The 1031 Exchange: Panacea or Placebo?

good afternoon ladies and gentlemen I'm delighted you could enjoy me I'm John McNellis we're here today to talk about one very specific topic in in the real estate developers panoply and that's the 1031 exchange the benefits of the 1031 exchange versus the pros and cons 1031 exchange being the tax deferred trade if you're interested and this is this talk the panacea talk is the fifth in a series of talks it started with a broader view on you know running a development company starting running hopefully succeeding with a development company if you're interested in that or in any of these specific topics Uli is kindly posted these topics on YouTube and you can check them out there or if you want you could borrow a copy of my book from one of your friends if you want to get your own copy they'll be for sale at the end of the the talk or of course they're on Amazon a bit of background I started 35 years ago with my partners in the retail development business developing neighborhood shopping centers over 35 years we developed about a little more than two deals a year a total of about 80 deals because we gave up having financial partners of in about 1990 we had by definition by necessity we had to either sell or trade about two out of every three properties in order to keep going the sale or trade from one property would fund the next property so a fair bit of experience with the topic that we kind of discussed today the 1031 exchange now for those of you who have been in business for a while if you spent time with some of the guys in this audience the guys who look like me the grizzled grave veterans the developers sooner or later you have heard some guys swear to you that he will never even think about selling a property unless he can do a trade guys are so taxed adverse they they think that you are simple-minded if you would consider selling a property for cash simple-minded it's the almost a sacrilege and because personally I've always kind of like breaking the odd commandment or two I'm going to challenge that deeply held belief today that commandment is not as carved in stone now before we get into that let's just review the basics of the 1031 exchange I think you all know this you have to identify your trade property within 45 days of the date you sell the first property you have to close the trade property within 180 days after that first date and are there any accountants in the room there must be one or two good that's good news oh there's one so with the apologies to the accountants I'm oversimplifying this a little bit the price and the debt on the new property the one you're trading into has to be equal to or greater than what you're sold and also with another nod to that one accountant in the back I need to make you have aware of one technical assumption we're going to assume for the purpose of this discussion today that your basis or actually my basis in the properties I'm going to discuss is exactly zero what that means is that a hundred percent of the sale proceeds are subject to tax and that's the only technical part about this whole discussion so that brings us to this 11th commandment and questioning it and it really the question is is that simple is a 1031 exchange where you're selling and avoiding tax is better or or more precisely always better than selling for cash or you sometimes better off selling for cash paying your taxes and reinvesting the net proceeds in the answer damn it's always the same with complicated questions the answer never simple the answer in this case like in so many other cases it depends what does it depend on I'm sure everybody in this room knows what it depends on for the most part it depends on the quality of the property or trading into now let's just focus on that for a second I'm a developer I've got a number of friends here in the audience who are developers developers when they look for property are looking for what value add deals which necessarily by definition entail a lot of risk it's it's impossible I think to find a value out deal that is risk free so here's the problem back to that 45 day 180 180 day paradigm it's possible and in fact it comes up often enough it's possible to find trade properties development deals with in that 45 day period you can find them finding them isn't the hard part the hard part is solving or swallowing all the risks within the ensuing 135 days remember it's a total of 180 very hard to identify and vet a development deal in 180 days so that's one problem and even if you are interested in buying nothing other than finished real estate 100% leased it's it's leased for 20 years it's totally paved there are no risk you can find those easily enough in 45 days and you can close on those easily enough in that hundred and eighty days but if you go back and ask those same grizzled veterans of real estate about their experience particularly if you pump them with a couple of beers so that they loosen up a little bit and then you ask them gee graybeard what's the worst deal you've ever done chances are often is not that it started with a rushed 1031 exchange but for our purposes today the it also depends on something and this is I'm talking really to the younger members of the audience it depends on the breadth of your financial perspective whether this is a good idea or not depends on what you see as your financial alternatives if if you're a developer starting out and you've got a few deals going and if your financial statement is nothing but real estate and de pocket change for pizza which is essentially a I'll admit this that was my financial statement