JF2613: 3 Pillars of Investing in Multifamily | Actively Passive Investing Show 65
In today’s episode of the Actively Passive Investing Show, Travis is joined by Jeremy Roll to discuss the hands off investor lifestyle and what it’s like being a cash flow investor. They talk about why multifamily is one of the top asset classes to invest in over the next 10 years, the benefits of class B multifamily over class A, and the 3 factors of diversification you need in order to reduce your risk.
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Travis Watts: Hello, everybody. It is Travis with the Actively Passive Show. I appreciate you guys, as always, tuning in to another episode. I have a really fun idea here. Theo and I, I think it was back in 2020, we did a three-part miniseries on this show, where we highlighted How to Vet a Deal, How to Vet a Market, and How to Vet an Operator or a Sponsor. And that was really a popular three-part miniseries, and I want to do that again, but I’ve got something even more unique this go around.
Some of you may know, some of you may not, I also host a show. It’s called Masters of Multifamily, where I bring on guests, which as you know, on this show, we don’t have any guests, but on that show, I do. And we talk multifamily, we talk investing, we talk taxes, and we talk strategy. So there’s three guests in particular, that I felt would be a great addition to this particular show.
And so what I’m going to do is, I’m not going to bring them actually on the show to repeat themselves, I’m going to share with you some highlights from the interview that I did with them on Masters of Multifamily. So it’s not going to be the entire episode, because sometimes those run a bit long. And of course, I want to keep that exclusive content to Masters of Multifamily.
So, if you enjoy this episode, leave a comment below, make sure you like and subscribe, and let’s connect on social media. If you have any feedback, this will be part one of the three-part series, I’m bringing on my dear friend Jeremy Roll, who’s a fellow passive investor like I am, he’s probably about a decade beyond where I’m at. So that makes for a really great conversation. So you guys enjoy. Without further ado…
Travis Watts: Well, Jeremy, I appreciate your willingness to come on the show, teach our listeners about the hands-off investor lifestyle, for lack of better words. You and I have a lot in common, and I just thought you’d be a great guest for the show. So if you wouldn’t mind, just tell the listeners a little bit about your background, your story, maybe how you got started and what prompted you to become a full-time cash flow investor.
Jeremy Roll: Sure. Thanks again for having me on. I really appreciate it. I know we’ve known each other for years, and we have very similar mindsets with investing. So I’ve been investing in what I call “alternative investments” like multifamily since 2002, and essentially, that was the result of my pivot, after I saw the dot-com crash in the stock market for those of you who are old enough. And for me, it’s all about more predictability and more control over exactly what I’m investing and understand what I’m investing in.
So I’m a big cash flow investor. I tend to look for more predictable cash flow. And I was trying to get away from the lack of predictability of the stock market after the dot-com crash where we saw 30-plus percent crash, just like the volatility and a lack of predictability were not a fit for me. So that’s how I started investing in real estate.
And then in 2007, I had a strong moment in the corporate world, I was working at Toyota headquarters here in Los Angeles at the time. And I had enough cash flow built up to live off of, which was not my intention. My intention [unintelligible [00:03:31].27] paycheck and then kind of have a more predictable income stream on the retirement account. But then I decided to take a risk, leave the corporate world and give it a shot and being a full-time passive cash flow investor, at that point. Gave myself two years, ended up working out, and here we are actually till last month, 14 years later. So that’s what happened for me, and it really wasn’t even intentional, right? It was more just kind of investing in something that I thought was a better fit for me.
Travis Watts: I love that. So many busy professionals out there, so many people looking to do passive investing. We have a lot in common, but certainly a lot of differences in our story as well. One thing I want to highlight, though – I know you invest in a lot of different asset classes, this is a multifamily webinar series… So I kind of want to hone into that, and I want to ask you, why multifamily may be one of the top asset classes to invest in for the next 10 years? I’d love to get your thoughts on that.
Jeremy Roll: Yes, multifamily is definitely one of my top asset classes the next 10 years for myself. It’s a great fit for someone like me for predictability. So I tend to look at stuff that’s more highly occupied buildings, and it’s also very well diversified, so there’s 100 or more tenants. So if one tenant leaves tonight, the diversification doesn’t cause a huge gap in the cash flow.
And to me, when I think in the next 10 years what’s going on with society – and we’re recording this in 2021 – we have housing prices going up tremendously, with some potential inflation. We have, unfortunately, less and less people being able to afford the purchase of houses, more and more people needing a place to live that’s more affordable, which is exactly what an apartment is, it’s an affordable alternative solution for somebody, of whatever income level they are…
And I’m a big believer that we’re going to need to have this affordable housing going on for many, many years to come. And especially in infill areas, where there’s a lot of high demand and continued population growth that’s projected, and continued economic growth is projected.
