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151: How to 1031 into a PASSIVE Asset

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Buck: Welcome back to the show. Today my guest is Lesley Pappas and she’s the founder of and also the due diligence officer for a company called Archer. So Archer’s focus is on advising investors on deferred 1031 exchanges and allows them to invest proceeds into large-scale institutional great commercial properties that can then of course provide that more truly hands-off management experience. She’s been featured and cited in CNN, ABC, CBS, NBC, Fox, I think we finished the alphabet there and in the Wall Street Journal of course, and specifically on this vehicle that I want to really dive into today known as the Delaware Statutory Trust which going forward we’ll just call a DST because it just twisted my tongue. Leslie welcome to Wealth Formula Podcast.

Leslie: Thank you so much, it’s really great to be here. I appreciate it.

Buck: So let’s let’s start at the beginning we always like to kind of get to know who we’re talking about and you have an interesting background you’ve been, it sounds like in real estate for about 20 years, but you have been in finance and all sorts of stuff for quite some time. Can you talk a little bit about how you ended up doing what you do?

Leslie: Yeah well you pointed out that I’m old so I am in fact old. I came into real estate around the year 2000 and I came from consulting background in Silicon Valley to high tech firms prominently. And basically the dot-com bust ended up in all consultants being fired immediately and then a whole bunch of employees being fired, well what in God’s name am I gonna do now? And it became real estate and I wish I had done it when I was in my 30s, I wish I had done it when I was in my 20s. It was a great field it’s always changing. I’m always learning something new.

Buck: Got it so somewhere along the line you got it into of course larger multifamily and other kinds of commercial property. What was that evolution to that from where you started necessarily in real estate?

Leslie: Yeah well I had everything to do with the availability of at that time 10 common investments. We’re in the field here of syndicated real estate and syndicated real estate it has been blessed by the IRS in two legal formats one is a tenant in common tick and the other is the Delaware statutory trust the DST. So back in the 2000s when this industry was born basically after the IRS issued revenue procedures outlining the rules and regs that ticks and DST’s would need to follow to be considered like-kind property. This industry blossomed to came from really very very little just private deal-making previously and blossomed into something much larger eventually the highest equity we have raised I believe was in 2007 it was about four billion. So what we found was a very early success because the popularity of the idea of owning like kind real estate that you defer taxes through 1031 exchange to get into like kind real estate where you don’t have to manage anything it’s a completely hands-off experience and you know the cash flows are pretty acceptable, the overall returns are fairly acceptable, we’re not talking about twenty and thirty percent returns per year we’re talking about a much more conservative asset than that. Mostly what my clients want us to keep their equity safe and they want to spin off a reasonable cash flow with some tax shelters.

Buck: So let’s back up a little bit. Of course in most people listening kind of already know what a 1031 exchange is but not everybody so why don’t you start out kind of explaining, you know give us give us the high level because I want to go from that into where the DST fits into it.

Leslie: Absolutely. So you own an investment property a rental property it could be a house it could be a condo it could be a piece of land that’s an investment property. And you’ve had it for many years you have built some equity there and now you decide you want to sell it. Well when you sell it you’re gonna get hit with capital gains tax. From California which is my home state the tax rate is around 35 to 40 percent all in when you count the feds the state depreciation recapture and the new tax for health care to high income people. So if you can imagine you’ve owned a property for awhile say you’re sitting on our $500,000 gain, imagine losing a third that you want to the government in taxes. Well 1031 exchange has been around since 1921. 1031 has been around for a long time the idea is that you’re selling an investment property and you’re going to buy investment property to replace it. So basically like exchange right like kind exchange and the like kind is very broadly defined you can sell land and buy a house if you rent the house you can sell a house that you’re renting and go buy a strip center retail you know there’s a lot of mixing that you can do here and from the revenue procedures in 2002 and 2004 from the IRS these forms have syndicated real estate tics and DSTs are now suddenly blessed as like I’m property by the IRS which created the industry basically.

Buck: Right. Let’s talk a little bit then about, let me give you some background in terms of what what most people in this audience are already accustomed to. So we we talk about syndications on a regular basis we have a an accredited investor club etc and we do you know your typical private placements indications where you have a general partner a limited partner etc and so one of the things I really like about this concept of DST is the reality is that you know if you already have property that you’re trying to sell you could get into private placement that we’re doing and benefit from bonus depreciation and that might be one avenue to consider but this DST gives you something completely different but explain how a Delaware Statutory Trust differs from your typical accredited investor private placement and real estate with a GP LP model.

