Now that you’ve narrowed down your real estate focus on multifamily, it’s important to be able to categorize this asset class further to help you decide where you want to invest your hard-earned money. Understanding the difference between Class A, B, and C will help you do just that, and we’ll walk through the differences in this brief article.
All three class types can make great investments, but the business plans look very different. Here’s some general differences:
Class A Properties
These properties are usually new or recently rehabbed and have the nicest amenities. They are generally in the best areas and can attract the best tenants and rental rates. Class A properties are also usually near the best transportation, employment centers, and are quite often considered the “safest” investments albeit not always the best returns.
Class B Properties
Properties in this class quite often were the Class A properties of yesteryear. They probably have original finishes and are showing the normal signs of the 20-30 years of tenants moving in and out. These are your standard workforce housing properties that provide a safe, clean, living environment for the blue-collar workers of our communities. From an investment standpoint, Class B properties provide excellent upside as there is a “value-add” component that can be leveraged to improve these to Class A type properties.
Class C Properties
Class C properties, as you might expect, have started to really show the wear and tear of the 20-30+ years in service, and there is likely some deferred maintenance. These are usually owned by “mom and pop” landlords that are tired and have not put much energy and effort into the property for many years. These properties most likely have some questionable tenants as well since the owners have been a little more lenient in their rental and collection practices. While these can also be a great investment, it’s important to know that it will take time to get the right tenants in place, there is possibly some crime in or around the property, and many of the systems will likely need significant repair or replacement.
As you can see, all three class types offer their own unique benefits and challenges, and it’s possible to have excellent results across them all. The most important factor when choosing one of these is to make sure your team is equipped to handle the unique challenges and opportunities associated with the property you choose. We’ll dig into the main areas of due diligence in future articles to help you gain confidence choosing your first deal.
@Paul De Luca. An ATM fund is a fund that purchases ATMs (Automated Teller Machines) and places them in large retail facilities across the country from preexisting contracts. The cash flow is very high ($1070/month on $52,000 investment), deprecation is very fast even without accelerated depreciation, but there is no large upside on the backend of the investment because the asset is essentially plywood, a computer chip, and a cash dispenser. The deal I invested in pays 24.7% annually for 7 years.
Hi @Randy Smith! This is a wonderful post IMHO and I'm really surprised no one has commented on it.
I completely agree. I've been a full time investor since I sold my company in the late 90s. Well, I actually I was a speculator for a long time and after losing money I am champion for investing versus speculating. I believe that investing is when your principal is generally on the safe side when you have a chance to make a return, while speculating is when your principal is not at all safe and you have a chance to make a return. I digress.
I have migrated from investing in lots of things to mostly real estate over 20 years ago. I've migrated from residential real estate to all commercial real estate in the past decade. The goal of our fund is to do exactly what you said which is to provide diversification across recession resistant asset types as well as geographies, operators, etc. I really like your post and just wanted to thank you for it!
@Paul Moore. Thanks for the note and for your comment about speculating versus investing. I, too, was a speculator in my early years of investing, and I would like to think I have grown more towards investing as the years have passed. I love the idea of a fund as well, and it's a great way for investors to spread their dollars across multiple assets and even markets.
If you hang around the real estate investing space for any amount of time, you will hear the term “1031 Exchange.” You’ll likely be curious why this strategy creates so much excitement, so that is what we’ll walk through in this short article.
A 1031 exchange is a tax strategy that allows you to sell a property and purchase another “like-kind” property while deferring your capital gains tax on the sale. Essentially, you get to kick the tax can down the road until some further time or even possibly forever. You can quickly see why this would get so much attention from real estate investors, and you can start to understand how many people pay little, if no taxes on their real estate gains.
Let’s walk through an example so you can see how powerful this can be. Imagine you invest $100,000 in an apartment syndication that pays you 5% cash on cash return every month, and the investment goes full cycle in 5 years doubling your initial investment. Each month you’ll receive $416.66 in cash flow ($23,749.62 over the lifetime of the hold period), and $76,260.38 upon the sale of the asset.