So when you think about it, multifamily has been around for decades, it’s an absolute core staple, people need the place to live. I don’t see that changing anytime soon in the next 10 years, and I just think there’s going to be more and more need for affordable housing going forward, and that’s really why I love multifamily.
Travis Watts: Thank you for sharing your thoughts and perspective on that. So let’s dive into affordable housing. I probably shouldn’t use that word… Apartments that are affordable for most Americans. Let’s talk about that. And more specifically, let’s hone into Class B apartments – what that means, what that is, why you and I invest in that asset class… But I’ll let you tell the listeners why you invest in that asset class.
Jeremy Roll: Yeah, so Class B has actually always been my number one target, and the reason is twofold. One is class A, while it’s enticing, because newer buildings are very nice, very pretty, and bring obviously higher incomes, during downturns I find that they’re more susceptible to rent adjustments, because the rents are already so expensive, and those people have the alternative of going into a B-plus building, that may have been freshly rehabbed, for example.
So if you’re looking at more predictability and less volatility, there’s definitely risk that the A can transfer to B. C Class tends to be challenging for someone like me, because there tends to be a higher level of turnover, a harder time collecting rents, and when you’re thinking about predictable cash flow and what could throw that off, all those things will throw off predictable cash flow.
So I’ve always found that like the core Class B multifamily is just the sweet spot for me in the middle for those reasons. I try to invest both for predictable cash flow, but also for a little bit of downside risk protection. And I feel like Class B has the best downside risk protection when you’re looking ABC within multifamily.
Travis Watts: Couldn’t agree more. So I want to take a quick pivot here, and I want to talk about tax benefits. And a quick disclaimer that you, Jeremy, nor I are tax professionals. We’re not CPAs, and this is not giving any kind of tax advice. I just wanted to get from a high level, your perspective of investing in multifamily apartments; we’ve both done a ton of that. What are some of the tax benefits that you have experienced in this space? Whatever you want to hit on in this category is fine.
Jeremy Roll: I think there’s two things to probably hit on. One is that the general depreciation you can get an investment multifamily just as a general term is that you will get, in a typical deal, your pro rata share as a passive investor of the depreciation benefits. Each deal is different. Some sponsors may not do that exactly on a pro rata basis, but in my experience, most of them do. And what that does is that it helps to the deferred taxes that are owed, so that you can offset.
So in other words, say you’re a passive investor and you get $10,000 in cash flow in a year from a building; it doesn’t mean that your taxable income is necessarily going to be $10,000, because you may be able to take a depreciation expense against that and not pay taxes on all that income. Often in multifamily I actually have either a zero tax, a negative tax, literally because of the depreciation, especially in the early years, and that is just tremendous, right? Imagine getting the cash flow and not to pay taxes on it this year.
And I want to be clear that—I think one important thing to clarify is that some people say that you don’t pay tax, but it’s actually deferred. So it does differ, in that there is potential recapture at the end when you sell the building. But from a time value money perspective, for an investor, that’s a tremendous benefit, and the compounding associated with being able to reinvest that money today, but not have to pay until many years down the line is tremendous when you look on the number basis and the return basis. So that’s number one.
Number two is that cost segregation can also be done by sponsors. And without getting into too much detail, because as we discussed, I’m not an accountant and financial advisor and all that, cost segregation involves the ability to actually segregate out specific assets within the asset, and then actually depreciate those individually, all the way down to light bulbs, and all different pieces of hardware and other things that are actually assets within the building – those can then be appreciated more quickly, potentially, than they would have been otherwise, which will then further depreciation expense, which will then further potentially benefit passive investors from a tax perspective. And I will typically get a K-1 which is a tax form at the end of the year, where the actual sponsor will summarize all the taxes owed and all the tax bases that the investor has.
So I take this one piece of paper – sometimes there’s a couple pieces – and I will hand it off to my accountant, and I’ll just plug it into the whole formula of things. So it tends to be quite simple, actually. So I’m actually highly diversified, probably over-diversified. I’m in over 60 LLCs right now alone. So I have a lot of K-1’s, and that becomes a bit of a—in fact just before we got on this, I was looking at which ones are still outstanding. I have a spreadsheet for my account, we literally track it on a spreadsheet. But the K-1s are very simple to handle. And especially if you have an account, even if you don’t, you just plug in certain numbers off of it from what I understand into the accounting software, it takes care of the rest. So it’s really great, because it’s very convenient, because essentially the sponsor is doing all of the calculation work for you.
