August 8, 2022

JF2897: Convince Me: Why Plan an Exit Strategy? | Round Table

Each week for the Best Ever Round Table, the three Best Ever Show hosts — Ash Patel, Slocomb Reed, and Travis Watts — come together for a deep dive into a commercial real estate investing topic.

In this episode, the Best Ever Hosts share the first episode in the mini series Convince Me where they will debate various aspects of commercial real estate strategy from different perspectives. In this episode, they discuss the advantages and disadvantages of long-term investors creating an exit strategy. 

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Slocomb Reed: Best Ever listeners, welcome to the Roundtable. I'm Slocomb Reed, an apartment owner-operator and investor-focused real estate agent in Cincinnati, Ohio. Today I'm joined by Ash Patel and Travis watts. The hosts of the Best Ever Show come together every week for a deep-dive into a commercial real estate investing topic, and today I'm starting a mini-series within the Roundtable called Convince Me.

The idea here is that we pick an aspect of commercial real estate investing or a particular strategy and we debate it. Our personal opinions may not be as strong as what we share in these episodes. We want to create a good conversation between two topics and make sure that we're adding value to you with our disagreements.

Today I want you guys to convince me that I need an exit strategy. I'm a buy and hold investor, and I got into real estate to build a cash-flowing portfolio that would continue to provide for my family after I was done building it, and maybe even after I'm gone. So I want to open with a question - what advantages are there to planning to sell properties when the goal is long-term cashflow? I do focus on forcible appreciation, BRRRR style deals, repositions things like that, so I have the potential to sell for a profit when I buy, but why should I be planning to sell? I want to start with Travis. Travis, why don't you go ahead and give us a little bit of your background?

Travis Watts: Sure. You bet. Thrilled to be here, guys. Travis Watts, full-time passive investor, Director of Investor Relations with Joe Fairless at Ashcroft Capital. So at the end of the day, the way I define myself is a full-time limited partner. I mostly invest in apartment syndications. So to your question, it's a great topic, it's a great question, and I'll start by saying, as an LP I've invested with operators who never underwrite to sell. It doesn't mean that they never sell, it just means I might be in a deal for 20-30 years. But mostly, I invest as an LP with operators that sell between three and five years, once they've completed a value-add business plan; once they've renovated all units or close to it on a property, they look to sell.

And the thing I always talk about on my show, the Passive Investor Tips, here on Best Ever, is the velocity of capital. So I use this example that the first home I ever bought was $95,000, that was the purchase price; I put 20% down, so using rough numbers, 20k. And if I held that property,let's say 10 years, as opposed to what I actually did - I'll share that in a moment - it'd be worth about $250,000. So on paper, that sounds pretty good, right? You put 20k in, and now you've got 135k in equity. And really, that was just market appreciation. But what I did instead is I used the velocity of capital. So I renovated, I had a roommate a bit, I did a little house-hacking, and cash-flowed it throughout the process, I sold a couple years later, and I essentially doubled my money at that point; the 20k turned into 40k. I took that and I did a rinse and repeat, and I bought a different property that was a fixer-upper, I influxed some capital and renovations into that, and ended up doing the same thing. I held it longer than one year, for tax-favored reasons, long-term capital gains, and forced the maximum amount of appreciation and sold.

So I kept doing this over and over... So if we look at that same 10 to 12-year timeframe, I turned that 20k into a little less than a million dollars. So that's a drastic difference, all because I was keeping my capital moving and active the whole time. That was just one strategy I was doing in the real estate space. But to me, that made a lot of sense.

So the way I look at it is if I had held that first property, again, long-term, what happens when you hold a property long-term,? If I fix it all up in 2022, and everything's top notch and good to go, what happens in 10 years? It needs paint again, it's probably gonna need roof repairs, the HVAC may go out on me, the furniture gets outdated and I've gotta replace it... A lot of maintenance and upkeep and things like that.

I remember another quick story, and then I'll shut up on this topic... I had this single-family home, it was cash-flowing about $250 a month positive cash flow, which again on paper wasn't bad. That's about $3,000 bucks a year, whatever that amounts to. And I had a sewer line bust on that property, and it happened in the front yard, which was outside the foundation of the house... And I had to pay $8,000 out of pocket, because the insurance would only cover what was within the foundation of the home. So my cashflow went away for three years nearly.

