Let me explain…<\/p>\n
What Is Maslow’s Hierarchy of Needs?<\/h2>\n
His theory was dubbed \u201cMaslow\u2019s Hierarchy of Needs.\u201d It became famous when my dad was HR director of an Ohio airplane manufacturer in the 1950s. He gobbled it up, as did millions of others in the people business around the world. It explained so much about why people do what they do. And why their motivations are so different than we expect.<\/p>\n
Maslow theorized that people only focus on the lowest level of his pyramid until that need is met. Then they progress upward, seeking to fulfill each level above until they reach self-actualization. Theoretically, this is the level where true happiness waits. Where our dreams are fulfilled, and we live out our reason we were put on Earth.<\/p>\n
Here\u2019s the pyramid:<\/p>\n
![\"\"](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2020\/10\/maslows-hierarchy.jpg\" "\\"\\"")
<\/p>\n
Maslow\u2019s pyramid of needs became popular because it rings so true. For example, he said those clawing to get their level one physiological needs (air, water, food, clothing, shelter, sleep, reproduction) met will be largely unconcerned with the type of car they drive (a level four esteem need). Conversely, those bent on level five self-actualization have typically moved past level two needs for personal security.<\/p>\n
Related: <\/em><\/strong>The 3 Critical Elements of Human Happiness (& Why Unlimited Money Isn\u2019t Enough)<\/a><\/em><\/p>\n And we\u2019ve all seen how those in a higher level are smashed in the face with a lower level need suddenly screaming for their attention. Eddie Van Halen was considered by many as the world\u2019s greatest guitarist. He was living in level five for decades (theoretically). But his wife, Valerie Bertinelli, left him after 20 years in 2001, and he got cancer around the same time. I\u2019m guessing he quickly dipped back into levels three and two seeking the love and health he had lost. We will miss him.<\/p>\n Visual Capitalist<\/a> has provided an insightful parallel pyramid they call “The Hierarchy of Financial Needs.” They claim that financial needs, like Maslow\u2019s physiological needs, can be categorized in a pyramid.<\/p>\n Take a look…<\/p>\n I\u2019m no psychologist, and since we talk real estate here at BiggerPockets, I thought it might be fun to apply Maslow\u2019s theory to a real estate deal. You may want to go further and apply this deal hierarchy process to your investment career as a whole.<\/p>\n This hierarchy applied to REI makes a good bit of sense to me. See if it works for a deal you\u2019ve done or a deal you\u2019re looking at.<\/p>\n Here it is:<\/p>\n <\/p>\n It\u2019s fun to dream about big profits and the joy that comes with them. But if you find yourself in a place where your cash flow doesn\u2019t meet your monthly expenses, those dreams will be the last thing on your mind.<\/p>\n You may be panicking about how to break even. This can happen because of unexpected vacancies, declining rents, surprise repairs, or dozens of other issues. Most are unexpected, of course. Nobody plans to lose money.<\/p>\n Well, almost nobody. There are brief periods where an investor is willing to fund the shortfall while planning for bigger and better things. Renovating, re-tenanting, or even rezoning for higher use (like upgrading from residential to commercial) are a few examples. Or doing a development project.<\/p>\n In several investments over the years, I recall that sad moment when I sank from dreaming of that big profit to hoping just to get my principal back. Most investors have experienced this. I hope it never happens to me again. Or you.<\/p>\n Related:<\/em> <\/strong>Yes, Money & Wealth Do Matter\u2014and Pretending Otherwise Hurts Everyone<\/a><\/em><\/p>\n Once you\u2019ve satisfactorily covered your expenses, you should look to reach a healthy DSCR (debt service coverage ratio aka debt coverage ratio aka DCR). The DSCR is the most important ratio in the real estate deal realm IMHO. (Yes, I\u2019m hip, and I use millennial shorthand. LOL. JK. Whatevs, yo.)<\/p>\n The DSCR is the ratio of the monthly net operating income (NOI) divided by the monthly mortgage payment (principal and interest). This is an important margin of safety that shows you how much cash flow margin you have available after paying all of your expenses and mortgage payment.