Episode 8 of the Fundamentals of Commercial Real Estate Investing is now available on your favorite podcast listening platform. In this episode, RealCrowd Co-Founder & CEO, Adam Hooper, discusses the tax advantages of real estate investing with Timothy Wallen, CEO of MLG Capital.
Timothy Wallen, is a Principal, CEO, and sits on investment committee for MLG Capital. Tim joined MLG in 1989 as the Chief Financial Officer. In 2000, he assumed the role of Chief Executive Officer. He serves on the Board of Directors, and is an Officer for the MLG Affiliation of Companies including MLG Capital, MLG Development, and MLG Management. As CEO, Tim remains committed and involved with daily, integral functions of the investment and development segments. This includes long-term and short-term business strategies, innovative concepts to debt financing, and complex partnership structures. Tim is also a Principal and Board Member of NAI MLG Commercial, which provides Brokerage and Property Management services to Wisconsin.
Prior to joining MLG, Tim was a Tax Manager with PriceWaterhouseCoopers in San Francisco and Milwaukee. He specialized in income tax planning for partnerships and corporations in the real estate industry. In 1989, he transferred to the Milwaukee office where he was promoted to the position of manager.
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Adam Hooper – Hey Tyler.
Tyler Stewart – Hey Adam, how are you today?
Adam Hooper – Hey real crowd listeners, thanks for joining another episode of the RealCrowd podcast. Tyler, what do we have on tap today?
Tyler Stewart – Adam, today we have Tim Wallen, the CEO of MLG Capital. And Tim’s going to be talking about the tax benefits and implications of real estate investing.
Adam Hooper – Great, yeah, so Tim joined MLG back in 1989, as a CFO. Prior to that, he was with Pricewaterhouse Coopers. Interesting background in technology, M&A in the Bay Area and somehow ended his way up at MLG in the Midwest. So, we’ll learn a little bit more about that transition.
Tyler Stewart – Yeah, that was a fun story about his transition and listeners really enjoy the two sides of expertise that Tim has. Tim is bringing to this podcast, his tax expertise and he’s bringing to the podcast, his expertise as a real estate sponsor. And he’s going to share how he’s combined both of those hats to formulate his commercial real estate investing strategies.
Adam Hooper – Yeah, it was a couple things that I thought were interesting. That may be not as pertinent to investors, but something they can maybe learn a little bit more about when they see different deals, is this cost segregation analysis, which really allows the real estate companies to take full advantage of the tax code and depreciating assets. And the biggest thing for me was his take away of not letting the tail wag the dog, right? Don’t let your tax decisions drive your real estate decisions. It should be the other way around. No amount of mediocre deal can make up for the greatest tax strategy.
Tyler Stewart – Yeah, that’s a constant theme we’re hearing from the real estate experts we’ve had on the podcast. That there’s ways to optimize your real estate investing, but it all comes back to make sure you invest with great sponsors with good deals. And that’s number one. And then from there, you can start to optimize your strategy.
Adam Hooper – Sounds great, well listeners, as always, if you have any comments or feedback, send us a note to firstname.lastname@example.org and with that, let’s get to it.
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Adam Hooper – Alright, Tim, thanks for joining us today. You come from a pretty interesting background, having worked before you started at MLG, from Pricewaterhouse Coopers. Can you tell us a little bit about your background at PWC and what you were up to there?
Tim Wallen – Thanks Adam. I appreciate being here today and having this conversation. I’m a Wisconsin guy, I grew up in Wisconsin, I went to the University of Wisconsin, and got my masters in tax CPA. I worked for Pricewaterhouse for four years in the San Francisco and the Milwaukee office. I was a tax manager there and had the privilege of having MLG as my client 28 years ago when I came back from California back to Wisconsin and joined them as the CFO back in 1989.
Adam Hooper – Good, so out of school, went to work for PWC and you were doing mostly real estate tax planning, or other companies, what was the company focus that you were zoned in on? Was it real estate companies?
Tim Wallen – Sure, when I was in San Fran, I was in their small business group, which grabbed, you know, many of the real estate companies and tech companies. Probably about half of what I did was real estate companies and the other half was tech. And I just got a great foundation in the tax issues relative to real estate.
Adam Hooper – And so something clearly, you saw with MLG that you liked because you ended up joining that firm. What was it about MLG and kind of, where was the firm at that point back in, I guess you said this was, ’89. Where was MLG at that point and what made you leave PWC to join those guys?
Tim Wallen – Well you know, real estate by nature is a numbers game and having strong numbers background was very valuable in the real estate industry. Plus, bringing the tax strategies, you know, on a daily basis to the organization really helped the culture being here. MLG was very entrepreneurial organization and kind of a funny story when I came from San Francisco, I had some pretty big name clients. I came back to Milwaukee, Wisconsin, my first actual assignment was to come out to MLG and I came there, and it was August of ’89 and I walk out there and the principals of the firm didn’t have a real strong financial background, but they were smart real estate guys and they slid a shoebox across the table to me, it was a shoebox full of checkbooks.
Adam Hooper – Oh boy.
Tim Wallen – These guys were brand new. Brand new company about 10, 12 guys there. And they had no general ledger. And so, I went from having some high profile clients in San Francisco to having this small, entrepreneurial MLG Group. It was pretty comical making that transition but smart guys and it’s been a joy being part of the group.