So it's stuff like that that really started to discourage me against the single family strategy that I was doing, and holding things longer-term. I'd rather just influx capital and get out. So that's kind of my long and short answer to it, in my opinion.

Slocomb Reed: I'd like an opportunity to respond, and then I want to hear what Ash has to say. To the question, "What are you going to do if you just hold a property for 10 years or longer?" Well, let's assume that there was some value-add play, or even it was a reposition play in the beginning and you've done the heavy lift... You start by cashing out all the money you had in it so that it can be redeployed, and then you have stable, boring cash flow for 10 years, that's tax-advantaged, with appreciation and debt paid down. That's my answer, is that holding the property lets me stay in the tax-advantaged components of real estate investing.

And let me say here that every buy and hold investor should be willing to trade up. So I'm not talking about buy and hold investors don't ever 1031, don't sell to increase while maintaining your tax advantages... But my favorite property right now - I was at coffee with someone, I can't remember if we discussed this already... I was asked what my favorite property in my portfolio is, and I own some stuff that was built before the Civil War, or right after the Civil War, some gorgeous construction, original wood trim that's 150 years old, tall ceilings... But my favorite property right now is a 24-unit that I BRRRR-ed from 2019 to 2021... Because it's just cashflow. It's all done. I got all my money out, I got my partner's money out... It's easy to manage. Again, I'm an active investor, so I'm the management company. It's easy to do, it's steady cash flow. I know it's going to be there, I know I'm getting my debt paid down, I know it's increasing in value as I increase the rents, and it's steady income. Ash, where do you want to come in on this conversation?

Ash Patel: A lot of different places. Best Ever listeners - Ash Patel. I've been a full-time non-residential commercial real estate investor for over 10 years, self-managed most of my portfolio, and... Great topic, Slocomb. Exit strategy. My very first interaction with an exit strategy was when I partnered on an office building with somebody, and during the talks of us buying the property, how our partnership was going to be arranged, he asked me "What's our exit strategy?" And I don't remember my answer, but I tried to come up with something that sounded intelligent, but I'm sure it was just all nonsense. And the truth of the matter was for a long time I didn't have an exit strategy. There is no exit strategy; you make it work at all costs.

It was a vacant office building that we were buying. As a matter of fact, it was unfinished, the builder ran out of money, and it sat vacant for five years. So there was no failing, there's no exit; you're going to make this work, you're going to finish the renovations, put this building together and get tenants in it. So that was my philosophy for a long time. And that changed a little bit when you start taking on investor capital; you have to align the expectations of your investors with your strategy and theirs. So if investors want to buy and hold, and not really worry about an exit, and the tax implications that come with it - awesome. Find a deal that fits their criteria. If investors want to churn and burn every three years, make sure that's part of your plan, and you align your interests with them.

Now, I also want to touch on something else - buy in hold, and cash flow. I had a conversation with my sister in law, who I mentored for a short time, and she's gone on to do some great deals... And after our second deal together, I asked her if she's going to quit her restaurants that she owns, and she said "No, because we're not really making money in real estate yet." And like "Whoa, wait a minute, what do you mean we're not making money?" And she said, "Well, our bank accounts aren't going up significantly." And I said, "Do you realize that when you signed your name on those two pieces of paper you made over $1.5 million?" And she's like, "Yeah, okay..." So I need the Best Ever listeners and you two to understand that equity and cashflow are unique, but equity can be broken down as a derivative into cash flow, meaning if you made a million dollars and your cashflow goal was $20,000 a month, how many years of cashflow have you just accomplished by increasing equity in a property? It's something that a lot of people don't think about. They're laser-focused on, "I need this much money every month in passive income for me to quit my job, for me to retire, for me to go into real estate full-time", whatever it is, but along that road, they're not looking at the amount of equity that they're building, or the dry powder that's sitting in these properties that you're not utilizing.

