Ask the Real Estate Investing Expert

The CashFlow Quadrant – How I Save Thousands on Taxes (Legally) 

One of the most life-changing discoveries came to me years ago when I realized I was earning income the wrong way. This was uncovered when I read the book, “Cashflow Quadrant” by Robert Kiyosaki. It’s a powerful book that helped guide me to become a full-time investor and to make financial freedom a top priority. Additionally, this book has single-handedly helped me save thousands in taxes over the years.  

Source: https://www.richdad.com/taxes-stealing-your-money

 

As you can see in the diagram above, each quadrant (E, S, B and I) represents a different way to generate income. Some people earn money in only one of the quadrants, while some earn money in multiple quadrants. There are advantages and disadvantages to each quadrant.

The two quadrants on the right side (B and I) are the primary paths to financial freedom. The majority of the Cashflow Quadrant book is about the unique skills and mindsets required to succeed on this path. If you haven’t checked out this book, it’s a worthwhile read. You can learn more here.  

Let’s Explore Each of The Four Quadrants:

E – Employee

An employee earns income via a job. This is the quadrant where most people earn their income. The job itself is owned by a business, which could be a single person or a large corporation. The employee exchanges his or her time, energy, and skills to an employer in exchange for a paycheck and often other benefits such as healthcare coverage and/or a retirement account match.

Employees can make a little or a lot of money, but when an employee stops working, or if the business goes under, the income stops.

The lack of control over income is a serious consideration of the E quadrant and something I became intimately aware of when I worked in the oil industry and layoffs began to occur around 2015. An employee’s financial freedom is dependent upon the success of the employer and the ability to show up to work and exchange time for money. 

Kiyosaki points out that the reason as to why most E quadrant workers pay around 40% of their income in taxes (as shown in the diagram above) is simply because most personal expenses aren’t deductible. You can’t, for example, deduct the expense of your personal car from your taxable income. Below is a simple illustration for educational purposes only. Please seek professional, licensed tax advice from a CPA for more information. 

 

Tax Example: 

Federal Tax: 27% 

State Income Tax: 5% 

Social Security Tax Rate: 6.2% (half paid by the employer) 

Medicare Tax Rate: 1.45% (half paid by the employer)

Total = 39.65% in Tax

 

S – Self-Employed

Many employees eventually get tired of the lack of control over their pay and schedule and choose to work for themselves instead. A self-employed individual still exchanges time for money, but they “own” their job. 

Common examples of the S quadrant workers include dentists, doctors, insurance agents, realtors, handymen, among many other skilled trades. It is possible as a self-employed individual to earn a large income, but like an employee in the E quadrant, when they stop working, so does their income.

Self-employed workers have more control compared to an employee, but more often than not, they also have more responsibility. As a result, success usually means working harder and working longer hours. Over time, this can lead to burn out and fatigue as I also experienced first-hand in 2015 when I was actively investing in real estate with fix and flips and vacation rentals. 

Kiyosaki points out that the reason why most S quadrant workers pay the highest taxes, around 60% of their income (as shown in the diagram above) is that Social Security and Medicare Taxes are paid 100% by the self-employed individual (they are not split by the employer as is the case with an employee). Additionally, an S quadrant individual often earns more income compared to an employee and therefore can be in a higher tax bracket. Below is a simple illustration for educational purposes only. Please seek professional, licensed tax advice from a CPA for more information.

 

Tax Example: 

Federal Tax: 37% 

State Income Tax: 5% 

Social Security Tax Rate: 12.4%

Medicare Tax Rate: 2.9% 

Total = 57.3% in Tax

 

B – Business Owner

Those in the B quadrant own a business system and they lead other people. In this quadrant, the business often has 500 or more employees. The systems and employees who work for the business can run successfully without the business owner’s daily involvement.

Unlike the S quadrant where a plumber, for example, might own and work in his own plumbing business, a B quadrant business owner might create a plumbing company and hire 500 or more plumbers, administrators, managers, and other staff to run the systems in the company.  

 

The wealthiest individuals in the world typically own B quadrant businesses. A few of these individuals include Bill Gates of Microsoft, Jeff Bezos of Amazon, and Mark Zuckerberg of Facebook.

Kiyosaki points out that the reason why most B quadrant business owners pay around 20% in taxes (as shown in the diagram above) is because businesses can deduct a wide variety of expenses from the income of the business, which can lower the businesses income taxes. Additionally, the recently passed Tax Cuts and Jobs Act in 2017 allows for a qualified business income tax deduction of an additional 20% for eligible businesses. You can learn more here. Below is a simple illustration for educational purposes only. Please seek professional, licensed tax advice from a CPA for more information.

Tax Example: 

C-Corporation Flat Rate Tax Rate = 21% 

Total = 21% in Tax

 

I – Investors

Now to my favorite quadrant. The I quadrant is comprised of investors who own assets that produce income. This is the quadrant for truly passive income.

Investors in this quadrant have usually accumulated capital that was earned in one or more of the other quadrants and now they place that capital into income-producing investments to produce even more income. This is the magic formula for financial freedom. 

For example, an investor might purchase shares of a company privately or publicly owned in the form of stock. This influx of capital from the investor helps to fuel the systems created by the business owner, and this fuel can lead to even more growth in the business and for everyone involved. Investing in real estate is a common example of an asset that can produce passive income from collected rents and other income-generating aspects on the property. Investing passively in private placements (apartment syndications) has been my preferred asset class in the I quadrant. 

Kiyosaki points out that the reason why most I quadrant investors often pay as little as 0% in taxes, legally (as shown in the diagram above) is that long-term capital gains tax rates (for assets like stocks or real estate held the long-term) are between 0% and 20% depending on the individual’s tax situation. You can learn more here. Below is a simple illustration for educational purposes only. Please seek professional, licensed tax advice from a CPA for more information.

 

Tax Example: 

2020 Long-Term Capital Gains Tax Rate (For Single Individuals) Earning $78,750 or Less = 0% 

Total = 0% in Tax

 

Conclusion:

There are many paths to financial independence, but most of them lead to the right side of the Cashflow Quadrant – B and I. If you want to achieve financial freedom, it will pay to learn the skills and mindset required to make this move to the right side. I have earned income in the E, S, and I quadrants but the I quadrant has been the most impactful. This is because of a concept I refer to as “Time Freedom”. Which to me, means having freedom and flexibility over your time. When you have more passive income than you have lifestyle expenses, you become financially free. This is where a new world of opportunities and possibilities open up and the world becomes your oyster.     

To Your Success

Travis Watts 

Disclaimer: Travis Watts does not provide tax, legal, or accounting advice. This material in this blog/article has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction, investment, or other change. 

 

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The CDC Eviction Moratorium – What You NEED To Know

You may have seen recent headlines referring to an “eviction crisis”: 

The COVID-19 Eviction Crisis: an Estimated 30-40 Million People in America Are at Risk – The Aspen Institute 

 

Experts fear the end of eviction moratoriums could plunge thousands of people into homelessness – CNBC

President Trump signed an eviction moratorium order that effectively bans evictions nationwide through the end of the year. According to the Centers for Disease Control and Prevention (“CDC”), the moratorium order has been issued to provide housing stability and to prevent the further spread of COVID-19. However, it is important to note that rent is NOT cancelled through the end of the year. Let’s dive into how this order effects landlords and owners of real estate…

 

According to the moratorium, there are stipulations in order to receive this “eviction protection.”

