All Forum Posts by: Stephen Anthony

@Luke Carl No longer have property in Omaha, but had a similar experience managing our multifamily when we did. Happy to exchange companies to avoid if it would help.

And to answer @Michael Smythe's question, I interviewed the crap out of management companies with what I felt were great, in-depth questions, both times we hired bad managers. Didn't help to my surprise. The (property management) owners had great knowledge, answers, and talked about their systems, but that didn't translate to execution at the manager level. I learned that (property) owner experiences are much more valuable than any interview of a management company.

In multifamily, I'd say yes absolutely, unless there's a larger market trend that is compressing CAP rates, you'd expect that 20% increase in property value to come with roughly a 20% increase in rents, because CAP rates stay the same. But I think a lot of the discussion around BRRRR in this thread has been around single-family investing, and in that world, CAP rates aren't consistent even on the same block. And changes in property values rarely correlate to changes in rents. (That's also why in my example I was careful to mention we're assuming that 20% appreciation did *not* come with corresponding rental increase - I think that's the type of example Joe was suggesting.) In that case, you're just not going to get the increased rents (and therefore NOI) to match your increased equity, so the best way to use your equity is to sell and re-invest. But as others have pointed out, there's a cost to selling and buying too. In my example, the $4k of useless equity left behind in the refinance may very well not be the worth the cash and time costs of a sale, 1031 exchange, and a buy.

Joe, I found this and your other post ("The property isn't the asset. Your equity is. The property is just the vehicle your asset is riding at that time. When you sell, you retain the asset...you just moved it to a different location. When you refi, you're paying for the use of that asset. You're using that asset as collateral, and you are paying for new money that the bank is selling you.") a fascinating concept, so I tried to put some numbers to it. Hoping this helps some other people think through this too.

Assumptions:
- An area where you can buy deals at a 7% CAP
- A lender that will loan and/or refinance 80% LTV at 4% interest on a 25 yr am

Starting Deal:
- Pay $100k for a property, with $20k down. (Side note, you can also imagine this as a more complete BRRRR where you bought & rehabbed that property at $80k total with hard money, and created $20k of equity for yourself with a property now worth $100k through your hard work. Either way, you have $20 equity.)
- NOI is $7k, Debt service is $5067, Cash flow is $1933
- 9.7% cash-on-equity return on your $20k investment (cash-on-cash return is also 9.7%)

Per Joe's example, appreciation happens and the property is now worth $120k. (I think it's worth pointing out here that I believe Joe was talking about market appreciation, not forced appreciation. If your increased property value corresponds linearly to increased NOI, we're talking a very different story than the numbers I'm sharing.)

You now have $40k in equity. While your cash-on-cash return is still 9.7%, your cash-on-equity return is now halved to 4.8%. That extra $20k equity is doing you no good. Sad.

You decide to find a way to use that added equity. (Great idea!) For sake of simplicity, you have two choices:
Scenario 1: Refinance your first property, and invest the proceeds into a new property. (Carrying on with the BRRRR model.)
Scenario 2: Sell the property, and invest all the proceeds in a new property. (I believe Joe is suggesting you do a 1031 exchange here to defer capital gains taxes. In my area, 1031 intermediaries can be found for around $600, so this is well worth it.)

Here's the numbers (hang with me):
Scenario 1:
  Property 1: Now worth $120k, your 80% refinance nets you a cash-out of $16k. This property now has debt of $96k and equity of $24k. Your debt service is now $6081. **Your rents haven't changed.** Your cash flow is now $919. Your cash-on-equity return is now 3.8%.
Property 2: You take your $16k cash-out and buy the highest valued property at an 80% puchase LTV you can, which is an $80k property. Same 7% CAP rate, so $5600 NOI, $4054 debt service, $1546 cash flow. 9.7% cash-on-equity return (same as our original property, which we'd expect!).
  Both properties together: $200k value, $160k debt, $40k equity, $2466 cash flow. 6.2% cash-on-equity return.

Scenario 2:
Property 2 (only): Remember, you sold property 1 and have $40k. You buy a $200k property. Same 7% CAP rate, so $14000 NOI, $10,134 debt service, $3866 cash flow. 9.7% cash-on-equity return (sound familiar yet?).
  Note: Real life isn't that simple, maybe a 7% CAP on a $200k property isn't possible (or maybe it is with a duplex, etc). Buying two new $100k properties would give the same numbers and returns (just harder work finding two deals).

Why the difference? (aka please tell me there was value in reading this long-*** number-filled post)
In both Scenarios, you're using all $40 of your equity to the maximum potential that your lending situation allows (80% LTV). But that equity isn't being used equally in both Scenarios.
In Scenario 1, for Property 1, after the refinance you've got an additional $4k equity (on top of your $20k original) that isn't generating any increased income. (Because rents didn't go up.)
In Scenario 2, all $40 of your equity is making a 7% CAP rate, because it was reinvested.

Joe, this is where I agree with your outcome and ultimate advice, but not quite on the reasoning behind it. Whether refinancing vs selling and re-investing, you're going to borrow roughly the same amount and pay the bank the same interest cost. The problem with refinancing equity gained through any kind of appreciation not linearly correlated to increased income, is it leaves a portion of your gained equity stuck in the original asset, not earning as much as it could in a new asset. (And maybe that is what you were saying, and I missed it.) Either way, I very much appreciate you making these points, it's a major reframing for me of the best use of equity gained through rehab/BRRRR/appreciation, and it's definitely worth everyone's while to think through and understand the concept.