Now, Slocomb, you're a buy and hold investor, you want to hold forever... I love that philosophy, and I had the same philosophy as well. A friend of mine gave me some pushback on a deal. It was a $5 million strip. Our plan was very quickly fill some vacancies, increase one person's rent, and the value would approach seven, seven and a half million dollars. And he said, "What's your plan?" I said, "Well, it's cashflowing great. We'll just keep it, and we'll get all the other rents bumped up; there's a few gross leases, we'll put them on triple net." And he's like, "No, why would you do that?" He's like "You made 80% of your upside in 20% of the time. Why spent the other 80% of your time to chase that last 20%?" And for the multifamily people, you can equate this by - if you renovated 80% of the units, and the last 20% - there's some roadblocks, material shortages, whatever... Why not sell it to the next person, leave meat on the bone, leave some upside, because you've already increased your NOI tremendously? And when you divide that increase in NOI by 0.08, or an 8% cap rate, there's the equity that you've built in the property. So I get the buy and hold, but like Slocomb said, if you can trade up and do it again, versus sitting back on your laurels and what you've already accomplished, why not do it again?

Slocomb Reed: Absolutely. Ash, I believe every buy and hold investor here should be in favor of trading up. What I will say though is, keeping in mind that I'm not saying go to the MLS, buy a four-family at market that needs some work and keep the market rents that you're buying and have a little bit of cash flow... I'm coming from the perspective of an active investor who is looking for opportunities to force appreciation. And as a buy and hold investor, get a cash out refinance, get capital out to be redeployed elsewhere. When you sell a property, you have the opportunity for major profits from capital gains and that appreciation you forced; you also are done making money off of that property. If you decide to cash out refi, leave some equity in there. If you recognize that you're going to have a solid return on that equity, but you can draw your capital to do another one, you're in a position where you can continue to reap harvests from the planting that you did years ago, which is part of what's happening in my portfolio now that I've been a buy and hold investor since 2014. There's hard work that I did in 2014, 2015, 2016, that's still paying me. Travis, where do you want to jump in here?

Travis Watts: Yeah, great points from both of you. In terms of a syndication - so the types of deals I'm investing in, 200 to 600-unit multifamily value add syndications; when you're holding longer term - and again, I'm just sharing that experience from the operator I invest with, that never sells... So yes, in times where interest rates are relatively the same, or ideally decreasing, like we've seen over the last 5-10 years, whatever it's been, it makes a lot of sense. Your equity is going up, and then you're going to refi and use that capital to make some moves. But when interest rates are hiking up, it may not always be possible. An alternative would be a capital call in the syndication structure.

Now, a lot of firms never want to have to do a capital call, which means calling your investors, saying, Hey, we need you to put in a little more money, because we've got to do A, B or C, or some renovations, and we don't have the budget to do it." Or you may be forced just to sell, and exiting the equity, or 1031-ing, or whatever.

Some people do 1031s. I generally don't do them myself personally in the syndication space, with the caveat that if I was still doing my own active deals, I would be doing 1031s. It's just harder logistically when you're in syndications. That's why. It can be a good strategy for some.

So ideally, I want to be in real estate as an asset class forever, but I also don't like to think in absolutes like that. So that's why I do the 80/20. I do 80% what I know and understand, and what's working right now; that's the value add multifamily. But I do 20% experimental - note lending, and self-storage, and mobile home parks and ATM machines... I'm always trying other things that generate cash flow, because you never know; the tides change, and things go in cycles, and there may come a time that something else makes a lot more sense. But at the end of the day, I'm just a big fan of real estate, mostly because of velocity of capital, value-add, like what we talked about... And the great thing is that real estate has great tax advantages, as we all know - depreciation, long-term gains, which are tax-favored...

Even on your owner-occupied home, another little side strategy I used to use is buying my own house and then fixing it up, and then you can exclude 250k of gains if you lived there for more than two years. I'm not a CPA or tax advisor, so check that stuff out, but the bottom line is there's a tremendous amount of advantages tax-wise to real estate. So anyway, on a rant there, but in a nutshell, that's my thoughts on exit strategies in my philosophy.

