Investing in Commercial Real Estate
[Editor’s Note: Dennis Bethel, MD, is an emergency doctor and a real estate investor. He submitted this guest post recently. He is also starting a blog called NestEggRx.com, where he discusses investing, mostly in real estate. He graciously contributed this guest post. We have no financial relationship.]
I’ve worked as an Emergency Medicine Physician for over a decade now. Most of that time, I’ve also been investing in real estate. Real estate has been good to me and I’ve been asked to share my story and strategy with the White Coat Investor community.
I finished Residency in 2002 and started my career as an Emergency Medicine Physician. Chronic understaffing, increased regulation, and the rigors of shiftwork caught up to me and eventually led to burnout. I began to see earned-income as a trap in which you trade your time for heavily taxed income. I knew I had to get out, but my options were limited – there is no insurance for burnout.
COMMERCIAL REAL ESTATE
I had been investing for years in residential real estate (primarily four-plexes) and was on the long, hard path to financial freedom. Since there are no economies of scale in residential real estate, the cash-flow was small and unpredictable. The rents from my properties would eventually replace my income as a physician, however, that wasn’t going to happen until the 30 year notes were paid off. In the meantime, I had managed to create a second job for myself managing the properties.
I wasn’t willing to wait 30 years and my second job as a property manager was contributing to my burnout. That is when I began to look into commercial real estate. I had four goals in mind:
- Capital Preservation
- Multisource Income
- Minimizing Taxes
- Use of Wealth Accelerators
MULTIFAMILY COMMERCIAL INVESTING
I ultimately landed on multifamily commercial investing. It was a natural fit for me, as I was already investing in and managing smaller apartments. Shelter is a basic need and people will give up their luxuries long before they give up the roof over their head.
I just needed to go bigger!
Properties with 100 – 250 units and larger had economies of scale that were not available to me with four-plexes. While I was the only investor with my residential properties, with commercial multifamily investments I could join like-minded investors to invest in these multimillion dollar properties as a fractional, passive owner.
While all investments have risk, the safety profile of commercial multifamily impressed me:
- Ability to choose the best markets and submarkets to invest in
- Extremely low foreclosure rate for Fannie and Freddie underwritten properties (1% – 2%)
- Bulk Buying
- Use of Non-Recourse Lending
- Ability to insure against loss
- Incremental return of initial capital investment through monthly or quarterly distributions
- Use of Sole Purpose Entity Structures like LLC’s for Asset Protection
MULTIFAMILY INVESTING = MULTISOURCE INCOME
The commercial multifamily investor can experience financial gain from three different sources: Cash-flow, Principal Pay-down, and Appreciation.
There is a fourth source of income if you count the reduction and or elimination of taxes, but more on that in the next section.
Over the past several years, I invested in multiple large multifamily properties as a fractional investor. Each property has its nuances, but they have all returned positive cash-flow regularly. When I factor in the principal pay-down from the tenants and appreciation that comes with increases in net-operating income (NOI), I am obtaining double digit returns on investment (ROI) on each property.
The apartments are managed on a daily basis by professional property managers. No more tenant headaches, and the scale of the investments have kept my returns consistent. I am now able to work part-time in medicine and am on track to reach my goal of retiring before I turn 50 utilizing these passive streams of income.
THE POWER OF LEVERAGE
Leverage (the use of fixed bank financing), as a means to purchase a property allows for a larger return on investment than is possible without financing. For multifamily commercial properties, banks will generally provide non-recourse lending up to 75% loan-to-value on properties with a 1.25 debt-service coverage ratio (annual NOI divided by annual debt service) and higher. As previously mentioned the safest deals are underwritten by Freddie Mac or Fannie Mae and have a national foreclosure rate of just 1% – 2%. The better markets have even lower rates.
VELOCITY OF MONEY
Velocity of money, in its simplest terms, is how quickly a dollar invested returns to the investor to be reinvested. With traditional stock or mutual fund investing you either buy, hold, or sell. If your investment goes up in value significantly, you will have to sell it (and likely pay taxes) to access your equity.
With real estate you can keep your performing investment and still access your growing equity tax-free through a refinance. This is known as equity harvesting and is a way that one property can become two properties and then two can become four over time.
Historically, taxes have been my biggest expense. My earned income as a physician is taxed at a very high rate. Developing reliable passive income streams with a minimal tax obligation was a top priority of mine. Fortunately, real estate investing happens to be one of the most tax-advantaged investments around.
- Depreciation and Accelerated Depreciation via a Cost Segregation Study
-gives a K1 paper loss despite actual gain
-generally allows one to take their cash flow tax-free unless they fall into the AMT
2. Liquidity Events can allow for tax-deferred or tax-free gains
-Starker 1031 Exchange: allows for property sale while deferring the tax on any gain
-Equity Harvesting: refinancing is always tax-free
THE EVOLUTION OF MY INVESTMENTS
I was asked to include a section on how I discovered fractional ownership and the evolution of my real estate investments.
My first deal was a stroke of good fortune and a story of right place, right time. One of the partners in my group years ago knew I was a real estate investor. His wife was a real estate agent and putting together a group of investors to buy a 72 unit property in a highly advantageous location. When a couple of their investors dropped out, I was asked to participate in the deal.
I purchased a 12.68% ownership stake and sold that interest back to the group three years later nearly doubling my money. I ultimately left over rising operating expenses. Two of the investors were managing the property instead of using professional management. I wanted to utilize professional management in better, more stable markets. Nevertheless, the experience was eye opening. It was clear that there was money to be made.
REAL ESTATE INVESTMENT TRUSTS
I tried my hand at Real Estate Investment Trusts (REIT’s). I made money in some REIT’s and lost money in one in particular. Due to their size, I had less control over the markets that my money was being invested in. I also had a real problem with what I considered to be a lack of transparency.
However, my biggest problem was the loss of tax savings. A REIT is a paper asset. In essence, it is real estate flavored stock. As such, I lost all of the tax advantages I wrote about earlier. Over the long-term, direct ownership of real estate has historically outperformed the returns for real estate investment trusts and with a much lower tax-burden.
To avoid the drag of taxes and to maximize my returns, I have moved back to the strategy of fractional ownership of one property, in one LLC, in the markets I deem worthy of investing in, using professional property management. I do this using a syndicator. There are many syndicators out there of varying qualities. Due diligence is important when choosing a syndicator and a proven track-record is of utmost importance. Additionally, I think it’s important to make sure the syndicator’s interest is aligned with your own. I personally feel that the syndicator should be paid for performance and quality of the investment. I have seen deals in which the syndicator gets paid largely up front and regardless of whether the asset performs. This incentivizes the syndicator to focus on volume of deals rather than quality of deals.
In summary, multifamily commercial real estate investing has multiple advantages. While it may not be right for everyone and you won’t get rich overnight, you can significantly increase your gains while diversifying a portion of your portfolio outside of the stock market.
I’ve watched far too many of my colleagues push back retirement as the stock market and economic cycles ruined their plans. Many of these same colleagues have asked me about real estate and have considered real estate investing for themselves. However, the thought of managing tenants and toilets did not sit well with them. They had no idea that they could enjoy all of the benefits of real estate ownership without having to become a landlord.
I have recently started an educational website intended to demystify the subject of real estate investing. Our mission is to help physicians and other health care workers find financial freedom through real estate investing and education.
To Your Success!
Dennis Bethel, M.D.