Happy 4th of July!

As our great country celebrates its independence, freedom and amidst the spectacular color and lights, as you gather with family and friends enjoying good food and laughter, we wish you a quiet moment to join us in reflecting on the wisdom and courage of the men and women who founded our country.

The values the set forth in the Declaration of Independence—life, liberty and the pursuit of happiness—are just as important today as they were in 1776.

Take a moment and thank all of the people that have helped us remain free and independent.

If you or a loved one was or is in the military service, I thank them for their thank sacrifice.

Remember: freedom is never free!

 

My 2 Cents

Amid all the that often surrounds politics in the news, there is something happening economically, across the country that isn’t discussed nearly as much, because it’s the numbers, not the political pundits doing all the talking.

The U.S. Department Labor says that the U.S economy is growing with 276,000 new jobs added on average per month in 2018 alone.  That is, 94,000 more per month than in 2017.

Unemployment is down, help wanted signs are up! 

Today the fewer Americans file jobless claims, since 1969 and in March we saw Help Wanted Twounemployment rate fall below 4% fo the first time since 2000.   The Consumer Confidence Index is at an 18 year high and wages for American worker have increased by more than we since since 2007, according to the Bureau of Labor Statistics.

These economic results seem to lean towards a theme that a combination of reduced federal regulations, lower taxes, protectionist trade positioning and an aggressive America first philosophy lead to a notable positive economic impact.

Potentially, this could mean continued higher earnings growth for workers and business owners.

Do you need help with your 401(k) plan?

Naples Asset Management Company, LLC (“NAMCOA”) is a federally registered REp2investment advisor, (RIA) and has the capabilities to help the employees of most employers manage their individual 401k, 403b or other retirement plan type.

To see if your plan qualifies for assistance,  please contact us  or phone Tom Cooper, CFP 352.857.7273, who can research your plan to see if you qualify.

 

Honoring Sacrifice

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Since the earliest ceremonies in small American towns following the Civil War, we have gathered on Memorial Day to honor and remember those who made the ultimate sacrifice in service to our nation. As in those early days of laying wreaths and placing flags, our national day of remembrance is often felt most deeply among the families and communities who have personally lost friends and loved ones.

Since World War I, more than 645,000 men and women have given their lives in defense of our freedom here at home and around the world. 

This national holiday may also be the unofficial start of the summer season, but all Americans must take a moment to remember the sacrifice of our valiant military service members, first responders and their families. Memorial Day is a day of both celebration and grief, accounting for the honor of our heroes and reflecting on their tragic loss.

This Memorial Day, join us in remembering those who bravely sacrificed their lives for our country. 

At NAMCOA we pay tribute to Honor, Duty and Sacrifice.  

What is a “Cap” rate?

The capitalization rate, often referred to as the “cap rate”, is an important fundamental concept used in the world of commercial real estate. It is the rate of return on a real estate investment property based on the income that the property is expected to generate. This metric is used to estimate the investor’s potential return on his or her investment.

Commercial real estate investors use capitalization rates to value properties. When you can raise rents without increasing expenses, your net operating income (NOI) increases. Since cap rate is a ratio of net operating income to the property’s value, this is a positive thing.

The capitalization rate of an investment can be calculated by dividing the property’s net operating income (NOI) by the current market value or acquisition cost of a property, expressed in the following formula:

Capitalization Rate = Net Operating Income / Current Market Value

In summary, the capitalization rate (aka cap rate) is defined as the first year “stabilized” net operating income (NOI) divided by the present value (or purchase price).

What is the Advantage of Using Cap Rate to Analyze an Investment?

The cap rate is a convenient and quick method to determine if the value or purchase price of an investment meets the investor’s criteria. The cap rate alone, however, should not be the sole reason to purchase a property. Investors must perform proper due diligence and consider other factors such as location, demographics, growth, supply vs demand, loan-to-value and debt coverage ratios to determine if an investment is worth the risk.

What are the Disadvantages of Using Cap Rate to Analyze an Investment?
The main disadvantage in using the cap rate to analyze an investment property is that the cap rate only shows the value of a property based on the first year’s stabilized net operating income. If the NOI of a property changes in subsequent years, the cap rate changes, therefore the value. The cap rate has an inverse relationship to value. Assuming the NOI remains the same, if the cap rate increases, the value decreases and vice versa.

Is it Better to Have a Low or High Cap Rate?
The answer to this question depends on who is evaluating the property, and why. Investors (buyers) want to have a high cap rate, meaning the value (or purchase price) of the property is low. Conversely, landlords (sellers) want to see a low cap rate because the selling price is high.

Factors such as loan amount, property type, age of the property, tenant, location, credit history, economic condition, etc. all play a significant role in determining appreciation rate, and ultimately value, of commercial properties.

Therefore, before investors rush out to purchase a property, do not just analyze the investment based on the cap rate. Proper due diligence needs to be performed to see if decisions are made based on real data.

Investors (buyers) want to have a high cap rate, meaning the value (or purchase price) of the property is low. Conversely, landlords (sellers) want to see a low cap rate because the selling price is high. … Even though Property A has a higher net operating income (NOI), the interest is higher.

