Is this a valid strategy?

Question

Aloha BP!

Living in Hawaii is great and I couldn't imagine my family living anywhere else. But when it comes to starting a portfolio of rental properties, it gets really expensive to do so. Instead of investing in my "own backyard" I've started to look out of state with turnkeys. Currently, I'm in the process to close on my very first deal sometime next week and I am stoked but I don't want to stop there or be comfortable.

I've thought of a strategy and I'd really appreciate the community's feedback. My plan is to purchase a few turnkey properties, use the cash flow to pay down their respective mortgages, then 1031 exchange them into a MFH complex. I see the value in owning a single MFH versus multiple SFHs and would like to pursue that avenue instead, eventually. There is something I am unsure of such as the 1031 process. Would the properties need to be free and clear in order for the 1031 to execute or is simply owning, say, 10 turnkeys at $100k each sufficient enough to 1031 then purchase a larger MFH. I apologize for my inexperience and I value everyones feedback/opinions.

In building my portfolio, I want to continually think of ways to gain traction and accelerate towards my financial goals. I don't need the cash flow so putting it towards the mortgage isn't an issue for me. My plan is to speak with a CPA (which I will do shortly thanks to another BP member here for providing me a contact) to speak about this strategy but I wanted to present this to the community first. Thank you all in advance, ALOHA!

Justin Young · Answer

@Anton Ivanov you're last question is definitely another option. My thinking is that doing a 1031 exchange would speed up the process a little. Saving income from my job plus the cash flow from my investments seems like a longer plan than the one I presented but I'm open to all options. I'm unsure of the 1031 process in general so forgive me. Can an investment property with debt be used in a 1031 exchange or does the property have to be owned free and clear?

Dave Foster · Answer

@Justin Young, There is no specific debt level that works for or against a 1031 exchange.  It is really all about your personal preference and strategy.  As you accumulate your SF properties that you have purchased to hold for productive use you can 1031 them as a consolidation into a larger MF property regardless of what your debt level is.

The requirements of the 1031 are that, in order to defer all tax, you must purchase at least as much as you sell (net sales price before mortgage payoff).  And you must use all of your proceeds in the next purchase or purchases (net proceeds after mortgage payoff).  So you do need to be concerned that you can replace the debt in your 1031 with either outside cash or new debt.  But there's no reason to let that hinder or dictate timing of your 1031.

A partial exchange may be appropriate - This is where you purchase less than what you sell or take cash out of the sale.  In this case your 1031 can stay intact but you would pay tax on the "boot" difference.

Brent Coombs · Answer

If you've already got enough to "purchase a few turnkey properties", why not go for a larger multi to start with? Using "the cash flow to pay down their respective mortgages" will be VERY slow in the case of Turnkeys, especially because you're already up for an extra layer of costs.

And if you pick the WRONG Turnkey provider - make that TWO extra layers of costs!

By all means, chat with a CPA, especially about 1031, tax implications and so on. Spend time to find a GOOD "boots on the ground" team in your preferred out-of-state market too!

All the best. Cheers...

Gilbert Dominguez · Answer

"The best laid plans of mice and men"

"Patience is a virtue"

First I may suggest to envision your end game, to own a smooth running, cost mitigating and profitable MFB( multi-family-buliding), MRB( multi-residential-building) or could it also be a MUCB ( multi-unit-commercial-building)?

Start to scour the market for this building. Where would it be located? What would be the ideal purchase price?What would be an acceptable or desired financial perfornce, costs versus income? What would this building need or offer? Do you want to self manage or would you want it managed for you? How much of a monthly income do you envision or desire to obtain from your proposed Multi-unit- property and in within what time frame? What advantages do you hope to have in place? Maximum tax write off, maximum income generation? ease of management? close proximity?

You have to have a plan that shows specific numbers as goals or milestones to be reached so that their performance effects applicable funds injection that will in fact create the real building blocks necessary to get you the Multi-unit-building you envision to own someday.

Brent Coombs · Answer

@Justin Young, over twenty million people pass through Honolulu airport per year. Either this year or next, YOU should be one of them! Pick your market - then fly there on "a three hour tour, a three hour tour". Before that, get some networking happening, right here on BP for example. Cheers...

Justin Young · Answer

@Brent Coombs Building the boots on the ground will take some time for sure and I'm haven't found a TK provider that does MFH. Ideally, I'd like to start with MFH first but am trying to get my portfolio started sooner than later. I feel the best to do that is by going the TK route which I know many are against but living in a HCOL area, its tough to just on the sideline and wait. If someone like me who doesn't have a lot of cash reserves to start with and no boots on the ground yet, what would be my next best option?

Anton Ivanov · Answer

@Justin Young

The benefit of doing a 1031 exchange is that you will not have to pay taxes on any capital gains you make from the sold property. For example, if you bought a house for $100k and sell it in 2 years for $150k, you will typically have to pay capital gains taxes on the $50k difference. With a 1031 exchange, you use the sale proceeds immediately to by a "like-kind" property (for example, another house). If you do this, you will not need to pay capital gains taxes on the $50k.

There is nothing wrong with 1031 exchanges - if you're going to sell one investment property to buy another, then this is the way to go because you will be saving money on taxes. However, beyond the tax savings there is no reasons to do it.

In my proposed strategy, you will not be selling anything. You buy your turnkeys and keep them forever and use their cash flow + your savings to save for a multi family property. I don't think it will take you longer, in fact, I think it will be faster than what you proposed and less risky.

It's less risky, because your plan depends on your properties staying the same price or appreciating in value. If they decline in value, you just poured all of your cash flow paying down the loans on the properties you cannot sell at a profit.

Hope this makes sense!

Anton Ivanov · Answer

@Justin Young

I agree with @Brent Coombs - this strategy isn't bad, but it will be very slow. You're likely to get only a few hundred dollars per month of cash flow from your properties and putting that toward their mortgages will not really pay down the principle that fast, especially considering that you pay more interest than principle at the beginning.

You're also buying turnkeys - so you will purchase them at market prices. This will give you minimum equity, so you don't have any wiggle room if the prices in your markets fall. You will then be unable to sell them or will have to take a loss, which is counter productive.

When you're first starting out with real estate, in my experience, your biggest growth potential comes from the money you can save from your regular job, not from your properties. After 5-10 years, your cash flow will be much higher, the properties will likely go up in value and your mortgage pay-off will be noticeable. But until then, provided that you have a relatively high paying job, that will be the biggest source of your growth.

I don't think there is anything wrong with purchasing turnkeys, but I don't think you should count on them to finance your multifamily property and I would not use their cash flow to pay down their mortgages. Why not just save all of the cash flow, add your personal savings to it and use this to save enough for a downpayment on a multifamily property?

Tom Ott · Answer

Hello Justin,

Start with turnkey properties is a great way to begin! Since you are living in Hawaii, turnkey allows you to invest in multiple markets and have your investments managed for you. Make sure you do your research on the company and find out if they will be ones that stick around after the sale! Sometimes there are fake providers out there who don't provide true turnkeys.

SFRs are great to go with as well. Sometimes multis have much more overhead that can be a burden. There is a lot of "shared space" in multis and those costs tend to fall on the owners rather than the tenants.

Feel free to send me a message if you have any questions. I'd love to discuss more!

Is this a valid strategy?

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