Are big operators buying Apartments just for depreciation?

Question

The market is frothy and cap rates have compressed. I am looking at the prices that large multifamily owners are paying and it makes me scratch my head a little bit. Buying at a five or six cap without much room for adding value seems like a very lean deal to me but bigger outfits are doing it left and right while money is cheap.

I figured that there is an element that just want to preserve capital or just squeeze out a little yield but then it occurred to me that they just might be buying mainly for depreciation. If they have been holding apartments for decades, they have probably run through a lot of their depreciation benefits. Their marginal tax rates between federal and state are probably above 40% on their last dollar of rental income. I was always taught not to buy for depreciation because it is really only a loan from the IRS. That make sense but if you plan to buy and hold AND can front load a lot of depreciation through cost segregation, then why not??? You save on taxes today, which is better than saving later. . .

Does buying for depreciation make sense? I am a full time buy and hold investor for the past couple of decades. I have seen my depreciation amounts reduce and my cash flow go up. If I was to buy an apartment complex at a six cap that needs a little work, my cash on cash return is also around 6-7%. That return doesn't seem to hot for all the work and risk involved, but say I do a cost segregation study and can write off 15% of the building value in year one. Now all of a sudden I have a whole lot of depreciation that I can use to offset my rental income from other properties. My overall return on this new complex is closer to 25% when I factor in the money I am saving in taxes on my other rental income. Does this make sense for me to do? Am I missing something?

I completely understand that depreciation savings eventually comes due, but I am a buy and holder. I would rather save the money today and deal with that way down the line. But maybe I am missing something? This is my first ever post on BP and would appreciate any feedback or words of wisdom?

Nick B. · Answer

Buying for depreciation makes sense if you (or your spouse) are a real estate professional (in the tax sense). Then you can write off excess depreciation against your regular income.

Also, excess depreciation can be used instead of 1031 for passive investors. If you have realized capital gains from one project and reinvest the proceeds into another that utilizes cost segregation and excess depreciation, you would likely shield you your gains from taxes if your share of depreciation is higher than the gain.

That said, I suspect that large operators are buying mostly for their own benefits: they get acquisition fee and asset management fee from the "day one" and if their investors end up holding the bag 5 years later, it's a ding on the operator's reputation but the fees have more than paid for that ding.

Matt George · Answer

I was once replacing a toilet in a unit because the tank lid cracked and we couldn't find one that fit the tank. A older gentleman came by in a rattly old truck. He owned over a hundred single family homes and condos and had to be in his 80s. I had heard of him so we got talking and he told me that he started landlording back in the 60s and still worked 6.5 days per week. Then he asked if he could have the old used toilet because he thought he might have a matching tank lid for it.

Nick B. · Answer

@Matt George, "mom & pop" and $50M don't usually belong to the same sentence :-) I know two or three people who have $50+ portfolios but they are in their 40ies and own not just the properties but also management companies that manage those properties and also engage in the day-to-day operations of the said companies. They don't have to sell but nevertheless they sell their smaller assets and trade them up (1031 tax deferred exchange) to larger ones. That resets the depreciation. Initially those lager assets don't cash flow much but the plan is always to raise the rents and get even more income than before.

I once spoke with a "mom & pop" owner of a 140+ units complex that was paid in full. I asked him why he would not sell and trade up to a larger asset and have tax deferred income. He replied that he gets plenty of income and not does not care if that income is taxable. I don't know if he is an exception or a rule.

Yonah Weiss · Answer

Great questions @Matt George, and great answers by @Nick B.! I will add simply, having spoken with hundreds of clients over the past couple of years, there definitely are some (including syndicators) that are buying for depreciation, and cost seg, but they are the minority. As you said above, if they have REPS, and lot's of potentially taxable income from other places, it may make sense to get the tax benefits in the current year.

Spencer Gray · Answer

We had a large group looking to be the main source of equity for a large project ($50M+) where they were all real estate professionals and were primarily looking for a low risk vehicle that would throw off significant depreciation via the cost seg.

They even wanted to front load the depreciation in the first year to their group with the remaining investors would get a catch up until it was even.

We ended up not doing the deal with them, but to answer your questions, yes, absolutely.

Russell Brazil · Answer

Well when the 10 year US Treasury is 1%, a 6% cap looks pretty good.  Where else do you think you are gettint 5 or 6% with relatively low risk?

Steve Morris · Answer

If by big operators you mean syndicators, here's why they're buying

1) They don't place it, investor money is on a rubber-band, it'll move to the next syndicator

2) They don't place it, they lose on future asset and prop mgmt fees

3) They don't place it, they lose the 2% they keep for income and appreciation

4) Tell me the other type of investment that is offering tax-sheltered returns better than CRE

5) Tell me the CRE doing better than apartments

6) Certain places like ATL, NC, MIA , Austin are darlings and only so much inventory so they need to reach

Nick B. · Answer

@Matt George,

Cost segregation study and decision to use it are done during due diligence process before even buying a property. I am not sure what you mean by "come back to bite you". Once the project is sold all previously accumulated depreciation is recaptured and taxed at something like 20% (ask a CPA for exact rules). If you hold "forever", there is no recapture tax (heirs get a step-up basis) but that would not work with a syndication as those are not held forever.

On your second question, the deal must meet ROI requirements first and for most. Depreciation does not change that and does not even apply to all investors (e.g. those with IRAs and 401Ks don't get any benefits from it). It is usually used a sales pitch for otherwise mediocre deals.

Jeffrey Donis · Answer

Great points!!

Jay Hinrichs · Answer

America is full of these types of landlords they are in every MSA and especially in the mid west were prices were so low for so many years.

Are big operators buying Apartments just for depreciation?

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