Investors also need to diversify across Strategy. There are three broad strategic categories you can select when building your real estate portfolio.
– Buy and Hold (aka “Rental” or “Income”)
– Improvement (aka “Value Add”)
– Development (aka “New Build”)
An important concept for how to choose between them is determined by your risk tolerance.
Risk tolerance in investing refers to an investor’s ability to handle fluctuations in the value of their investments. It’s like knowing how much uncertainty or ups and downs in the stock market you can handle without feeling uncomfortable or making rash decisions.
Factors like age, financial goals, and personal feelings about risk all play a role in determining your risk tolerance.
For example, younger investors may be more willing to take on higher risks in exchange for potentially higher returns, while older investors nearing retirement may prefer more conservative investments to protect their savings.
Buy and Hold
When people first think of real estate investing, this is the first strategy that they hear about. Buy and Hold properties are properties in great condition, being managed well, and providing a reliable cashflow. They may or may not be in a great location.
These are often newer properties, or older properties that have just come off a significant renovation program and are in great shape. You can purchase a property like this easily on your own.
A more practical – and tax advantageous – method is to purchase some shares in a REIT (Real Estate Investment Trust). This enables you to get a diversified portfolio of many properties (usually all in the buy and hold strategy, and in one asset class, but in many locations). REITs have a tax advantage for many people, in that their income is usually taxed at a lower rate than your marginal income tax rate (especially if you are in a higher tax bracket – ask your CPA for additional information).
Another great thing about REITs is that many of them are publicly traded (like the stock market), so you can buy and sell (e.g., have access to liquidity) on a much more flexible basis than if you own the underlying assets directly.
A downside to REITs is that they are not allowed to pass along depreciation (a passive tax write off for many investors) to their owners. Directly owning real estate allows you to get access to that depreciation.
Finally, non-recourse loans can often be available for REITs and large (over $5 MM) multifamily loans. That is, you may not have to personally guarantee the loan if something goes wrong or the market changes. There are a whole host of pros and cons, but many larger investors do like non-recourse loans. Lenders for smaller investments almost always require personal guarantees.
Advantages of Buy and Hold
– Cashflows right away.
– Generally, the lowest risk of the real estate strategies.
– Most predictable cashflow.
– Easiest to finance, and usually on great terms.
– Often, non-recourse lending is an option if loan size is large; else personal guarantee likely will be needed.
– Easiest to sell.
– Smallest need for special expertise to do well.
– May offer depreciation tax write-offs if you invest directly.
– Often, pride of ownership.
– If in a REIT, you can buy and sell easily, almost like trading stocks.
Disadvantages of Buy and Hold
– Most expensive to purchase.
– Lowest return on investment.
– May not offer depreciation tax write-off if via a REIT.
– Often, least upside for above-average appreciation.
In summary: Safer, less work, and less return.
Value-Add
Next, Value-Add properties are those which are not in great condition. Any property, without constant care and thoughtful oversight, will eventually devolve from a pristine Buy and Hold to a Value-Add project. This might be in condition of the units themselves, the common areas, or both. They may also have poor management and/or deferred maintenance in the infrastructure (e.g., elevators, HVAC systems).
A common way this happens is when an active investor buys a property and has the energy to keep it in top quality condition. As they age, health problems interfere with their ability to take care of the investment. Their spouse and/or kids usually lack the passion and expertise to provide the right oversight to the property manager. Since by this point their mortgage is either paid off, or has a minimal payment, there is no urgency to maximize the cashflow.
There is a strong incentive to pass property to your heirs. If the older owner dies, their kids will inherit the property (assuming the estate plan is set up this way). If they purchased it for $1 million thirty years ago, it might be worth $5 million today. If they sold it while they were alive, they would owe tax on a $4 million capital gain (plus depreciation recapture, which we will discuss in a later chapter).
If their kids inherit it, usually they will be able to get an appraisal for the value at the time of their death. That becomes their tax basis in the property. So, their starting point is now $5 million. They can sell the next day for $5 million, and no capital gains (or depreciation recapture) are due. This is among the best ways to transfer wealth between generations.
All the while, the property has degraded, has more deferred maintenance, and usually low occupancy and below-market rents. The kids often just dump the property ASAP after the probate process is wrapped up. These properties will often trade at a significant discount to what the same size buy and hold property will sell for. Not all Value-Add properties follow this path, but many do.
