A look at how commercial real estate wealth is gained over time, and an investigation of the age-old relationship between wealth and happiness.
One of our most popular posts here on the blog details what we call the Wealth Cycle, a three-phase investment journey that begins with wealth creation, moves on to wealth preservation and ends with a plan for wealth distribution.
In the first phase, we work to create wealth through hard work and savvy investing that is often associated with taking greater risk.
In the second phase, we become more focused on preserving our growing nest egg, while we continue to increase the size of our portfolios, but with a decreasing appetite for risk, as we realize that we may not have time enough to recover if we get out over our skis.
In the third phase, we have what we need to live our lifestyle of our own choosing, but concentrate on developing a sound strategic plan for distributing the fruits of our labor to our heirs.
We don’t necessarily jump from one phase to another. It’s a matter of changing our emphasis over time to make sure that we build wealth without taking unnecessary risks that can result in the unraveling of what we worked so hard to acquire. And, while all this is happening, we live the ups and downs of daily living, raise families, pursue our passions and achieve both business and personal life goals.
For many, the two are intertwined, as personal interests and talents, combined with hard work, become our source of wealth creation. Those who do best at striking this balance are more likely to live happier and more fulfilling lives.
Most of us know a few multi-millionaires who are miserable and a few others of limited means who are happy and content. Being rich is no happiness guarantee, but being poor is not a choice most of us would make in terms of pursuing happiness.
Many of you, our clients and friends, have been extraordinarily successful in life, and we are grateful and honored to have had the opportunity to work with you and learn from you through the years. In return, we hope that you value us in the same way.
Today, we want to explore a question that the answer to we think is essential: when is more just more and at what point does accumulating wealth lose value in terms of living a fulfilling life?
Part 1: Tail Wagging the Dog
When we begin a career, we have no idea what the outcome will be. Some success paths ascend in a linear fashion, but most don’t. Challenges, interruptions, distractions and the hazards of daily living tend to interrupt us.
Sometimes we fail altogether and have to pick ourselves off the dirt, dust ourselves off and find our way on a new path. From each of our failures and wrong turns, we learn. Think about how many times Thomas Edison failed to make a functioning light bulb. Once he did, the world changed and he became one of the most famous inventors of his time. Even so, his bet on DC current was a failure, and AC current prevailed. Think Beta vs VHS.
So, now that you are well on your way, what will you do with the rest of your life? What will you do with your money, your ideas, your interests and your passions? How much will you need to follow a path that will take you where you want to go? Do you even know where it is you want to go?
Though these questions are not real estate specific and we are just real estate guys, we think your answers to these questions should figure into your decision-making matrix as it relates to your real estate holdings.
So, we ask you to put some thought to these questions, and then take a high-altitude look at what you already have in terms of personal wealth, current income and also your liabilities.
Then, without considering the tax consequences of disposing of any of your assets, ask yourself if deploying your capital differently could make a difference in the quality of your life. Why do we say not to consider taxes?
Because actions in your best interests not taken re-define the concept of the tail wagging the dog. It’s an exercise that won’t cost you a penny and it can be done anywhere; on your way to or from work, in your Sunday driver on your way to breakfast, or just sitting in front of the TV watching your favorite sport.
Part 2: Taking the Tax Hit
Before you can answer “At what point is more just more?” you’ll need the answer to many more questions like; how much money do you need to pursue your personal interests? Your lifetime goals? How much will you need to care for your family while you are here and after you are gone? How hard do you want to work? When do you want to retire? What do you really want to do once you actually do retire? What mark do you want to leave on the world when your time is up? We could go on, but you get the picture.
At what point do you say; I have enough and now I need to make sure my wealth is deployed to support the priorities in my life?” In our last post, we suggested taking a quick inventory of your assets and asking yourself what you would do with the money if you sold one or more of them.
We also asked you to remove tax consequences from the disposition equation, as that is tantamount to ceding control of your life to the IRS and the Franchise Tax Board, which could just be the only thing worse than actually writing big checks to either of those agencies. As much as they take, we still keep more, at least under current tax law.
Right or wrong, fair or unfair, taxes are an inescapable aspect of life, but we still call the shots at the end of the day.