Those who are eligible must meet additional criteria before presenting their landlords with a declaration, which will be made available on the CDC website. This criteria includes: 

  1. The resident has sought all available government rental assistance
  2. The resident will earn no more than $99,000 in 2020 (or $198,000, if filing jointly)
  3. The resident can’t pay their rent in full due to a substantial loss of income 
  4. The resident is trying to make timely partial payments, to the extent they can afford to do so
  5. The resident would, if evicted, likely end up homeless or forced to live in a shared living situation

What to do if you (the landlord) receives a CDC Declaration from a tenant?

 

According to Colton Addy from Snell & Wilmer Law, if a landlord receives a CDC Declaration from a tenant, the landlord should respond in writing to the tenant to encourage the tenant to make partial payments of rent (and similar housing-related payments) to the extent the tenant is able, in accordance with the CDC Declaration. Additionally, the landlord’s written correspondence should remind tenants that the rental amounts are not forgiven and will ultimately need to be paid. 

 

Additionally, many tenants may not be aware of the government assistance programs that are available to tenants to help tenants pay their rent during the COVID-19 Pandemic. Landlords should include a list of available resources that tenants can use to pay their rent. The Department of Housing and Urban Development (HUD) has stated that nonprofits that received Emergency Solutions Grants (ESG) or Community Development Block Grant (CDBG) funds under the CARES Act may use these funds to provide temporary rental assistance to tenants. 

 

The following websites provide information on federal assistance that is available:

 

www.hudexchange.info/programsupport

https://www.hud.gov/coronavirus

https://home.treasury.gov/policyissues/cares/state-and-local-governments 

 

Additionally, landlords should include other programs that may be applicable in their jurisdiction. Landlords may also consider filing an eviction proceeding for one of the reasons permitted by the CDC Order, but landlords should use caution in pursuing such actions as eviction proceedings in the current climate are likely to draw additional judicial scrutiny.

 

Penalties:

 

The penalties for individuals who violate the Order are severe, including:

 

 

  • A fine of up to $100,000 and up to one year in jail, if the violation does not result in a death; or
  • A fine of up to $250,000 and up to one year in jail, if the violation results in a death.

 

The penalties for an organization violating the Order are even more severe.

In summary, the moratorium order provides temporary relief to those residential tenants facing eviction who submit the required declaration, through the end of the year.  The order, however, does not absolve a tenant from paying rent or restrict a landlord from applying penalties, interest, or late fees on the tenant’s account for non-payment of rent.  Additionally, the order does not relieve landlords of their debt service obligations if a tenant seeks relief under the order. 

 

Disclaimer: The materials contained in this blog post are for educational and informational purposes only. Nothing in this blog post is to be considered as the rendering of legal advice. Readers are advised to obtain legal advice from their own legal counsel. Additionally, please note that the orders and laws related to the COVID-19 Pandemic are changing on a daily basis and your jurisdiction may have stricter rules related to evictions in place. Please verify the rules currently affecting your property at any given time.

 

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Debunking a Common Myth About Apartment Insurance Rates

A common practice when underwriting multifamily apartment deals is to assume a stabilized insurance expense equal to the T-12 insurance operating expense. In other words, the assumption is that the insurance premium paid by the current owner will remain the same after acquisition.

This practice was indeed correct for the past five to ten years. However, according to commercial insurance expert Bryan Shimeall, who was interviewed on the Best Real Estate Investing Ever podcast, this is no longer a safe assumption.

Due in part to the onset of coronavirus, as well as to the increase in the number of people entering the commercial real estate investment realm, insurance rates are rising fast.

Towards the end of 2019, the insurance market transitioned from a soft market to a hard market. 

In a soft market, insurers are competing for apartment investors, resulting in more competitive rates. Therefore, when underwriting deals, apartment operators were assuming the T-12 insurance rate would remain the same after acquisition, or even potentially decrease. 

However, in a hard market, the opposite is true and apartment investors are competing for insurers. As a result, insurance rates are rising. 

The magnitude of the increase is geographically driven. According to Bryan, an apartment investor should expect between a mid-single-digit and up to a 20% increase in the insurance rate when underwriting deals.

He also said that insurance companies are pickier about the types of apartments they will insure, as well as offering non-renewing insurance policies. If an apartment qualifies for insurance, there is no guarantee that it will continue to receive the same rate, the same coverage, or any coverage at all once the initial contract has expired.

Now that you know about these recent changes to insurance rates, what changes should you make when underwriting apartment deals?

The most important thing you need to do is have a conversation with your real estate insurer. If you do not have one, you need to find an insurance company or broker that specializes in real estate.

Ask the insurer about the insurance rate increases in the market you invest in.

Another important factor besides geography that is driving the rate increases are the history of losses. Bryan says it is more important than ever to provide your insurer with the history of losses as soon as possible.

Once you know you are serious about a deal, email the listing broker (if on-market) or the owner (if off-market) and request a copy of the history of losses for the apartment. 

Your insurer will need accurate and complete information about the history of losses at the property to provide an accurate insurance quote. Without the history of losses, the insure will generate a quote based on a clean history.

If your insurer obtains the history of losses report that isn’t clean, the insurance rate will be higher. Depending on the type of losses, the insurer may decide to not provide insurance at all. 

The worst-case scenario is your insurer receives the history of losses and won’t provide insurance on the apartment after you’ve invested tens of thousands of dollars into due diligence. Another bad scenario is the new insurance quote is significantly higher than your original projections and you need to back out of the deal or renegotiate a new purchase price.

Therefore, to avoid canceling contracts and wasting thousands of dollars, do not assume an insurance rate that is the same as the current insurance rate. Instead, have a conversation with your insurer prior to submitting a contract to understand the projected rate increase in the market. Then, obtain a history of losses as soon as possible so that your insurer can provide you with the most accurate quote before you have progressed further into the due diligence period.

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High Net Worth Frugality – How To Save Like The Wealthy

Frugality has played a major role in my life, starting in childhood and being brought up by two very frugal parents. I have tremendous gratitude looking back on the lessons learned and seeing the impact that saving money has had. In this post, I want to share with you some interesting data I recently came across and a unique perspective on frugality.

Americans spend the majority of their money on three expenses: Housing, Transportation and Food, according to the U.S. Bureau of Labor StatisticsYou probably already knew that, so I want to dive a bit deeper in a direction I think we could all benefit from. I want to share with you how High Net Worth Individuals save and spend their money compared to everyone else in these three primary categories. Obviously, there is no official handbook or methodology that all wealthy individuals follow; so I compiled some data and research so we can take a peek behind the scenes. 

