330: Ask Buck Summer 2022
Buck: Welcome back to the show, everyone. Of course. This is again Ask Buck. These questions have been accumulating probably since like, May or so. By the way, if you want to, again, add some questions, go to WealthFormula.com, you’ll see the Ask Buck button and you can actually record your question, which is generally what I prefer because I think it’s more fun that way. But if you want to, you can just write a question as well, and I’m happy to address that as well. Anyway, let’s start with the recorded questions again because that’s what I generally like better. So let’s get through those first and let’s start now.
Anonymous: Hi, Buck. Please tell us your general opinion about investing in opportunity zones. And please tell us whether you would ever consider creating an Opportunity Zone fund that we can invest in. Thanks, Buck.
Buck: Well, it’s an interesting question. So let’s start out with what exactly are opportunities Zones? So opportunity zones are essentially they’re an economic development tool that allows people to invest in distressed areas in the United States. And it could be for real estate, but it can also be for businesses and stuff like that. The idea is to spur economic growth, job creation and low income communities and at the same time provide tax benefits to investors to encourage this whole thing. So these funds are appealing potentially to investors because investing in them can either potentially defer or eliminate capital gains taxes of all kinds. So investors, basically what you can do is you can place existing assets with accumulated capital gains into these funds, right? And those existing capital gains are then not taxed until either the end of 2026 or when the asset disposition occurs.
So for capital gains, place and Opportunity funds for at least five years, investors get a jump up in bases of 10%, which means basically, okay, you pay capital gains on 10% less essentially, and if you’re invested for at least seven years, the investors basis jumps up by 15% and all that’s fine. But the big thing is for investments held for at least ten years, investors pay no taxes on the capital gains produced through their investment and opportunity funds. So that sounds great, right? It sounds like not a bad deal at all, but especially if you have to pay no capital gains on profits after a decade. So yeah, initially when this came out, everybody was super excited about it. Here’s the problem in my view. In my opinion, first of all, rehabilitation of very downtrodden places is difficult in the first place, okay? Inherently there are substantially more risk to these kinds of acquisitions than those in markets that are already emerging that we already know have got a lot of momentum behind them. So these are markets that really are kind of an absolute mess and there’s no reason necessarily to go in there thinking that it’s going to turn around.
So obviously in our group we do a lot of this sort of value add stuff in communities. They’re usually blue collar communities, but they’re enraging markets. These are not enraging markets. That’s why these are opportunity zones. Right. Anyway, so that’s one of the problems next. Now most operators in the real estate space that I’ve spoken to, including obviously our own operators through Western Wealth Capital and through Toro, but also operators like Kenny McIlroy, we discussed this and from the syndicator’s perspective, people are used to doing value add. These are not particularly appealing parameters that are set when you are involved with one of these in order to make it count as an opportunity zone. And namely, one of the big issues outside of the fact that you’re in these places that are hit or miss in the future is the amount of capital expenditures required in these projects. It’s really excessive. They want you to put a lot of money into these things and it makes it frankly more difficult to make money in those.
Another problem, the idea that you’re investing in areas that are in need of economic stimulation might lead you to expect that you’re going to get a discount compared to nicer areas. Right? I mean, it makes sense. Why would you shouldn’t it be at a discount? Well, the problem is that opportunity zones themselves have essentially attracted a premium now. So now you’ve got a bunch of opportunity funds all trying to take advantage of an area and it drives prices up. And of course that affects your return because you’re not buying things at a discount, you’re buying them at a premium compared to where the market is now. So in effect, the benefits of the taxes have already been baked in on the purchase price. So again, I don’t see a lot of value in this compared to the amount of risk. That’s my concern. And I have yet to find an operator that I think I could do a good job, that can do a good job, and making money for people on a consistent basis with this model. If we thought we could do it, we would do it, right? I mean, this is value add stuff and if we thought it was really useful and that investors could make a lot of money doing it, we’d be doing it, but we’re not. Does that mean that we’ll never do it? I don’t know. It doesn’t. But right now it’s not something that we think is necessarily the best way to go. You can always find someone who says they’re going to make you money, but in reality in this space too, again, because it’s attracting a lot of money from the retail space, there’s a lot of charlatans you got to be careful of.
