Please Evaluate My Plan

42 Replies

A little background first. In 2011-2012 purchased with 20% down loans 10 condos in sunny San Diego. Averaging about $48,000.00 cash flow. Life was good. Then I calculated my return on Equity and noticed San Diego property values escalating rapidly in about the end of 2014. The return on equity was barely 3%. Sooooooo, decided after educating myself, decided to begin 1031 exchange these 2 and 3 br condos in for Apartment complexes in North East Ohio. I traded in one Condo in June of 2015, that was cash flowing $4,000 a year for a ten unit apartment complex in Cleveland Heights, Ohio. Back up a little and the end of 2014 I started buying with cash, duplexes and half duplexes, along with one 4bd/1bath single family in Euclid Ohio that cash flows $3,200 a month presently on a $240,000 investment. I am using the same property manager for the apartment complexes too. They are a small mom and pop property management company. They are parent's of a colleague of mine and I trust them. So, back to the 10 unit in Cleveland Heights, Ohio. I only put down $30,000 on the property in San Diego, that was cash flowing about $4000.00 a year. I bought that property for $125,000 and sold it for $215,000 in Feb of 2015, two years after purchase. The Cleveland Heights 10 unit, after 3 months of repositioning is break even and by Jan I expect it to cash flow at $15,000 for the next 12 months and then with rental increases, cash flow will increases to $20,000. We purchased this property for 420,000. We only put down about $100,000. Then, in August we traded in a condo that we purchased for $120,000 in 2012, that was cash flowing $4500.00 a year for a 15 unit in Painesville, Ohio. We expect after 3-6 months of repositioning to be at $25,000 cash flow. Then, since most tenants are on month to month leases and 100 dollars under market rents, that NOI will rise dramatically. This property we purchased for $592,250.00. Now, presently we are exchanging a property here in San Diego that we purchased for $152,000 in 2013 and just sold for $270,000 for a $500,000 8 unit in a really nice area of Shaker Heights, Ohio. Rents are significantly higher and the tenants earn a lot more money, practically double what Cleveland Heights and Painesville tenants earns. We are signing final loan docs on Oct 3rd. Nice cash flow almost right out of the box. Just have to rent out old owner's unit and one vacancy. Of course at market rent of $975.00 for a 2bed/1bath. Right now all units are at an average of $890.00. Finally, we are selling another property and will 1031 too. My goal is to eventually have $1,000,000.00 in cash flow each year. If you have been where I am going, your suggestions would be greatly appreciated.

Swanny

Hard to follow all the details here and check your numbers, so my only comments on the plan is you're (A) exchanging your equity for present cash flow and (B) benefitted from an abnormal and historical rise in values on your SD portfolio.

Both of these are highly dependent on market dynamics in both locations and how they go in the coming months and years (more so than a plan that is single market or simpler in nature).

Other thought is you're trying to get really large cash flows, which have high tax implications you don't have with the condos. With the $420k property, for example, your $25k in cash flow won't be covered by the depreciation.  Just another line item to consider.

Good luck

Hi Justin,

Each of these pricey properties in San Diego were traded in by a 1031 exchange.  We are only putting down 25% down and depreciation, starts all over again, upon purchase.  We can take straight depreciation, or accelerated depreciation on certain components in the complex too.  Our loan on these new complexes are 20 year amortization, 4.8 fixed for 5 years and then we could do another 5 years at the then current FHLB, or payoff loan then.  I want to reposition and sell after 2 to 3 years with a 1031 and use that money to buy a larger complex.  The plan would be to defer,defer, defer, defer, getting to $1,000,000.00 in cash flow and then die.  Then kid inherits, at a stepped up basis, starting depreciation all over again. If he sticks to the plan, he can do the same.

Well done @Michael Swan !  The key for me investing in an area many states away would be quality PM.  Have you been okay so far not being able to put eyes on your properties so far? I think that would drive me crazy, but that's just me. Were you self-managing in SD? 

I would have realistic appreciation expectations in that market (inflation) and anticipate higher expenses in the winter there.  I just hope you have a solid PM that will turn off valves and such in the winter if anything is vacant.  Getting old reading about folks amazed that their northern properties 10 states away flooded from a burst pipe in the winter!

I applaud your exchange till the end strategy.  I plan on doing much the same for the most part, forever changing my family tree.  Cheers and congrats!

Hi Steve,

At this time, my little mom and pop PM are doing a great job.  They also do they get units ready to rent, rehab, and do all.  I meet with them by phone a few times a week and get email reports.  They are my eyes and ears.  So far so good.

Swanny

Hi again Steve,

Yes.  I am self managing my condos in San Diego.  I will be glad to trade all these properties in soon.  One thing I don't want to be is a burnt out landlord.  The worst long term property manager is the owner.  You get jaded really quick like.  I want to work on the business, NOT in the business.  Besides, I am a teacher in San Diego!!  I could travel to visit my properties or PM in the summer if I like.  It would be another write off.

What a country!!