#1 Housing 

You might be familiar with the fact that Warren Buffett paid $31,500 for his home in Omaha nearly 50 years ago and he has not increased his spending in this category ever since. This is an extreme example, but how much do you think the average American spends on housing as a percentage of household income? To my surprise, the data shows nearly 30% of household income is spent on housing costs according to the U.S. Bureau of Labor Statistics

 

Now let’s take a look at another High Net Worth example; we’ll use Tim Cook (the CEO of Apple). Tim Cook has an estimated net worth of 650 million dollars and he bought his California residence for 1.9 million dollars. This home purchase represents less than 3% of his net worth (if he paid cash) or a mortgage payment of approximately $7,500 a month if he financed the home with a traditional loan and 20% down payment. If the house is mortgaged, that means Cook spends approximately .072% of his annual income on housing costs based on the 125 million in compensation he received from Apple in 2019. It’s interesting that Buffett and Cook have the ability to buy nearly any home they desire, but they chose to embrace a reasonable frugality in this category. There are, of course, hundreds of other High Net Worth examples like these, but it is fascinating to consider this mindset when the majority of American homeowners max out their debt leverage to buy the most expensive house they can afford.  

 

#2 Transportation

According to a study done by researchers at Experian Automotive (and published on Forbes), 61% of wealthy individuals (defined as earning $250,000 or more in income per year) drive Hondas and Toyotas and Fords. You may also be familiar with the fact that many billionaires drive inexpensive vehicles as well, many of which are valued under $30,000. A few examples include:

 

  • Steve Ballmer (Billionaire) Ford Fusion Hybrid MSRP $30,000
  • Mark Zuckerberg (Billionaire) Acura TSX MSRP $30,000
  • Jeff Bezos (Billionaire) Honda Accord MSRP $20,000
  • Ingvar Kamprad (Billionaire) Volvo 240 MSRP $25,000

 

According to AAA research agency, the average American spends $9,282 a year on their vehicle, which equates to $773.50 a month. The median household income (for 2018) was $61,937 according to Current Population Survey and American Community Survey, which are surveys conducted by the U.S. Bureau of Labor Statistics and the U.S. Census Bureau. Americans dedicate nearly 15% of household income to a vehicle. 

 

#3 Food

This is one of my favorite topics when it comes to personal finances. In this post, I will keep it brief, but you can check out some of my other blogs and articles that dive deeper into the topic. According to The National Study of Millionaires, which is a 71-page nationwide study conducted on 10,000 U.S. millionaires and their spending habits, it was found that 36% of millionaires spend less than $300 each month on groceries and 64% spend less than $450, and only 19% spend more than $600 a month on groceries. The punchline; non-millionaires spend about 57% more on groceries compared to millionaires. But that’s just groceries, so what about restaurants and dining out? I’ll get right to the point on this one… 

 

To turn a profit, many restaurants charge around a 300 percent markup on the items they serve. When you go out to eat, you are paying for service, convenience and atmosphere. There is certainly a time and place for restaurants, but if you are eating out frequently, consider that you could make a $15 meal in a restaurant for $5 at home. The statistics are also interesting. According to a study from the JPMorgan Chase Institute that focused on fifteen specific metropolitan areas, studying credit and debit card purchases from more than fifteen billion anonymous transactions and characterizing them by quintiles of income, the poorest 20% spent 16.6% of their income at restaurants, trailing the wealthiest income quintile at 17.8%.

 

Takeaways

Perhaps it’s time to remove “The Joneses” from our life and start keeping up with ourselves instead. 

 

There are two sides of the money coin. One side is about making money and the other side is about saving money. Long-term financial success requires a commitment to both. We can’t forget about mentors like Mike Tyson, who amassed over 300 million dollars in a career and filed for personal bankruptcy in 2003 after going completely broke. Or perhaps the more recent example of Johnny Depp “losing” his 650 million-dollar fortune due to wild spending habits like $30,000 a month on wine and renting 12 storage facilities to store his “memorabilia”. We all know of athletes and celebrities who unfortunately were not taught about frugality, or simply chose not to pay attention. The goal for you and I may not be to join the Billionaires Club, but perhaps it’s a worthwhile pursuit to find a balance between having enough and living life on your own terms. 

 

To Your Success

Travis Watts 

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9 Things to Consider When Converting Apartments to Condominiums

Besides the traditional three apartment investment strategies (turnkey, distressed, and value-add), condo conversions is another less common business plan that can be very lucrative.

The condo conversion investment strategy involves purchasing an apartment community, converting it from individual rental units to individual condos, and reselling the individual condos for a profit.

This post isn’t going to discuss which investment strategy is the best, because like most things in real estate, it depends on what you are interested in and what your goals are. However, if you do decide to pursue the condo conversion investment strategy, here are the 9 things you need to consider:

 

  • Speak to an attorney: First and foremost, speak with a real estate attorney that specializes in condo conversion projections. You need to know the state and local laws on condo conversions and the step-by-step process you must follow.
  • Vacating the property: The largest potential challenge is the process for vacating the apartment building. An attorney will tell you the laws that protect the rights of the existing residents. In some markets, the residents must be given a specific time frame of the notice to vacate. You may even be required to cover their relocation costs and give them a chance to purchase a completed condo. The longer it takes and the more expensive it is to vacate the property, the greater the holding costs.
  • Hidden fees: There are a lot of hidden fees involved in condo conversions, which the attorney can help you uncover. There are application fees with the city, surveying fees, attorney fees, and fees related to code compliance. Once the conversion is completed, the city will inspect the condominium for code violations, which you will be required to address. Therefore, another fee is associated with hiring a private condo pre-inspection specialist to inspect the property to give you an opinion on potential code violations and the costs of the repairs. Another hidden fee is the increase in insurance costs. Insurance on condominiums is generally higher than apartment insurance, so make sure you obtain a quote for the new insurance premium. Last are the upfront and backend fees you charge for putting together and managing the project.
  • Financing: You will need to speak with a mortgage broker who specializes in condo conversion projects to securing financing. This conversion needs to begin prior to placing the deal under contract so that you can estimate the debt service and other important loan terms, like I/O periods, loan term, interest rates, prepayment penalties, financing fees, and closing costs.
  • Timing: To determine the holding costs and hold period, you need to know the estimated timelines for each step in the condo conversion process. First, how long will it take to vacate the building? Once vacated, how long will the renovations take? How long will it take to list the condo units for sale after the renovations are completed (i.e., post-conversion requirements like setting up the HOA, inspections, etc.)? Lastly, what is the average days on market and closing timeline? Add these all together and you have the hold period and can calculate the holding costs.
  • Holding costs: The holding costs are the ongoing expenses paid during the hold period. These include insurance, taxes, utilities, and debt service. Since you will be generating no cash flow (or some cash flow in the beginning while vacating the property), these expenses must be covered by initial equity.
  • Renovation costs: There are four aspects of the renovation costs to consider. One is the cost to convert the apartment units into individual condos. Two is the investment amount is required for the common areas. Three is the cost to address deferred maintenance. Last is the size of the contingency budget.
  • Sales process: The first thing you need to know is the projected after-repair value of the condominium units, which requires a sales comparable analysis. You also need to consider the costs associated with marketing and selling (i.e., the broker’s commission) the condo units.
  • Limited partner compensation: Lastly, you need to determine the compensation structure offered to the limited partners who invest. What type of return will you offer (i.e., preferred return, profit split, or both) and when are they paid (i.e., after each condo is sold or when all condos are sold)?