<\/p>\n For example, if you own a fourplex renting for $1,000 per unit, its gross income is $4,000 per month. If you have expenses (not including mortgage) of $1,000, your NOI is $3,000. If your mortgage payment is $2,000, then your DSCR = $3,000 \u00f7 $2,000 = 1.50, or a 50% margin of safety.<\/p>\n Banks typically like to see a minimum DSCR of 1.25 to 1.30 to provide a loan. That gives them a 25% to 30% margin of safety.<\/p>\n So the 1.50 DSCR in this fourplex sounds good. Unless one tenant moves out unexpectedly. Then your gross income drops to $3,000. If your expenses are fixed at $1,000, your net operating income drops to $2,000 and your DSCR drops to 1.0\u2014you\u2019re right at breakeven, below the bank minimum.<\/p>\n At that point, you\u2019ll be praying that a second tenant doesn\u2019t move out, which would drop you down to level one in Maslow\u2019s real estate hierarchy as you write a large monthly check to stay afloat.<\/p>\n As a professional passive investor, I like to see a much higher DSCR. Our fund currently has a DSCR well over 2.0, meaning there is a 100%+ margin of safety. And by investing in a diversified portfolio of larger properties, vacancies barely move the needle. For example, in a 607-unit self-storage facility in Beeville, Texas, 10 move-outs in a month would only drop occupancy by 1.6%.<\/p>\n A 2.0+ DSCR also means my Maslow level is up to at least level three or four…<\/p>\n When your cash flow exceeds basic expenses, you have positive NOI (level one). When it exceeds minimum DSCR you have a safe (or safer) deal and you\u2019ve surpassed level two. In level three, you (the investors and the operator\/syndicator) are enjoying monthly cash flow.<\/p>\n This is parallel to the \u201cAccumulating Wealth\u201d phase in the financial pyramid above. And you are accumulating wealth because you are building equity as you build cash flow.<\/p>\n Why?<\/p>\n Because cash flow leads to net operating income. NOI is the numerator in the commercial real estate value formula. That formula is:<\/p>\n Value = Net Operating Income \/ Cap Rate<\/em><\/p><\/blockquote>\n So in level three, your goal is to increase the net operating income. Your secondary goal is to shrink the cap rate<\/a>, but that is only partially in your control. You are already increasing your bank account balance by receiving cash flow. And by increasing the value, you are increasing your equity and ultimately your net worth\u2014and that of your investors (at least on paper). But the appraised value isn\u2019t money in your pocket until levels four and five.<\/p>\n This is parallel to the \u201cFinancial Freedom\u201d level in the pyramid above. This is when theoretical gains of level three turn into a secure asset with the risk off the table. This is parallel to a future retiree with an irrevocable pension.<\/p>\n How do you get there in a deal? There are multiple ways, but one great path is through refinancing. Let\u2019s say your asset has grown in value to a level that dwarfs the level of debt. And perhaps you\u2019ve paid down principal on the loan, as well. You may be able to capitalize on lazy equity through refinancing it and putting it to work.<\/p>\n By adding a second layer of debt through a supplemental mortgage, or by just getting a new higher LTV mortgage, you can potentially withdraw your principal balance from the deal. By doing this, you have now effectively removed the \u201cI\u201d from \u201cROI.\u201d<\/p>\n And when \u201creturn\u201d divided by \u201cinvestment\u201d is a number divided by zero, you know that the answer is a math error. But some refer to this number as \u201cinfinity.\u201d Since you have no principal left in the deal, you could refer to your cash flows and eventual sale proceeds as an infinite return. You can see why this fits into level four: \u201cDeal Freedom.\u201d<\/p>\n As I mentioned earlier in the article, like Mr. Van Halen, it is possible to drop to a lower level. One way to do that here is through overconfidence. Overleveraging your property to take principal off the table could result in a too-narrow margin of safety (the DSCR of level two). This could cause problems in the event of increased vacancy or lower rents.