Swanny

Originally posted by @Michael Swan :

Hi Justin,

Each of these pricey properties in San Diego were traded in by a 1031 exchange.  We are only putting down 25% down and depreciation, starts all over again, upon purchase.  We can take straight depreciation, or accelerated depreciation on certain components in the complex too.  Our loan on these new complexes are 20 year amortization, 4.8 fixed for 5 years and then we could do another 5 years at the then current FHLB, or payoff loan then.  I want to reposition and sell after 2 to 3 years with a 1031 and use that money to buy a larger complex.  The plan would be to defer,defer, defer, defer, getting to $1,000,000.00 in cash flow and then die.  Then kid inherits, at a stepped up basis, starting depreciation all over again. If he sticks to the plan, he can do the same.

Correct my math if I misread your situation, but... The $420k replacement property you bought is going to have an adjusted basis of $320k (the $100k profit carried over from the condo you 1031'd).  Straight line, that's $11600 per year.  My comment was just that you're probably exposing yourself to $14k in taxable income you didn't have to before.

I too own rental property in SD, and the tax implications of increasing cash flow is, for me, one of the contributing reasons why I chose to maintain a majority of the portfolio in SD.

Sounds like you're planning to ladder up again in a couple years, though.  If so, and if you can force the appreciation, and the market will support it, the strategy itself is sound.  The challenge is in the execution risk (the PM, ability to stabilize, avoiding an errantly bad property purchase, etc).  Go for it!

Hi again Justin,

I have lived in San Diego since 1978 and have seen this roller coaster act before.  They are beginning to give loans to people with subpar credit scores (600).  We are only about 15% from the peak on the condos I own here in San Diego.  All of this equity could vanish in the next 2 years again.  That is another reason I am 1031 exchanging these properties in San Diego.  What area of San Diego do you hold rental properties?  Have you been down my road or are you just hypothesizing?  I need to get advice from people that have already been on my path.  Let me know.

Swanny

Originally posted by @Michael Swan :

Hi again Justin,

I have lived in San Diego since 1978 and have seen this roller coaster act before.  They are beginning to give loans to people with subpar credit scores (600).  We are only about 15% from the peak on the condos I own here in San Diego.  All of this equity could vanish in the next 2 years again.  That is another reason I am 1031 exchanging these properties in San Diego.  What area of San Diego do you hold rental properties?  Have you been down my road or are you just hypothesizing?  I need to get advice from people that have already been on my path.  Let me know.

Swanny

I'm holding non-beach MFR in the area bounded by Clairemont down to North Park and east to College.

No advice implied - I haven't been down the road of laddering up properties.  I hope you hear from folks who have.

That said, I'm at a similar scale to you and have also had to decide what my strategy is going forward.  I did actively decide not to ladder up and seek increased cash flow outside CA as you have.  So, observing your mindset and numbers and this thread in the interest of constantly challenging my status quo.

Justin please check your inbox.  I am also wondering how you found Multifamily over 7% cap rates to purchase in San Diego 5 units or more, that are not in scary areas of San Diego if you know what I mean. Let me know.

Swanny

Swanny, double check your depreciation assumptions in the 1031 exchange(s). As I understand it from my own experience, you maintain the original (condo) depreciation schedule and term, cannot claim depreciation on the deferred gains, and start a new depreciation schedule for the replacement property (less the sum of the amount of depreciation still being claimed on the original schedule + the non-depreciable deferred gain). This will result in slightly less depreciation on the replacement property than if you had bought it without the exchange, but seeing as you only had the condos for a few years you shouldn't see too much impact from that.

Thank you Dan,

You have done this before?  I expect to trade up every 2 or 3 years maximum, after repositioning is complete.  Of course we are making improvements to each property, writing that off too.  I will specifically ask my tax specialist about your point regarding depreciation and the effect on my my defer, defer, defer, defer, and die business plan.

Swanny

@Michael Swan I have a friend who owns a 44 unit in Cleveland and is struggling with property management, if you don't mind who are you using as a management company?

Sorry John,

I have a little mom and pop, that only has about 90 total front doors with my properties.  They don't want to get much bigger than what I am doing.  They are growing with me.  They manage 41 of my front doors alone.  Where is your friend's property located?  I may be able to refer you to a guy that I am interviewing Oct 3rd.  I am worried that in a few years as I keep trading up, my current PM may not want to get that big.

Swanny

@Michael Swan this is just my personal preference, but I find it much easier to digest a long series of words if there is some white space in between them.

@Michael Swan , yes, I just completed an exchange last month. Check with your own advisors about their reading/understanding of the code, but what I described is how I distill it down. The IRS forms related to exchanges are extremely dense. 

Swanny,

I'm right with you as far as 1031 exchanging appreciated CA property for cash flowing property elsewhere.  My game in San Diego and now in Memphis has been to rehab class C apartments to raise rents and force appreciation.

Like you, I noted that my ROE was dropping as my San Diego properties appreciated.  I'm also worried about a dip in the market in San Diego.