We have been compiling our own bucket lists of things we want to experience in our lives, and we hope you have one of your own, as well. But, before we get to our lists, we thought it might be helpful to model the sale of an industrial building that we believe reflects the situation so many of you are in as property owners.
Property values have been increasing rapidly for the past several years after falling by as much as 50% in the last recession.
Many of you have seen your property’s value triple since the recovery began, and those of you who bought at the top of the last cycle have seen your property rise well above the previous peak. If you bought your property 20 years ago, you are literally sitting on a virtual mountain of cash.
The problem for most of you comes down to not having a sound strategy for reinvesting the proceeds without taking an enormous tax hit. That is enough to keep most property owners hunkered down with their fingers crossed that the next market correction will be kinder and gentler. So, we decided to include the tax consequences in our scenario to reflect that reality.
The fact of the matter is, you can probably pay all the taxes on a sale of your property with the appreciation earned in just the last two years, which this model makes clear. Check-writing day will be ugly, but knowing that what’s left is all yours to do with as you please, is a thing of beauty.
So, let’s call the owner of our model property Mr. Smith. He decided to buy his 20,000-square-foot building in Anaheim for his 3PL company back in 2010 because he stayed in touch with his local market and saw it moving off the bottom of the cycle. He also saw the opportunity to borrow money at historically low rates, thanks to the aggressive monetary policy of our central bankers at The Fed.
Prices were down and money was cheap: a good formula in the mind of Mr. Smith. So, he cut the following deal back in Q4 of 2010:
|Purchase Price:||$2,000,000 ($100/square foot)|
|Down Payment:||$500,000 (25% of purchase price)|
|New Loan:||$1,500,000 @ 6% interest, 25 year amortization, 10 year call|
|Monthly payments of $9,664|
The investment has worked well for Mr. Smith and his company still uses the building. But, he still follows the market and he also knows that property values have tripled for buildings in his size range since he acquired his property.
He could pull his cash out by refinancing, but he’s 63 years old and doesn’t like the idea of taking on more long term debt, even if it is at a lower rate than the one he is already paying. So, he has decided to sell and bite the tax bullet because he’s been around for a while and knows that gravity works and the market will eventually experience a correction.
Mr. Smith lists his property to see just how crazy things really are.
In short order, he has four offers at or above his asking price and he decides to take the best one, executes the purchase agreement and opens escrow at an unbelievable $340 per square foot. The property sails through the due diligence process and the new buyer closes the deal with just a 10% down payment and a loan for the balance at a rate of just 4.5%, with fixed payments for 25 years. He’s happy and so is Mr. Smith.
Now it’s time to find out what Mr. Smith gets to keep. It is important to note that we have to make some assumptions here as it relates to some of these numbers, but we are confident that our scenario reflects estimates that are very close to reality.
To model the disposition of your own assets, consult a professional tax advisor. In the meantime, here’s what our Mr. Smith is facing:
|Less Accumulated Depreciation:||$461,000 (based on 12 years, using a 75/25 building-to-land ratio and 39 year economic life)|
|Sales Price:||$6,800,000 ($340/square foot)|
|Cost of Sale @5%:||$340,000|
|California State Tax:||$639,860 (estimated at 13% of total capital gain)|
|Depreciation Recapture Tax:||$115,250 (25% of total depreciation taken over 12 years)|
|Federal Capital Gains Tax:||$1,061,718 (23.8% of gain after subtracting depreciation)|
|Total Tax on Sale:||$1,816,310 (just under 37% of total gain)|
|Cost of Sale:||$340,000|
|Proceeds Before Taxes:||$5,415,000|
|Proceeds After Taxes:||$3,598,690|
The bottom line here is that Mr. Smith invested $500,000 in cash and walks away with almost $3.6 million, AFTER TAXES and loan payoff when he sells.
Yes, he’ll pay over $1.8 million in taxes, but if he held the property through a 25% correction because of that potential tax bill, his loss in equity would be $1,700,000, and he would still have substantial state income tax, federal capital gains taxes and depreciation recapture taxes to pay when he eventually sells the property.