My last thought on this is that, listen, blocking away profits for ten years in hopes of not paying taxes, I don’t know if it makes a lot of sense to me. I mean, that’s a tremendous amount of risk, especially if this is a great big capital gain or liquidity event. I just don’t know if I want to take that kind of risk, especially right now with other opportunities in place. For example, if your capital gains were from property from real estate, you could reinvest that and use bonus depreciation. And in many cases, bonus depreciation is actually going to be a better deal for people than even doing a 1031 exchange. And it’s 100% bonus depreciation this year. Of course, next year it’ll decrease down to 80% and then another 20% after that. But there’s still a significant opportunity to make money rapidly even without this kind of opportunity zone thing, right? So say you did your bonus depreciation for capital gains on real estate and now you didn’t pay taxes on that. And then our divestments, as you probably know, typically in multifamily real estate specifically, are yielding over 30% annualized returns in general, which means you’re doubling your money in every three years. So what’s the point of locking up for ten years and not getting any benefit at all. Okay? So that’s my opinion. More importantly, I guess the bottom line is we’re doing assets that are in really good markets that we already know that creates a substantial risk mitigation. So most of my syndicator colleagues do not think it’s worthwhile as an endeavor from the operations side. Anyway, good luck to you. Hopefully that helps with your analysis of the situation. But that’s mine.
Now. I think this question might be from the same person. Here’s another one.
Anonymous: Hi Buck. I was hoping you could give me a clear understanding about whether 100% of the losses I will see on the K1s from my Western Wealth investments from bonus depreciation this year can be used to reduce the capital gains that I will see on the stocks that I am selling this year. Or do these types of gains and losses reside in separate buckets for some specific tax reason? I’m not a real estate professional with any gains from real estate sales. So that’s why I’m asking the question. Thanks a lot, Buck.
Buck: So yeah, you’re not a real estate professional and as a reminder, I’m not a CPA because I don’t want to get myself in trouble. So anything I tell you is from my own what I’ve heard, I’m just a guy who knows a guy, right. Anyway, my general understanding is that there is of course a difference between various types of income. Okay? Your gains from stocks would be considered portfolio income. Portfolio income is a different kind of income than real estate. So therefore profits from portfolio income cannot be offset by the losses visa depreciation on real property. Right. That sort of sucks because as you I’m sure you know, the bonus depreciation does not work against active ordinary income either. Right. So basically you’ve got this IRS kind of barricade of losses and then there’s not much we can do about it without changing legislation. Now, bonus depreciation from real estate is there primarily to allow you to use against other passive sources of income.
So it might not just be real estate. Right? I mean, that’s certainly one way. If you have passive capital gains from real estate, the idea would be that you could offset that by reinvesting that in something else and then getting the depreciation on that. Now, I can tell you that I’m just about to do that because I finally sold my house, that is in Chicago and that I was renting out for a while and now I think I’ve got a few hundred thousand dollars of recapture because I did a cost segregation analysis and then I have another few hundred thousand dollars of profit. And then what’s going to happen is if I invest that and leverage it, I should be able to knock out all of the recapture and the capital gains through the passive losses that would come from the acquisition using bonus depreciation and after cost segregation analysis. By the way, if this discussion of bonus depreciation and all that business is confusing, go back to one of our last aspects shows, because we talk about this all the time.