Travis Watts: I remember I used to invest in active single-family, and trying to keep track of all these receipts and all this accounting, and then your receipts fade, and all of a sudden you got blank pieces of paper, so I’m always in fear of getting audited and all these different things… But yeah, K-1s can definitely simplify your world. And in some funds as well, you can get a consolidated composite K-1. So it’s kind of nice, you could be invested technically, in five or 10 deals, but just get one K-1 tax form. So – something to think about, something to have a conversation with your CPA about for sure.
So let’s transition a little bit. There’s typically two ways that people invest – you’re either investing for appreciation or equity, I’ll call it, or you’re investing for income or cash flow. I feel like most of us are brought up with the understanding that investing is all about buy low and sell high, which would be equity, or appreciation. Very few people are tuned into the message of passive income, cash flow. So talk to us about why you decided to invest in passive income or cash flow exclusively.
Jeremy Roll: Yeah. So I’m biased, because I’ve always invested cash, that’s my number one focus. I always look specifically for predictable cash flow. And to me, there’s two ways to invest; you can either invest for cash flow or you can invest for appreciation. And when you invest for appreciation—there’s actually really 1,000 ways to invest in terms of things you can do, but there’s a general strategy; there’s two ways to invest and probably a hybrid of the two, right? You can have value-add deals and also cash flow, but just sticking with the two buckets.
The challenge I have with investing for appreciation in things like Bitcoin and other things, the word is speculation. And I’m not comfortable speculating, because to me, that is literally the opposite of predictability. If you’re hoping something’s going to go up, but you’re not sure, then that’s one thing. But when I go to sleep tonight, and I’ve invested in a 200 unit apartment building that’s 97% occupied, unless there’s a major event, God knows what, that happens at that exact property, the next morning I’m waking up and those tenants are still there, the vast majority of them are still paying rent, presumably, and I’m presumably going to have a high probability of getting that cash flow distribution.
So to me, investing for cash flow is about the strategy of being able to deploy a strategy of predictability when you invest, and that’s what was so attractive to me. Like, when I was trying to figure out how do I get away from the stock market and invest with more predictability, the answer to me was actually stabilized cash flow. And that’s what I’ve been looking for, ever since; it’s almost 20 years later.
So I’m very biased, because I’ve been doing this the whole time, but I actually really liked the fact that it actually matches my personality really well, which I think is important, and it matches my goals well, and I’ve stayed the course and only focused on that type of profile for me, tried not to stray off of it too much, because I just know it works well for me.
Travis Watts: Jeremy, you brought up something earlier in our conversation, and I want to take the time to circle back to it… I think it’s critical, very important for people to understand, and that is diversification. So when I was investing in single-family homes and self-managing everything, I ran into a really big problem, at least a perceived problem, in my opinion, that I wasn’t diversified. I had all my properties within a 50-mile radius, they were all single-family homes, and I started freaking out, because I thought, “I don’t want to not be diversified 10 years from now, 20 years from now. What if all I have is 100 single-family homes on one market, and a tornado or a flood comes through or the tax laws change in the state?”
So talk to us about being able to diversify as a limited partner/investor, why you do that, and the importance of diversifying.
Jeremy Roll: Absolutely. So what I tell people and this is my own theory is that, as a passive investor, I trade control for diversification. And diversification to me means you have to be diversified across asset classes, geographies, and operators, and that’s the way I’ve always looked at it. So if I don’t take advantage and actually diversify, then in theory, as a passive investor, I believe I increase my risk, because you’re giving up control. So there’s pros and cons to both sides of the table, active and passive.
But one of the major pros, to your point, is that you can invest across many markets, in many different asset classes, including multifamily, and even in many market just for multifamily, that you happen to like, and be really strategic. So because you don’t have to know the market nearly as well as the person you’re making a bet on, you can get a high enough level of knowledge of a market and decide it’s for you and not even realize it was a good market in retrospect, and you wouldn’t have had the bandwidth to figure it all out yourself, but then get diversified across a lot of different markets… And you can tell — we use the word diversification a lot, and I am a big fan of diversification to reduce risk. But I also think if you’re not going to take a diversification strategy as a passive investor, you’re not only not going to take advantage of what passive investors have access to, but you’re going to increase your risk as a passive investor. So it’s just a very important topic to me.