Without the 1031 exchange, you'd have to pay long term capital gains taxes on the $76,260.38 at 15-20% depending on your income level ($15,250.08 at 20%). Now, if you reinvested the $61,010.30 that's left over after paying taxes in addition to your initial $100,000 investment, you'd be earning $670.88 per month in cash flow on a similar investment type (5% COC and double in 5 years).
If you chose to leverage the 1031 exchange, everything would be the same on the front end except for paying taxes, but you’d have $176,260.38 invested into the next deal creating $734.42 per month in cash flow. The extra $63.54 per month is not super exciting, but when you take this out to three full cycle deals, your capital has grown to $547,504.10 with the 1031 exchange strategy compared to $417,328.10 without the 1031 exchange. If you placed those two amounts in another investment earning just 5% returns, your monthly income would be $2,281.27 compared to $1,738.87 – 31% more!
There are several rules and timelines that you will need to follow, but here are four of the big ones to know before considering this option:
As you can see, the rules and timelines can make this a very tedious process, so it is extremely important to work with the right professionals.
Whether you chose to leverage this tool or not, it’s important to know that it is available, and it’s a great way to increase your returns by as much as 31% by simply jumping through a few hoops along the way.
Benjamin Franklin was quoted in 1789, “…nothing can be said to be certain, except death and taxes.” I’m not going to suggest that we can avoid either of these, but I will suggest that investing in real estate through the syndication model can certainly help you kick the tax can down the road especially if you leverage cost segregation and accelerated depreciation. In this brief article, I’ll walk through two great strategies that real estate investors can use to help decrease their tax burden at least temporarily.
What is Depreciation?
Depreciation is an expense that investors get to count against their income because real estate assets decrease in value over time from wear and tear. Residential real estate allows you to depreciate the asset over 27.5 years, and commercial real estate allows you to depreciate the asset over 39 years. It’s important to note that the land cannot depreciate so only a portion of the total purchase price can be depreciated. As an example, let’s say you purchase a $375,000 house, and the land is worth $100,000. You could then apply $10,000 in depreciation expense against your investment income every year for the next 27.5 years ($375,000 minus the land cost of $100,000 divided by 27.5 years). If you are personally in a 20% tax bracket, this would save you $2,000 per year in taxes. Wouldn’t you agree that this is very cool?
What is Cost Segregation?
A cost segregation study allows you to break the asset down into smaller units that depreciate at a faster rate so you can take advantage of the tax benefits of depreciation sooner. As an example, carpet and refrigerators might depreciate over 5 years, and appliances and furniture might depreciate over 7 years. To leverage this strategy, a 3rd party cost segregation special must be contracted to perform the full analysis of the property, but you can clearly see how this would be advantageous to your tax strategies.
What is Accelerated Depreciation – 100% Bonus Depreciation?
The Tax Cuts and Jobs Act of 2017 adjusted the existing tax law to allow an incentive to immediately deduct 100% of the itemized depreciation expense in the first year of ownership versus deducting it over the normal 5-, 7-, or 15-year depreciation periods. This was a tremendous win for real estate investors, and it provides a unique opportunity for the passive investor to take advantage of tremendous passive losses the first year they invest in an investment through the syndication model.
In the same example as above ($375,000 house with land worth $100,000), your depreciation expense could be closer to $100,000 in the first year compared to the $10,000 per year for $27.5 years. Imagine the tax savings you could have at the end of the year in this scenario. Now, imagine what that could look like if you were buying $20MM or $50MM apartment complexes.
Please note that the example above is shared just to show the power of this strategy, not to suggest any specific tax guidance for you personally. I am not a tax professional, and this is not intended as tax advice. I do, however, encourage you to work with your tax advisor to see how these strategies can work for your unique situation.