Note to everyone: Again I want to reiterate, gaining equity from a direct increase in NOI is a different story (this is more common in multifamily). If I turn that original $7000 NOI into $8400 NOI, and the property is now worth $120k because of that (still a 7% CAP), a refinance will keep me at exactly the same 9.7% cash-on-equity return for that property. No difference in that case between refinancing and selling. But if I also gain additional value/equity from turning a class C property into a class B property (i.e. the CAP rate goes down) - now we're back to the same scenario where refinancing leaves equity earning less income, and selling and re-investing is the best use of equity. I'm living that example right now actually, and very, very glad we sold and are re-investing the equity. (Hello, William Nickerson's "How I Turned $1,000 Into One (Five) Million in Real Estate in My Spare Time".)

Hope this was all helpful to someone else, because it's way past my bedtime!

@Nicholas Aiola Thanks for confirming that! Yes, I had to explain active participation vs. material participation to the CPA too (insert eye roll).

@Nicholas Aiola I was searching online for "cpa real estate forums" in a desperate attempt to get a 2nd opinion and somehow it brought up this thread. First off I have to say wow, two years later and still answering people's questions - that's an incredible service you've provided to the community here! Thank you!

When a gain or loss from a partnership (that only conducts rental real estate activity) flows down from a K-1 to Form 8582 (Passive Activity Loss Limitations) on a personal return, is that gain or loss recorded in Part I, #1a or b (Rental Real Estate Activities With Active Participation, assuming there was material participation in the activity) or is it always recorded in Part I, #3a or b (All Other Passive Activities)?

Everything I see in the IRS instructions points to partnerships and K-1s can definitely show up under Rental Real Estate Activities With Active Participation, but I have a CPA who is insisting anything from a K-1 is always always always recorded under All Other Passive Activities only.

IRS Tangible property and DMSH FAQ

I'm going to throw out a few potential answers to my first two questions, all sources from the IRS Tangible Property Regulations FAQ (above), oddly enough.

1) Under "What is the de minimis safe harbor election?"

"The de minimis safe harbor election eliminates the burden of determining whether every small-dollar expenditure for the acquisition or production of property is properly deductible or capitalizable. If you elect to use the de minimis safe harbor, you don't have to capitalize the cost of qualifying de minimis acquisitions or improvements." 

As the IRS specifically mentions improvements here, that seems to say that materials/supplies can be expensed even if they're for improvements.

2) Same source and paragraph as above, specifically "acquisition or production of property". Production implies the involvement of labor. You don't produce a table just buy buying a pile of lumber.

Additionally under "If you use the de minimis safe harbor, do you have to capitalize all expenses that exceed the $2,500 ($500 prior to 1-1-2016) or $5,000 limitations?" it mentions both "repair and maintenance" and again "production of property", again implying labor costs.

Resurrecting this thread because the previous answers actually cited the regs, and there was some great discussion and information. I'm in search of a couple clarifications on de minimis safe harbor (DMSH) and specifically sources for those opinions.

Assuming:
1) The real property is in service
2) Items in question are below $2500 and not subject to the anti-abuse rule
3) Books for the business consistenly demonstrate corresponding DMSH treatment
4) Any other key assumption I probably didn't realize (feel free to point it out)

Questions:

1) Do materials/supplies still qualify if they are for a betterment or improvement? Source? (Example: 20 new light fixtures, Example: Vinyl plank flooring for two previously unfinished rooms)
2) Do labor expenses or combined labor/materials qualify under DMSH? Source? (Example: Install a new egress window, Example: Convert a dining room to a bedroom)
3) Does DMSH exclude structural components or any other parts of a building, either from a materials or labor perspective? Source?
4) Realize this may be a much larger question, but at a high level do Tangible Property regs and UOPs have anything to do with DMSH when we are talking about improvements to real property?

My examples are made up, feel free to change them if it better illustrates the answer.

Easy links for possible sources:

§ 1.167(a)-11 - Placed into service definition - e(1)(i)

§ 1.263A-1 - Capitalization of real property

§ 1.263(a)-1 De mimimis safe harbor (DMSH)

§ 1.263(a)-2 - Treatment of tangible property

IRS Tangible property and DMSH FAQ

Thank you in advance!!

As many others have mentioned, pretty sure I know of the investor who owns these houses. We started looking at his properties in fall last year.

Now, not 100% sure we're talking about the same properties/owner, but if we are, the vast majority have been incredibly neglected as have the tenants. The owner I am thinking of would not hesitate for a second to drastically lowball the amount of work/$$ to rehab or hide problems from potential buyers. He keeps his properties in miserable condition - little to no maintenance, does not address pest problems, not to code including basic safety devices, etc.

Proceed with extreme caution with these, especially if you're out-of-state/relying on someone's elses word about their condition.

Feel free to message me and I can confirm if it's the same investor, share further details, etc.

(And Brian you're correct, he wants out but isn't particularly motivated and is basically waiting for the right buyer who doesn't do their due diligence and will pay way too much for them.)

BofI Federal Bank has really low origination costs and title costs. They'll match or beat any rate you find.

Few random things that might help in the future. You can have up to two Google voice numbers per account with a small fee ($30) and a bit of a convoluted process. You can also have two Google voice numbers from two different accounts forward to the same phone with some finagling, even though that's not supposed to work.

The Google voice app also makes things fairly slick, because you can get notifications for texts and voicemails from an unlimited number of accounts on the same phone.