Travis Watts: Absolutely. And there’s so many parallels too between investing in stocks, because so many people can understand that or were brought up that way, and I was as well. If you’re going to invest in Apple, for example, you don’t have to know the ins and outs of the business or how a microchip is made, or how they’re doing their trade deals internationally. At the end of the day, it’s exactly what you said, you’re taking a bet on the team that they can succeed, and they’re going to be profitable in whatever venture they’re doing.
Jeremy Roll: Exactly. It’s really all about making bets on good people. And I would even take it to the extreme that I believe that who you’re making a bet on in the passive investing world is more important than the actual assets you’re investing in itself. Now, I will tell you that the asset is a very close second, but who you’re making a bet on can make all the difference about how something performs. Even if it was 100%, occupied and stabilized to begin with, if you make a bet on the worst person, it’s going to go to foreclosure, right? If they don’t know what they’re doing, if they’re just doing horrible mismanagement, it’s not going to survive.
And then on the flip side, if you’ve got an asset that’s very challenged, but you’ve got a fantastic manager, they can turn that around, and end up in really good shape and make it very successful. So who you’re making a bet on is really, really important, and it’s important to really assess that as a passive investor.
Travis Watts: I couldn’t agree more. I almost had that happen to the foreclosure point, but not quite. But great deal, great market, bad management. So great points.
So let’s take a pivot now, let’s talk about business model and dig in a little bit deeper to value-add; that’s a term, again, used pretty loosely, in my opinion, in the industry. I’ve seen deals from operators that say, “Hey, I have a value-add deal”, and the deal is three years old, from new construction. I’ve also seen the other extreme where, “Hey, we’ve got a value-add deal. We’re taking it down to the studs, we’re kicking everyone out, we’re going to rebuild the whole thing.”
So what’s your definition of value-add? Or, I guess, maybe more importantly, what do you look for as an investor in a value-add project?
Jeremy Roll: I think the simple definition for value-add from my perspective is literally a business plan that involves adding value somehow through some type of change or effort; it could be an investment in the landscaping; it could be you’re kicking all the tenants out and redoing all the units and increasing rents and anything in between.
So just because of my low-risk profile, I focus on minor and medium value-add. To me, I could do development as a value add, because you’re adding value to a land that’s barren, like building a brand new building from scratch. I’ve never invested in that, because that risk profile isn’t in sync with mine. Major value-add, so they’re going to kick out all the tenants and empty the building, and then redo it. You could probably make a ton of profit on that; again, not cashflow-focused, predictability isn’t as obvious, risk is higher, reward potentially higher. Wrong risk profile for me.
So there’s 1,000 ways to invest, none of them are wrong. But for me, when I look at value-add, I look at minor or medium value-add. And the way I define that is – probably the most extreme value-add I have an interest in typically is you take on an apartment building that is in need of some major upgrades, both in the interiors and in the exteriors of the units, and the general common area. That money is spent and deployed in 2-3 years; as people’s leases come up, they’ll go ahead and rehab the units and increase rents based on the fact that you’ve got a newer, nicer product. And then within hopefully 2, 3 or 4 years, you’ve got value-add implemented, you’ve got much higher degree of revenue coming in. And of course in that equation, the cost of the capital expenditures are outweighed by the benefit of the increased revenue. That’s the whole mathematical equation.
And at the same time, let’s recognize the fact that you’re making that community better, because you’re turning that building into a nicer building, with potentially more amenities. You’re making the lives of the people there better, because now they’re living in a nicer place… Which – we don’t talk a lot about that as investors, but it’s a fact, and I love the fact that often the money that you’re investing is going towards helping people and making their lives better.
Travis Watts: And improving communities. I love it.
Jeremy Roll: Yes.
Travis Watts: I love it.
Travis Watts: I hope everybody listening is taking notes. If you’re not, you should be. Get the recording of this when it’s made available, and rewind and take some notes. And if you haven’t started yet, take some notes right here on this section. It’s kind of a loaded question, Jeremy, so don’t freak out… But I want to talk about the three pillars to investing in multifamily. These are just my three pillars I talk about all the time, it’s really three segments to consider when you’re investing in multifamily; it is the team or the operator that you’re investing with, it is the market that you’re investing in, and it’s the deal itself. So if you wouldn’t mind sharing maybe just a couple of bullet points on each of those three pillars that people might want to consider or look out for when they’re choosing to make an investment in this asset type.
Jeremy Roll: Yeah. Team, look for an experienced team. Always look at the track record. I’m sorry, this is going to sound the wrong way, but the reality is, I won’t be the first or second or third deal someone’s doing because I want them to learn off someone else’s money, because there is a learning process, and I don’t want to be the one taking that risk, because I’m a low-risk person.