If NOI rises while the market value does not, the capitalization rate will rise and, if the opposite happens, the capitalization rate will decline.

For a real estate investment to remain profitable at a certain level, NOI needs to increase at the same rate as the property value increases, or at an even greater rate.

Time Heals

In the near term, cap rate increases can have a dramatic impact on property performance. But, real estate performance is less sensitive to cap rate changes as the investment horizon lengthens. Time has the potential to heal most, but likely not all, wounds from rising cap rates through the magic of compounding annual NOI growth rates.

NOI growth can have a powerful impact on property values; the stronger the growth, the greater the protection against adverse movements in cap rates. This last point has important implications for property and market selection and suggests a strong preference for investments with solid NOI growth.

Ask a dozen economists about the effects of rising mortgage interest rates on the housing market, and you’re likely to get two dozen answers. You see, it isn’t simple marketplace, and the interaction between interest rates and performance is really dependent on who has a stake.

For example, home buyers obviously don’t like seeing interest rates rising, unless they’re lucky enough to already be in a transaction with a mortgage rate lock. It makes homes less affordable and forces decisions about buying less of a home or continuing to rent. Those potential buyers who are saving for a down payment or working on repairing their credit are at risk of rising rates during their preparation.

The home buyer perspective is simple, the lower the interest rate, the lower the payment, and the more I can get for my money. When rates fall, it spurs home buying. But, rates have been historically low for years now and the housing market has only experienced what many would call a weak recovery. When rates rise, it certainly doesn’t help overall.

For Real Estate Investors it is more of a glass half full for real estate investors when mortgage rates are rising. Sure, if you’re getting a mortgage to purchase a rental home or commercial property, you’ll incur greater expense and lower cash flow. But, this negative is usually fully offset by benefits to investors.  But when buyers aren’t buying, they have to live somewhere. They rent, and the rising demand for rental properties increases occupancy rates. This reduces vacancy costs, with more renters renewing leases rather than shopping again and moving when properties are scarce.

Rental Rates are related to occupancy, it’s just good old “supply and demand” in action. Reduce the supply and/or increase the demand and prices rise. When occupancy rates are high, rents can usually be increased without a significant effect on vacancy costs.

 

Benefits of the Tenant-In-Common Vs. Delaware Statutory Trust

Real Estate Tenant-In-Common or TIC Offerings 

Technically there are two types of Proportional Ownership products referred to as Tenant In Common  (TICs), which are structured as a securitized TIC or a Real Estate TIC.

Since the favorable ruling by the IRS in 2004 allowing a Delaware Statutory Trust, under specific restrictions, to be eligible for a 1031 exchange the use of securitized TICs has diminished.  Some security professionals have abandoned the TIC structure for the more lucrative business model that the DST format offers. For the sake of this comparison we will focus on the Real Estate TIC and how it compares to a DST.

A tenancy in common investment (better known as a real estate TIC) is an investment in real estate which is co-owned with other investors. Since the taxpayer holds a deed to real estate as a tenant in common, the investment qualifies under the like-kind rules of IRS Section 1031.

This type of an investment can appeal to taxpayers who are tired of managing real estate. TICs can provide a secure investment with a predictable rate of return. Real Estate TICs are often developed by commercial real estate professionals with an emphasis and expertise on the underlying real estate asset. They are marketed by real estate professionals and not security brokers.

A small number of TIC sponsors take the steps necessary to structure their TIC so that the investment is a real estate investment not subject to state security laws. Usually this means that the TIC sponsor will not be responsible for management of the investment and independent management will be employed by the owners.

Real Estate TICs have significant limitations when it comes to leveraging the properties with debt or investing in large complex commercial real estate that require ongoing management where the quality of the return is reliant on a third party. These limitations force Real Estate TIC sponsors to invest in debt-free high-quality Triple Net Leased properties. These limitations tend to produce a simple structure with a high level of safety and security.

The largest draw back to a Real Estate TIC is that each owner must take an active roll in decision making. This can be cumbersome with even a modest number of owners. The need for decisions can be mitigated up front by not taking out debt against the property and engaging in long term Triple Net Leases with investment grade tenants. This structure effectively eliminates the need for decisions in the near and intermediate term.  The tenant in common agreement for each property sets forth the structure whereby these decisions are to be made. Some can be structured with drag rights or other provisions to facilitate decision making.  Investors should closely review the tenant In common agreement.

Delaware Statutory Trust or DST Investment Offerings

In an effort to create an instrument that would increase the profitability for securitized TIC Sponsors as well as facilitate the placement of debt on properties the securities industry joined with commercial lenders and invested significant resources in developing a complex alternative fractional ownership structure that would overcome what they saw as the weaknesses and limitations of the traditional Real Estate TIC Investment Property offerings.  The result was the fractional ownership structure known as the Delaware Statutory Trust or DST.

The Internal Revenue Service issued Revenue Ruling 2004-86 on August 16, 2004. This ruling offered seven significant management limitations that if followed, permitted the use of the fractional ownership structure of the Delaware Statutory Trust or DST to qualify as replacement properties as part of an investor’s 1031 Exchange transaction.