One additional attractive dimension of Value-Add projects is the depreciation. You can think of depreciation as an interest-free loan from the IRS. For a residential property, you can “depreciate” it over 27.5 years.
Your CPA can help you split up the value of your purchase between the land and the improvements (e.g., the building). In this example, you would write off $100,000 per year.
From the IRS point of view, it is as if you wrote a check to some vendor for that amount, and it reduces your income (and tax bill) that year. Since you don’t write this check, you get to keep the cash without the tax. When you sell the property, you must true up with the IRS (which is called “depreciation recapture”). For an older property, you can often accelerate the depreciation to generate even larger write-offs in the first year or two. I’ll cover this in more detail later in the book.
Advantages of Value-Add Projects
– Much less expensive to purchase.
– Much higher potential return on investment if you know what you are doing or hire an experienced team.
– Depreciation tax write-offs.
– Potentially large passive loss write-offs.
Disadvantages of Value-Add Projects
– Limited, or negative, cashflow to start.
– A significant renovation budget is usually needed.
– Usually requires a construction loan vs. more favorable long-term financing.
– Recourse financing is almost always required.
– Project management and turn-around property management specialists required.
In summary: More work, more risk, and much higher returns.
Development
Finally, Development projects are building a property from scratch. You’d first need to do a demand study to be sure that your project would be right for the location.
For example, if you wanted to build a new economy extended-stay hotel, you’d do a study to determine:
– The current demand for lodging in that market
– How that was disaggregated across different hospitality sectors
– What the likely growth of the market is projected to be
In this example, you’d love to see that 18% of the stays in the market are over seven nights (e.g., extended stay), but that only 10% of the available hotel beds in the market are configured as extended stay hotels (e.g., the rooms have mini-kitchens and other amenities for longer term guests). There’s a lot more to a demand analysis, of course, but this illustrates it at a high level.
Once you know there is demand for what you want to build, you’d look for land that would be appropriate to serve that need. The starting point could be:
Raw land
– Cheapest to purchase.
– May or may not have the correct zoning in place.
– May involve a lengthy process with local government planning authority to get permits (to build).
– Often the longest project, with highest risk, and on average, highest returns.
– Usually you will not be able to generate income while you are holding it, so you need to have more reserves to make bank interest payments and pay property taxes while you go through the zoning and permitting process.
Improved land
– Intermediate cost of the three development options.
– Already zoned correctly.
– May have some/all the pre-construction design and engineering complete.
– In some cases, projects are sold “shovel ready” where you can pull the permit and start right away.
– No surprise: Lower risk, faster timelines, and lower returns than raw land.
– Fewer holding costs before construction.
Existing site
– Demolish (“scrape”) an existing building and replace it with something new (usually a lot bigger).
– Often zoned correctly, but might require some of the re-zoning steps in “raw land”.
– Many times, the existing building can generate cashflow to offset holding costs while you navigate the paperwork with the government.
If you are highly confident that you’ll (eventually) get your government approvals, you can work on the other development tasks in parallel to save time.
Some sample tasks would include:
– Environmental reviews
– Soil testing and civil engineering (to design the foundation)
– Architectural and engineering design for the building
– Sharing these reports with general contractors to get bids
– Meeting with banks to explain the project, assess interest, and gather term sheets
Once you have your permits (you are “shovel ready”), you can close on the loan with the bank and get started. Either you will need to be on site frequently to assess progress, quality check, and solve the innumerable problems that come up, or have an “owners rep” that does all of this for you.
I’m continually amazed at how many people have an interest in becoming a real estate developer. It sounds sexy to people, for some reason, but it really is a lot of work. There is a big satisfaction at the end when you see the finished product (especially if you managed to make a profit in the process), and that’s likely the appeal.
Advantages of Development
– Very high potential return on investment if you know what you are doing and/or hire an experienced team.
– Most problem solving and potential for creative solutions if that’s what you enjoy.
Disadvantages of Development
– Limited, or negative, cashflow to start.
– Always requires a construction loan vs. more favorable long-term financing.
– Recourse financing is almost always required.
– Advanced project management and turn-around property management specialists required.
– No depreciation in early years for passive losses.
– Not recommended if you can’t handle stress.
– Has the most problem solving if you are NOT into that.
In summary: The highest effort, highest risk, and highest returns.
There are as many ways to build a real estate portfolio as there are ways to build a stock portfolio. I personally am not interested in Buy and Hold since I have the experience to pursue the two more advanced strategies that generate much high returns in most economic environments. Everyone will have a different perspective on this.
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