Leslie: Well it’s a trust that’s the basic difference and instead of owning instead of being a partner I should say in a limited partnership you own shares in a trust that trust owns the property. The trust has a trustee. The trustees job is to manage the property as if they owned it themselves to its highest financial benefit to the investor and so it’s just a completely different legal structure. In effect it feels very much the same being a passive partner and a limited partnership. You don’t have decision-making authority, you didn’t you know you don’t necessarily have a vote to do anything. This is very much the same it’s simply a legal trust that’s the difference.

Buck: So who are the decision-makers typically in terms of, you talked about the trustee who is getting the highest and best use for the property and etc and presumably gets some sort of asset management fee for that.

Leslie: The trustee is a sort of a figurehead. The individual truly responsible for the property is the asset manager and again the asset manager acts as if they own the property themselves making decisions about opportunity and risk in the local marketplace. So you know you have lengthy detailed financials going into these projects that project out ten years. You know the asset managers are pivotal in terms of developing these projections. And in general the firms that I work with use very conservative projections. For example if a local red market is truly experiencing five percent gain is year over the year, they might in their models put in two percent or three percent increases in revenue and you know the spirit of the industry for the sponsors with whom I work, a sponsor being a syndicator you know the spirit of the industry is to under promise and over perform kind of and we should talk a little about the industry you know people like and and the sponsors and what’s going on then.

Buck: Yeah tell me about that. I know I’d always do a little research on him everybody I interview rather than coming out you know what sometimes when I gone to interviews by the way people literally say to me the first thing is say, what you want to talk about? Like so you don’t even know who I am, why did you invite me to your program. But I did do a little bit of research on you so you know, listened to some of your other interviews and so let’s talk a little bit about the kinds of properties because a lot of what we do in our you know typical traditional private placements is heavy value add and then we sell to reads we sell some but we take sub institutional level properties and we do you know prove but a bunch of capex in there and then ultimately sell to larger institutions and REITs and that’s I think so you in this situation would be you would be on the buying end of those kinds of situations I assume you’re not doing like heavy value-add capex types type of acquisitions.

Leslie: No. Today the Delaware Statutory Trust format specifically prevents us from doing heavy value-adds. The idea is that because this is a trust and because there’s a trustee who’s got so many powers, the IRS put in its guidelines rules that would protect the investor from the trustee being a bad guy basically and you know financing on the property is disallowed, doing major construction is disallowed, there are other things too but those are the two big ones.

Buck: I’m sorry can I interrupt you, did you just say that there is no debt on these properties?

Leslie: No there is debt on the properties there is debt on almost all the properties and in fact the better properties all have debt. There are a handful of all-cash offerings they tend to be more mediocre real estate.

Buck: Sure of course so what are you looking, so you’re looking for things that typically are not requiring a lot of value add as so you know you want to talk about the kinds of properties that you look for, maybe the graphics you know the cities and I guess you know presumably if you’re you know these days you know if you’re not in that value add space what kind of you know potential cap rates and LTVe that you can you can be looking at.

Leslie: Right well my actual favorite kind of property to get my clients into and to recommend to them is value add, but as you point out it’s a light value add, it’s not a big heavy reconstruction. We’re not tearing down walls we’re not building new buildings and garages or do cosmetic upgrades to you know residential units. We’re doing cosmetic upgrades to common areas, we’re refurbishing a property that might be 10 or 15 or even 20 years old, refreshing it and as for you know putting a couple a few million dollars into this property to dress it up, we’re raising rents. And as we raise rents we improve net operating income as improve net operating income we basically create appreciation for ourselves.

Buck: Are you allowed to actually when you create the trust it’s in acquisition with the purchase cost, are you allowed to actually I guess I don’t even know what you call it raise money for capital expenditures?

Leslie: Yes. Usually allocated out of the loan proceeds otherwise constitute what’s called boot to the investor that’s a taxable event that we want to avoid.

Buck: And so what kind of properties are you looking at and where?

Leslie: They run in all kinds of categories. We have large scale multifamily projects that tend to be in the suburbs of secondary cities such as Orlando, Atlanta, Nashville, Raleigh, Austin, Las Vegas, places like that for the multifamily. They tend to be Class A, A minus to B plus even the value adds tend to be B plus to A minus where we’re going to try and convert them into an A. And as you your listeners know these ways of typing property is extremely subjective, what is the classic property it’s a very subjective thing but it tends to be one that’s well amenitized with newer finishes and a very good location that’s you know in general how you might define a class A property.