 

To address all the above, you will need to work with at minimum an attorney, a mortgage broker, and listing broker, and a contractor – all who specialize in condo conversions.

Purchasing an apartment community and converting the rental units into individual condo units is an alternative to the traditional apartment investment strategies. However, you need to understand the laws surrounding condo conversions, the added costs, and the required team members to properly underwrite the deal, successfully complete the conversion and conserve and grow the investors capital investment.

 

 

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How to Create a Compelling Property Management Incentive Program

As an apartment syndicator, your most important team member is their property management company. The property management companies main responsibilities are to manage the day-to-day operations and implement your business plan.

However, what if – due to market conditions or lack of skill on the part of the property management company – the your net operating income projections aren’t being met? Occupancy is low. Collections are struggling. Rental premiums aren’t being met.

One strategy to turn operations around, or to avoid operational challenges all together, is to create a property management incentives program.

Why Create an Incentive Program?

An incentive program creates an alignment of interest between you and the property management company. The better they perform, the more money you, and your investors, and they make.

What is an Incentive Program?

An incentive program is an agreement between you and the property management company in which the property management company is given an objective, and if they complete the objective, they are rewarded.

Two Types of Incentive Programs

Incentive programs fall into one of two categories. 

  • Type 1: Incentive programs that begin at acquisition and end at sale. 
  • Type 2: One-off incentive programs that end after a fixed amount of time.

Examples of Type 1 Incentive Programs

The most obvious and common is a program in which the objective is to effectively manage the property and the reward is a property management fee equal to a percentage of the collected income. Plus, they aren’t fired.

Other objectives are investing their own money in the deal, acting as a loan guarantor, or bringing on their own investors. The reward for all three is more equity or cash flow.

You can also create type 1 incentive programs for key performance indicators, or KPIs. For example, the objective is to grow total revenue by a certain % each year. Or maintaining or exceeding a specified occupancy rate. 

Just make sure the objective results in alignment of interest. For example, a bad objective is to grow the occupancy by a certain percentage each year, because there is a maximum occupancy rate. Once they achieve high-90’s, it will become impossible for them to achieve their objective without first sabotaging occupancy so that they can then increase occupancy again to receive a reward.

Examples of Type 2 Incentive Programs

Type 2 incentive programs are used when you want to target a specific KPI that is underperforming. For example, if occupancy drops below 90%, you can create an incentive program. The objective is to achieve a specified occupancy rate within a specific time frame (i.e., achieve 95% occupancy within two months). 

Once the desired objective is achieved, they receive a reward and the incentive program expires.

Type 1 vs. Type 2 Incentive Programs

Both incentive programs can be beneficial.

The type 1 incentive programs create alignment of interest from the start. Whereas the type 2 incentive programs can be used during the business plan to improve a specific lagging KPI. 

However, you need to be careful and mindful when creating incentive programs. For example, if you set an occupancy-based type 1 incentive program (i.e., maintain 95% occupancy), the management company can accomplish this goal by offering unnecessary concessions to increase occupancy. Or for a “number of new leases”-based incentive program, the management company can let in unqualified renters to inflate the number of new leases.

Therefore, type 2 incentive programs are the ideal option for KPI-based objectives. If a KPI is lagging, target it with an incentive program. Whereas the type 1 incentive programs are ideal for non-KPI-based objectives, like effectively managing the property, investing in the deal, etc.

Other Best Practices

The objective of the incentive program needs to be realistic and attainable. For example, an objective to raise occupancy from 85% to 100% in two weeks is too unrealistic. A good strategy to ensure that the incentive program is practical is to plan a brainstorming session with key members of the property management team and discuss objectives and rewards.

Also, be creative with the rewards. They can be financial based, like a gift card or bonus. However, other reward ideas are dinners with you or someone in your company, an extra paid vacation day, a free education or training course, a special trophy or plaque, etc. 

Lastly, the best incentive programs do not punish property management companies for failing to achieve the objective. If they miss the mark on an incentive program, don’t reduce their management fee. However, this doesn’t mean that you NEVER punish (i.e., fire) a property management company

Overall, incentive programs are a great way to create extra alignment of interests with your property management team and can help you target specific KPIs that are lagging behind.

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President Trump Signs Coronavirus Relief Executive Orders

President Donald Trump signed an executive order on Saturday night after negotiations reached a deadlock in the House over another coronavirus relief package.

Click here to read the full memorandum.

Here is everything you need to know about the executive orders:

Unemployment Benefits

Unemployment benefits include an additional $400 per week, retroactively starting August 1st. The federal government would contribute $300 and the states would contribute $100.

White House economic advisor Larry Kudlow said Sunday that people could expect checks in a couple of weeks.

Eviction Moratorium and Renter Assistance

The executive order did not provide specifics on a renewed eviction moratorium or renter assistance. Instead, it defers to other governmental agencies to make that determination.

The decision to ban evictions will be decided by the Health and Human Services Secretary and Centers of Disease Control and Prevention Director.

The decision to provide financial assistance to renters will be decided by the Treasury Secretary and Housing and Urban Development Secretary.

Student Loan Payment Deferrals

Student loan debt interest would be waived through the end of the year. This only applies to loans held by the Department of Education, so it does not apply to privately held student loans.

Payroll Tax Cut

The federal tax withholding for the payroll tax would be deferred (not forgiven) starting September 1st and through the end of the year for people earning less than $100,000 a year.

The Treasury Secretary may also exercise his authority to defer the withholding, deposit, and payment of the tax, meaning it may be forgiven. He could also extend the program for a full year.

 

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Why Multi-Family? Why Now?

Why Real Estate? 

Most people who are career focused and have money to invest or people who are coming to the end of a professional career, often look to real estate as a viable investment option either for building equity or for income generation. Unfortunately, real estate investing is typically thought to be a sole ownership strategy. Very few people are aware of the passive investing opportunities in multi-family private placements or “apartment syndications”. 

Why Multi-Family?

Syndications and/or private placement offerings are all about “pooling” your money together with other investors to purchase large assets that may otherwise be unattainable as a sole ownership purchase (for example, a 300-unit apartment building). If you have 10 million dollars to use as a down payment, you might have the means of purchasing an asset like this individually; however, if you prefer to only invest $100,000, that’s where a syndication structure can be a huge benefit and allow you to participate in a deal of this size. 

Why Value-Add?

I tend to invest in value-add projects. In this business model, the General Partner or Managing Partners and their teams often add value to the apartment community in a number of ways. Common value-add strategies include renovating the units, updating to modern appliances, countertops, in-wall USB ports, smart thermostats, on-site storage lockers, improve the landscaping, renovate the clubhouse, gym, pool, parking lots etc. Every property is unique and the business plan will be different for each; the overall goal is to update the property and match the current market demand while increasing below market rents along the way.

The value (price) of an apartment complex is primarily derived from the NOI (net operating income), which is comprised of the total collected rents and income minus expenses to operate the property. When the net operating income increases, the value of the complex increases. For example, let’s say the annual net operating income on a property increases by $100,000 a year. A $100,000 a year rent increase could potentially bump the purchase price up by nearly one million dollars (for example/educational purposes only). 

Why Invest? 