If you’ve started to consider passive investing through the real estate syndication model as an option to help diversify your retirement or investment portfolio, it’s important to know the difference between single asset and multi asset funds in this space. In this brief article, I’ll share the high-level pros and cons of each type to help educate you on your options so you can make an informed decision with your hard-earned investment dollars.
Single Asset Real Estate Investments
By no surprise, single asset real estate investments are limited to one specific property. It could be a single-family home, a mobile home community, a 250-unit apartment complex, or even a strip center in the middle of Kansas. There are many different pros and cons of this strategy, and I’ll outline a few of them below:
Pros
Cons
Multi Asset Real Estate Investments
Once again, it’s not difficult to figure out that multi asset real estate investments include more than one specific property. What might not be as apparent, are the pros and cons for this type of investment so I’ll outline some of those below:
Pros
Cons
Be sure you understand the differences before you invest, but both options can provide amazing returns that will help you decrease your dependance on your W2 income as well as your stock market holdings.
After spending a few years investing out of state in long term rentals, I realized that I would have to accumulate up to 100+ houses at the infamous “$100/door” target to completely decrease my dependance on my W-2 income. The path to five doors was an arduous one, and I couldn’t imagine the time, energy, and effort it would take to hit my new target. Like many others, I decided that investing in multi-family would be the best route to get there, and my research showed that the best way to do that would be as a limited partner in a syndication. Unfortunately, I had spent all our capital on buying and renovating our other “passive investments.” So, where would the capital come from to test my new theory?
Introducing Self-Directed IRAs
A self-directed IRA is an individual retirement account that allows you to take advantage of all the same tax benefits of a traditional IRA, but it also allows you to have more control of your funds AND you can invest in alternative investments like real estate and real estate syndications. While there are a few hoops you must jump through to leverage a self-directed IRA, this option opens real estate investing to anyone that already has an IRA or an old 401k from a previous employer.
So How Does It Work?
At a high level, you'll need to transfer your funds from your existing IRA, 401k, or other retirement account to a self-directed IRA custodian. Your funds will then be available to invest in real estate transactions or any other type of alternative investments. I suggest finding a self-directed IRA custodian that will assign a dedicated account manager to handle your account as you will likely want to have someone holding your hand as you do your first few transactions.
It's not the goal of this article to tell you all the details of this type investing, but it's more to inform you that this is an option for you to consider. I would encourage you to research a self-directed IRA custodian and be sure to do your due diligence before moving forward.
By leveraging my funds from a former employer 401k plan, I was able to invest in three different syndicators across multiple markets which gave me the confidence to invest in many more opportunities over the past two years. While I won’t be able to have these funds deposited into my regular checking account until I reach retirement age, I do have more control of the funds, and I get to continue my education and experience in various real estate opportunities I wouldn’t have access to without this strategy.
As of this writing, the S&P 500 was down a little over 17% year to date, and in the same period, my passive investments have been kicking off 5-7% monthly distributions, one of my passive investments went full cycle in just 14 months producing 80% returns, and I sold my long-term rentals that produced about 20% returns annualized over the past 2-3 years.
Bottom line: I’m very glad that I invested heavily over the past 10+ years in the real estate space, and I believe that everyone should have at least a portion of their net worth in the hard, physical assets like real estate.
I’m not suggesting that everyone should have over 50% of their net worth tied up in real estate investments like my wife and I, but real estate investments can and should part of your diversification strategy to make sure 100% of your investments are not subject to the volatility of the stock market.
I’ve recently started tracking my investment allocations across the following categories: stock market in retirement accounts, personal residence real estate, passive real estate investments, cash and autos (anything with an engine – Yes, that’s a Dave Ramsey’ism). I regularly track those percentages much like I track the breakout of my stock market investments (Growth, Growth and Income, Aggressive, and International (Yes, that’s another Dave Ramsey’ism). Specifically, I have a strategy on how I want to invest my assets both in the stock market and in my real estate investments, and I readjust those amounts throughout the year.