until I was about 50 you know zero liquidity if that's your statement if that's all you've got then trading is as important to your success rather than selling a trading is as important to your success as say a booster rocket is to the Space Shuttle no trade no liftoff again if your only alternative is to trade into even a marginally located asset a second-tier asset say and I'm not going to pick on Walgreens but I'm gonna pick on Walgreens you a big Walgreens is famous you you may know for having leases that go into infinity and beyond fifty seventy-five years and they're flat that whole time and they're also famous for trading extremely low cap rates five six percent you're still better as a young developer trading into one of these deals that goes out forever then you are selling your property paying the capital gains tax capital gains remembers twenty percent for federal zero in certain states Texas Nevada up to thirteen in tax ravaged California but if you say twenty-five look we're going to assume twenty five percent for total taxes if that's your only alternative by that Walgreens versus pay your twenty five percent in taxes and then put the money in the bank earning zero of course you're going to trade but what I'm here to tell you today there is there's another alternative and what better way to expose that alternative than to tell you about a bad trade that we made there's a town in California in northernmost California called weed it has nothing to do with an agricultural product and it didn't recently change its name it's been called weed forever it's in northernmost California I don't know if you can see that it's on highway 5 which is the main north-south arterial of California and it's claim to fame is Mount Shasta truly a magnificent to mountain it's one of the tallest peaks in California it's over 14,000 feet tall that white cone is of course white shat it Mount Shasta so the astute among you looking at this might say John why did you buy 5 acres of dirt in a town that is nothing but dirt and the answer is Walmart was then has been for 20 years 25 years one of our best tenant relationships in 2007 when we traded it in to this property so just to give you a perspective for some of your 2007 was a lot like 2018 2007 the party was roaring and prices were at an all-time high Walmart said hey Jon we're going to buy the 30 acres next to this five well we're gonna build a super Center it'd be nice if you came out and built the shops so we said sure sounds like a good idea what happened was what had happened was the recession started about two hours after we closed on this property I'm not kidding and suddenly oh my god and then a Walmart says well sorry understandably Walmart took a walk on the 30 acres and we owned this five acres of dirt and I swear for nine years nine years this piece did not have a pulse didn't have a pulse the only thing we did we did two things with this property for nine years we spent 150 bucks and had somebody paint a sign and I was by the freeway you've seen a thousand of them it says for sale for lease we'll give it away you know for a case of beer and weed again he calls on that sign the other thing that we did was was kind of smart just for a good developer practice on our financial statements we took and I I think I pointed out we paid one point three six million for this dirt within a couple years we wrote that dirt down to zero on our financial statements didn't mean anything but it impressed our accountants and it also impressed our banker you know with our financial discipline and it also got used to us used to the idea early on near the point of the boiling frog thing we got used to the fact that we'd lost all that money but it really wasn't a bad piece of property it was just caught in timing 2016 fast forward then nine years we were lucky along came a first rate discount grocery store chain grocery outlet and we made a deal with them and this is how the numbers looked we had paid for a deal for a build-to-suit supermarket we paid it one point three six million for this property now pay attention to this that second line item that the two million seven that's Al and Carrie at ten percent now we because we've been around for a while we had paid cash for the property that we did not have a loan did not have a financial partner but if you as a young developer had done this deal chances are you would have had both for us this 2.7 million it was a theoretical journal entry but it kind of it's also good financial discipline for you starting out this would be a real number so our all-in cost including the four million on the land and then the 3.4 million and that's the hard cost of construction architecture engineering bank fees leasing commissions and everything are all in cost was just under seven and a half million dollars and that's without a dime to us so we're into this deal from 2009 to 2010 2008 een eleven years no money to us it's all going out the other way this folks is the Grocery Outlet Store on its happiest day it's probably the grand opening day two things to notice that little mountain in the back is that's a matter of perspective that is actually Mount Shasta 14,000 feet tall and its glory but somewhat obscured by this magnificent Grocery Outlet and also notice we have the Grand Opening banners still up this picture was taken I think right after the mayor cut the ribbon and we put this thing on the market right away how did that turn out it turned out pretty good all things being equal a five and a half cap for a single tenant market and a let's be kind and called a secondary market that's a very good price