At the Passive Income MD Conference (Financial Freedom Through Investing in Real Estate) back in October, I was in charge of moderating a debate between active and passive real estate investors. People were surprised to see me give out my cell phone number to the whole conference, but I did it so they could text me questions they had for the panel. (And no, nobody ever called me after the conference.)
By the end of the debate, the folks on the stage had answered all of my questions and many of those from viewers, but I was left with a plethora of questions I could have asked them. That probably means we need a Q&A session at the end of the conference next year, but for now, I thought it would provide a ton of great material for a blog post! Let’s get started!
Physician Real Estate Investor Q & As
Questions #1 & #2: Assembling Your Team
Q. How would you go about assembling your team or should you just go with a turnkey property promoter?
Q. What are your thoughts on using turnkey investments for getting started in out of state real estate investments before developing a team you can trust?
#1 The Accountant
Personally, I would start with the accountant! I do my own taxes, but the hardest thing I ever did with them was report taxes on a single rental property. No way would I still be doing my own taxes if I were a direct real estate investor. You want an accountant that has experience working with many serious real estate investors and preferably even invests in real estate herself. It should only take 2 or 3 questions to know if this is the right person for you or not.
#2 The Attorney
I’d probably go with the attorney next, as you’ll want someone to help you put a plan in place for tenant contracts and evictions.
#3 The Realtor
Now you can go out and get yourself a property, so a realtor is next. No reason you have to only use one, of course, so why not try out a bunch and stick with the one(s) that seem to be able to best follow your instructions for the properties you want to see.
#4 Property Manager and Handyman
Once you have the property, a manager and a handyman come next. You may want to start out doing these things yourself for a while so you know exactly how it should be done. Again, if someone can’t follow your instructions, you can fire them and move on. Get referrals from other local real estate investors.
Buying turnkey properties are a big step away from being an active real estate investor. Obviously you only have to hire one person (well, you still probably need the accountant), but then they take care of the rest including buying, finding tenants, managing, and selling. It’s really a different kind of person who goes for turnkey properties–busier, less interested in control, less experienced, less of a DIYer. You just need to figure out what kind of person you are. Personally, I don’t ever want to own properties directly, even using a turnkey company, out of state again. If I ever invest directly again (and I probably won’t), it will certainly be a property I can drive by regularly.
Question #3: Full-Time Manager vs Property Management Company
Q. How is having a manager (like Dr. Fawcett has) different from having a property management company.
I’m sure Cory will be along to correct me, but when you own five different apartment complexes, you can simply hire your own full-time manager rather than using a property management company. Cory managed his own properties for the first year, so he knew exactly what the job entailed, had put systems in place, and could train his own full-time manager.
The nice thing about being big enough to be able to hire and train your own manager is it gets you away from the property management industry which is crowded with companies that are mostly gathering assets while offering as little service as they can get away with. It’s really a volume play. But until you’re big enough to have your own, especially if you don’t want to do it yourself, it may be a necessary evil. (There are also likely some good companies out there.)
Question #4: Active Vs Passive % Return
Q. What % return do you lose or gain between active vs passive or what hourly rate is the management cost between active and passive considering all other factors are equal?
I actually gave this question to the panel at the conference, but I didn’t like their answers. They all waffled “it depends” etc. Well, of course it depends, but this number isn’t that hard to figure out. You just look at what the general partners in syndications are charging you. That’s the difference. That’s typically something like 1% a year plus 20% of profits. So if the project has an IRR of 20% a year, perhaps the difference is 5%. But bear in mind you got something for that 5%. You got the time you would have had to put in to keep that 5%!
Question #5: Financial Literacy
Q. For the financially illiterate just starting how would you start?
I think the truly financially illiterate would benefit from first acquiring a basic framework on which to place later knowledge. One of the best ways to do that is to take the WCI Online Course. Learn the basics of personal finance, taxes, retirement accounts, investments, insurance, etc.
Real estate is just one asset class in your portfolio, and certainly not the easiest one to invest in. I would also read at least a handful of good real estate books before I touched any real estate investment. Consider those on my recommended list.
Question #6: Depreciation Losses
Q. Can you use capital losses from real estate depreciation against investment gains from a taxable account or other investment gains such as from surgery center income on a K-1?
Real estate expenses, including depreciation, show up on Schedule E and flow onto line 5 of Schedule 1 of Form 1040. Investment gains show up on Schedule D and flow onto line 6 of Form 1040. Passive partnership income is also reported on Schedule E, but is totaled separately on line 32. Because both real estate depreciation and partnership income are both totaled up on Schedule E, it appears that you can use depreciation losses to offset partnership income.
Of course, if your Adjusted Gross Income is under the phaseout range of $100-150K per year, you can simply deduct your real estate losses against your ordinary income up to $25K a year, but most readers of this blog will only be able to deduct real estate losses against ordinary income if one of the spouses qualifies for real estate professional tax status (750+ hours/year in real estate and no profession you spend more time on.) Now it is not clear to me if your “surgery center income” is active or passive, but if passive, then it is essentially in the same category as your real estate depreciation losses.
