How to evaluate this important part of your financial plan?
In the past several months the team of professionals here at Eckhoff Wealth Management, LLC and Eckhoff and Company have been performing dozens of analyses for clients who own investment property. On average we are seeing that these properties have risen in value tremendously over the past 5-8 years1. These smart investors are now seeing the current value of their real estate portfolios soring back up over record levels.
While we believe principal appreciation of all asset classes is important, I want to encourage investors in income producing real estate to also regularly evaluate and benchmark the net income they are receiving for their investment. After all, owning investment real estate is owning an active business with clients, vendors, employees, assets, liabilities, inventory, income and expenses just like any other business.
If you do not already, please start to think of and treat your income producing real estate as a business, not just owning another property similar to owning your personal residence. Some own multiple investment properties, making them have a virtual conglomerate where we then need to evaluate each business within it.
This blog post will address the income evaluation considerations in your real estate business. By understanding this evaluation, you can then make informed decisions on how to proceed with each of their properties. I’ll finish with an option for some investors who are seeking to improve their income and are ready for passive ownership in commercial and multi-family real estate.
Consider Your Risk of Ownership
Frequently people start investing in real estate with rose colored glasses thinking of all the positive characteristics of owning income producing real estate. I agree, there are many benefits of owning real estate and yes, we believe real estate is an important component of wealth management.
Investment real estate can help enable investors to realize regular income, capital appreciation, diversification from stocks and bonds and tax benefits.
We also want investors to realize owning investment real estate involves taking on many risks – local markets, national economy, interest rates, natural disasters, wear and tear, tenants, vacancy, general liability, etc.
As an investor we recommend you’re regularly evaluating if you are being sufficiently rewarded for the hard work and risks you are taking by owning real property. Is the amount of income and appreciation worth the level of work, and in some cases hassles, you are experiencing in your market at this stage of your life? Are the benefits worth all this work AND the risks associated with owning real estate?
Evaluate Your Property Based on Current Market Value
We find most people are being taught to evaluate their property based on the initial investment they made when buying the property. This often misleads the owner into thinking their property is performing better than its peers in the marketplace.
As mentioned previously, many markets around the country have seen appreciation of real estate back up to historic record levels. Evaluating how well your property has performed with appreciation or loss of value relative to its peers in your market is appropriate, however comparing the metrics of income you are receiving from your property based on purchase price won’t take into account the benefits you’ve received from appreciation.
We do not know the actual value we can receive on real estate until we put it on the market and see what a willing buyer is willing to pay in a healthy market environment. We can, however, estimate value based on recent sales, discussions with local professionals and ultimately having a formal appraisal completed.
As we evaluate how well an investment property is performing for income purposes (a.k.a. yield or cap rate) we want clients to understand if their property is still providing a level of income the owner is happy with based on the property’s current value, as this is most relevant for the current market conditions.
Calculate ‘Cap’ Rate
It is important for investment real estate owners to understand this important component of running their business and ensuring this large asset is performing well relative to its peers, your needs and your expectations.
When evaluating the income you are receiving from your real estate we normally use a calculation called Cap Rate. You may think of it as yield or percent of income you are receiving. I like to teach people to think of cap rate as a tool to evaluate how well your property is capitalizing on estimated current market value based on the current net operating income you are receiving.
This will show you how well your business is operating.
[(Gross Income – Operating Expenses)/Estimated Current Market Value] x 100 = % Cap Rate or Yield
Operating expenses include management fees, utilities, maintenance and upkeep and other expenses directly related to running your property.
Operating expenses do NOT include debt service, depreciation and other expenses that are not related to running the property.
[$60,000 - $10,000)/$1,300,000] x 100 = 3.8%
Does the result of this calculation surprise you? Does it make you happy, sad or mad? Is this what you had hoped for when you bought the property? Does this number compare well to comparable properties in your area? Does this number compare well to comparable properties in attractive markets outside of your area? Does this number shine compared to other investments you currently have or other opportunities you may for the capital tied up in this property?
