A Real World 1031 Exchange - Part 3: The Research

A Real World 1031 Exchange                            6/30/2014

Part 3: The Research.

Once my property went into escrow, I enlisted the services of Christina Suter, leader of the Pasadena FIBI (For Investors, By Investors) REI group as my advisor.She helped me form a strategy and analyze deals that came my way.Christina became my investment psychologist, guiding me through the wonderful land of RE.She set up a spreadsheet so we could compare properties and estimate cap rates.Finally she can do background checks on the people with whom I consider investing.

My goal is to parlay the appreciation from our first investment property into multiple cash-flowing properties in about three markets outside of California.I plan to retire in a couple of years, and I would like to get $3000/mo net of all expenses.

To defer all taxes, after closing costs, I need to acquire $1,200,000 in properties.Of that, $585,000 needs to be cash and $615,000 needs to be financed.This doesn't take into account the $240k mortgage on my home that was used for the original property's down-payment.

We still have over $850,000 in debt that we will have to cover with our new properties.I assumed that mortgage rates would be about 5-5.5% which would mean about $5000/mo just to cover the principal and interest.By my math, to realize a total of $8000/mo on a total portfolio of $1,200,000 would equal a cap rate of 8%.

I’m using capitalization rate (Net operating income / purchase price) to compare my investment options.I am looking at my mortgage as spread across all of my properties so any property with a cap rate under 5% would not cover its portion of the mortgage.

So I began looking for 1031-approved investments with at least an 8% cap rate.I began my search in earnest in February 2014 when my property went into escrow.Luckily for me, the escrow took three months, and didn’t close until mid-May.

Besides directly acquiring properties, there are more passive options for investment.There are several syndication programs that accept 1031 funds.They tend to be for long-term leases on large residential properties, triple net shopping centers, or corporate buildings.The options available to me tended have lower cap rates on residential properties, and I was uncomfortable with the possibility of losing the entire investment.I tried to find a smaller syndication, but most of those did not accept 1031 funds.So I am left with direct ownership of rental properties.

I had the entire country to choose from and had a hard time narrowing down the markets.I believe that many baby-boomers will be retiring to the warmer climates of the South and Southwest so I began looking at Florida markets.Recent research showed that six of the top ten growth areas were in Texas so that was on my radar.Investment forums pointed out that Memphis and Atlanta had been hot for several years, but Indianapolis and Ohio were the current darlings.Chicago is always a strong rental market.My family lives in Missouri so Kansas City and St Louis would have to be considered.See what I mean?

Besides the 1031 limitations, there were some other considerations.The housing crisis actually helped the rental market so multifamily properties are now selling for a premium, and many believe that there is little room to grow for the near future.My research showed that the price per door for single family residences (SFR) is less than for many multifamily units.However the price-point for houses with good cash-flow is well under $100k in many markets, and remember, I have to spend $1.2M.Additionally I can only finance ten residential properties through traditional lenders due to Fannie Mae restrictions.

I wanted to diversify over 3-4 cities or investment types.I really wanted to partner with an experienced landlord/developer for part of the funds, but I couldn’t find a project during my 45-day limit.(After the deadline, I got several offers.)

I tried to make something work in the Orlando area.I worked with a turn-key provider and a RE agent who specialized in gated-community vacation rentals near Disney World.Although I think there is lots of appreciation potential in Orlando, the turn-key cap rates would not cover my mortgage.The vacation rental, while interesting, would require a sizable outlay in furnishings (not included in 1031).

Having grown up as an Arkansas Razorback, it was difficult for me to invest in Texas.By the time I got to the dance, Austin was out of the question and Dallas was a 6 cap.I think some of the Houston suburbs will be a good appreciation play, but I still remember the devastation there during the oil bust of the eighties.

I found real estate agents in Indianapolis, Columbus, OH, Kansas City, St Louis, and my home town of Columbia, MO.I got in contact with turn-key/rehabbers in Memphis, Chicago, Birmingham, and Philadelphia.

I now believe that getting the right real estate agent can make all the difference when buying on the open market.In most cities, the agents did not show me properties that met enough of my criteria.The exception was Kansas City where William Robison helped me find multifamilies that met my cap rate requirements and that he would like to manage.A knowledgeable BPer recommended a property management company in St Louis.Through them, I got an agent who turned out to have no investment property experience.As we investigated properties, I felt like I was educating him.(Talk about the near-sighted leading the blind.)

Eventually I settled on Kansas City and St Louis (due to their proximity to my family) and Birmingham because I trusted the rehabber and felt that the cap rates were reasonable.I wanted to get my preferred properties under contract before my 45-day deadline so it was time to start making offers.