Multi-family real estate investing has a lot to do with diversification of an investment portfolio. There are two common reasons why people invest in real estate. Most people either invest and wait for the property to increase in value or “force” the appreciation (equity investing) or they rent it out and collect the cash flow (income investing). Why not do both? Value-add business plans are often designed to capture both of these strategies. 

Multi-family real estate is a diversified asset in itself. This is largely due to the fact that when you buy an apartment building, you are investing in many units. With single-family homes, you have (1) unit and (1) tenant. If your tenant moves out or doesn’t pay rent, you are 100% vacant and 100% unprofitable. With a 300-unit property, it is not uncommon to have the ability to lose 70-90 tenants at any given time, and still be profitable. The diversification does not stop there. Many people invest passively in syndications because they can spread out their risk geographically among several properties and Sponsors.  

Why I Decided to Invest in Multi-Family

In 2015, after a complete burnout of trying to expand my single-family portfolio, I decided to return to the drawing board in search of a more sustainable and scalable approach to investing in real estate. I was desperate to become a hands-off investor after realizing how active this business can be. In 2015, after reading 52 books, listening to podcasts, networking in real estate groups and seeking mentors, I ultimately decided that multi-family real estate was my solution. More specifically, investing passively in apartment communities via private placement offerings (syndications). 

These Were a Few of My Reasons:

  • I needed a hands-off approach to invest in real estate 
  • I wanted tax advantages equal to or exceeding single-family 
  • I wanted geographic and asset type diversification 
  • I was seeking a recession-resistant asset class
  • There was (and still is) a nationwide demand for affordable housing 
  • I wanted to leverage other people’s expertise, track record and deal flow

Whether you decide to be active or passive in the multi-family space, I wish you success in your journey. This asset class has truly been a blessing for my family and I. I have a passion for helping educate others in real estate. If you have any questions, please reach out anytime. I would be happy to connect on a call or email to help in any way I can.  

 

To Your Success

Travis Watts 

 

 

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“You Shouldn’t Use the Radio to Generate Leads” Myth Debunked

“Don’t waste your money or time advertising on the radio.”

“The radio is prehistoric.”

“No one listens to the radio anymore.”

I am certain you’ve heard one or a version of the above in your real estate career. Consequently, most real estate investors believe they should not use the radio to generate leads.

However, the statistics on radio usage may surprise you. Radio is still one of the most powerful mediums in the United States with a weekly reach of around 90% among adults. Since adults are listening to the radio and adults own real estate, the radio can be a great way to generate leads.

But the myth isn’t quite debunked just yet… Enter Chris Arnold.

We interviewed Chris on the Best Real Estate Investing Advice Ever Show. He has closed on over 2,500 real estate deals. And guess what? Every single deal came from a lead generated using the radio!

Now, the myth is officially debunked.

One of the main reasons why Chris has had so much success using the radio is because most people believe the myth this blog post is attempting to debunk. How many real estate investors do you personally know who use the radio to generate leads? For most of you, I bet the answer is a big fat zero.

Many people are listening to the radio yet very few real estate investors utilize it to generate leads. Therefore, there is a massive supply-and-demand imbalance from which Chris is benefiting, and so can you.

How can you replicate Chris’s success on the radio? Here’s his simple four-step process:

Define Target Audience: First, you need to define your target audience. Chris’s target demographic are people over the age of 50, because this is the demographic that is likely motivated to sell a home due to things like retirement, inheritance, tired of being a landlord, etc. Since defining a target audience isn’t the purpose of this blog post, click here and here to learn more about this topic.

Create the Advertisement: Once you’ve defined your target demographic, the next step is to create your advertisement. Like any advertisement, it needs to touch on the pain points of your target demographic, as well as include how you will alleviate that pain point and a call-to-action. Chris says you can either record the ad audio at home or, if you don’t have the proper equipment, you can use the local radio station’s studio.

Find a Radio Station: After you’ve created your advertisement, you need to find the right radio station on which to air your advertisement. Selecting the right radio station is easy. You’ve already defined your target audience, so all you need to do is determine the type of music they prefer. Since Chris targets the 50+ demographic, he airs ads on classic or old school rock stations. If your target demographic is rural, he says country music radio stations are best. Or R&B stations if your target demographic is urban.   

Negotiating the Costs: The last step is negotiating the costs of the advertising spot. Chris says the average person calls into a local radio station, asks for their media packet, and pays that price. However, Chris pulls reports on the value of the radio station prior to calling. Based on the reports, he calculates how much the advertising spot is actually worth. Then, once he calls the radio station, he tells them how much he is willing to pay based on his research rather than asking how much do pay. As a result, Chris is able to pay $1,500 for 100 sixty second ad spots per month.

 

One of the major benefits of using Chris’s method is that it is a set-it-and-forget-it strategy. Record the ad, send it to the radio station, and wait for the phone to ring. This is contrasted with other, more active marketing strategies like cold calling, direct mail, or driving for dollars.

And, as I mentioned previously, the number 1 benefit of using the radio to generate leads is that no one else is doing it. 

Chris’s episode is scheduled to air July 22, 2020. Be sure to mark your calendars so that you can listen to his episode to learn even more about this powerful lead generation strategy. 

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How to Navigate 2020 – 5 Tips for Real Estate Investors

What a crazy year this has been! It has certainly been a rollercoaster to say the least, but the good news is that there are ways you can not only survive, but thrive in 2020 as a real estate investor. 

Here Are 5 Tips That Can Help:

#1 Educate, educate, educate. Working from home? Can’t travel? Attend some online events, webinars, read a few books, listen to podcasts, watch “how-to” videos, get on BiggerPockets and read blogs. 

“An investment in knowledge pays the best interest” – Benjamin Franklin 

#2 Re-define your goals and investing criteria. What are your long-term goals? What do you REALLY want to gain from investing in real estate? It’s not all dollars and cents and it’s not all about cashflow vs equity. Take a couple hours this summer to write down what it is you really want to achieve in life. Money can only be exchanged for experiences or “things” – what are you after? 

“You should set goals beyond your reach so you always have something to live for” – Ted Turner

#3 Volunteer your time – seek mentors. Learn from other’s successes and failures. Mentorship can come in many forms, but the most effective is usually in the form of having a personal coach or mentor. This has made the biggest impact in my life over the past decade. Have money to spare? Consider hiring a coach or mentor. Don’t have money to spare? Consider volunteering your time to add value to others in exchange for mentorship.  

“The richest people in the world look for and build networks. Everyone else looks for a job” – Robert Kiyosaki 

#4 Get your personal finances in order. What can you do to reduce overhead or save additional cash? Could you start a side business for some additional income? Stay focused and disciplined on your long-term objectives. Any time you spend money on things you don’t need, you move further from your goals.

“Personal finance is only 20% head knowledge and 80% behavior” – Dave Ramsey 

#5 Learn from mistakes. You will make mistakes and you will likely lose money based on inexperience; I know I have. Reading biographies, seeking mentors, asking people about their “lessons learned” can help you cut the learning curve. 

“It’s good to learn from your mistakes. It’s better to learn from other people’s mistakes” – Warren Buffet 

I hope you find these helpful. Even if you only implement ONE of these, you will be 90% ahead of most. This year, more than ever, is a time to grow, expand and thrive. 