Once you’ve decided on the percentage you want to allocate to real estate, you then must choose what type of asset class and what type of structure you’d like to place those funds. There are a ton of options here, but I’ve chosen to leverage the passive investing model where you can spread your funds across multiple asset classes, operators, geographies, and properties in increments as low as $5,000-$10,000. Specifically, my passive investments are currently distributed as follows: 66% single asset apartments, 5% apartment funds, 15% mobile home funds, 7% self-storage funds, and 7% ATM funds. My goal is to increase my exposure in non-apartment asset classes, but it’s hard to argue the results I’ve received in recent years in this space.
I realize many of the readers of this article are not investing in real estate outside of their personal residence yet, and the strategy I outlined above could be a little overwhelming. My suggestion is simply this, consider holding a portion of your net worth in real estate assets as an investment in addition to your personal residence. Once you’ve made that decision, pick someone that you know, like and trust that is working in this space, and they can help you navigate those first investment decisions. Before you know it, you’ll be smiling on the sidelines when the stock market roller coaster takes its next dive, and everyone will be wondering why your so calm, cool, and collected.
When I first started investing in real estate, I was often asked if I was a growth or cash flow investor. I constantly heard people referencing the infamous “cash flow is king” saying, but I never really gave much thought to it. At the time, I was a high-income earner at the top of my game in my sales career, and the main metrics I tracked for my household were annual income and net worth. Today I know that it’s much more important to understand if you are a growth or cash flow investor, and I’ll walk through a few reasons why below.
Growth Investors
Growth investors generally want to see their net worth increase without much concern about the cash flow that is generated from their investments. The challenge with this strategy is that you do not get any benefit from the investments during the buildup phase. In addition, if you should run into any situations that cut off your W-2 income (think layoffs, medical issues, getting fired), then you don’t have any cash flow or readily available assets to fall back on.
Let’s consider an example where an investor puts $25,000 into a passive investment that generates 20% average rate of returns over a 5-year period. In this example, your $25,000 would grow to $50,000 in five years, $100,000 in ten years, and $200,000 in 15 years. That becomes exciting when you start to consider adding $25,000 per year into your investments going forward. It’s easy to see how the growth investor can get excited about this strategy.
Cash Flow Investors
Cash flow investors focus on one thing and one thing only – will this investment create monthly cash flow to help offset my living expenses. In this strategy, the investor focuses more on the cash-on-cash returns (COC) associated with a deal versus the internal rate of returns (IRR) of the deal.
Let’s consider the same $25,000 investment/year example above for the cash flow investor. If the investor can expect to get 10% cash on cash returns every year, the $25,000 investment creates about $208/month in income ($25,000*10%/12). While this is not something you’ll want to leverage to run out and quit your job in a year or two, it is a great way to gradually decrease your dependance of your W-2 and create a secure future for you and your family.
I know today that I was a growth investor when I had my W-2 because I was trying to grow my nest egg so I could someday become a cash flow investor and live off the income that the nest egg could generate. This strategy worked well while my W-2 income continued to grow, but it came to a screeching halt when I was laid off from that “safe,” corporate America job a couple of months ago. The old sales mantra of “Go to bed a hero and wake up a zero” had a whole new meaning to me that morning I received the call giving me the news.
My strategy today is a blended strategy that focuses on growth and cash flow to help maximize my monthly cash flow while growing my nest egg for the future. Only you can determine what strategy is best for you, but my biggest suggestion for you is to do something. Pick a strategy, jump in, and adjust as necessary.
@Randy Smith I'm new to the forums here but all your posts are $$$$ You can't be comparing apples to oranges especially when you're pitching deals to investors. 100% agree that IRR is the most important metric to look at and it's the only metric we use when evaluating deals. I'm curious as a passive investor on a value add muti-family deal what IRR benchmark are you looking to hit?
@Connor Lawson Most deals are going to show IRR around 15-18% these days in the value add multi family space, but it's more important to look at what the group/operator is using for their assumptions and what they have done in the past. Groups can make the IRR look like anything if they adjust their assumptions.