In this scenario, he pays his taxes with his windfall profit and walks away with a pile of cash that has already been taxed.
Now the big question is: What will he do with all that money to improve the quality of his life?
Working through your real estate strategy
for the next 3, 5, and 10 years?
Part 3: The Joy of Spending (and Preserving) Wealth
Let’s continue with Mr. Smith, who decided to sell his highly appreciated industrial property, pay his taxes and walk away with a pile of cash to do with as he pleased.
To get top dollar, he sold the building to an owner/user and moved his own company into another building on a 5-year lease that will give him greater flexibility down the road.
This scenario, in our view, mirrors the position that many of you are in today, so we thought it would be a good way to discuss the more qualitative aspects of navigating the Wealth Cycle.
Why We Care About Wealth
We believe it is safe to say that most of us set out to create wealth so we can take care of ourselves and our families, and earn the ability to make choices regarding where and how we live.
For many of us that means having a beautiful home in an area with great weather, beautiful beaches, great schools and a wide variety of cultural and recreational amenities. Think Orange County.
For others, it may also mean being able to pursue passions like world travel, collecting vintage cars or volunteering time and resources in support of a noble cause. Think about the thousands of lives the late great Jerry Lewis touched as a result of his passion for ‘his kids’.
He made his money and earned his fame by being a funny guy, but he will be remembered more for his philanthropy than his antics on the sound stage. For Mr. Lewis, acquiring wealth became a means to an end, not the end itself.
Now, it makes perfect sense to preserve our wealth once we have acquired some. No one likes the idea of starting over from scratch.
However, it is equally important for our wealth to be put to its highest and best use in terms of the quality of the lives we lead. Sure, how much money we have is a good indicator of how well we are doing, but at some point having more money reaches a point of diminishing return in terms of the quality of our lives.
So, what did our Mr. Smith do with his windfall profit?
First, he decided to take his original $500,000 in cash and reinvest it in stocks and bonds through an account managed by professionals. That way, some of his money is back in play and he still has nearly $3.1 million in after-tax cash burning a hole in his pocket.
For the sake of our exercise, let’s assume that he already has a retirement plan with adequate funding to meet his daily living expenses. He and his wife own their home with a small mortgage balance and their children are grown and living independently.
As we mentioned earlier, Mr. Smith is 63 years old and each year seems shorter to him than the last one. As a result, having more time to engage in activities other than work has moved higher on his list of priorities.
But, he still loves to work and wants to see his successful company keep growing for the sake of his family and employees. So, he decides to promote his warehouse foreman, Jack, a loyal, hard-working employee of 18 years, and begins training him to take over day-to-day operation of the company.
Within a few months, Mr. Smith is working just three days a week, spending more time on the golf course and taking long weekend trips with Mrs. Smith, including more frequent visits to Boston to visit their first grandchild. The company is still doing well and the $50,000 raise he gave to Jack is turning out to be money well spent. In fact, Jack’s new ideas and enthusiasm for his new role has resulted in increased revenue and profits that more than offset the raise he got.
Mr. Smith has always been a car buff, especially for 60’s era muscle cars. His first car was a midnight blue 1966 GTO and he has long lamented selling it to help pay for college.
He decides to buy another one, completely restored for $65,000, so he can drive it to the coffee shop on Sunday mornings to visit his other car-crazy friends. Before long, he has added a 1969 Chevy Chevelle SS, a 1967 Camaro and a vintage Shelby Mustang to his stable.
In return for hogging their garage and spending so much time tinkering with his cars, Mr. Smith makes good on a 40-year-old promise to take Mrs. Smith on safari in Africa, which has always been number one on her personal bucket list. The trip exceeds their expectations and they plan to go again.
After all this, Mr. Smith has spent a chunk of his windfall, but his company is doing better than ever, his new toys are going up in value, the rest of his cash is still carefully invested, and he is spending serious quality time with family and friends.
We think that sounds like a pretty good outcome to the sale of his building.
Did we make this scenario up? Yes, we did. Is it completely believable? We think it is. Did it make you stop and think? We hope so.