Buck: And what do you think when you say good locations you’re not just talking about New York and Los Angeles.

Leslie: No we’re in fact not talking about New York Los Angeles because it’s close to impossible depends a lot of cash flow mean in those kinds of cities San Francisco, Chicago, the top tier we don’t really do participate in the top tier we’re in a second tier.

Buck: Yeah so we we do primarily in our group we focus typically on like Scottsdale, Dallas, Fort Worth, Houston, Atlanta, things like that the similar rates.

Leslie: With the exception Houston, failed one of my tests. I qualify property. Some of the tools I mean do that well one of the things I look for when I’m looking at multifamily which is where I do a great deal of for many reasons which I can explain but I’m looking for growing population, not just in the in the overall market but in this sub market within that market. I’m looking for growing incomes over time in that sub market and the most important factor that I can convey in terms of multifamily and trying to minimize risk is that the property should be surrounded by many different employing industries. It should have healthcare, it should have finance, it should have manufacturing, it should have military, it should have education. As many categories of the support we can put into this area it helps us with our tenancy so we don’t have a preponderance of any one industry in our tenancy. Let’s take Silicon Valley my hometown is an example you know it’s a one-trick pony it’s all about technology and you can make a fortune in Silicon Valley as you well know the real estate it’s all based on appreciation now and on the long hold period. But when technology went sideways in 2001 and we had the dot com bust, you could see through the office buildings going up into the mountains on the other side of them there’s nobody in the office buildings, lots of businesses closed down and it affected everything in the local economy. It affected the rents, tenancy rates, occupancy rates, it affected everybody from the CPA the medical doctor to the woman who does the nails and the dry cleaner. Every business was suffering as a result in you know so what I look for to protect my clients as best I can and I view that as my job is to try and protect them as best I can against loss is a local economy that’s very diversified it is not depending on any one industry and that’s why I’m not nuts about Houston because you’ve got medical and you’ve got oil and gas and that’s what you got there.

Buck: Well there’s a lot moving in also if you look at the demographics in terms of u-haul it is the number one city in the country right now in terms of people moving in, that’s another conversation.

Leslie: We can have that conversation over a drink.

Buck: Yeah yeah yeah. I actually am pretty bullish on Houston. I wasn’t for a long time but I am now because there is a number of things happening in Houston that I think are are exciting and I think the u-haul metrics are useful to kind of emphasize that as well but at any rate let’s talk about a little bit more about the DST structure. So I was mentioning to you offline that last year I had a significant clearly significant capital gain thing and so what I ended up doing was well for me it was a little different you know technically I you know I had carry-forward losses and then I had a fair amount of what you know bonus depreciation from the new cash and then the new Trump laws on aggregating all of the cost segregation analysis on properties etc. But it would have been something that would have been useful the reason I did not 1031 is because I just didn’t think that on for the the level I was at I’m not as an individual. With my team I’m interested in value add but with you know with buying a you know 50 unit building or whatever I could have with my capital gains I wasn’t there so instead I decided you know what I’m not gonna I’m not going to 1031 but that’s a situation where DST would have come in handy. But the question that comes to my mind is so does it if you’re buying shares view describe it it shares in a trust where can you sell your shares in other words do you have to wait until disposition again on that property before you can say all sudden you say you’re interested in you know you finally found that property I wanted I wish I could 1031 out of the DST into that property that I actually want to buy that’s you know in you know in El Paso or something like that or do you have to wait for disposition.

Leslie: You have to wait for disposition. It’s an illiquid investment. There is no marketplace to sell your shares. Now I’ve never been asked to do this in 15 years of doing this for a living but if a client needed to get out of an investment for some reason they would come to me and say Les I need to get out of this investment, I would go to this are involved and asked them if they would have an interest in purchasing that share. If they didn’t have an interest they would send a communication out to the investors in that investment and ask if anybody wants to pick up some more shares. The problem with this scenario is it’s a very limited market place and the person selling is at a gross disadvantage. I have heard I don’t have personal experience with this that any time this has happened in the past with an investor selling out early they’ve lost money. They don’t get out as much as they put in. So they are at a disadvantage so you know it’s very important that my clients understand going in this is gonna be an investment that could be three years long it could be 15 years long. You know historically properties are held five to seven years on average over the last 30 and 40 years in this marketplace but that doesn’t mean we’re gonna have a liquidity in that time market and where our property is situated is is in a bad state for one reason or another it may not be a good time to sell you may elect to hang on until the market cures itself over time. So it is a liquid investment it is a long-term investment.