but notice with that land carry had we actually borrowed money had we had a financial partner in other words had we been in your shoes we would have lost almost 1.9 million dollars had a young developer done this deal it would have been a terrible trade had we done it had we done it we did do it there's a reason they don't pay me for this we did it I mean without a carry we made eight hundred and fifty thousand dollars after a lot of work we netted 2.2 million which was our original one point three six and the eight hundred fifty thousand you do the simple arithmetic there that's a 4% annual return beats a passbook savings account rate but does not get you into you allies hall of fame now here is where I want us to focus today this and this took me a long time to come around to is we in real estate tend to think of ourselves as the entire universe unfortunately I'm here to tell you we're not that there's larger universes beyond us this is what I might have done instead with this the stock market had we in 2007 taken that 1.3 six million and paid our taxes even in California California highest capital gains rate in the country 13% 20% for the feds so it's 33 percent had we paid 33 percent taking our money and put it in an S at Standard & Poor's S&P 500 index mutual fund I think you all know what those are kind of just I kind of know what those are an index mutual fund is one where you take the 500 largest companies the S&P 500 you set up a mutual fund that exactly mirrors each of those companies market capitalization in the S&P so if Apple is 5% of the SP and Google is 10% or whatever the mutual fund exactly mirrors that so you're you are buying a basket that exactly mirrors how the SP as a whole performs how do we done that we would have netted two point you know two million seventy thousand dollars almost an identical amount of money almost an identical amount to the mount we made to two but how do we make to two we took a lot of risk we did a lot of work we probably spent a hundred hours it's a long drive from San Francisco to weed a hundred hours developing this property we borrowed three and a half million dollars we had to personally guarantee that we took the risk on the construction and we of course we took the risk on the sale now that the clever among you or say wait a second had you've done this at your soldier property hold my calls please had we sold the property and put it in the stock market we would have been taking a stock market risk absolutely true stock market particularly an individual stock or any individual stock in the short term is laden with risk you all know that but the market taken as a whole and taken over a long period of time has been amazingly consistent in its returns you see here over at the eleven year period that we were talking about it was just under what's that it's just under 11 percent annual return you know they tell you if you go to a presentation 20 minutes half an hour you're only going to remember one or two things so try to focus on the important here's a hint this is the thing to remember from today's talk the stock market has produced a 9% compounded return for the last 90 years 9% compounded return so if we focus on this if you take your money and you pay if your trade and then let's go back to Walgreens if you trade into that Walgreens and get a 5% return on your 2.2 million all you need is zooming a 25% tax rate all you need to do in the stock market with after-tax money is I'll tell you the answer it's 6.6 percent in other words you take $100 take 25 off six point six percent on seventy-five the after-tax dollars is the same as five percent on a hundred ninety years this is a have been an amazing revelation to us let me just make sure I'm not this of course this works in California California has the highest tax rate in the country in New York and maybe here in Massachusetts also has but California is a thirteen percent tax this works a whole hell of a lot better if you're in Nevada or Texas or Washington State a state where there is no income tax where you're only paying 20% and this is not an idle comparison the sage of Omaha Warren Buffett Warren Buffett says swears is absolutely confident that the stock market which is around 25,000 right now is going to go to a million and that's kind of boggling but the million means of stock market has to toll only has two double another six times if it does that what I'm here to tell you is you'd be better off putting your money in the stock market paying your taxes having absolute liquidity and not worrying about leaky roofs or what that tenant what Walgreens say which is notorious for this what it's going to do to you when the lease option comes around and you don't have to worry about what the residual value of your land is going to be at the end of Walgreens lease if drones are so suddenly delivering all of our prescriptions Walgreens may be out of business and I can tell you and I think we have any bankers here because I'd like a nod or two and there's a banker my general impression over the last 35 years in this our bankers are far more impressed with actual cash than claims of equity if you have $10,000 in a fidelity account they like that a whole lot better than $100,000 that you claim to have equity in an LLC nod yes no okay I got a big nod back there thank you audience participation now there's a reason we're in real estate I just did the stock market versus real estate comparison against a bad trade now we're going to do it against a very good trade and you'll see what happens at the beginning of this year when we sold this property you know my partners and