So anyway, again, I’m not a tax professional. However, here’s my understanding. It’s a bonus depreciation, if you get real estate, can offset all kinds of passive ordinary income. That’s not portfolio income. So property. There’s a number of people in our group and our network who have ownership of businesses that are passive, such as surgical centers. Infusion centers, they’re not involved in DayToday activity. Therefore, these are considered passive endeavors and therefore the depreciation from real estate can be used to offset. Again, because these businesses, this income is ordinary income, but it’s passive. Therefore, that’s why you can use bonus depreciation on that. Bottom line, though, going back to your original question, in your case, I wish it were not the case, but I don’t think it’s going to work for you because you’ve got portfolio capital gains. And that’s one of another reason that I’m not a big fan of stocks in general myself. So you just don’t have the tax benefits that you do in real estate.
Now, one last thing, of course, I should add, and again, I’m not a CPA, but I’ll add one more element here. Again, that if you are a real estate professional, one of the benefits is, yes, you could take your losses from the depreciation, offset it against any kind of income. That’s my understanding. And as a real estate professional, I’ve seen this first hand. But anyway, that’s it for that question. Thanks for asking.
All right, next question.
Dreau DuBois: Hey, Buck, thanks for all that you do. My question is, when investing has an LP into a deal, is the time the money spent sitting in a fund account before and after the deal is closed or sold, taken into account when determining the return on investment? And if not, what would you say is the typical amount of time to consider when factoring in the time the money sits in a fund account before a deal is closed or after a deal is sold? Thank you for your time and expertise.
Buck: So this is a really good question because it addresses one of the reasons that I don’t like real estate funds as a general rule. And that’s why in our Investor Club, you almost never see them. Why? Well, let’s say someone wants to start $100 million blind fund and acquire a bunch of real estate through it. Okay? Let’s just say that they get their money raised and then what? That’s when you go out and look for properties to buy. Now, there certainly have been times in the last few years where it would be relatively easy to deploy that much capital if you had access to deal flow. But it’s not always the case. Look at right now. What if you just started 100 million dollar fund three months ago.
Opportunities right now are sparse, and you would be forced, therefore, to buy properties just so that you’re not losing money by holding on to cash. You’d be forced to buy properties that you might not otherwise want to buy. It really just comes down to what I would call the efficiency of capital. The way I prefer to do things, you have a specific asset, big apartment building, whatever, you know exactly how much money you need to acquire, and you know generally approximately the amount of capital expenditures you’d like to add to the capital raise, and you’re not raising very much more than that, if any. And the fact that you don’t have very much dead money sitting there waiting to deploy maximizes the returns for investors, it’s just basic math, right? You got $100 million, and you’re sitting on 50 million. And that 50 million is just losing buying power over time anyway. Funds always have a lot of money sitting around, too. Again, it’s just not efficient. It’s not a really good way to make money, in my opinion. Of course, even with specific assets, the way that we do it, you have an apartment building. Typically with every opportunity, the operator is going to give you an idea when the closing is, and it’s typically going to be within a couple of weeks of the funding deadline. So if you were funding shortly before the deadline, you probably have a tack on about two to three weeks until the closing. So that’s dead time.
And then, conservatively, when there’s a disposition, when the property is getting sold, you may not get your money. I would say an average of about three to four weeks after the closing of the real estate project, after disposition. So all in all, you’re looking at probably a month and a half, two months of additional hold time. Now, of course, I think what you referenced earlier, you’re wondering what numbers the operators are showing you. What they’re really showing you is at the project level, right? I mean, returns are calculated from the day you close to the day when you sell the property. But you’re right, you’ve added a couple of extra months. And hopefully it doesn’t make a big difference in terms you’ve made a bunch of money, but that extra hold time does technically reduce the return as a function of time. And again, in the case of specific assets, I think the math, if it were me, I’d probably just tack on a couple of extra months if you really want to try to figure out how much effect it has on your return. Good question, though.
All right, let’s see.
Evan Spano: Hey, Buck. This is Evan from San Luis Obispo, California. I’m wondering if rising mortgage rates will make it so that multifamily operators will be less likely to do a refinance. Thank you.