To Your Success

Travis Watts 

 

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Senate Announces HEALS Act Stimulus Package: Here’s What You Need to Know

On Monday afternoon, the Senate Republicans unveiled the Health, Economic, Assistance, Liability Protection and Schools (HEALS) Act, the second stimulus package meant to offset the economic impacts of the coronavirus pandemic.  

Here’s what we know so far about the potential terms of the second stimulus package based on the HEALS Act:

Second round of stimulus checks: Like the CARES Act, the HEALS Act should send payments to qualifying individuals and families. The payment amount was up to $1,200 per person in the CARES Act, and the HEALS Act will likely follow the same payment model. What is undecided are the eligibility guidelines. However, it seems like the negotiation is between keeping the eligibility guidelines the same or allowing more people to receive the payment. Therefore, people who were eligible for the CARES Act stimulus checks will likely be eligible to receive a second payment. The goal is for people to receive checks in the beginning of August.

Unemployment benefits: People who applied for unemployment for the first time due to COVID or were already collecting unemployment will receive a weekly payment on top of the ordinary unemployment benefits. People who were unemployed received $600 a week from the CARES Act. However, the HEALS Act would reduce the extra payment to $200 a week and over time increasing to $500 a week.

Payroll Protection Program (PPP): The PPP program provides forgivable loans to small business to cover payroll (and other costs) as an incentive to keep employees on the payroll. The HEALS Act is expected to target the hardest-hit small businesses with PPP loans. 

Employee retention tax credit: This tax credit program was introduced in the CARES Act. Companies receive tax credits for wages paid to their employees during the pandemic as another incentive to keep employees on the payroll. The HEALS Act proposes to include additional tax relief for companies who hire and rehire workers. 

Return-to-work bonus: If an unemployed person gets a new job and begins working at a previous job again, they will receive a bonus of up to $450 a week on top of their wages.

Renter assistance: The renter assistance programs proposed would help tenants pay their rent, help landlords pay expenses and put another hold on evictions for up to a year.

The next step is for the House to negotiate the terms of the act to finalize the bill. Hopefully, Congress comes to an agreement by next Friday, August 7th, which is the last Senate session before a month-long recess. 

We will keep you posted on any developments regarding the next stimulus package.

 

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How to Go From Solopreneur to a Business That Can Run Without You

Want to go from working 20, 30, 40 or more hour per week while doing one deal a month to working an hour per day while doing over 100 deals per year?

Mike Simmons, a wholesaler and fix-and-flip investor who Theo interviewed on the podcast, was able to go from a solopreneur to operating a business that runs without him by following one simple trick.

For nearly five years, Mike worked 7:30am to 4:30pm in a W2 job. After work, on weekends, and sometimes even during his lunch breaks, he would work in his fix-and-flip business. Since it was just him, he did it all. He found the deals. He negotiated the contracts. He attended closings. He managed the contractors. Overall, he spent 20 to 30 hours on his business each week, resulting in one deal per month. 

Flashing forward to present day, Mike almost never sees the houses that he buys. He doesn’t attend closings. He doesn’t find deals or buyers. Yet, he completes over 100 deals per year.

His secret? Every step in the flipping and wholesaling process is automated, and he has hired an employee who is responsible for overseeing each of these processes.

When to Hire?

The first step in going from solopreneur to a business that can run without you is knowing when to start delegating. In other words, when do you hire your first employee?

The answer depends on how quickly you scale your business. 

Here are three examples of when you should hire your first employee.

You identify a bottleneck. Mike’s first bottleneck was the process of ensuring a wholesale transaction is completed once a deal is under contract and an end buyer is identified. He spent more time on this part of the process and less time finding deals and finding buyers (among other things). So, his first hire was a transaction coordinator to oversee this step in the process.

Your business is generating enough income to pay the salary of an employee. Mike paid his first employee $12 per hour. So, he was generating at least that much income in his business

There is something you really dislike doing or are really bad at. Another reason why Mike’s first hire was a transaction coordinator was because he had poor attention to detail skills. He needed an employee who was detailed oriented.

Who to Hire and In What Order?

As I mentioned above, you hire your first employee when you’ve identified a bottleneck in your real estate process and/or when there is something you don’t like doing or are not good at. Also, when your busines generates enough income to pay an employee’s salary.

After you’ve first hire, who do you hire next?

The decision on who to hire next is similar to deciding who to hire first. Either there is something else you don’t like to do or are bad at, or a new bottleneck is created by the previously hired employee.

Mike’s second hire was a salesperson. Mike thought of himself as a decent salesperson. However, he didn’t like it. After hiring a salesperson, not only was he able to focus on aspects of the business that he enjoyed more but he was also able to complete more transactions due to the higher level skills of this new hire. 

Mike made his third hire based on a newly created bottleneck. The salesperson was responsible for answering the phone calls for income leads. This took time away from the salesperson getting in front of potential sellers and negotiating contracts. To remove this bottleneck, Mike hired a person to answer the phones. That way, the salesperson could spend more time negotiating contracts and less time on the phone qualifying leads.

Now that Mike had a dedicated person to answer the phones, he had the capability to handle more leads. Therefore, he hired a marketing person to generate more leads to keep the person who answers the phones busy.

Overall, the order in which you hire new employees usually starts with tasks you don’t like doing and eventually evolves into alleviating bottlenecks created by a previously hired employee.

Doer vs. Leader

When you are a solopreneur, you are wearing all the hats in your business. You are working in your business.

Once you start to hire employees, you slowly work less “in” your business and more “on” your business.

When you work in your business, you are a doer. When you work on your business, you are more of a leader.

The skills required to be a real estate doer are different than those needed to be a real estate leader.

One tip Mike provided about how to be a better leader to your employees is to document a process prior to hiring someone to oversee that process. A bad leader hires an employee for a role and says, “just get it done.” A good leader hires an employee for a role and says, “here is what you need to do in order to be successful.” But rather than telling them what they need to do, you can provide them with documentation with the step-by-step process for how to successful in their role.

 

To go from a solopreneur to operating a business that runs without you requires hiring employees. To ensure that the business runs successfully without you, make sure you are hiring employees for the right reasons and in the right order. And as you hire more and more employees, make sure you are improving your leadership skills.

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Turn a Decade Into a Year – How to “Knowledge Hack”

I love helping other people cut the learning curve. There have been several instances in my life where I condensed years and even decades of time by using a simple “Knowledge Hack” strategy. 

 

I Have a Question For You…

Have you considered having a mentor? Is it worth your time to read books, listen to podcasts, watch how-to videos, and network with others? 

 

Today I was researching some of the most successful people in America from the Forbes 400 List and realized that almost all of them had mentors at some point, and many still have mentors today. 

 

A Few Examples Include:

 

  • Bill Gates had Ed Roberts as a mentor
  • Oprah Winfrey had Mary Duncan as a mentor
  • Mark Zuckerberg had Steve Jobs as a mentor
  • Warren Buffet had Benjamin Graham as a mentor
  • Sam Walton (And family) had L.S. Robson as a mentor
  • Michael Dell had Lee Walker as a mentor 

 

Rather than thinking about having a “mentor” think of the word “coach” instead. It’s essentially the same thing, but using the word “coach” helped me put all of this into perspective years ago.   

