What Maslow’s Hierarchy Can Teach Us About Real Estate

Are you needy? I’m guessing you are.

Oh yeah, you may look tough and act like you’ve got it all together. But celebrated 20^th-century psychologist Abraham Maslow said that everyone at every level has needs. And he created a famous pyramid to explain how our needs differ at every stage of life and vary in terms of where we focus (and what we ignore) at every level.

Let me explain…

What Is Maslow’s Hierarchy of Needs?

His theory was dubbed “Maslow’s Hierarchy of Needs.” It became famous when my dad was HR director of an Ohio airplane manufacturer in the 1950s. He gobbled it up, as did millions of others in the people business around the world. It explained so much about why people do what they do. And why their motivations are so different than we expect.

Maslow theorized that people only focus on the lowest level of his pyramid until that need is met. Then they progress upward, seeking to fulfill each level above until they reach self-actualization. Theoretically, this is the level where true happiness waits. Where our dreams are fulfilled, and we live out our reason we were put on Earth.

Here’s the pyramid:

Maslow’s pyramid of needs became popular because it rings so true. For example, he said those clawing to get their level one physiological needs (air, water, food, clothing, shelter, sleep, reproduction) met will be largely unconcerned with the type of car they drive (a level four esteem need). Conversely, those bent on level five self-actualization have typically moved past level two needs for personal security.

And we’ve all seen how those in a higher level are smashed in the face with a lower level need suddenly screaming for their attention. Eddie Van Halen was considered by many as the world’s greatest guitarist. He was living in level five for decades (theoretically). But his wife, Valerie Bertinelli, left him after 20 years in 2001, and he got cancer around the same time. I’m guessing he quickly dipped back into levels three and two seeking the love and health he had lost. We will miss him.

Visual Capitalist has provided an insightful parallel pyramid they call “The Hierarchy of Financial Needs.” They claim that financial needs, like Maslow’s physiological needs, can be categorized in a pyramid.

Take a look…

I’m no psychologist, and since we talk real estate here at BiggerPockets, I thought it might be fun to apply Maslow’s theory to a real estate deal. You may want to go further and apply this deal hierarchy process to your investment career as a whole.

Maslow’s Hierarchy for an Individual Real Estate Deal

This hierarchy applied to REI makes a good bit of sense to me. See if it works for a deal you’ve done or a deal you’re looking at.

Here it is:

Level 1 – The Base: Cash flow to meet property expenses

It’s fun to dream about big profits and the joy that comes with them. But if you find yourself in a place where your cash flow doesn’t meet your monthly expenses, those dreams will be the last thing on your mind.

You may be panicking about how to break even. This can happen because of unexpected vacancies, declining rents, surprise repairs, or dozens of other issues. Most are unexpected, of course. Nobody plans to lose money.

Well, almost nobody. There are brief periods where an investor is willing to fund the shortfall while planning for bigger and better things. Renovating, re-tenanting, or even rezoning for higher use (like upgrading from residential to commercial) are a few examples. Or doing a development project.

In several investments over the years, I recall that sad moment when I sank from dreaming of that big profit to hoping just to get my principal back. Most investors have experienced this. I hope it never happens to me again. Or you.

Level 2 – Financial Safety: The critical ratio

Once you’ve satisfactorily covered your expenses, you should look to reach a healthy DSCR (debt service coverage ratio aka debt coverage ratio aka DCR). The DSCR is the most important ratio in the real estate deal realm IMHO. (Yes, I’m hip, and I use millennial shorthand. LOL. JK. Whatevs, yo.)

The DSCR is the ratio of the monthly net operating income (NOI) divided by the monthly mortgage payment (principal and interest). This is an important margin of safety that shows you how much cash flow margin you have available after paying all of your expenses and mortgage payment.

For example, if you own a fourplex renting for $1,000 per unit, its gross income is $4,000 per month. If you have expenses (not including mortgage) of $1,000, your NOI is $3,000. If your mortgage payment is $2,000, then your DSCR = $3,000 ÷ $2,000 = 1.50, or a 50% margin of safety.

Banks typically like to see a minimum DSCR of 1.25 to 1.30 to provide a loan. That gives them a 25% to 30% margin of safety.

So the 1.50 DSCR in this fourplex sounds good. Unless one tenant moves out unexpectedly. Then your gross income drops to $3,000. If your expenses are fixed at $1,000, your net operating income drops to $2,000 and your DSCR drops to 1.0—you’re right at breakeven, below the bank minimum.

At that point, you’ll be praying that a second tenant doesn’t move out, which would drop you down to level one in Maslow’s real estate hierarchy as you write a large monthly check to stay afloat.

As a professional passive investor, I like to see a much higher DSCR. Our fund currently has a DSCR well over 2.0, meaning there is a 100%+ margin of safety. And by investing in a diversified portfolio of larger properties, vacancies barely move the needle. For example, in a 607-unit self-storage facility in Beeville, Texas, 10 move-outs in a month would only drop occupancy by 1.6%.