Adam Hooper – Good, so since ’89 when you joined there, obviously you guys have grown a ton. Can you just take a quick couple minutes to kind of talk about MLG, where you’re at today and some of that history and what you guys focus on right now?
Tim Wallen – Sure. Well, it’s been a great run. Again, I’ve been here, yeah, it’s my 28th year now. And MLG’s been a long history of buying commercial real estate. In the form of asset classes apartments, office, industrial, and retail. Historically, our main focus was Texas, Wisconsin, and Florida. But we’ve really broadened our geographic platform. We’re really in 14 to 15 states today. We’ve done about a billion in acquisitions. And our focus and what makes us really unique is we’re your classic real estate operator. You know, strong property management operations. You know, we manage roughly eight million square feet of commercial assets. Another 8,000 apartment assets. But what makes us unique is that we’re also a private equity firm. In that we actually will invest in other operatives around the country. We have about 850 relationships around the country. And we see about 60 to 65 deals a month from those other operatives around the country. So, we bring the talent and history of being a real estate operative but also a unique element in that we’re willing to invest with other real estate guys. I really respect what other operatives bring to the table, and the local relationships. And the opportunities that they bring that we would never know about.
Adam Hooper – One that’s also, I mean, that has to give you some pretty interesting insights into markets that you normally wouldn’t go into, right? I mean, if you’re not going to build up an operation or a presence in any one of those particular markets but you have solid relationships with guys on the ground that are in those markets, seeing deals and executing. That’s got to give you some pretty unique insight into what’s going on around the country.
Tim Wallen – It’s really beneficial. I mean, we go to a market like Minneapolis and we talked about opening an office in Minneapolis. It’s like so hard to get talent. You can’t recreate you know, the 20s and 30 years of relationships that just bring those great opportunities. It’s really hard to hire and grow that. So, we decided it was so much better to grow by the private equity strategy in other geographies. And the cool thing is we get great ideas from other operators that we can share with other operators. So, for example, we had one group that was importing China direct, granite direct from China. And delivering renovated apartment units for several hundred bucks per unit. New granite versus historic ways of doing it. So, great ideas and great idea sharing.
Adam Hooper – Good and I think the deals that we’ve done together have all been direct with you guys as the main operator sponsor. And listeners out there stay tuned. We’re going to have another update here soon. With the deal update on the fund and deals that we’ve done with MLG, so we’re excited to continue that relationship and hopefully get some more information out there. Tell us real quick, Tim what are you seeing where we’re at in the market currently? You know, where are we in terms of the cycle for you know, buying private real estate assets? Have we, are we reaching the end? Are we somewhere in the middle? Kind of give us your thoughts on macro picture where we’re at right now in the cycle and what you’re seeing in these different markets.
Tim Wallen – Sure. I mean, there’s two main elements to commercial real estate. You know, it’s the business operations. How well you are doing relative to growing operating income. You know, how well, what are your occupancies? What are your rents? And really, across the country, it’s a very much a stabilized environment. You know, industrial occupancies, 94%. Apartments, you know, close to 96%. Office is a little more struggling. You get more of systemic vacancy issues where you’re at 85% occupancy in suburban office and 87 in CDB. You know, retail is surprising. You hear all these retail guys that are closing but retail occupancies are still in that 94% range. And that’s always kind of interesting to me. And a lot of this gets back to, in some regards, there’s this balance of demand and supply relative to is there new construction happening? How much is demand growing? In the retail side, you’re not seeing much in the way of new development. Greatly slowed down so you don’t have that supply side growing so much, which impacts in overall occupancies. The second main element is really valuations. Again, valuations are strong still. Low rates, a lot of capital available on the debt and equity side. So it makes valuations very strong. And I get this question a lot, relative is the game over? Has the market run? You know, at MLG we’ve been been buying for 30 years in all kinds of markets and the 2009, ’10 time frame was the exception, not the norm. So…
Adam Hooper – Right.
Tim Wallen – You know, the reality is it’s a local business and you got to find deals on a local basis and real estate’s a basic, very simple economic story of what is the balance of supply and demand on a very local basis. What’s happening in Dallas doesn’t necessarily impact what’s happening in Milwaukee. Dallas is much more capable of having supply growth just because there’s so much job growth and population growth versus a market like Milwaukee. So, it’s an interesting time. And there’s still opportunities that exist in the market place. And there’s great deals to be found and one thing I’d like to elaborate a little bit on is just if you think about buying in 2010, ’11, ’12, it was hard not to make money.
Adam Hooper – Right.
Tim Wallen – And obviously, the thing was different then. If you had like, an office building, and it had vacancy, it was harder to lease up because the economy wasn’t as strong. Whereas today, if you find, a deal that there is something wrong with the asset, as a problem to be fixed, it’s a much healthier economy. So if I have an office building today that I find is vacant. A retail shopping center that’s vacant, I have more confidence in leasing it up quicker because we’re in a healthy economy. So just cause things have improved, doesn’t mean it’s a bad time to buy. It just means it’s harder to find opportunities. And it takes more effort and the bottom line comes down to, the good news is there’s people involved in real estate and people make mistakes. And it’s our job to find people’s mistakes that we can fix. And actually there’s a recent story. We just bought a shopping center in the western part of Milwaukee in Waukesha, which is the wealthiest county. And had a deal that was 18% occupied, screwed up by course debt and poor lenders and we bought it from the lender for 20 bucks a square foot. In a very health sub market, and we just leased in 60 days after buying it,
Adam Hooper – Wow.