 

A Quick Story

From 2009 to 2015 I did everything on my own as an active real estate investor in the single-family home space. It wasn’t because I thought I knew it all, it was because I did not see the need for a mentor or coach at the time. 

 

What I finally realized in 2015 (after 7 years of trial and error), was there were other people in the active real estate investing space who were operating much more efficiently than I was. They had more connections and were finding better deals and had a broader range of skill sets and ultimately… they were more profitable than I was. I had to do some soul searching, self-reflection, and take a long, hard, look in the mirror. Was active investing really the best use of my time and skills? 

 

What Happened Next?

I made a decision to start partnering with investment firms who had better skill sets, track record, connections, and efficiencies than I did. I essentially “piggybacked” off their success by becoming a limited partner investor in other people’s private placement offerings (mostly in multifamily apartments). This provided a hands-off approach to investing where I had the best of both worlds. I could participate in real estate, which I love and enjoy, while not having to be “in the business” of real estate in an active way, which I did not enjoy. 

 

After dedicating some time to networking, reading, listening to podcasts, watching how-to videos and seeking mentors, I inevitably became a full-time passive investor in real estate. I left the active single-family strategy behind because I was tired and burned out from trying to do it all myself, trying to make the right calls and know all the ends and outs. In addition, the hands-on approach was taking too much time away from the things I loved doing. I had far less spare time because my real estate projects were consuming more and more of my availability. 2015 was the beginning of an entirely new education process that has been life-changing to say the least.  

 

Takeaway

Mentors can come in many forms. The best advice I ever received was to seek out a mentor or “coach” who is doing what you want to do and is successful at doing it…because success leaves clues. 

“If I have seen further than others, it is by standing upon the shoulders of giants” – Sir Isaac Newton

 

To Your Success

 

Travis Watts

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1031 Exchange: The Rules

As the owner of investment properties large and small alike, there’s a vehicle available in which you can actually continuously invest into larger properties and delay the capital gains expenditure that is due to reveal itself at some point. This vehicle is called a 1031 Exchange.

 

According to the United States Internal Revenue Code (26 U.S.C. § 1031), a 1031 Exchange allows a taxpayer to defer the assessment of any capital gains tax and any related federal tax liability on the exchange of certain types of properties. In 1979, federal courts allowed this code to be expanded to not only sell real estate but also to continuously purchase within a specific timeframe with no liability assessed as that time.

 

In addition, these exchanges must be utilized for productive use in business or investment. Prior to 2018, properties listed under the code included stocks and bonds and other types of properties. However, as of today, the 1031 Exchange only includes real property which makes this excellent for investors.

 

1031 Exchange Rules Explained 

 

There are 7 primary 1031 Exchange rules which require a deeper study: 

 

  • Like-kind property 
  • Only for Investment or Business Intentions
  • Greater or Equal Value Replacement Property Rule
  • “Boot” is denied
  • Same taxpayer rule
  • 45 day identification window 
  • 180 day purchase window

 

1031 Exchange Rules Explained 

 

Like-Kind Property

 

According to the IRS, each property must be utilized in trade or business for investment purposes. Keep in mind that property used personally, like personal residences or second homes, will not qualify for the 1031 Exchange opportunity. 

 

However, real property, most commonly known as real estate, does include land and anything attached to the land or anything built upon it, or an exchange of such property held primarily for sale does not meet the requirements for the utilization of a like-kind exchange.

 

Only for Investment or Business Intentions

 

To meet the criteria for a 1031 Exchange, the real estate must be utilized for investment or business purposes only. The investment vehicle must be property that is not considered a primary residence but is used to generate income and profits through appreciation and that can take advantage of certain tax benefits.

 

For example, real property identified for investment purposes can be any property that is held for the production of income, whether it be a rental for leasing option, or if the value increases over time (capital appreciation). In order for it to meet the criteria for the tax deferral, the property must be held strictly for either investment or business use.

 

Greater or Equal Value Replacement Property Rule

 

The greater or equal value replacement property rule identifies a limitless amount of properties as long as their combined value does not exceed 200% of the originating, or previously sold property. In addition, this rule also includes the acquired properties to be valued in the neighborhood of 95% or higher of the property that is being exchanged for.

 

“Boot” is denied

 

The term boot is where money or the even exchange of items considered to be “other property.” If it is determined that a taxpayer does receive boot, that booted exchange or a portion of will become taxable.

 

Rules of Thumb for the Boot Offsetting Provisions:

if the seller receives replacement property of the same or higher value than the net sale price of the property previously sold, and in addition, the seller spans all of the proceeds from the acquisition on the property being replaced, then that exchange does meet the criteria to be totally tax deferral. If the seller follows these guidelines, then there is no consideration of this being considered “cash boot” received and either took on new mortgages in addition to the previously dissolved mortgage or the seller gave the “cash boot” to reconcile any received “mortgage boot.”

 

The Same Taxpayer Rule

 

It is mandatory under the same taxpayer rule that the seller who previously owned the property that was sold must be the exact same person, via tax identity, who takes over ownership of the property being replaced. The question is why? The answer is because if the taxpayer changed their identity, based on tax law, then there would be no continuous action of the tax. Therefore, the proceeds are subject to become taxable.

 

45 Day identification Rule

 

Under the 1031 exchange code, the taxpayer has a 45 day window from the date of the sale of the previously owned property to identify the replacement property. The 45 day window is commonly referred to as an identification period. This process must be done in writing with the authentic signature of the taxpayer.

 

When identifying the replacement property, remember the following suggestions:

  • Any real property as long as it is being considered for business or investment purposes may qualify. The property can be located anywhere in the continental United States. In addition, in 2005 there were certain temporary regulations that were allowed for rental real estate to be purchased in Guam, and the Northern Mariana Islands, and also in the US Virgin Islands.
  • The property must be clearly identified with a physical street address or legal property description, and in some cases, specific unit addresses are mandatory.
  • In the process of identification, the property may be changed or additional real estate can be added by 12 midnight on the first 45th day of your identification window. Keep in mind that there are two rules that must be remembered and they are the 3-Property Rule and 200% Rule. Sometimes, revoking your original identification may be required while you are in the process of making a new one.
  • If there is any property purchased within the window of the 45 day rule then there is no formal identification needed, however, keep in mind to take the identification of other properties in consideration.
  • Purchasing replacement properties from relatives should be given careful scrutiny.

 

180 Day Purchase Rule

 

When completing a 1031 exchange, the 180 Day-Purchase Rule mandates that the replacement transaction must be completed within 180 days or six months in total. Regardless, the rule always applies. This means that conveyance of title must be completed by this date. If you ever decide to participate in an apartment syndication, please adhere to this rule.

 

Executing a 1031 Exchange

 

Example 1: Assuming that a taxpayer has decided to invest into a multifamily unit and he has decided to sell it. To the taxpayer’s surprise, the property generated $300,000 in gains, and after closing, the net proceeds were $300,000. With the taxpayer staring at a capital gain tax liability of 200,000 in taxes (federal capital gain tax, depreciation recapture, state capital gain tax, and net investment income tax) after the property sells. Only $100,000 in net equity is available to be reinvested into another property.