However, when it comes to your capital gains from your taxable brokerage account the story is a little bit different, AND SHOULD BE, thanks to the lower long-term capital gains brackets. Do you really want to use up those valuable real estate ordinary income tax deductions on the lower cost long term capital gains? Probably not. The whole point of the Qualified Dividends and Capital Gains Worksheet under Line 11a in the 1040 Instructions is to separate long term capital gains/losses from other income/losses like that from real estate.
So yes, it can offset your passive surgery center partnership income, but not your capital gains. Note that capital losses can offset up to $3K per year of ordinary income gains.
Question #7: Triple Net Properties
Q. Comment on Triple Net Properties?
Triple Net Properties or NNN leases are leases that specify the tenant is responsible to pay for real estate taxes, building insurance, and maintenance cost. The benefit is it eliminates the risk to the landlord of those expenses being particularly high. The downside is no tenant in their right mind is going to pay the same amount of rent for a NNN property that they would pay for a property where the landlord is covering those costs. So in essence, the NNN lease lowers your risk and hassle a bit for the property making it more passive. A NNN lease is common in commercial property, particularly large commercial properties, and very rare in residential property.
Question #8: Cashing Out a 401(k)
Q. Should I cash out my 401K ($300K) and invest in real estate? Also, should I sell my $1M house, move to an apartment, and invest in real estate forever?
Cashing out a 401(k) while in your peak earnings years is generally a colossal mistake. Not only do you pay taxes on all that money in your current bracket (and likely a big chunk of it in even higher brackets), but you also have to pay a 10% penalty on that money. So no, do not cash out your 401(k).
If your desired asset allocation dedicated to real estate is a higher percentage than you have available in a taxable account, consider using your 401(k) or IRA money to purchase real estate. Publicly traded REITs, such as those in the Vanguard REIT index fund, are easily invested in using an IRA and most 401(k)s. You can also use a self-directed IRA and possibly a self-directed individual 401(k) to invest in real estate either directly or more passively via syndications or funds, but it does add a layer of complication to the process.
In my opinion, you should generally max out your tax-protected accounts and then invest above and beyond that in a taxable account. Equity real estate tends to be a great holding for a taxable account as depreciation can often shelter all or most of the income and through careful exchanging (and dying) depreciation recapture can be eliminated completely. Debt real estate investments are terribly tax-inefficient and so do well in a tax-protected account.
Most physicians who have been living in a $1M house are not going to be very happy living in an apartment. However, if you have found yourself to be “house-poor” with all of your money tied up in your residence, downsizing is a good way to free up some capital for investments. Another alternative is taking out a mortgage on the property and using those proceeds to invest, hopefully earning more than the interest will cost you.
As a general rule, however, doctors should be in a good enough financial position that they do not have to put their residence at risk in order to invest successfully in any asset class, including real estate. There is no rush and a 20-40 year physician career is usually plenty of time to build a massive fortune without taking undue risk or enduring significant inconvenience.
Question #9: Passive and Active Tax Filing Complexity
Q. Is there a difference between the increased complexity of tax filing between passive and active investing?
Yes. Passive investing only requires you to enter the K-1s you are sent into Turbotax. The tax reporting on active real estate investments is significantly more complex. That said, if you own a private real estate equity fund that invests in multiple states, you may find yourself filing taxes in a dozen different states for a single investment, which is no fun either.
Questions #10 & #11: Funding Deals
Q. How do you fund multiple real estate deals to scale up your real estate investment business after spending a significant amount of money for a down payment on the first deal?
Q. What’s the best way to scale up after your first 2-3 deals and you’re out of liquid cash?
There are no risk-free shortcuts, although it does get easier as you go because the first few properties contribute income to the purchase of later properties. The least risky way and slowest way to invest is to save up the entire cost of each property before investing. Any amount of leverage above that increases risk. The most risky (but potentially fastest) way is to put the absolute minimum amount of money down on each property, sometimes even pulling it from previously purchased properties when you are able to, and hoping the house of cards doesn’t collapse on you due to negative cash flows, interest-only loans coming due, real estate property crashes, vacancies, and decreasing rents.
Most real estate investors find a middle ground, using a reasonable amount of leverage (perhaps 1/3 down) to ensure positive cash flow and less risk in a downturn. If the first property appreciates quickly, perhaps you can take some of the down payment from it to buy the second, but most likely you’ll need to use savings from your day job and the first property’s income to make up a significant portion of the down payment for the second property.
Obviously buying properties with “no-money-down” can also help, but that usually means you either buy a property for much less than it is actually worth, rapidly but inexpensively improve it so it is worth much more than when you bought it, or talked the seller into lending you money at particularly favorable terms that allow you to cash flow without a down payment.
Question #12: Multi-Unit Building Pros and Cons
Q. What are the pros and cons of buying a larger multi-unit building? It seems you are now putting all your eggs in one basket, but it also allows for efficient management.
There are two investing schools of thought:
- Diversify broadly (don’t put all your eggs in one basket)
- Put all your eggs in one basket and watch that basket very closely.