Tim Wallen – and we’re back at 90% occupancy in 60 days. So, the reality is there’s human beings involved. Human beings make mistakes. And you just got to find those opportunities.
Adam Hooper – You know, one of the things that we’ve obviously been keeping an eye on and you mentioned during that comment, was the supply of capital in the market right now. Both on the debt and equity side. Obviously what we do with, on RealCrowd is on the equity side, but what are you seeing there in the debt capital markets? You know, obviously post election, there was a pretty big spike in rates. It seems like they’ve kind of calmed down a little bit. Obviously, crystal ball is anybody’s guess but what have you seen in the last, you know, 30 to 60 days in terms of what the financing, the debt capital markets are looking like? Are we seeing some stability? Do we see more stability going forward? Are we going to see some increases? What are your thoughts on that?
Tim Wallen – Well, I mean right now, I think that the debt is plentiful. I mean, CBS market has made a major recovery from where it was. I mean, obviously it was a major part of the real estate lending world. And went away in the 2010 cycle, and it’s fully back. Insurance companies are there. Banks are very active. I’m on a bank board, and banks are very active and pursuing real estate deals. So, there’s plenty of debt available. Obviously, real estate is very debt dependent. So when you have cycles where the debt side gets to be tough, it will have a major impact on real estate because leverage is such a big part of real estate and people, you know, other, the institutional world’s very different. There’s institutional world and non-institutional world. But the non-institutional world is heavy users of debt and it will always have a major impact if there’s changes. But right now, it’s a very healthy debt environment.
Adam Hooper – Good. Let’s switch a little bit from kind of macro to more of your specialty, again, obviously on the tax side. Can you tell us a little bit about how your background and expertise in the tax side of the world. How does that impact your strategy at MLG and then how you guys look at assets and acquisitions?
Tim Wallen – Yeah, this makes me kind of smile because when I was back at Pricewaterhouse, all’s they had clients that had come in. They’d made a bunch of money and they’re crying about paying taxes but the good news is that they’re making money. So, but when it comes to real estate in particular. Our focus is always about doing smart real estate deals first. You can’t let the tax stuff drive your strategy.
Adam Hooper – Sure.
Tim Wallen – The smartest thing, you want to do smart real estate deals first and then tax planning second. But the reality is, if you do a poor real estate deal and you lose money, there’s no tax planning that had to be done. You know, if you’re losing your money, what good is tax planning? So, you got to do smart real estate first and then do good tax planning around those great deals that you’re doing.
Adam Hooper – Yeah, that’s you know, I think that certainly echoes a lot of what we’ve been hearing from sponsors we’re working with as well is you know, with the manager selection and the deal selection, if you’re not in good deals with good managers, then it’s tough. It’s a tough road to hoe from not a good start there. You know, again, on the tax side of things though, you have authored one of our most read blogs on the website, which is tax advantages of private real estate investment. You were able to take a little bit of a deeper dive on there. To expand on that, you said, you know, again, find good deals first. Avoid poor investment structure. Don’t worry about paying taxes. Is that still true? In this part of the cycle? All parts of the cycle? That’s just kind of a credo that you guys stand by, yeah?
Tim Wallen – Absolutely. You know, I hate paying taxes like everybody else. But I also hate losing money more. So, you got to do smart deals first. And don’t let Uncle Sam scare you away.
Adam Hooper – So, what is a smart deal in the MLG world?
Tim Wallen – A couple core elements that are critical for us, I mean, everything we buy, is an underlying stand. It has to have a strategy to grow operating income. To grow your net NOI. You achieve that through higher rents, or higher occupancy or lower expenses but we don’t believe in just buying an asset. Oh, it’s in a great spot. And the market’s just going to grow the rents all by itself and there’s nothing to do. We want, we like to have proactive strategies to grow operating income. And again, the best defense is a strong offense, so if we have rates going up, possibly here and very likely here in the next couple of years. If I’m growing my operating income, that greatly offsets any risk of higher interest rates versus an asset that doesn’t have a great strategy for growing operating income. The second main thing for us is really, what I’ve described as believable assumptions. Are you using real data? You know, when you’re seeing rents are going up and your occupancies are going up and your expenses are going down. On what basis are you really making those statements? And, do you have real market data to back that up? So really stress testing the assumptions you’re making and really making the assumptions believable. I saw one deal from an operator and he built a project and he was to build the property next door and the last year’s stuff was just a year younger and he was projecting rents to be 20% higher on the next phase.
Adam Hooper – Wow.
Tim Wallen – And it’s identical product. So how can you make that assumption when you got the property next door where the rents are 20% lower and you’re going to that kind of bump. So, believable assumptions and also, the old adage you hear all the time, you know, great locations. I mean, you want strong locations. You want locations that have limited risk of new supply creation. The biggest thing that hurts us real estate guys. We get great excess of excess supply versus demand. And that really crushes you when you got excess supply. That’s where you get hurt in our business. Is you got to avoid situations where you have high risk of supply and demand being out of balance.
