Long term holds

Why do real estate private equity investors sell assets?

After all, most private owners of real estate generating really nice cashflow hold forever.

And selling forces you to either re-place the capital via a 1031 exchange under duress (eg with a short window) or to pay huge tax bills.

So, again, why do the smartest guys in the business sell?

It all comes down to the incentive structure built into the pref / promote model.

Sponsors (developers) are penalized for holding by rapidly accumulating preferred returns (eg the longer they hold the asset, the smaller their share of the eventual profit is). And their promotes (their share of the profits) are calculated based on pre-tax returns to investors, so they don’t care about the post-tax, “real” returns.

This incentive structure works well for the kind of institutional investors who back Blackstone, etc., because many of them are foundations or endowments and thus pay no taxes.

But, for an individual investor or family office, investing with a sponsor who intends to sell doesn’t make much sense.

When you have a good asset in an improving area, you put on sensible debt, and you hold it forever.

One unit left at our brand new complex on Ave 50 in Highland Park

Think we still have one unit left at the small building we just built on Ave 50, right near all the cool stuff in Highland Park.

It’s a 3/2 with two parking spaces, laundry, AC, etc. for around $3000.

Figueroa there is probably the most interesting retail corridor in the city right now… loads of new shops, coffee, bars, etc.

Here are some pics:

Email this guy if you want to jump on this.

Imagining a cashflow monster

Regular readers know I’m an avid follower of Berkshire Hathaway, Warren Buffett’s company.

One interesting thing about BH is that Buffett never issues dividends. His argument is that he can find better uses for cash the company generates than the investors could on their own (particularly given that dividends are subject to taxes at the individual level).

By constantly re-investing the cash thrown off by BH’s vast holdings, Buffett is able to compound the value of its holdings perpetually.

Public real estate companies are organized differently – as Real Estate Investment Trusts (REITs). This structure acts as a pass-through entity (like an S-Corp or LLC) so that the distributions investors receive (effectively, dividends) are not subject to double taxation.

In exchange for this special treatment, REITs are required to distribute the vast majority of their earnings to investors. In other words, they are unable to re-invest their earnings. To grow, they need to sell more shares to the public, effectively diluting the ownership stakes of their present investors.

Why am I thinking about this stuff now?

The (ever-shifting) Republican tax bill winding its way through Congress right now is designed to cut corporate taxes (on C corps, like BH, Apple, Google, etc.) from 35% to 20%… a level which is well below the individual rate.

What if, in response, you organized a real estate holding company C-corp.?

Investors would be given the following rules of the road:

  1. The company will buy income producing real estate;
  2. The company will utilize sophisticated tax structuring to absolutely minimize taxable income, and any such income would be minimally taxed;
  3. There will be no dividends – so no double taxation;
  4. There will be no new shares issued – so no dilution;
  5. Instead, the company will reinvest all cashflow from operations, refinances and (eventually, asset sales) back into more income producing real estate, which will in turn generate more cash for reinvestment.

At some point, the company would need to provide a market for its shares… probably via being publicly traded. This would allow investors who wanted out to get liquidity.

But, so long as management is smart and frugal with overhead, I think most investors would be happy to leave their money in, effectively permanently, and have it perpetually compounded in a tax-efficient manner.

It would be the ultimate, diversified, tax-efficient, long-term real estate play.

Another successful Adaptive deal

We just closed on the refinancing of an 11 unit apartment building.

We bought the building two years ago for $2.65MM, then spent another $900k renovating it, bringing the total investment to ~$3.55MM.

Our net loan proceeds on the refi are $3.54MM and we’ve accumulated ~$250k in cash from operations since lease-up.

So, today we’re going to be able to return a bit more than 100% of the capital invested in the deal to the investors.

Since this is beautifully renovated (to the studs!), non-rent control building in a prime area, we’ll hold it forever, with a levered yield that is, literally, infinite.

The refi was delayed by 2-3 months due to some wrangling with the bank, so I wouldn’t say this is literally the perfect Adaptive deal.

But it’s close.

What a successful deal looks like

Just finished stabilizing a deal and thought you all would like to see some numbers.

Bought this large, non-rent control property in late 2015.

Renovated and re-tenanted it, with everything finishing up in the last week or so.

All in for about $3.6MM.

New rent roll is $369k (so, 9.8x GRM).

Looking like roughly a 7.8% unlevered yield.

Think it’s worth $5.2-5.5MM now.

Just beginning the refinance process, through which I think we’ll be able to pull out ~100% of the capital invested.

Then we’ll return the refinance proceeds to our investors and the partnership will collect cashflow from this building forever.

These deals are really hard to find, but when you do, the model really zings.