<\/p>\n Related:<\/em> <\/strong>3 Ways to Reduce Risk in Your Real Estate Portfolio<\/a><\/em><\/p>\n You\u2019ve climbed up four levels. You\u2019ve faced the challenges every operator faces and enjoyed the fruits along the way. Now it\u2019s time to cash in your chips and move to a new pyramid. It\u2019s time to sell your asset.<\/p>\n In level four, you enjoyed the freedom of a largely de-risked investment. By taking your principal off the table, you enjoyed the feeling of freedom in this deal. But you still had the risk of dropping to a lower level.<\/p>\n At level five, you will sell your asset and forever lock in your gains. All the capital appreciation and principal paydown will flow from intangible (in the asset) to tangible (in your bank account). It\u2019s time to celebrate.<\/p>\n But you\u2019re not entirely out of the woods. Why?<\/p>\n You\u2019ve got to deal with at least three types of tax. And you\u2019ve got to figure out where to reinvest.<\/p>\n Your taxes may include capital gains, depreciation recapture, and the Medicare surtax. Certain states like California also have state capital gains taxes. There are several ways to defer these taxes, the most famous being the 1031 exchange. Many who utilize the 1031 exchange plan a \u201cswap till you drop<\/a>\u201d strategy, which means you or your heirs will never <\/em>pay the accrued taxes.<\/p>\n Whether you use a 1031 exchange or not, you will be tasked with replacing the asset you sold. You will go through a similar stringent due diligence process as the one you went through last time.<\/p>\n Please realize that if you\u2019re selling at the top of the market, you may end up buying at the top, as well. This can introduce new risk to a situation that you previously de-risked through much effort climbing the five levels. But that\u2019s part of the game. Most investors go from riskier to less risky assets as they gain years, wealth, and experience. I discuss this in detail in this recent post<\/a>.<\/p>\n Suppose you are moving from an actively managed asset to a passive investment. You may be able to relax and enjoy the fruits of your labor while someone else does the heavy lifting. This is quite easy to do when selling your asset through a \u201cnormal\u201d sale process.<\/p>\n But it\u2019s usually quite challenging to find a passive replacement property when using a 1031 exchange. This is where a Delaware Statutory Trust<\/a> can save the day. This structure preserves the tax deferrals while a professional manages the property and assumes all debt. We love this structure for 1031 investors, and it even works for some who are just looking for a stabilized asset with predictable cash flow.<\/p>\n So what does this have to do with your deals? Maybe nothing. Perhaps everything. Using this framework to analyze an upcoming deal may allow you to project what it will take to reach each new level.<\/p>\n Unless you\u2019re investing in a development project, I\u2019d recommend you qualify your investment solidly on levels one and two on the day you acquire it. If it doesn\u2019t work here, maybe you\u2019re paying too much. And if you don\u2019t have a plan to get to the higher levels, why? What is your specific plan? It\u2019s not enough to buy it right and hope for the best.<\/p>\n I hope this pyramid is helpful. And I hope to see you at the top!<\/p>\n![\"\"](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2020\/10\/MM16_Hiearchy-of-Financial-Needs-3-3.jpg\" "\\"\\"")
<\/a><\/p>\nMaslow\u2019s Hierarchy for an Individual Real Estate Deal<\/h2>\n
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<\/p>\nLevel 1 \u2013 The Base: Cash flow to meet property expenses<\/h3>\n
Level 2 \u2013 Financial Safety: The critical ratio<\/h3>\n
Level 3 \u2013 Cash Flow to Investors: Accumulating NOI and value<\/h3>\n
![\"calculating-cash-flow\"](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/calculate-taxes-702x336.jpg\" "\\"\\"")
<\/p>\nLevel 4 \u2013 Deal Freedom: Taking principal off the table<\/h3>\n
Level 5 \u2013 Deal Legacy: Perpetuating this investment forward to the next deal and beyond<\/h3>\n
Conclusion<\/h2>\n
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