Adam Hooper – Now, with you guys functioning both as a primary operator and also as a capital provider, essentially on the joint venture side, you must see all different types of investment structures out there in addition to the asset level fundamentals. When you guys look at structures and for listeners out there, they’re looking at different structures on almost every deal that’s on RealCrowd has a different structure with that sponsor.
Tim Wallen – Sure.
Adam Hooper – Can you take a minute just to kind of walk through when you’re looking at these structures, what do you see as better structures or worse? What would you consider a kind of poor investment structure? Because that’s, again, that’s what investors are looking at on our side are a lot of these different structures. Can you take a minute just kind of see, what your thoughts are on the structure side of the equation?
Tim Wallen – Sure. Let me first comment on about 1031 Exchanges in that context the article I wrote there for you guys.
Adam Hooper – Oh, sure.
Tim Wallen – That was really talking about 1031s and that comment was really driven heavily on the poor structures. You know, the big tenant commons have major issues. The tenant common structure is a great tax planning tool. But, it’s critical, very critical, that the objectives of the parties are aligned. And that you have trusted relationships with the other tenant common members cause you have to have direct title and there’s all kinds of corporate governance issues. You know, operating budgets, capital budgets. You know, adjusting when there’s a major hiccup. You know, if a property needs major capital, how are you going to do that? When you have a tenant common structure with 30, 40, 50, 60, 80 players in the thing, it’s very difficult to deal with an asset that’s got a major hiccup like 2009 or losing a major tenant. So, tenant common structures really are great tax planning vehicle, but only in the context of very close, tight relationships where maybe you only got a couple members that are part of the tic structure and versus you know, these tics with 30, 40 players in it. So I really strongly beware of the large tic structures.
Adam Hooper – Yeah, and that was what we saw obviously when the tic crisis happened was you have, just a massive number of people exchanging into these assets with very, very little alignment in their goals. And then, when, I guess, it’s exactly as you said, if a capital event needs to happen or something happens at the asset level, the tic structure requires unanimous decisions, correct? So it requires everybody to be on the same page and there’s a capital contribution, everybody’s got to do it. So there’s certainly some issues around that. Not that the structure itself is inherently flawed, but just the way that it was executed in the last go around with the big run up of the tic structures, that that seemed like it was more of a again, an alignment issue versus a kind of fundamental structural issue of a tenancy in common.
Tim Wallen – Yeah, it was a great vehicle. Poorly used.
Adam Hooper – Right, right.
Tim Wallen – Is what it really got down to. And there’s all kinds of horrific stories where people lost all their money and then they also had to write a bill to the government and had no cash to do it because once it got foreclosed and they lost the asset. So there’s just some horrible stories there.
Adam Hooper – Similar to tenancy in common, we’ve seen lately some Delaware Statutory Trusts, DST deals. Do you have any thoughts on that? Have you seen many of those out there?
Tim Wallen – You know, to be honest, I’m not an expert in that space. But anytime you’ve got a vehicle where you got a lot of parties involved, you have to look closely at all the corporate governance issues. You got to do that what if, that what if scenario stuff. Lot of times you do legal docs on the front side, there can be painful conversations about well, what happens if this happens? And this bad event happens, what are we going to do? You got to think through all the bad that can happen and are you going to be happy with the result that happens or can you live with the results that may happen in any kind of legal structure you do. And I know there’s issues with DSTs relative to some of that stuff, and you just have to look at it closely. I think those, from my understanding of the vehicle, is they work well when you have long term credit situations.
Adam Hooper – Right.
Tim Wallen – But if you have any kind of risk of a hiccup asset, you really have to be careful on those assets.
Adam Hooper – How does capital structure fit into that equation too? We talked about obviously, real estate is a fairly finance heavy, debt finance heavy, asset class. How do you see the capital structures between how much of the capital stack you’re filling with debt, preferred equity mezz, common equity. How do you see capital structure play in to those issues and decisions?
Tim Wallen – I’ve been in the industry for 30 years, and the biggest problems are when people get over leveraged. And a cycle comes up during a commercial asset side, you lose a major tenant and how’re you going to deal with losing that major tenant? Do you have the proper capital structure? So, leverage can enhance your current returns and make it look good on paper but the question is, what if there’s a hiccup? What’s that going to look like? Are you going to lose all your equity? And so, at MLG, our target leverage is only 65%, so I don’t think the extra debt is worth the extra returns in many, many cases. So you have to be really careful in understanding the asset that you’re investing in, and what are the possible hiccups that could occur and can you withstand the downturn when, and if, it ever comes. And too many times where people are looking at trying to maximize returns, and when you lose your principal, it’s very difficult to get it back. If you lose your equity in a deal foreclosed on ya, because you were too leveraged, you can’t get that money back.
Adam Hooper – Right.
Tim Wallen – And so, it’s just like using margin on the stock market. People that margin up and there’s a deep cycle, you get crushed. And so you have to be very careful on that leverage issue, and overall.