I thought about it and we decided what the hell we'll try again we honest with you we have not had great luck we're very cautious or conservative have not had great luck doing 1031 exchanges that the time limitations it's hard to find good properties but because we're in retail because we know that all the stories about the demise of retail or a lot of bunk because we know that a supermarket or drug store anchored shopping center is still a great investment we thought hey maybe there's a chance maybe we can find a decent shopping center a solid performer with a good return at a fair price so we put the money into an exchange and we went out and looked for it and sure enough we were able to find a highly competition constrained shopping center on the highway 1 corridor at an 8 point 3 cap this slide is accurate except it's simplified is that involved a couple more trades but the cap rate the 8.3 cap rate on a shopping center the debt level that's 70 percent in debt the interest rate 4.8 these are all accurate numbers what this produced and this is really good is a 16 percent cash on cash return on the 2.2 million that is a heck of a good deal for just a solid deal there was no upside in it it was 100% leased center it was just a good deal to roll in to compare that back to the stock market had we taken that the 2.2 million invested the 33 percent excuse me paid the 33 percent in taxes then invested the balance in the stock market and then the sage of Omaha approved correct that is it continues at 9% we would have made a hundred and thirty three thousand a year that's a great return but it's about a third of what we were doing or what we were able to do within the shopping center nine percent cash on cash year but back to the 2.2 it's only 6% but that goes back to my earlier point comparing the sale here against a bad trade that is the 6% return here still beats trading into a Walgreens or any other asset that has a long-term low yield a fixed so the big picture if you can find if you can do a development deal if you can invest a million dollars in a deal and make - and then take the trade into the next one take two and make four you should be trading every day of the week you should be trading until the cows come home but if you're going to trade into a week deal particularly a long term low yield deal then you should be traded you know if you're going to try to do a week tail I wouldn't do it the the problem with trading into one good deal after another as I alluded to it's very hard to find good deals in 35 years of doing this we have not once not one single time have we sold one property and then found a development deal in the next 45 days that just hasn't worked for us what we have managed to do over the last 10 years I counted it up we attempted seven trades seven separate trades we attempted only two of them worked in other words we put the money into an exchange account after the sale we went out look for trade property five times we decided now we weren't going to do it why because either the properties were overpriced or they were just snake-bitten with risk we decided it wasn't worth it that we'd rather pay our taxes and when we did manage to change it was like this this weed project it wasn't a long term dirt one trade we did because we already had a development deal teed up it had been in the shop for months and so when we sold the other proper we were able to roll into the trade but having had enough time to solve all the problems and then finally and I counted this up we've had three in the course of 35 years trades like this shopping center that I just mentioned where we just traded into a solid performer we knew we weren't going to hit a homerun with it but it was a great way to let you say defer our taxes and expand our cash flow so my advice is if you can stumble across a fair deal in 45 days and the 1031 is really your best friend but before you pull the trigger on a weak deal before you buy that Walgreens on the wrong corner in the wrong town in South Dakota you might consider paying your taxes and expanding your investment horizons the bigger picture and for those of you who have heard me talk before I always talk about specialization how in your day job as a real estate developer how important it is to specialize I absolutely believe that but once you get some momentum going once you start to have a little bit of net worth then you need to diversify like I said we are highly specialized very concentrated in neighborhood shopping centers that's pretty much all we do but over the years we've managed to diversify our holdings into urban office small buildings and high-end residential also small and of course the liquidity I'm talking about in the stock market diversification is your best friend you know actually I was thinking about this on the plane out ideally you would like your financial portfolio to fly like a 747 if each of your you know financial engines if they're separate if you have stock holdings if you have real estate if you have others you'd like to be able to lose one engine or even two engines and still land the planes fleet liquidity is also one of your best friends nothing solves a problem and nothing solves a real estate developers problem like a little bit of liquidity the earth is 71% water 71% liquid I don't think a real estate developer is ever going to get that far but that I think is what we should aspire to a liquidity and now I'm going to be open for questions and answers and I'd like to end these things with saying everybody in this room is far luckier than 99% of the people on the planet you know we've all been dealt