One of the problems a beginning money manager has is deciding whether to sell or hold completed projects.
To understand dilemma, you first need to understand what we’re generally left with when a project is completed:
- Fully renovated building with all new plumbing, electric, etc.
- High quality tenants on modern leases with good security deposits
- An un-levered yield on cash invested in the deal of 7-9%
Implicit in the final bullet point above is a bunch of value creation and, therefore, unrealized capital gain.
To understand why, consider a hypothetical deal into which we invested $2MM and which is now generating an 8% unlevered yield… so NOI of $160k.
We’re theoretically in a 5% cap market (though, for maxed-out properties, probably more like 5.5-6%), so that property is potentially worth $3.2MM. Assuming 7% cost of sale, that’s a net value of $3MM and an unrealized gain of $1MM or 50% on the $2MM investment.
The incentives for selling ASAP are clear: Return capital and realize profit.
The above sounds pretty compelling, right? After all, the whole point is to make a lot of money quickly.
But the downside of the above is the requirement of paying taxes.
To keep things simple, assume the manager is entitled to 20% of the gain and the investors the rest. That means the investors are taking $800k of the profits… a 40% ROI.
But the problem is that they are going to pay taxes. In CA, depending on your income, you’re looking at paying 25-30% in taxes. Assuming 25%, the investors are looking at $600k net.
And guess what? They’re left with the problem of where to invest both the original $2MM AND the $600k profit. If they just buy plain old 5% cap properties, they’re looking at generating NOI of $130k… worse than holding the original property (even accounting for the manager’s take)!
What’s the better solution?
Refi at 60% LTV on the new valuation. Pull out $1.9MM in cash. Assuming a 4.5% interest rate on the $1.9MM loan, that means annual debt service of $116k and free cashflow of $160k-116k= $44k. That’s a 44% return on the $100k in equity remaining in the deal.
And the $1.9MM in loan proceeds that the investors get back? That’s tax free money.
Much better solution, right?