That said, we are not advocating that every highly appreciated asset should be sold just because there is a big profit on offer. There are actually many good reasons to hold valuable real estate for the long term. Indeed, most commercial property investors do just that.
What we are saying is that it’s not all about how much we make, but what we do with how much we have.
Working on your real estate strategy
for the next 3, 5, and 10 years?
Part 4: Seeking Financial Advice
We may not all be as intentional about making money as Jim Carrey, who allegedly wrote himself a $10 million check when he was a struggling comedian as motivation to actually receive a real check in that amount for starring in a hit movie.
Apparently, it was good idea for him because he received several checks in even larger amounts just a few years later.
Most of us just put our heads down, do what we do best and keep at it until we fail or succeed at our chosen profession.
Let’s pick back up with the story of the fictional Mr. Smith, successful business owner and eventual seller of a 20,000 square foot industrial building he bought for $100 per square foot in 2010.
As you may recall, he put $500,000 down, borrowed $1,500,000 at 6% interest and walked away with nearly $3,600,000 in after-tax cash by selling the building for $340 per square foot to another owner/user in 2022.
He promptly reinvested the original $500,000 in stocks and bonds through a financial advisor, gave a healthy raise to his right hand man and began training him to help run his company, reduced his workweek to 3 days, bought 4 vintage American muscle cars, improved his golf game, took his wife on safari in Africa and makes routine visits to Boston to visit his daughter, son-in-law and newborn granddaughter.
If he had kept the building, it would still be going up in value, but it would be in illiquid form and at risk to a potential market correction that was making him increasingly uncomfortable given his age (63) and his loosely defined strategy to retire around age 65. It is also likely that he would still be working every day and Jack would not be in the front office learning how to run the business.
Neither of those alternatives is such a bad thing, but we like the first one better. It sounds like a lot more fun and has a large impact on the most important people in Mr. Smith’s life. To us, it appears to be the smarter of the two paths from a quality of life point of view. He had to suffer a significant tax hit, but now that’s behind him.
Most investors keep exchanging to delay the payment of taxes, but Mr. Smith wasn’t interested in paying a premium for someone else’s highly appreciated asset just to delay the pain of paying taxes. For him, it was either keep the property and stay the course, or sell it, cash in his chips, bite the bullet on the taxes and invest some of his equity in the people and things that mean more to him than a concrete box.
For those of you who have been following our little story, we encourage you to become Mr. Smith and role play the sale of a commercial property asset that you own.
You’ll need the answers to some basic questions about your real estate that we can help you with. We can give you the low down on the market and an estimate of your asset’s approximate value.
Your accountant can run the final numbers because he knows your situation better than anyone. Warning: the estimate of your tax liability will be something you’ll want to hear sitting down. It will literally make your eyes roll back in your head and you might go on a short but energetic expletive-laced rant.
The good news is that in most of the models we run, the entire tax bill is less than the increase in a property’s value over just the last two years. The rest of the gain will be yours and that adds up to a number you will want to get up and dance to.
If nothing else, the exercise might be fun, kind of like thinking about what you would do with the money if you won the lottery. Admit it, you’ve done that before and it was fun.
Many of you who follow our blog own multiple commercial property assets along with investments in other asset classes like stocks, bonds and equity stakes in other companies.
So, the asset that you use for this exercise doesn’t have to be an industrial building. Maybe you made a good pick on a stock when the Dow was at 7,000. Maybe you bought an 8-unit apartment building in 2009 or 5 houses in Phoenix from a bank that you rent for passive income.
The choice is yours, but we suggest an asset that is highly appreciated and may be at significant risk if an economic correction occurs.
Since industrial property values have been driven up sharply by low interest rates, we think it is an asset class at particular risk given the fact that interest rates are likely to move substantially higher as the Fed boosts its benchmark Fed Funds rate and works to reduce its balance sheet of US treasuries and mortgage-backed securities.
Remember, gravity works. What goes up, comes down unless it’s a rocket with power enough and fuel enough to reach escape velocity. The Fed fueled the surge in prices, but the fuel it used to do so may be running low.
So, go have some fun, and give us a call if you’re ready to crunch the numbers – we’d be happy to help.