Buck: Got it and okay so say there’s a disposition now I have to figure out a home for this. Is there any reason why I have to stay within another DST or could I then externalize that back into into a property and I ask you that because in part that might be tough right because if you own fractional ownership of a 25 30 40 million dollar asset and then I’m doing a like exchange technically it needs to be of the same value right.

Leslie: Same value of your shares. So you may own 1% of the 50 million dollar project. To answer your question, you don’t have to stick with DST. You can go into any like-kind property. The idea from an estate planning standpoint is to we call it swap til you drop. Keep exchanging until the day you pass away. And the reason you’re doing that is because every time you exchange, you’re deferring paying taxes, you’re deferring paying taxes again and again and again and under current tax law someday when you pass away those who inherit this asset will get a stepped-up basis and all the capital gains tax burden from the previous years go away.

Buck: Right we call that why borrow and die around here. I stole that from a Democrat Ed McCaffrey. So you buy borrow and die is the concept. So you know I know you don’t generally probably want to talk about personal returns and that sort of thing but if you’re talking about A, A minus maybe B Class B plus stuff, what and with modest value add, what kind of target, first of all I guess cash on cash and then potentially IRRs are you looking at?

Leslie: Sure you know the disclosure of course past performance doesn’t predict future performance.

Buck: Especially over the last decade. But I can tell you that there are actual performance numbers for the sponsors I work with they have a history. There’s one company called Arcade Properties extraordinary company it’s been around for 42 years doing this kind of work. They have a track record in really fairly conservative investments of 12% IRRs to the investor each year.

Buck: Including just those so meaning including disposition so with Liggett cash-on-cash of like…

Leslie: Ballpark around six, appreciation is around six and you is that high because of the value-add right the Hollywood creates that. So another company named Pascoe who I work with a lot in addition to RK they have a 10 percent IRR historically over 20 years of operation. So you know this is not the kind of project that your listeners could compare to the sorts you’re doing on your own.

Buck: I mean it’s not super sexy money machine but it is a very good option potentially for somebody who’s got a million, couple million bucks and pulled out and doesn’t want to go back directly into an asset and be fine making six seven percent, makes a lot of sense. So in terms of like you just mentioned you know these sponsors and all that, so what is what is Archer and what is your role specifically? Is it as a basically a matchmaker kind of or?

Leslie: Well no I take my role as one to try and develop a portfolio for each of my clients that has the least risk possible in my opinion with matching their needs for return as best I can. And that means to me it means after-tax return which is one reason I really like residential class property because we get much more tax advantages there. So you know I’m a broker that’s my title but I’m more of an advisor in terms of how I operate. I have the advantage this is not done in my field but I do it I go see the properties that my clients invest in. And so I can take say there are eight properties that are approved at this time, if I’ve seen six or seven of them I can take them rank them against each other in terms of risk versus reward potentials because I’ve been to the marketplace I’ve seen we have spoken to the property manager I know what’s going on there I’ve made the evaluation. It’s not just a matter of looking at a book full of numbers and disclosures, it’s more than that. So my role is actually very active in terms of forming a portfolio for each client individual to them.

Buck: So you’re more of a portfolio manager sort of for real estate.

Leslie: Yeah I gues that’s a good way of putting it. And since we’re touching on the subject of portfolios, diversification is really important and it’s a great benefit of DSTs because the minimum investment is only a hundred thousand dollars. So if I have a client with a million dollars they’re probably going to buy four or five different properties and carve the money up in between those properties. Now they’re going to be in four or five different geographies they might be in three multi families one student housing one medical office they might be in you know an industrial property, I don’t really haven’t done much in years in office or retail it’s just not been a place that would be considered safe, as safe as residential, even if it’s truly still not have recovered these areas these segments in the commercial real estate world.

Buck: You always got to live somewhere you know, that’s my philosophy on things. So where can we learn more or less it has been really an interesting conversation.

Leslie: Well thank you glad I brought some value. You can learn more, I have a book I’d be happy to send off to you if you’d give me a ring or send me an email, certainly phone calls I’m available to folks to talk this over this is what I do.

Buck: What’s the what’s the website? We’ll put it in the show notes as well.

Leslie: It’s called Archer Investors archerinvestors.com.

Buck: Lesley Pappas and Lesley it’s been great talking to you. Thanks for being on Wealth Formula Podcast today.

Leslie: Thanks so much for having me I really appreciate it.

Buck: We’ll be right back.