Each co-investor owns an individual beneficial interest in the Delaware Statutory Trust. The DST itself shields the investor from liability with respect to the underlying investment property owned and held inside the DST.  These instruments are created and sponsored by securities professionals with expertise and an emphasis on creating a quality security instrument. They are sold by securities brokers with no required training, experience or education in real estate and are governed by the SEC.

As discussed above individual investors in a Real Estate TIC structure must vote on all major property decisions. Without a majority owner and appropriate structure, it can be somewhat dysfunctional to get the individual TIC Investment Property co-investors to agree on major decisions. To address this issue, the individual investors or beneficiaries in a Delaware Statutory Trust are not permitted to vote. In the DST structure partners relinquish the agency and authority to make all decisions regarding the management and wellbeing of the property and investment and vest it in a single trustee – the sponsor. However, for the DST to be 1031 qualified the Trustee must relinquish the right/ability to make major property decisions. This can create an even more difficult situation than the TIC structure.

Financial institutions can loan to a DST entity. Because the loan is made to the Trust there is no need for a lender to separately underwrite each co-investor for purposes of loan qualification since the DST is the borrower and not each individual investor. This structure allows DSTs to hold multiple properties with multiple and varied debt structures. This can provide a false sense of security to investors. Although individual investors are not underwritten by the lender or personally sign on a loan, their investment is used as collateral and is 100% at risk in the event market conditions, fraud or other issues create a default. The debt structure of any DST should be thoroughly evaluated and understood by each individual investor.

The Seven Deadly Sins of a DST

Internal Revenue Ruling 2004-86, which forms the income tax authority for considering a Trust as Real Estate for use with a 1031 Exchange has extensive prohibitions over the powers of the Trustee of the DST. In a 1031 qualified DST structure, the trustee is restricted from many actions that would otherwise be normal in typical ownership structures such as an LLC. The trustee may not renegotiate leases, make capital calls, or even re-finance the property. These IRS imposed restrictions are sometimes referred to as the “seven deadly sins,” and include the following:

  1. Once the offering is closed, there can be no future equity contribution to the Delaware Statutory Trust or DST by either current or new co-investors or beneficiaries.
  2. The Trustee of the Delaware Statutory Trust or DST cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any other lender or party.
  3. The Trustee cannot reinvest the proceeds from the sale of its investment real estate.
  4. The Trustee is limited to making capital expenditures with respect to the property to those for a) normal repair and maintenance, (b) minor non-structural capital improvements, and (c) those required by law.
  5. Any liquid cash held in the Delaware Statutory Trust or DST between distribution dates can only be invested in short-term debt obligations.
  6. All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis, and
  7. The Trustee cannot enter into new leases or renegotiate the current leases.

The Springing LLC aka The Nuclear Option

These restrictions are significant. They are put in place to enable favorable consideration by the IRS and may even seem to provide protection for individual investors. However, they place significant limitations on the trustee in the event tenants default or market conditions require deviation from the management plan. In the event any of the above seven restrictions need to be violated, there is a way out. Delaware law permits conversion of the trust to an LLC. This is referred to as a “springing LLC”. This will allow for any or all the prohibited actions to be performed by the trustee without the consent of the members. This is the ultimate safeguard, but it comes with a massive price. This action will disqualify any of the tax-deferral benefits afforded by Section 1031 to the initial investors. The springing LLC clause is required in most DSTs because it gives the lender additional comfort that the trustee can perform necessary actions in the best interest of the bank even though activating this clause will have detrimental tax consequences to all 1031 investors in the fund. The alternative to having a Springing LLC clause is not pretty and typically does not provide the Trustee the tools necessary to react to even slight deviations in the anticipated investment course. This could result in a catastrophic failure of the Trust during a market correction.

For more information on 1031 strategies, please contact us.

 

Real Estate Agents and 1031s

According to the National Association of Realtors, in 2017, 60% of all real estate agents in the US participated in one or more 1031 replacement transactions. 

The history of 1031 exchanges goes back to 1921. Most people in the real estate industry have heard of them and seem to have a good working grasp of how they work, and what the requirements are. Occasionally we get calls from someone who has not heard of a 1031 exchange, or has no clue what the rules are. So now would be a good time to do a refresher on the basic rules of an exchange.

People ask, “Why should I do a 1031 exchange?” I can answer this question in two words: “Financial Leveraging.” By doing a 1031 exchange, the taxes you would have paid to the government are now working to earn you money.

A 1031 exchange allows a taxpayer to postpone their long-term capital gains tax when selling an investment property by exchanging both the basis and the gain into a new investment property. This gives an investor financial leverage. If you have a property used for investment or business and you plan on buying another property used for investment or business, then yes, you need to do a 1031 exchange.

In simple terms, a 1031 exchange moves the gain from the sale of an old investment property into the purchase of a new investment property. By moving the gain into a new property, you defer paying tax on that gain into the future.

A 1031 exchange is NOT ‘a-sale-and-a-purchase,’ but an exchange of one property for another. There must be a written exchange agreement that shows that ALL the steps, from the transfer of the old property to the receipt of the new, is part of an overall plan.

For more information, please contact us to discuss your situation.