If you are investing directly, you will certainly be watching the basket very closely. It’s like owning a small business. Yes, it is risky to be in business for yourself. Many small businesses go broke and many real estate investors have poor returns. So you need to make sure you are going to be good at it if you are going to do it. There is a lot more skill and effort required here than buying a handful of index funds.
One way to perhaps get the best of both worlds is to use real estate syndications. Instead of using your $250K as a down payment on an 8 unit building in your town, perhaps you split it into 5 syndications investing in 200 door apartment complexes across the country. It not only gives you greater diversification and economies of scale, but it is also far more passive. The downside? Loss of control. Only you can decide where you fit on the spectrum of real estate investing.
Question #13: Bitcoin
Q. Do any of you view a 1-3% allocation of Bitcoin as a viable hedge in my portfolio.
I don’t see Bitcoin as an investment at all, but you can do whatever you want with 1-3% of your portfolio (including smoke it) and probably be fine.
Question #14: A Second Job
Q. Why not just call active real estate investing “changing professions”? It’s not really a physician doing a little real estate on the side when you’re qualifying for real estate professional status. Maybe you “picked the wrong major or career.”
I agree. Real estate investing has significant aspects of a second job and the more active you are in the investments, the more it is like another job. That said, in many ways, it is a better job than medicine when you consider the tax benefits and the ability to outsource the hassles. It’s really a combined job/investment. I think it’s clear that a lot of docs who do a lot of real estate probably would have been happier working full-time in real estate from the beginning of their career, but we’re all very different people at 42 than we were at 22, so it’s hard to blame them for having a cloudy crystal ball.
Question #15: Active Investing Skill
Q. How can you actively gauge your skill at active investing?
It is probably more about interest than skill. If you have the interest, you will put in the time, and you will get the skill. But to gauge your skill you simply need to look at your track record and compare it to the overall market you are investing in. If properties like those you invest in are appreciating at 5% a year and yours are appreciating at 3% a year, maybe you’re doing something wrong. Likewise, if you can’t seem to get your property to cash flow despite putting 1/3 down. But the worst real estate investors are usually the least happy. If you hate dealing with your portfolio of rental properties, you probably aren’t going to do a very good job with them. But if you enjoy the process and never make the same mistake twice, you’ll likely do very well. The investor likely matters more than the investment.
Question #16: Average Returns
Q. We know how much passive real estate should return on average but what are some rough realistic numbers on how much a “door” can cash flow for the active investor?
It depends. It depends on the cost of the property, the cap rate for the property, how well the property is managed, and how much leverage you used. If you put nothing down, a door may not cash flow at all. You may find yourself “feeding the beast” every month. The best cash flow comes from putting 100% down. A cap rate 6 property bought for $100K will cash flow $6K per year. For a multi-door property, just divide by the number of units. If it is a $2M complex that was a cap rate 7 and put $2M down, you will cash flow $140K/year. If it has 10 doors, that’s $14K/door per year. But if you borrow a bunch of money and your mortgage cost is $100K/year, then your cash flow will only be $40K or $4K/door per year. All else being equal, costs and cash flow will be higher in a high cost of living area versus a low cost of living area. A property that costs $300K and rents for $3K/month is going to have more cash flow than one that costs $100K and rents for $1K/month, but the percentage is the same. Hope that helps.
Question #17 & #18: Investing $200K
Q. If you had $200K to invest, where would you allocate the funds and why?
Q. How would you maximize $200K? And what should you expect in return and what time frame?
I would fold that $200K into the rest of my portfolio in accordance with my written investing plan. My plan is 60% stocks, 20% bonds, and 20% real estate. So $80K would be invested into real estate. Since I generally invest in the Vanguard REIT index fund, private real estate funds, and private syndications, that money would likely go into some combination of those. The other $120K would go into my index mutual fund portfolio.
If you wish to maximize your money, you can simply dial up the risk and hope for the best. In real estate, the usual dial is the leverage button. Want a higher return? Put down 10% instead of 30%. That might mean you have to do the management and repairs yourself, or subsidize the property from your clinical income for a while, but as long as the risk doesn’t show up and force you into bankruptcy, you should come out ahead. Most wise real estate investors don’t start from this point of view though. Instead of asking how to maximize $200k, they ask “What is the best way for me to reach my financial goals in the safest possible way?” and then proceed accordingly.
Question #19: Funding Multi-Family Properties
Q. If you are investing in single family homes in a HCOL area such as Southern California and want to get to multi-family, what are the best ways to do this without taking on partners/investors?
Save up a bunch of money, sell the single-family homes and exchange them all into a multi-family complex via a 1031 exchange to avoid any tax consequences. There’s no free lunch or magic formula. You need to have enough equity in there that the property cash flows and it needs to come from somewhere — your personal budget, the other properties, by rapidly and inexpensively improving the property, or from the previous owner (by giving you a tremendous deal).
I had a wonderful time at PIMDCON. It was great to meet so many of you. Sorry it took so long to get your questions answered!
What do you think? Did you enjoy the conference? What were your big takeaways? What answer would you give to these questions? Comment below!