution to have by using no leverage and no debt.

So I still think if you’re in the space, this is again, part of my personal criteria that I’ll share. But I like investing as a limited partner in these syndications, in the unit size of 200 to 600 units. To me, that’s kind of a good sweet spot. Because as we go to the exit, we’re often going to exit to institutional capital, who’s needing this type of yield. We could also sell to another syndication group, we could also sell to wealthy individuals, family offices, stuff like that. But it gives us a lot of exit potential strategies to use.

So at the end of the day, I think the demand is for yield, and I think that people have seen through this pandemic, that B and C class value-add products have really held up. Yes, it’s been impacted, I’m not trying to sugarcoat it, but it’s not been to the effect of office, retail, other asset types in real estate. So that’s my final thought on it. And I know we’re getting short on time.

Theo Hicks: Yeah. We actually have the Best Ever conference coming up in about a month, and the first webinar they did, I think it was somewhere along the lines of should you buy or should you sell in 2021, and one of the speakers was a tax expert. And, as we mentioned before, about the impacts of the new tax plan, I kind of really like what she said, and it kind of goes along the line of what you’re talking about. It’s like, look, [unintelligible [00:24:37].20] he taxes, sure, it might impact other industries more than others, but it’s going to be an across the board thing, right? It’s going to affect everything, more or less equally.

The same thing with the pandemic, or any kind [unintelligible [00:24:48].27] in the economy, it’s going to affect things more or less equally. So when you’re thinking about whether to invest or not, or what to invest in, you can’t really compare it to the yields that you were getting five years ago, or these massive IRRs and cash and cash returns. It’s more of like, what are your options right now? What’s your best option in investing right now? You have to do something with your money, so what are you going to do with it? Are you going to keep it in your savings account? Or are you going to invest it in something? And if you invest it in something, what are you going to invest it in that has the least risk with the highest returns? Which are more important to you?

So that’s why all these equity sources are so interested in real estate; it’s not necessarily because they’re going to make the most money they never made before, its’ because this is the best option right now. So that’s what I thought about when you were talking about yields. It’s not the best yield ever, but if the best yield of the options right now.

Travis Watts: Yup, a hundred percent. Times change. Before the 2008, 2009 collapse, you could have bought US bonds at 6%, relatively taking no risk. So that would be a hell of an option today, if you could…

Theo Hicks: Exactly.

Travis Watts: But instead, you’re getting half a percent or something, or one percent. So to your point, you’ve gotta go with the current environment. And a lot of folks hang on to the old ideals of things, and where that phrase was hot in multifamily, you have, “Double your money in five years.” Well, perhaps it’s still possible in some aspects, but maybe don’t count on that in today’s environment. But yes, it’s put a lot of pressure, this low yield environment we’re in with interest rates, and everything else – it put a lot of pressure on the stock market, which is why we’ve seen these huge crazy rallies in the midst of a pandemic. And then also onto real estate. So just like you said, you’ve got to make the choice for you. Where are you going to park your money? Clip a 0% coupon in the bank, or go into some kind of asset with a moderate yield?

Theo Hicks: Exactly. All right Travis. Well, thanks again for joining us. I really enjoy these conversations and getting your perspective on these things. You’re deep in the trenches every day looking at this information. And Best Ever listeners, as always, we appreciate you for tuning in.

As we mentioned in the beginning, this is going to be based off of the blog post called Top 10 markets To Buy Multifamily In In 2020, so check that out to actually get the top 10 markets. We also have a link to this 100 plus page report. But if you just want to read the report yourself, we’ll have that in the show notes as well.

So again, thank you for joining me, Travis. Best Ever listeners, thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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JF2333: How Much Do You Need To Have Invested In Order To Achieve A Retirement Goal | Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Travis will be sharing an infographic that will help you understand how much you need to invest in order to achieve your retirement goal. Obviously, everyone has a different number in mind, but this information will help you simplify the calculations. Travis uses $100,000 a year as a goal since that is one of the most common numbers people tend to name when asked about retirement.

We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening and I will talk to you tomorrow. 

Click here for more info on groundbreaker.co


TRANSCRIPTION

Travis Watts: Hello and welcome Best Ever listeners. I