As I'm also in process of switching from equity to cas flow, I can't give advice from the other side, but I'm always very interested to learn from those who are more experienced.

Erik

@Michael Swan - Reading through your post, it sounds like you have a solid plan.  I love reading the plans of other investors when they are well thought out and the best thing you have done is train a good, small management company to react to your needs over in Ohio.  Best of luck as you start your next steps in motion.

@Michael Swan , @Dan Schwartz is correct.  You're depreciation does not start over at the completion of the 1031.  Your basis is carried over and continues in the next property.  So there is a finite benefit on depreciation of your original basis.  However, you do get a second clock on additional basis that you buy over and above what you sell.  So one goal as you defer defer defer could be to monitor your tax future and buy additional basis in a 1031 if you anticipate needing the tax break (which will reduce cash thrown off due to additional debt) or leaving only the original basis in play if you want less debt and more cash flow.  Both are appropriate at different times.  The biggest key is that the tax is completely deferred even once depreciation is exhausted, until you sell without a 1031, die, or start to convert property to your primary residences over time.

So Dan and Dave, Right now we are buying properties that are valued an average of double what I am selling my 1031 properties here in San Diego.  If I am reading what Dave just said correctly, the additional basis that I am buying these multifamily properties and I am only putting down 25%, which is the 1031 exchange money from the properties I sell here in San Diego, the additional debt is key.  Is that correct?  The plan is to reposition and defer again in 2 to 3 years on each multifamily.  I would like to have a few 200 unit or greater complexes someday.  Please reply that I am interpreting your replies succinctly.

I really appreciate your help.  Dave have you already attempted what I am doing now.  I need someone to help that has traveled a similar route in the past.

Swanny

Hi Chris, 

Thank you for the words of encouragement.  It means a lot coming from you.  I have read many of your posts etc...

Swanny

Hi Erik,

It should be an interesting ride for us in the next few years.  It will take my PM another 3-6 months to reposition my 4 complexes and begin increasing rents.  It sounds like you have already been down that road.  Any advice about forcing appreciation like you say?

Swanny

@Michael Swan , the debt is a good indicator.  The most accurate picture will come from the form 8824 which your cpa files for the non-recognition treatment.  This will show beginning and ending basis and allow him to then set up the additional depreciation schedule for the additional basis purchased.

I have traveled your road.  I've also had many clients who have trod the same ground.  The key is to always evaluate actions based on the current lay of the land.  a plan is only as good as is resemblance to reality.  Flexibility and response to real time conditions will be your friend as you execute your plan.

I think your idea is a great one and wish I had the money to buy more than just my primary at that time in SD. The market is almost about lost in SD. You can't find anything that isn't in horrible neighborhoods to cash flow. Without large amounts down. At that point why not just exchange into large apartments. Great idea and I hope to do the same with my duplexes and increasing income. I agree Lenders are offering horrible loans again and there is a flood of buyers that can't afford these homes still buying them from me, and stretching their financials to the limit. Leaving no room for any changes in lifestyle. I see the market continue to decrease after rate hike in SD. I would get out now!!!!  Not worth the possible 3% gain if I'm wrong and next  summer is the last of the rise. I would gladly help you sell the condos and would love to talk about our similar plans. I'll PM you

Swanny,

In San Diego, I've rehabbed small multi units in Normal Heights, City Heights and Ramona.  There have been some major repairs, but mostly interior upgrades.  Since these areas are not the nicest part of town, I don't have to go all out with the upgrades.  Most of the tenant pool is happy to get a clean and working unit.  Some upgrade touches in the kitchens and bathrooms usually is enough to get them to sign on the lease.

In Memphis, I've started with a massive rehab project.  I need to bring 130 units back on line.  The work ranges from paint and carpet on the easy side (about 10 units) and complete mold bombs that need to be taken down to the studs (about 10 units) at the other end of the scale; the remaining units range in between.  The value I'm adding here is that in this neighborhood a vacant unit is worth about $5-7K and a rented unit with a good tenant is worth $17-20K.  This, again, is not the best part of town, but all I am doing is making the units attractive enough to find a tenant with steady employment and a decent track record.

So, my repositioning here is to take a mostly vacant property, repair and rehab the units into habitable conditions, find a tenant and move on to the next one.  I'm not going to pretend to turn class c into class b units.  

Unlike my San Diego projects, this is not about forced appreciation, this project is about forced cash flow.  Every unit I rehab and rent will cost me on average $5K per unit, rent for $6K per year and cash flow $3-4K per year.  

I may have to extend my original timeline of 2 years though, it's really hard to find decent tenants in this part of town.  More than half of our prospects look at our requirements and go elsewhere and of the applications we do receive, we turn down 2 out of 3.  I've been renting in rough parts of San Diego, but I was not prepared for the volume of felonies, bankruptcies and evictions in Memphis!  But I'd rather be cautious and move slow than to lower my standards, it usually only means more management work once you let the bad tenants in.

Another difference between our strategies is that I live on site while doing the project.  This kind of rehab project requires hands on presence.

Best of luck on your projects!

Erik

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