 

Example 2: If the same investor chose to complete an exchange, the investor would have had to have identified the new replacement product being a multifamily unit within 45 days and invests the entire 300,000 into the purchase of the replacing property with no capital gains due.

 

For an investor, a 1031 exchange is an excellent opportunity. When you decide to invest in properties, it is natural to migrate to larger units, specifically multifamily properties.

 

As you continue development and growth in this area, you may even want to consider becoming an apartment syndication investor. This will allow you to pool resources from other sources that will facilitate the overall growth of your portfolio and investment profile. Understanding the 1031 Exchange can generate large revenue and save taxes.

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How to Calculate the Preferred Return and IRR for Apartment Syndication Deals – Ask The Expert

One of my consulting clients asked me two questions about calculating the two return factors that are the most relevant to passive investors: preferred return and internal rate of return.

Questions #1: When a syndicator purchases an apartment complex, how can they determine what the preferred monthly return is going to be?

Questions #2: When a syndicator purchases an apartment complex, how can they determine what the profit is going to be that gives them the estimated IRR?

Theo Hicks, who is the key underwriter for my consulting program, provided answers to these two questions and here is what he said.

 

Question #1 – How to Calculate Preferred Return

The preferred return is a threshold return that limited partners are offered prior to the general partners receiving payment. If the preferred return is 8% paid out monthly, for example, the limited partners will receive the first portion of the monthly cash flow up to 8%.

To calculate the preferred return amount, multiply the total equity investment from limited partners by the preferred return percentage. If the preferred return is 8% and limited partners invested $1 million, the annual preferred return is $80,000 (0.08 * $1,000,000). Typically, profits above the preferred return are split between the general partners and limited partners.

The general partner sets the preferred return percentage based on the business plan, the goals of their limited partners, and what other general partners who are implementing similar business plans are offering.

When underwriting a deal, the average annualized cash flow should exceed the preferred return amount offered to investors so that you can distribute the preferred return.

 

Question #2 – How to Calculate Internal Rate of Return (IRR)

To calculate IRR, you need to know the amount and date of all payments to investors. Unlike cash-on-cash return and equity multiples, IRR takes into account the time value of money (i.e., $100 received today is worth more than $100 received in 5 years).

Typically, the IRR calculation includes the ongoing distributions plus profits at sale. If there is a refinance or supplemental loan, those proceeds are included in the IRR calculation.

When underwriting a deal, you set income and expense assumptions based on how the property is currently operating, market rates, and conversations with your expert property management company. The output of your underwriting is the projected ongoing cash flow and sales proceeds. IRR assumes that distributions are paid annually. A more accurate IRR metric is XIRR, which tracks real time distributions.

 

Click here for more Ask The Expert blog posts. If you have a question you would like to have answered by an Expert, comment below.

 

Are you a newbie or a seasoned investor who wants to take their real estate investing to the next level? The 10-Week Apartment Syndication Mastery Program is for you. Joe Fairless and Trevor McGregor are ready to pull back the curtain to show you how to get into the game of apartment syndication. Click here to learn how to get started today.

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Two Common Real Estate Scenarios: Communication and Protection

Two Common Real Estate Scenarios: Communication and Protection

In this blog post, we’re going to be looking at two niche real estate scenarios that can happen to just about any investors.

The first scenario involves dealing with older potential clients and original buildings. If you’ve been in this situation before, you know that it can be quite a delicate process getting older owners to sell.

Communication Issues

Imagine this: You just found a potentially amazing off-market apartment building deal. It has 150 units and a $4 billion portfolio. It was purchased back in 1978, just over the 39-year expiration of the depreciation tax benefits law. The owner is in his late 80’s and purchased these buildings when they were first built at the time. You give him a call and ask him if he has any interest in selling, but he has trouble hearing you. He hands the phone to his caregiver, who abruptly says no and hangs up. What solution is there?

What one should do in this situation is to get curious. Start asking yourself some questions, then draft a letter to them. This is how you can learn more about their situation while introducing yourself to them. This is your chance to say, “I’m not sure where you’re at in this stage of owning these properties, but I can tell you that you might be worried about tax liability when you sell them. I have experience purchasing these types of buildings and I’d be happy to talk about some solutions any challenges you might be having.”

Penning a handwritten letter shows care and integrity. Keep in mind that many people of a certain age are struggling to keep up with the constant innovations and growth in the tech and digital world. A handwritten letter could be a breath of fresh air and a means to communicate that potential sellers may appreciate.

Protection From Embezzlement

Now, think of this scenario: You’re embarking on a general partnership in the real estate industry. It is your first time committing to such a project, and you’ve heard horror stories from colleagues involving embezzlement, fraud, and massive loss of funds. The general partner controls the business plan as well as the financial account connected to the project. You’re wondering how you can protect yourself from them embezzling funds from the operational account, and what auditing protocol you can use to protect yourself as a passive investor from theft.

There are several ways to approach this, but we can look at the most tried and true method.

You can have some checks and balances before the deal is done, which won’t be very much. After the deal is closed, though, you can do a lot more. For this scenario, we’ll look mostly at what a beginner real estate investor can do preemptively to stay safe in a general partnership.

There is no money for a potentially untrustworthy or shady general partner to take before the deal, but you can do some due diligence prior to a deal. If a shady partner is going to steal money from the entity itself, then they would have to do it afterward. This is because that is when the money is physically in the bank account.

Before the deal closes, there are a few things you should do. First off, you should absolutely take the time to look at the overall structure of the deal to make sure that there is at least an 8% preferred return. Make sure that the general partner is getting paid an asset management fee if and only if they are actually performing. If they’re proving themselves and they’re returning the preferred return, they can get that asset management fee. Otherwise, they get nothing.

Obviously, these are things that aren’t going to outright prevent someone from stealing money in a general partnership. When it comes down to it, they’re just small things you can do to ensure that the deal itself is set up in the mutual favor of you and your general partner, so that you have an alignment of interest.

Those are some things you can do before the deal. Another thing you should absolutely be doing before signing on anything with a general partner is to check those references. You can absolutely not go into a general partnership blind with no knowledge of who you’re working with. Even if the hearsay is overwhelmingly positive, you absolutely need to still check in with the partner’s references. By doing so, you’re going to get a really good picture of what the partner is all about.

Call their references and listen to what they have to say. We’re talking about past partners, firms, project managers, any business colleagues or people who have worked with this particular partner. Even if you get glowing reviews, you should then Google your partner. Those are things you’re probably already doing, but it really can’t be optional if you’re a baby real estate investor. You can be seen as an easy target because you don’t necessarily know the signs and symptoms of a parasite real estate partner. When you Google them, look for the partner’s name or firm title. And don’t be afraid to dig deep.

This doesn’t directly answer the question of how to make sure they’re not embezzling money, and we’re aware of that. However, there is some prep work that needs to be done on the front end to mitigate the risk of getting in with a group that is known for criminal activity. Sometimes that front end research is really all you need to check out.

What do you think about these two scenarios in real estate? Have you experienced either situation in your career? Tell us your real estate story in the comments below!

Image courtesy of Pixabay

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Joe Fairless