So I’m looking for experienced team, who has a good track record, who is typically focused on one asset class, at the absolute two maximum; I’d much prefer someone who’s just doing multifamily, for example, if I’m going to invest in multifamily, and a very specific type of multifamily, Class B… And preferably even a specific market so they know those markets really well. So that’s really high-level team; we can get into much more depth, but the team is so critical.
Then we have a market. The market to me — the high-level things you’re going to look at are how is the actual market projected to increase in terms of population? How is the economic growth projected to increase over time? Are you looking at population migration towards that market or area of the country in general? A really easy example to use right now – there’s been an aging of the population… And forget the pandemic; even without the pandemic we just experienced, aging the population has shifted population from the North to the South, as a general mention.
So if you’re looking at Southern states, there’s a higher probability you’re going to see population migration trends going up, and if you’re looking at really Northern states, it’s a higher probability the population trend is going down. That’s really critical, because when you investing long-term in an opportunity, if you’re investing a five or 10-year term, you’ve got to think far out. Because if that building isn’t as much in demand for the route, not only you’re going to have a challenge, but potentially meeting your business plan or whatever rents are projected, but then you may not have a bigger pool of buyers that’s interested, right? Because the next set of investors are looking for a growth market, and you may not be that growth market.
So the market’s really critical. And within the market, you’re going to want to look at the exact location for so many reasons – traffic, crime, schools, many other things associated with the exact location, proximity to certain conveniences, to freeways to other things. So a lot of things to consider, depending on exactly what type of building you’re investing in.
So there was the team, the market, and then—what was the third? I’m sorry.
Travis Watts: The deal itself.
Jeremy Roll: The deal. Thank you. So the deal… The deal has so many components to it. I think generally, the first thing you want to do is take a look at the business plan and the general goal of what the operator is trying to accomplish by buying the building. And if that is not in sync with your risk profile or what you typically invest in, you’re comfortable with – well, that doesn’t make sense. So that’s the first thing to look at, high level.
Then do you necessarily agree with where the building’s located, and what they’re buying, and what they’re trying to do with it, who they’re targeting. Do you agree with the assumptions they’ve made, as far as do the projections look reasonable or not? Sometimes sponsors use very conservative and reasonable assumptions, and they’re setting reasonable expectations for you, where they’re hopefully going to underpromise, overdeliver and build a long-term relationship with you. But as an investor, what you’re trying to avoid is someone using very aggressive numbers, making the numbers look really great and the deal look good, but they’re using possibly unrealistic or just very aggressive assumptions that aren’t conservative, that may potentially set them up to overpromise and underdeliver. But maybe they’re more of a marketing [unintelligible [00:26:37].10] and they don’t care as much, and they’re not quite focused on building a relationship, and you’re trying to read between the lines as an investor and figure out who you’re making a bet on here. And that has to do with the property level sometimes. And do you agree with all their projections? Do the cash flows meet the type of cash flows you’re targeting? And then do you agree with what the exit strategy is? When is it potentially going to happen? And what the pricing assumptions might be when you’re hopefully going to exit?
I’ve done this very quickly, very high level, but there’s a ton of stuff – capital expenditures, does that align, or there are enough reserves? Was the expense ratio reasonable? Is it conservative? There’s a lot to go through. But higher level, those are the three pillars, I think, and they’re all really important.
Travis Watts: Well, this has been absolutely amazing. I appreciate you so much for coming on the show. I’m so glad that we were introduced years ago; you are fundamental in helping educate people in the private placement space. Can’t thank you enough for that. Before we go, can you please tell our listeners how they can reach out to you if they wish to connect or have additional questions for you?
Jeremy Roll: Yeah, absolutely. And again, thank you for having me on. I hope that what we get here is helpful for whoever’s listening. That’s the main goal. I remember, Travis, you and I connected at a conference, we met at a conference a long time ago. Networking is so critical, and I’m just really glad — you and I have shared a lot of opportunities together. It’s just been great, and I really appreciate you having me on. So the easiest way to reach me, and please feel free to reach out to me, and if you’d like to connect from a networking perspective or I can help anyway, my email address is firstname.lastname@example.org.
Travis Watts: Well, there you have it. There’s the episode with Jeremy Roll and myself, snippets from Masters of Multifamily. I appreciate you guys so much as always tuning in. I hope this was helpful. As always, if you have feedback, reach out to me, happy to help implement that.
If you have any ideas too for 60 Seconds questions that I do weekly, where I’ll answer your question in 60 seconds and we post those to social media, email me, email@example.com, and we will see you next time on The Actively Passive Show. Thanks for tuning in.
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