The primary goal in investing in real estate should be to convert the value of your property into cash. This conversion is known as an exit strategy. There are various exit strategies. Some convert money tied up in equity into cash, and some convert property into other property (performing a 1031 Exchange, for example). When you refinance that new property, you convert that property into cash, and reduce your taxes—all part of an exit strategy. Employing cost segregation analysis, i.e., using depreciation to reduce taxes, is another exit strategy. We will be talking about these exit strategies—1031 Exchanges and Cost Segregation Analysis—in greater detail in later chapters.
New investors need to think about exit strategies all the time.
LET YOUR PROPERTY APPRECIATE IN VALUE; THEN EXTRACT (HARVEST) THE CASH FROM IT.
Real estate can be thought of as an ''equity farm,'' because every time a property appreciates in value the borrower can extract the cash from that property, in effect ''harvesting'' the money and getting cash. That is an exit strategy.
This chapter talks about various optimal exit strategies in real estate—strategies that our investors have been using successfully for years.
You should think about why you are investing in the first place. You should think beyond the immediate moment. There are a lot of vehicles you can use to get into real estate. It is perhaps even more important to make sure you have a good plan for getting out of such an investment vehicle and converting your equity into a cash-producing venture. It's that cash that ultimately enables you to live better—or to just live!
Most people think of an exit strategy as coming up with optimal ways to sell something. But that is not the point. The real point is that you can retrieve your principal on a mortgage. More important, you can also make a profit by utilizing the usable cash from the equity that has been building up in your home mortgage.
Real estate affords numerous exit strategies that allow you to keep ownership of the asset—unlike stocks or bonds that require you to sell the asset, whatever it is, in order to realize or get back your money. The beauty ofreal estate is that you can retrieve your money, perhaps even make some profit—and not have to get rid of the asset.
Obviously the first exit strategy is the sale of a property.
The second exit strategy is the refinancing of a property.
The third would be incorporating the use of a 1031 Exchange. We devote an entire chapter to 1031 Exchanges later in the book.
(A variation of the third would be using a 1031 Exchange and refinancing the property to take cash out.)
A fourth exit strategy could be utilizing depreciation in order to shelter income generated from a property as part of detailed cost segregation studies, which are used to identify the components of a commercial transaction. There is a chapter later in the book on cost segregation studies.
Depreciation in Real Estate
One of the most misunderstood and most underutilized methods in real estate is depreciation.
What is depreciation? It's a non-cash loss. You can write that non-cash loss off against any income you have or against any passive income from other sources.
The objective in any real estate transaction is to create cash flow. And some of the ways that create cash flow are refinancing the property, having the property appreciate, or selling the property.
Let's say you have a property worth $350,000 and you have taken a loan for 90% of its value, $315,000. You can take that $315,000 of tax-free money and do whatever you want to do with it.
Now let's say the value of the property drops from $350,000 to $200,000.
You don't have to make up the difference in loss unless you sell the property. In that sense, real estate is different from the stock market where you do have to repay the loss if you have taken a loan against the stock.
If the stock goes up from $20 to $50 and you take out $25, you just might have to repay the loan on the stock—you might have to repay $25.
Now let's say the stock goes from $50 to $25, prompting a margin call. It's the worst call in the world. That phone rings and your secretary or someone says your broker is on the phone. You say, my broker who? My what? Tell him I'm not here.
If you don't come up with the cash to bring the margin call back into ratio, they sell the stock. So you automatically have created a tax loss. Great. This is what is called a real cash loss.
In the example above where you took $315,000 out of the $350,000 property, and the value of the property dropped to $200,000, so long as you are making your payments on that $315,000, you have a performing loan and that's it. They can't call the loan or force you to pay the difference, even if you have the cash on hand. There's nothing they can do about it as long as you keep the property.
If you sell the property at that point, then of course you have to pay off the difference, which could be substantial. But there's nothing that says you have to sell the property. You can weather that cycle.
What you've done is take cash out of the property as the property has been appreciating and converting that cash into other secured investments—and you still own the property!
Another example: You could take the money you pulled out of the property and buy more real estate at the new, depressed value. When the market turns itself around, you'll have two properties with incredible potential.
Real estate moves in cycles. It has done so, it seems, since there have been records that can be tracked. In today's world, real estate cycles seem to run every seven years. All you have to do is be patient.
In 1991 real estate was in the tank, lasting until 1995. Then the market started to come back.
People say the real estate market will go up forever: they are very mistaken. The one good thing about living to be 60 years old is that I've been through at least seven real estate cycles. If I
live to be 89 I'll go through another four or five, because it is going to happen.
The point is that you have to think in the long term and take advantage of slow markets. You have to prepare. For ourselves and our clients, we prepared for the down cycle by making a conscious effort to move into other kinds of real estate, income-producing properties. We were in single family investment property, waterfront property, small and large professional buildings, small and large shopping centers. We continue to invest in income properties such as professional buildings and shopping centers.
Remember: it's the conversion of equity into cash—by refinancing or selling—that forms the exit strategy. Cash allows an independent person to live better or to just live. If you don't have an exit strategy, you can get stuck in that equity trap.
Most people have it upside down. They look to create equity in real estate and they want to have no debt on their property. The problem is that this is only part of the story. They should be trying to figure out how to convert their equity into cash. Then they should find ways to take that cash and put it into tax-deferred or tax-sheltered vehicles and use more of their money. Most people don't realize that they need to use more of their money to accumulate wealth.
Most are in a situation as we noted above, where when the stock market goes down, and a stock goes from 100 to 50, they now need to get a 100% return on their money. But it's a lot harder to get a 100% return on your money, i.e., to hope that the stock goes back to 100, than it is to get an 8% return on your money in the real estate field. For the 8%, the person needs to shelter cash, putting it into assets that can preserve capital.
It is just a matter of picking the right real estate. We buy and sell contracts on commercial properties and others can do the same thing. The problem is most don't know how to do it. They don't even understand how a contract is written. And they cer tainly don't understand how to sell that contract to someone else. These are the things we do and we do it all day long.
We tell our clients: You can't go into the real estate business with one eye open and one eye closed and half asleep. You have to use all of the tools available to you.
Before we look at the specific tools for helping one in developing exit strategies, we want to call your attention to a mistake that we hope you will learn to avoid.
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