A 2.0+ DSCR also means my Maslow level is up to at least level three or four…

Level 3 – Cash Flow to Investors: Accumulating NOI and value

When your cash flow exceeds basic expenses, you have positive NOI (level one). When it exceeds minimum DSCR you have a safe (or safer) deal and you’ve surpassed level two. In level three, you (the investors and the operator/syndicator) are enjoying monthly cash flow.

This is parallel to the “Accumulating Wealth” phase in the financial pyramid above. And you are accumulating wealth because you are building equity as you build cash flow.

Why?

Because cash flow leads to net operating income. NOI is the numerator in the commercial real estate value formula. That formula is:

Value = Net Operating Income / Cap Rate

So in level three, your goal is to increase the net operating income. Your secondary goal is to shrink the cap rate, but that is only partially in your control. You are already increasing your bank account balance by receiving cash flow. And by increasing the value, you are increasing your equity and ultimately your net worth—and that of your investors (at least on paper). But the appraised value isn’t money in your pocket until levels four and five.

Level 4 – Deal Freedom: Taking principal off the table

This is parallel to the “Financial Freedom” level in the pyramid above. This is when theoretical gains of level three turn into a secure asset with the risk off the table. This is parallel to a future retiree with an irrevocable pension.

How do you get there in a deal? There are multiple ways, but one great path is through refinancing. Let’s say your asset has grown in value to a level that dwarfs the level of debt. And perhaps you’ve paid down principal on the loan, as well. You may be able to capitalize on lazy equity through refinancing it and putting it to work.

By adding a second layer of debt through a supplemental mortgage, or by just getting a new higher LTV mortgage, you can potentially withdraw your principal balance from the deal. By doing this, you have now effectively removed the “I” from “ROI.”

And when “return” divided by “investment” is a number divided by zero, you know that the answer is a math error. But some refer to this number as “infinity.” Since you have no principal left in the deal, you could refer to your cash flows and eventual sale proceeds as an infinite return. You can see why this fits into level four: “Deal Freedom.”

As I mentioned earlier in the article, like Mr. Van Halen, it is possible to drop to a lower level. One way to do that here is through overconfidence. Overleveraging your property to take principal off the table could result in a too-narrow margin of safety (the DSCR of level two). This could cause problems in the event of increased vacancy or lower rents.

Level 5 – Deal Legacy: Perpetuating this investment forward to the next deal and beyond

You’ve climbed up four levels. You’ve faced the challenges every operator faces and enjoyed the fruits along the way. Now it’s time to cash in your chips and move to a new pyramid. It’s time to sell your asset.

In level four, you enjoyed the freedom of a largely de-risked investment. By taking your principal off the table, you enjoyed the feeling of freedom in this deal. But you still had the risk of dropping to a lower level.

At level five, you will sell your asset and forever lock in your gains. All the capital appreciation and principal paydown will flow from intangible (in the asset) to tangible (in your bank account). It’s time to celebrate.

But you’re not entirely out of the woods. Why?

You’ve got to deal with at least three types of tax. And you’ve got to figure out where to reinvest.

Your taxes may include capital gains, depreciation recapture, and the Medicare surtax. Certain states like California also have state capital gains taxes. There are several ways to defer these taxes, the most famous being the 1031 exchange. Many who utilize the 1031 exchange plan a “swap till you drop” strategy, which means you or your heirs will never pay the accrued taxes.

Whether you use a 1031 exchange or not, you will be tasked with replacing the asset you sold. You will go through a similar stringent due diligence process as the one you went through last time.

Please realize that if you’re selling at the top of the market, you may end up buying at the top, as well. This can introduce new risk to a situation that you previously de-risked through much effort climbing the five levels. But that’s part of the game. Most investors go from riskier to less risky assets as they gain years, wealth, and experience. I discuss this in detail in this recent post.

Suppose you are moving from an actively managed asset to a passive investment. You may be able to relax and enjoy the fruits of your labor while someone else does the heavy lifting. This is quite easy to do when selling your asset through a “normal” sale process.

But it’s usually quite challenging to find a passive replacement property when using a 1031 exchange. This is where a Delaware Statutory Trust can save the day. This structure preserves the tax deferrals while a professional manages the property and assumes all debt. We love this structure for 1031 investors, and it even works for some who are just looking for a stabilized asset with predictable cash flow.

Conclusion

So what does this have to do with your deals? Maybe nothing. Perhaps everything. Using this framework to analyze an upcoming deal may allow you to project what it will take to reach each new level.

Unless you’re investing in a development project, I’d recommend you qualify your investment solidly on levels one and two on the day you acquire it. If it doesn’t work here, maybe you’re paying too much. And if you don’t have a plan to get to the higher levels, why? What is your specific plan? It’s not enough to buy it right and hope for the best.

I hope this pyramid is helpful. And I hope to see you at the top!

Can you look back at a deal and see how it went up the various levels? Can you see how you had to drop back a level or two when things got rough?

We’d love to hear about your life and your deals in the comment section below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.