great hands and the way to kind of thank God or Darwin or whoever you believe in is to give back not just writing checks but give back with your time to those less fortunate happy to answer questions that's the presentation folks there the question is how do you stop doing the exchanges it the only way that you ultimately that there there's a really good solution but no developers seem to embrace it the way you kind of stop finally is you die you get a step up and basis when you die otherwise you know what happens if you do trade after trade after trade you know I talked about having a zero basis with neither negative nor positive if you keep doing trades what ends up happening is you have an enormous li- basis so let's say that property that I talked about at five-and-a-half million let's say our basis was a negative 3 million so that the gain will be based on 8 well you get to a point whether you cannot sell you have to trade that that's a difficult situation and again the only solution is the unhappy one you die or you just say here's you tell your kids here's an asset that we cannot ever possibly sell you know there's got to be a trade next question the question is a reverse exchange I'm glad somebody asked that if you understand a reverse exchange and you have the ability to do one then you don't need to be in this class the the reverse exchange is what I call the rich guy exchange they work great the problem with the reverse exchange is you need to have all the money in hand in your pocket to buy the second property so the reverse exchange you go out in our case you buy that shopping center for 7.3 million and then you sell - of the the wheat property after so you need to whatever let's say you need a two and a half million to buy that and then you sell the weed property and you replace the capital it works great it's not a particularly useful strategy for somebody just starting out unless he or she picked his parents or her parents really well because it requires a lot of cash but it we have done reverses and they work great it's there they're just capital constrained so the question was it doesn't need to be a 1031 exchange let me the question was do we couple 1031 exchange with cost segregation studies and the answer is yes but let's just uncouple the to a segregation a cost segregation study might get my accountant in the back there is a great way particularly since I think Trump helped us with the most recent tax bill a segregation study what it does I think you have still a thirty nine and a half year depreciable life if you buy a shopping center or an office building apartment building you depreciate it over thirty nine and a half years if you spent about ten thousand dollars on that guy in the back that the accountant he'll do a segregation study for you that will say okay your HVAC equipment will last five years you can write it a you're segregating each of the items your your roof will last ten years each item will last and what ends up happening is you get to depreciate an enormous amount in the first year or two so the answer is I think yes if your of this the belief that if the government is going to give it to you you ought to take it then I think you're a fool not to do a segregation study and you get an amazing write off in the first couple of years but that leads back to your you end up with a significant negative basis pretty quickly but yes we do segregation studies that shopping center that we just acquired we're doing a segregation study on right now I think it's good practice and so they're questioning all right so you all know what a real estate investment trust is it's a reach one way that that back to your question which I suppose I could have thought of one way that you stop and get out when you say you know No Mas I don't want to develop anymore but I've got all these assets with these wickedly low bases is you go to a REIT in my world that would pay Regency centers you go to a big well-thought-of REIT and you say I have this portfolio of 10 shopping centers or or I have this portfolio of apartment buildings I would like to trade and how this works as a trade I don't know but it but it's it's legal I would like to trade my real estate portfolio for shares in your reach it's called up reading and what you end up with so you give your 10 million dollars worth of property in exchange for 10 million dollars worth of shares in this company I thought about it briefly and said well that could work but I think we do a better job owning our own property and managing our own property than this Reid and I don't know that that Robert who's the president of this REIT is going to be the president in five years and I don't know what's going to happen so Scott we've never given that any serious consideration the question was do I want to talk about charitable remainder trust talking about exits the answer is no honestly I don't know anything about charitable remainder trust so that this gentleman just clarified my layman's understanding you actually when you do an up read you get units of partnership but as far as I know they're they walk talk and quack like a duck I mean that they act more or less the same as shares of stock is that a unit yes I understand right right so I guess the trick is then you wait until you die and then you get to dying solves so many problems anybody all right well then ladies gentlemen thank you very much for attending this presentation [Applause] you

Channel: Urban Land Institute

Views: 6,058

Keywords: ULI, land use, real estate, cities

Id: ME7wgSbBmYU

Length: 35min 30sec (2130 seconds)

Published: Mon Nov 12 2018