Buck: Yeah, Evan, absolutely. I think that’s absolutely the case. So in our portfolio. We have a number of properties that we were planning on doing a refinance this year that now we’re really not so sure about that and we’re just now holding on. The reason of course is that rising interest rates mean higher mortgage payments as most of these loans and commercial real estate are floating and then refinancing. Essentially what that does is it takes out equity and then it’ll reduce your overall net income of a property and that’s really not what you want to do in a volatile rate situation like we’re in right now. Now the good news for our investors again, I just bring this because I know there’s a bunch of people in lots of real estate right now in our investor group. The good news for our investors, these properties are doing really well. So we are actually more likely to, I would say, sell these properties earlier than before then to refinance because I think that would be less risky proposition. So what are we waiting for if we think it might be a good idea to sell? Well, part of the problem is that the lending markets I shouldn’t say part of the problem, I would say the majority of the problem is the lending markets are volatile. Right. Because of all this rate movement, lenders have gotten very conservative with both leverage fanny Freddy, very poor leverage offered and the spreads between sofa which is what replaced Libor and the actual lending rate. Those spreads have gone way up in the private lending market. So effectively buyers are not lining up to buy right now, they are waiting. So to be a seller in this environment is a little tricky. Right. The number of active buyers has easily been reduced tenfold in the last six months. And I’m talking about big institutional and family offices and stuff like that. They’re just not buying. So if you want to maximize what you sell your property for, it may not be the best time to sell. Right. You want a bunch of ravenous buyers out there to overbid. Kind of like bring your own trailer, right? That car thing, you should check it out. It’s kind of cool to see but there’s basically people have these vintage cars and they’re really cool but they always end up going for way over what they should because there’s a lot of people looking at them anyway. I digress. Bottom line is with our property that we have, we’re not worried about losing anything. It’s just a matter of time before lending markets stabilize and when they do, everyone will go back to work and we’ll start selling properties and consider refinances and all that. Yeah, hopefully that answers your question or at least kind of addresses something peripheral to it. Okay, I think this is the last one we will do today.
John Wright: Hi Buck. I’m curious to know what the current increase in interest rates will do to apartment syndications in terms of asset performance. I know a lot of operators forecast a refinance or even a lower interest rate when they initially do their pro forma. So I’d like to get your insight on this.
Buck: This question, again, relates very much to the one before. I would just say again that the lending markets are really driving what’s going on in real estate, in the real estate markets right now, especially in multifamily, that’s what we’re focused. And again, that’s why you’re not seeing many refines and why you are not seeing a bunch of transactions. However, again, I’ll take this opportunity to emphasize that personally, I’m not worried. I’m not worried overall. And believe me, if this market was in trouble, I’d be very worried because I have the vast majority of my net worth bulldozed into these assets. So I’m not worried especially for property that we have in our investor club portfolio, which is the stuff that I invest in. We are in the business of value add and that’s really important in this kind of environment. Our whole model is predicated on driving up rents, right? We’re not a buy and hope model. We are focused all the time and driving up rents. And so interest rates are high right now, but that doesn’t happen in a vacuum, right? They’re high because inflation is high. And so interest rates are following that. But guess what? If inflation is high, we ramp up our rent even more than when inflation is not high, right? So we basically cancel that out. And that’s why multifamily in the hands of competent operators is a hedge against inflation. Now, I do believe that there is a chance you’re going to see some struggling properties that you’re going to hear about. And I think that is going to happen because in reality, there’s a lot of indicators in the last six, seven years who hopped on board and their approaches has been relatively lazy or just they’re not really pushing rents, they’re not creating value. And in the last several years, it’s been very easy for people to make money by doing nothing but just holding on and waiting and hoping for rents to go up and for people to bid higher because of lower cap rates. Well, that environment, it’s just not there anymore. So for people who are buying syndicators, who’ve bought and who are not into the mindset of driving up rents, this could be a difficult time. And I think as yet to be seen, I haven’t heard of a lot of that kind of stuff happening yet, but I wouldn’t be surprised if you did see that. But again, the good news is this is what we’re built for.
Let’s take a break and we’ll be right back.