Adam Hooper – Yeah, and I think the, if I could put a theme to that is again this concept that we’ve been drilling down on on most of the podcasts is this whole concept of risk adjusted returns, right? What is that financing risk that you’re taking to get to that return? Is that what’s best for that deal? You know, do you need to push the leverage to 70, 75% or more, if you’re laying on junior subordinate debt. Or is there a way to get a healthier risk adjusted return by being more conservative in that underwriting? And that debt where you’re maybe not going to get, you know, the huge IRR spike that you would get if you levered it to the max. But as a risk adjusted part of your portfolio, those are certainly things that investors should be considering on the lower end of that risk spectrum.
Tim Wallen – Yep, you know I would take an example that I’d rather earn 14 or 15% on a deal that’s 60% leveraged than 18, 20% on a deal that’s 80% leveraged. It’s, to me, that extra yield is not worth the risk in most cases. Because stuff happens in life, you know. Don’t expect if it happens. I’ve seen cycles, I’ve seen pain in deals and it’s not fun when it goes the wrong way on ya.
Adam Hooper – Yeah, like you said, if you’re, if you lose all your money, there’s no taxes to pay anyhow. But I don’t think that’s what you mean by say don’t worry about taxes. So when you say don’t worry about taxes, find good deals and worry about taxes later, what are you trying to get to there with not worrying about taxes, at least earlier on in that decision making cycle?
Tim Wallen – The main thing you should be worrying about is finding great deals. That’s what we worry about. And then when you find great deals, you know, then you do great tax planning next to it. But it’s not the driver. The driver is worrying about finding great deals. Deals that you can grow operating income. Deals that you have executable, you know, assumptions. Believable assumptions and great locations. That’s where your energy, that’s where your worry should be. And, there’s many times when people worry about taxes. They’re missing the opportunity to talk specifically about a 1031 transaction where you know, a guy accepts a deal that’s a five or 6% rate of return, and when, if you pay the tax, he could find deals that might earn 12, 13, 14, 15, 18% rates of returns versus the five or six he’s taking by deferring to taxes. And, you know you think about the simple rule of 72. A 6% return doubles in 12 years and a 12% return doubles in six years, and a 18% return doubles in three or four years. So, there’s huge power in higher returns and compounding in returns that more than can offset paying Uncle Sam. So, just, you know, the opportunities where it does make sense to do a trade, and I’ve done them myself and where the tax planning is critical because you’re soft side down on the tax side of it, but you still need to be making smart business decisions on the deals that you’re doing.
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Adam Hooper – And now, just to take a step back. 1031 Exchange, for the listeners out there that may be not familiar with that, can you just take 30, 45 seconds to walk through the concept of a 1031 tax deferred exchange?
Tim Wallen – Sure, a 1031’s are just a strategy the government allows us to do. That allows you to have a gain on a real estate asset and to defer that gain into the future. When you have a 1031, if you sell an asset for 10 million, to defer all that gain, you got to buy an asset that’s 10 million and higher. If the debt was six million, the debt’s got to be six million or higher on the next asset. It’s a very technical provision of the IRS code. You have roughly a 180 day cycle to reinvest that money, but you only have 45 days to find deals and you can identify up to three properties within that 40 day period and buy one of those three properties within the 180 days and you’re able to defer your gain. So, it’s a very good vehicle, it’s very technical in nature, there’s some more complex things like reverse exchanges, where you can buy the asset before you sell the other one. It’s called reverse exchange. But, it’s a great tax vehicle to be used if used appropriately.
Adam Hooper – So now we’re getting into some of the benefits of real estate and the tax benefits of owning real estate assets. Let’s dig a little bit deeper in that. Tax deferral is one, and again, the deferral is the key word there, right? You’re not getting rid of the tax on those gains, you’re just deferring that until a future date, which could in theory, be in perpetuity, right? As long as you continue doing exchanges, you can defer those gains indefinitely, is that correct?
Tim Wallen – Yes, I mean the ultimate tax planning tool is to die. If you keep deferring stuff, and when you die, you’ll never pay income tax on that gain. So, you will have estate tax issues to worry about, but as income taxes you do a deferral, deferral, deferral, using like the 1031s, you’ll never pay income tax on that gain. So, but unfortunately, it takes death to ultimately carry that plan out to death.
Adam Hooper – So you got a fine step plan, yeah.
Tim Wallen – But eventually if you don’t, if you sell before you die, you will have to pay it in the future, whatever tax rates exist at that time.
Adam Hooper – And, one of the things that obviously with real estate, you’ve got two different tools of wealth creation. You’ve got the income from rental income and then you’ve the appreciation. Can you talk about how those are looked at differently from a taxation basis ordinary income versus capital gains?