Break: [00:17:43.28] to [00:19:29.14]

Slocomb Reed: It's really easy in conversations like this to remain hypothetical, and talk purely about the numbers... One of the reasons to be a buy and hold investor is much more emotional. I'd like to give you an anecdote from my own investing. I bought in 2019, 5/50 with a partner, a 24-family that had 15 tenants at the time, but only nine of whom had any intention of paying rent. So a reposition. The heavylifting of getting it fully occupied was great, but there weren't any major rehab issues with the property. But now it's worth 1.5, and we've decided in 2021 to do our cash out refi and put it on a 15-year fixed mortgage at 4%. People thought we were crazy in 2021 for going to 4%, because we could have gotten a 5.25, or maybe a 7.25 at three and a quarter; we're recording at the end of July 2022, that 4% fixed for 15 years doesn't seem as crazy. But part of the deal here and part of the reason that we will likely own that property for at least 15 years is because 15 years from when we closed that refi my oldest child and his youngest child will be graduated from high school. Assuming we don't refi again, we will have 100% equity, we'll own outright a building worth at least 1.5, even though it is going to see 15 more years of rent growth and appreciation. And basically, do I really need to worry about funding my daughter's college anymore? I don't know that I do if we just hold on to this 24-unit that's easy to manage now, momentum has been built... We just have to keep at least and keep make sure I'm taking good care of my tenants and I'm putting my daughter through college with one deal that I'm done doing.

Ash Patel: Okay. I don't understand this... So all of that hustle that you've put in to make a tremendous amount of equity... Why not do it again? Take the cash, do it 2, 3, 4 more times? Are you just comfortable? You sitting back? You've got this nice property... Are you done hustling or what?

Slocomb Reed: [laughs] Outside of the argument and just being a staunch buy and hold investor for the sake of good conversation and good listenership for our audience, I'm doing other deals. I pulled money out of that to go hustle in other places. My partner on that deal has come to a point in his life where he wants to rest on his laurels, which is really one of the reasons why I think we'll end up owning that property for 15 years, is that he's more than happy to not hustle as hard the way that I am. I have continued to do other deals, recycle capital the way that we've been discussing.

Slocomb Reed: One thing I learned much later than I wished is it's easier to manage a $5 million property than it is a $500,000 property. So for me, having that cash on the sidelines is important, because lenders want proof of funds. When you take these deals down, there's large amounts of earnest money that go in... And I would rather reap most of the benefits and still bring some investors along for the ride... But I don't do deals where it's all investor capital; it's usually half of my money and half investors. So I need the dry powder.

And in terms of measuring your success in real estate, for me there's one metric, and it's looking at your balance sheet at the end of every year; once a year, write down a true version of how much equity you have in each property, and figure out all your brokerage accounts, bank accounts, assets, liabilities, and spend some time creating that balance sheet, that personal financial statement. And do this once a year, because when you apply for loans, lenders are going to want to see that. So for me, that's the measure of success in what I'm doing, and as long as that increases significantly every year, I know I'm doing the right thing.

So if I were to stop doing what I'm doing, and just let my properties continue to cash flow and not chase more deals, that balance sheet wouldn't increase the way it has. So for me, it's always chasing the next deal. And again, once you extract 80% of the value out of a property, why not sell it? There's other properties where they're not positioned well to sell. For example, an office building that still has mom and pop tenants on gross leases - it's not attractive to out of state investors, it's not going to trade at a great cap rate; or smaller apartment buildings that I have joint ventured on - there's just not a whole lot of demand for properties like that. So those, by all means, buy and hold; cashflow those. But at the end of the day, we all want to increase our balance sheets, and I think actively trading is the way to do it.

Travis Watts: I love those points, Ash, and a couple of things for our listeners... I'm a huge advocate, to your point, Ash, about just tracking. I do it every quarter; I track income, expenses, assets, liabilities net worth... I've built out a pretty cool sheet. I've kept a budget since high-school, and I keep tweaking it every year to make it a little better, with formulas and different calculators you can use. If anybody wants that - it's not any kind of sale or upsell - I'll just send it to you; just DM me on social media, @traviswatts, or @passiveinvestortips. That was a great point.

Ash Patel: I would love to get a copy of that. Would you email me, please? Or I'll send you an email.