We feel that If you are not achieving 5% - 7% capitalization of your property we recommend reviewing options for improving your situation.
Options to Improve Your Income
If you’ve completed this exercise and are answering negatively to many of these questions, then you may want to consider options to improve your situation.
One such option is completing a 1031 tax-free exchange into commercial and/or multi-family real estate procured and managed by highly experienced professional institutional real estate companies.
A Delaware Statutory Trust (DST) is a trust approved by the IRS as a legal option for replacement property in a 1031 exchange for accredited investors2. The trust is managed by a sponsor that identifies, purchases and supervises the management of properties on behalf of the owners of the trust…owners like those who read this blog.
The types of properties available in DSTs include large apartment complexes, NNN single tenant, senior housing, student housing, self-storage, distribution and/or warehouse facilities, office, retail, etc. etc.
DSTs are only available from licensed financial advisers and are highly regulated securitized products with many rules in place to protect investors. Among these rules, sponsors cannot change the structure of the deal, financing, fees and other specifics that must be followed. As you will see in a moment, it is in the best interest of the sponsor to do what is in the best interest of the investors. You are on the same side of the table as the DST sponsor.
DSTs are meant for those who are not interested in running the property or making the decisions regarding the ultimate disposition of the property. A DST is meant for those who are ready to turn over that work and decision making to professionals who do this sort of work as their business.
As you might expect, DSTs have all the same risks associated with them as owning real estate. Amongst them are interest rates, vacancy, natural disasters, etc.
DSTs Can Enable Real Estate Diversification
As a CFP®, I’m constantly reminding people of the importance of diversification of their portfolio. This is not any different when it comes to owning real estate. When we see that clients own the same type of real estate in the same geographic region, we may get concerned. When we see client own only one very large property as a significant part of their overall assets, we get concerned.
Many DSTs have several properties in multiple geographic locations. This provides a tremendous amount of diversification3.
Quite often we can invest the proceeds of a 1031 exchange into multiple DSTs. The result of this is diversifying a client into multiple property types in multiple geographic locations.
Diversification in real estate is just as important as diversification in stocks and bond investments.
We want clients to think of their DST investments as at least 5 – 7 year investments. Some projects will go full cycle sooner and some later, but generally this is what we expect.
Once a project goes full cycle and is sold you will have many options for your proceeds from this investment. You can look to do another exchange into a DST with this sponsor or another sponsor. This is something the sponsors are keenly aware of and are therefore on the same side of the table as you. They want you to be happy so you will continue to work with them. They want you to tell all your friends, family and colleagues about your experience.
You can also decide to do a 1031 exchange on your own or you may even decide to take the proceeds and pay the tax.
Should you pass away while invested in a DST, the step up in basis and transfer of ownership will occur just as in any other real estate ownership.
How Eckhoff Can Help
At our firm, our CFP® and CPA professionals can help you complete a proper evaluation of your real estate portfolio to ascertain if your current situation is what you want and expect from your investment.
Additionally, we can help you review your options for a DST investment by working with the top DST sponsors in the country. We create and recommend portfolios and evaluate the income and tax ramification of such a transaction.
Finally, we help you understand how this potential change will impact your overall financial plan and wealth management for you and your family.
I hope this post helps put some perspective on how to evaluate your current investment real estate and some options for how you can improve your current situation. Of course, there are many considerations and risks involved, many of which go beyond the scope of this writing. Most of the risk in owning real estate applies to DSTs including, but not limited to, interest rates, vacancy and inflation. You will find DSTs are very transparent and professionally sold and managed in order to provide the investor with all the information they need to make informed decisions.
1California Association of Realtors California Housing Market Update, June 2018 https://www.car.org/marketdata/data/countysalesactivity
1What it means to be an accredited investor: https://www.sec.gov/files/ib_accreditedinvestors.pdf
2Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment loss.