Tim Wallen – Again, the two main things in taxes and tax planning is deferrals, tax deferral deferring paying tax saved versus the future. And second major element is trying to create as much capital gain income versus ordinary income and you know, the way you do that, I mean, there’s non taxes expense, depreciation’s the big one. I own multi-family assets, you know, 27 half year life, commercial 39 year life and the personal properties five year life and so that’s the main thing. Another key strategy in a context of creating more cap gain in compares ordinary income, is also doing what we just refer to as cost segregation studies. So, on the front side when you buy an asset, you go in there and you do a detailed study of all the assets and the laws allow you to really break that up. So, for example, you can value your curbing, your paving, your fencing, and get a 15 year life versus 27 years or 39 years. You know, equipment’s you know, seven years. Appliances in apartments and furniture whatnot are five years. So there’s all kinds of cool elements there. It also allows in a context of, I’ll use one of our multi-family rehab deals where we’re doing a complete rehab. On the front side, if we identify, take a deal that we’re going to totally eliminate all the insides and totally gut it, so we’re putting all new appliances, all new refrigerators, all new stoves, all that kind of stuff. And because they are operating and functioning on the day of purchase, we can allocate purchase price to those items, even though we’re going to throw them away within 12 months. So, you buy the asset, you allocate purchase price to those appliances, and then when you get rid of them 12 months from now, not only do you have the depreciation in the short term, you can fully expense that appliance, those furniture items, or equipment items that you’re disposing of 12 months later if you got a good cost segregation study to do that. So, a lot of guys miss the cost segregation thing. They just do the depreciation thing, and they miss opportunity for additional write-offs.
Adam Hooper – The cost segregation that allows you to further that accelerated depreciation based on the results of that cost segregation. And so as an investor, what is the benefit to me from this depreciation, whether it’s from again, the straight line 27 1/2 or, you know, 39 on the commercial side versus this accelerated through a cost segregation study?
Tim Wallen – In our case, like at MLG Funds, we allocate and we push all the benefits of depreciation and the write-offs and cost segregation to our investors. You do have to look at that in your legal. Sometimes, the sponsors grab that piece. And so we give all the tax benefits to our investors. So, again, you’re trying to eliminate as much of the ordinary income as you possibly can and maximizing the cap gain income. And these strategies allow you to do that. And the numbers, you know are pretty compelling if you’re really proactive about doing that.
Adam Hooper – And the depreciation against that, that’s offsetting this ordinary income from
Tim Wallen – Right.
Adam Hooper – the asset level. Is that a dollar for dollar, or is it on a tax bracket basis?
Tim Wallen – Well, I mean, really, it depends on, it is a every dollar depreciation expense does offset your ordinary income. So, if you got $300,000 in rental income and $300,000 in depreciation expense, you pay zero current income on your operating income cause that depreciation expense and the write-offs offset your rental income. So, it is a dollar for dollar offset against your operating income.
Adam Hooper – And again, MLG, you said that you guys do pass that through to the investors, but not everybody does that there? That’s something that…
Tim Wallen – First of all, to be honest, we used to grab it ourselves. We used to grab half of it in years past. And with the special allocation rules, you can do that. And part of the reason we did that, is because many investors weren’t able to use the losses anyways, due to the pass of loss rules. But we decided over time, that that probably wasn’t the fairest thing and we switched our beliefs on that and we now, you know, give 100% of those benefits to the investors.
Adam Hooper – Good, and now obviously again, these are, we should have prefaced with conversation with we’re not tax consultants, so obviously, listeners out there , consult your tax advisers on all these issues when you’re looking at these different deals.
Tim Wallen – Absolutely.
Adam Hooper – You know, one of the things that we’ve, you know, when you’re looking at the tax world again too, is as you said, this deferral. The longer you can defer those taxes, the better. And you said the ultimate exit strategy is unfortunately, passing away. Sometimes we hear that I’m too old to take advantage of these issues, right? Is that true or is that a myth?
Tim Wallen – Ah, yes, it’s such a myth. There are some things you have to watch out for. There’s a huge estate tax benefit of investing in these tax vehicles. Unlike the stock market, if I have a million bucks in stocks, and I’ve got a million bucks in private real estate investments and I die. Well, let’s assume that your tax , you get ten million because you need to be above a certain threshold when you have estate tax but let’s say you have a taxable estate, a million bucks in stocks will get taxed roughly at 50% tax rate if the thresholds are above ten million really. But if real estate, I will get what’s called a minority discount. So a million dollars of real estate investment will only be valued typically about 70% of that million, or $700,000. Get roughly about 30% discount. So if I invest in a real estate deal today and I die tomorrow and I put a million bucks in that real estate deal and I got a taxable estate, I effectively will save $150,000 in estate taxes immediately because that million dollar investment will now be worth $700,000 and not the million and I’ll save $150,000 in estate taxes the next day for the benefit of my kids and family. So, it’s a great tax benefit vehicle. I do want to caveat one thing here. The main thing and the issue of investing in stuff like private real estate is the liquidity issue.
Adam Hooper – Right.
Tim Wallen – You need to have proper liquidity for your estate planning needs. If you’ve got proper liquidity, real estate is a great, private real estate is a great structure for getting that minority discount. And a great investment vehicle. It’s important to note that you have to be a minority partner, so for example, if you own 100% of an apartment complex yourself, that doesn’t get you the minority discount. You have to be part of an investment structure where you truly are a minority partner and it’s that being that minority partner thing that gets you the 30% discount. It’s not the fact that it’s real estate. It’s the fact that you’re a minority partner in an investment structure.
Adam Hooper – Interesting. Do tax benefits, do they change based on the asset class? If you’re talking office, retail, industrial, multi-family, do you see much of a difference across those different food groups with the tax treatment?