Travis Watts: Yeah.

Slocomb Reed: Awesome. A couple of things I'd like to say here that will really kind of merge our two positions. One thing that hasn't been discussed yet is the impact of market cycles on buy and sell decisions. Market cycles are an inevitability; the timing, of course, fluctuates, but the cycle does not. And one thing that we didn't discuss is that there are clearly times in the market cycle of commercial real estate when it is very advantageous to be a buyer, and there are times when it is very advantageous to be a seller. And any serious, sophisticated investor in commercial real estate needs to be keeping in mind the market forces that are at play, because there are naturally excellent times to sell some of your properties when you look at the macro factors, and the micro factors, like Ash was discussing, sometimes, based on the actual property and its current condition, location, what's happening in the neighborhood - it's better to hold on for the long-term, even if you're an investor who's more focused on what you're doing to your balance sheet than your cash flow.

One last thing - and I think this plays more to Ash and Travis' side of the argument. There's an author, and I believe he either is or was an apartment investing guru, Steve Burgess. The point that he would make here is that when you have the skill set that I and my buy and hold, forced appreciation and cash-out refi investors have, of taking an asset like an apartment building and being able to increase the value substantially over a short period of time - that short period of time is when my money is working the hardest.

For example, just use simple numbers - buy a building for 500,000, put 100,000 down, put 100,000 in it, I'm all-in for 600k, 200k of that is my own money... If I get it to the point where it's worth a million dollars, then my equity position has gone from the 200k I put into it to 600k. I've been able to triple the value of my money in a short period of time. Any money I leave in that deal by cash-out refinancing is done tripling. To Ash's point and to Travis's point, if I sold that property and got my 600k out and put it somewhere else, I'd be in a position to triple it again. And as a buy and hold investor, I just have to decide the point at which I am ready to be done, or I am ready to start leaving equity in assets, so that I have stable, steady cash flow to live off of, and I have something to leave to my family. Any final thoughts, Ash or Travis?

Travis Watts: Real quick, one thing we didn't discuss that I think is really fundamental to this conversation... You have to love and enjoy what it is you do, and you have to be good at it. So the reason I left the active space personally is I didn't love and enjoy the single-family stuff, and being a landlord, and everything that came with it. And the time commitment. That was just a personal thing. And frankly, I wasn't good at it. I just really wasn't a competitive player in that space. So you've really got to look at that.

So my philosophy has always been "Do actively what you love and enjoy, your highest and best, and then invest passively." And that's the advice that I've followed. So whether that was working in the oil industry, and investing in real estate, or whether it's a GP. And I point this out because Joe Fairless publicly said this at Best Ever this past year - he's obviously a GP with Ashcroft capital, which is fantastic, and consumes most of his time... He's also an LP in 80-something deals with other operators. So that's the philosophy that I look at. It's just a way to leverage your income and maximize your time.

Slocomb Reed: Great point. And reiterating what Travis said is you have to love what you're doing... And hopefully you do, and that's why you're listening to this roundtable discussion. But I do want you to create that balance sheet and stress-test it in different ways, do different models. Don't just take our word for it, figure out what the right strategy is for you and balance that with your time.

So if you think buy and hold is the right way to reach your number on your balance sheet, test that against selling half your portfolio and trading up; look at different options. Get out there, do the research, and there's a lot of different ways to achieve your goal... But pay a lot of attention to it; stress-test everything, work different models into what you're doing.

Slocomb Reed: Awesome. And the last piece of advice I have for our listeners on this topic is be aware of your emotions surrounding real estate investing, recognize that when it comes to the big-picture decisions we make, they're often not purely rational, and we need to do what we know feels right... And some people need to be doing what they know feels safe, comfortable, secure, what feels like growth, feels like abundance... Make sure that you are deciding on your investment strategy based on what you know that your needs are.

Thank you for tuning in, Best Ever listeners. If you've gained value from this conversation the merits of buy and hold and the merits of more transactional investing, please do subscribe to our show. Leave us a five star review and share this episode with an investor friend of yours who you know we can add value to you through this conversation. Thank you, and have a Best Ever day.

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