Tim Wallen – Well, from our viewpoint and the math will prove it out. I mean, multi-family is by far the most tax advantaged. Office, retail and industrial properties are really and generally referred to as commercial assets are not as advantageous as multi-family. The biggest driver of that is you know, multi-family has so much more personal property with all the appliances and dishwashers and refrigerators and all that kind of stuff. Which is five year property, you’re able to expense this stuff over five years. You know, commercial assets doesn’t have the volume of personal property like multi-family does. Plus commercial properties on the real estate side have a 39 year life of depreciation, whereas multi-family is 27 1/2 years. So, it’s just set up for more advantageous just on the simple mathematics of the rules and the depreciation lives of the underlying assets.
Adam Hooper – And then what about strategy, if you’re looking at a core, you know again, kind of a longer term, more stable, less value add versus you know, some of the heavy renovations or even development. How do those strategies differ from a tax perspective?
Tim Wallen – Yeah, again, everything I say involves a generalization, there’s always exceptions, but in general, the value add and opportunistic deals will create a much better tax story and a much higher allocation of cap gain income versus ordinary income and there’s a couple, the big driver of the value add opportunistic versus the core core plus, is generally you’re repositioning an asset. You’re buying an asset with low occupancy. If you’re buying an asset with low occupancy, you’re creating operating losses cause your expenses may exceed your operating income, plus you got depreciation expense. So you might have real cash flow losses cause you’re repositioning an asset. And then on top of that, you get depreciation. So you get to create these large losses on the front side but if you can’t use due to passive loss rules or able to carry those losses forward and offset future operating income, so you generally have a very high percentage of cap gain income versus ordinary on the value added opportunistic versus a core, or core plus and that’s especially true of the multi-family space. The numbers get crazy, crazy, crazy good on that side. I’ll just give you a quick, small story. One of our deals, we did a value add deal, repositioning deal. It’s an apartment complex. We bought it in late 2015. All-in capitalization roughly 58 million. And on that deal, roughly 22 million of equity. But a million dollar investor that invested in that deal. And that property had 98% occupancy when we bought it. So it was stable asset. Okay, so I put it in the value add bucket. Stable asset that we were going to make old, new again. We spent $20,000 per unit, making old new again. And by doing that, we were changing over the tenant base. A lot of people left because rents were going up. And rents went from 98%, I mean, the occupancy went from 98% down to 80%. And now we’re back up to achieve plan up to 100% occupancy. And we did a cost seg study on top of it. So in 2016, a guy that put a million bucks in that deal, received his 8% rate of return on that million bucks. He got $80,000 that year in cash flow, but yet he had a $400,000 loss on his K-1. So, 40% of his original million dollars was a loss. Now, he could do the passive losses, and may not have been able to use that, but for sure it’s carried forward to offset future operating income in years to come. And very powerful, that deal, on our performa, it looks like we’re going to have negative operating income during the whole period. Probably about 30% of the original million dollars and about 130% cap gain income, which is incredibly powerful in that. Now, if you compare that to a stable deal. In general, stable commercial core deals, your cash flow is pretty close to your taxable income. There’s not nearly the of deferral and so, generally in a higher, core has higher ordinary income, lower after tax rate of returns because of that nature. Now, the counter to that. You take the less risky, right? That’s the theory of it, and so you’re willing to accept those lower returns. I’m not so sure I totally agree with that. I view some of the core deals as more corollary to bond deals as rates go up. I think they have more risk of being hurt than value add and opportunistic, but we’re value add guys so that’s my biased.
Adam Hooper – Good. And now, is excuse me, as investors are looking at these different deals and looking across different deals, commercial, you know, industrial, office, retail versus multi-family, whatnot. What kind of advantage do you see in building a portfolio across product types, across strategies, blending that all across or investing in a fund structure? What are your thoughts around those?
Tim Wallen – Sure. So I mean, big picture, you have these passive loss rules. And what the passive loss rules do, if you have a loss and the loss is limited, meaning, if you get a loss by real estate deal you invested in, your losses get limited. And in the context of a fund versus individual deals, the key is having a mix of assets. So, in a fund that’s got 20 properties, you’re going to be able to blend some of the tax attributes of the different asset classes. What you could also achieve by buying 25, 20 different individual deals. There’s power in both of them. So, let me give you a quick concept here. If you’re buying value add apartments that kick off losses, but maybe only produces a 5% cash flow rate of return versus a stable industrial deal that’s producing a 9% rate of return, that blends out to maybe a 7% cash and cash yield. But the industrial may have been almost all taxable, but you have that multi-family losses that can offset the industrial income or maybe you pay no tax, or very limited tax and you get a blended 7% after tax yield on a current basis. So, there’s a lot of power in blending those together.
Adam Hooper – In a fund, you can use losses from one property to offset cash flow in another asset at the fund level and then blend that across versus individual assets. That would be on an asset by asset basis, if I understand that correctly?
Tim Wallen – What happens, is yeah, all the passive losses and passive income flow through to you as an individual. So, if you got 10 individual deals and one fund investment, or 20 individual deals. The effect of it is all those passive incomes, losses, flowed through to you and the limitations are not on a property by property basis, the limitations on passive loss rules are on an aggregated basis. So, if I had income from one, that income from one is reduced by the passive loss of the other and it really is not, it doesn’t matter if it’s in the fund or if it’s individual deals that are all individual syndications where investing in, you know, 20 individual deals versus one fund. You have the same effect.
Adam Hooper – And now, funds versus individual assets. 1031 Exchanges, obviously, individual assets is what that’s designed for. Any way to do a 1031 into or out of a fund vehicle?
Tim Wallen – The answer is no. The bottom line is when you invest in the 1031 rules, you have to have direct title in the asset that you’re trading into. So, for example, if I sell an apartment complex and I was the owner of that asset, I have to trade into another investment asset, another real estate investment asset and I have to have direct title. You don’t have to have 100% ownership, you could do a tenant in common structure, where you own 50% undivided interest as a tenant in common, but you have to have direct title in the real estate and you can’t trade into a security interest. The LLC interest is a security interest. It’s not a titled real estate interest. Even though the security owns real estate inside that LLC, that does not qualify under the 1031 rules.
Adam Hooper – Got it. And so, types of assets though, again. Real estate could be multi-family, could be commercial, could be office, retail or industrial, right? Does land apply sometimes in 1031s? Or is that outside of that?
Tim Wallen – If the land’s held for investment. There’s a definition of investment, so for example, land that you are developing into a subdivision, is development land, which is considered to be ordinary income land, not investment land. So you can’t trade it into like, a residential subdivision. But you could trade it into a big, you know, 300 acre farm that you’re going to hold it for investment. There’s some rules of thumb there that you need to you know, hold it for two years, you know, down the road, if you intend, down the road you could turn it into develop that in the future, it wouldn’t necessarily be the idea tax money wise, but you know, you could buy it and develop that thing later on. But at the time you buy it, it’s a picture, it’s a photo of that moment in time. Are you buying this asset for investment, yes or no? And you have to answer that question and be able to document that to any kind of IRS agent that shows up.
Adam Hooper – And then, as you guys are acquiring new assets for listeners out there, do you guys often accommodate investors that have 1031 exchange needs through tenant in common structure or otherwise do you guys work with investors that are exchanging out of other assets into acquisitions that you guys are performing?
Tim Wallen – Yes, yes, we do. Frankly, it’s got to be a decent size of capital. Small dollars, it’s not worth the legal brain damage. There’s additional cost, legal costs in creating the tenant in common structure. You know there’s some governance risks that we take by accommodating that. And, long as it gets back to that alignment thing. We have a lot of conversations with those people trading. What’s your objective for this money? What are your goals with this money? What, if we have a hiccup, can you withstand that? Again, all those attributes and are we like minded? Do we trust one another? Because you’re taking some leaps of faith because you need people to sign off on certain things when events like financing a sale, you need sign off. So the corporate governance is very different versus in our fund, we have full discretionary authority and we can sign anything and we do that on behalf of our investors. But you get in the 1031, you got all the corporate governance issues that come in.
Adam Hooper – Good, and just final question here as we’re about to wrap up. You know, when you’re looking at some of these different things that we talked about whether it’s cost segregation, or structuring it a certain way to achieve some of these tax strategies, how do you guys look at that cost benefit of what might be best for the property versus the tax benefits or pass through to the investors? Can you walk us through kind of how that, cost benefit decision is made?
Tim Wallen – Yeah, you know, as we mentioned, the front side, not, I’m a real estate expert, I’m a tax expert, and frankly, this never comes to mind for us. We’re always thinking about the real estate first. And then, once we got the best strategy for the real estate, and the maximizing the returns, then we do the tax planning on backside of that. It is, it just doesn’t come to our mind, even though we’re very, very conscious of the tax effects of what we do. But our focus is doing smart real estate first. And I can’t think of a scenario that I would let the tax situation override my core values and beliefs of what a good real estate decision is. There may be a situation where I accept and I trade into an asset that I’m accepting some lower returns because I can’t find anything else, cause remember with the 1031s, you’ve got that 45 day window to identify.
Adam Hooper – Right.
Tim Wallen – You have a short window of time to find stuff. And you know, there’s a point where it makes sense just to pay the tax. But if you can’t find a deal that makes sense, and you got risk of losing your capital, that’s a big deal. But there are fact patterns. I had one deal we did, we sold and I did the math on it. And if I sold it, I would only net about 35 cents on the dollar after tax. So if I sold it, I got a million bucks in cash, I would only net $350,000 after paying $650,000 in taxes because of so many years of owning an asset and trades and whatnot. So in that fact pattern, it did impact my decision somewhat for sure, but I found a deal that was acceptable. But it’s a rare situation that the tax situation would ever override good real estate decisions.
Adam Hooper – Perfect. Well, I think that’s a pretty good wrap-up. To reiterate what you said on that blog post. Find good deals first. Avoid poor investment structures. And don’t worry about paying taxes. That pretty much sums it up. Do good deals.
Tim Wallen – Alright, thank you Adam. I appreciate the time today.
Adam Hooper – Tim, we appreciate it. I hope the listeners got some good information and as we said, please stay tuned for the deal update from MLG. As always, if you have any questions, send us an email to email@example.com. Thanks for listening.
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