The Wealth Cycle: Creation, Preservation & Distribution
Nearly 5 years ago, we posted a series of six blog posts on what we call The Wealth Cycle that described the lifetime path of an investor in three phases: Wealth Creation, Wealth Preservation and Wealth Distribution.
Since then, we have used the concept to help many of our clients evaluate their real estate strategies and make necessary adjustments to optimize their opportunity for maximum return on their lifetimes of hard work and savvy investing.
What follows is a compilation of those posts that have been updated to reflect the most recent trends in the commercial real estate market. While things have changed substantially, we believe the Wealth Cycle concept is every bit as relevant today as it was 5 years ago. We hope you find it meaningful and helpful.
At some point in our lives we decide what we want to be when we grow up.
Some of us are fortunate enough to pick right the first time, while others hit dead-ends but keep trying until they find the one that works best.
Once found, the real work begins, and we set out to achieve our goals, both personal and financial. When those two line up, good things can happen and successful careers are realized.
The accumulation of financial resources is high on the list for most of us engaged in business. We believe that the more money we have, the more choices we have in terms of what we do, where we live, how we provide for our families and pursue the quality of life that we dreamed of at the beginning. In our role as real estate advisors, we are fortunate to connect with so many amazing people who have achieved enormous success, each in their own way.
This is one of the things we enjoy most about what we do and we are grateful for the privilege of knowing so many bright, hard-working people who achieve at the highest levels in their industries.
In this series we will discuss the three phases in what we call the Wealth Cycle.
The first is wealth creation. The second is wealth preservation and the third is wealth distribution. In each, our risk profile is different and so is the process by which we make decisions about money. As we move through life our priorities shift and the balance between the quantity and quality of our lives changes accordingly.
Thus, it is important to understand where we are in life to make decisions that keep us on the right path. We have all made business decisions we regret. Taking risks, following our instincts and having to react to unexpected circumstances don’t always work out for the best. But, looking back on our “mistakes” often reveals the fact that we lost touch with a longer view of things, and if we could do things over, we would.
This is why it is so important to consider where we are in the wealth cycle.
It is perhaps our best guide to making informed decisions that serve our ultimate goals and objectives.
So, let’s take a look at each phase of the wealth cycle to see if it offers any meaningful guidance for you.
Part 1: Wealth Creation
For you, it may have started with a paper route or mowing lawns for the neighbors.
You decided that there were some things you just had to have or things you just had to do. So, you took it upon yourself to earn the money required to make it happen on your own.
That motivation spurred you to take independent action to change your circumstances. You spent the time, took the risk and sacrificed other things and activities in pursuit of your goals. As a business owner making decisions every day, you still do the same thing. You are motivated to take the risk and make the effort to achieve your goals.
Think back on how hard you have worked to build your business. You took risks, worked harder than the next guy, scrimped and saved, all so that you could accumulate enough wealth to have the freedom of choice that comes with it.
When we are in the wealth creation phase, we are generally young, ambitious and confident in our ability to succeed. Our appetite for risk is bigger, too. How many business owners have mortgaged their homes, tapped lines of credit, and otherwise put it all on the line to take things to the next level?
In the wealth creation phase, there has to be a willingness to fail and enough time to start over and do it better the next time if it does.
So, if you buy commercial real estate for investment in this phase, you must have the ability to bridge the gap between peaks in the real estate cycle. This is particularly true today for buyers.
Prices for Southern California industrial properties have exceeded the previous peak and many expect the market to either level off or move into correction territory soon. But, for the investor with the time to go through another cycle, buying quality, functional property is still a good option for a couple of reasons. First, the cost of long-term financing is still historically low, which fixes occupancy/debt service costs for up to 25 years. Second, supply is short and most SoCal submarkets have little land remaining for development.
Controlling quality product for the long term provides stability for a thriving business.
Vacancy has dropped to 1% in most submarkets and very little new product is being delivered due to the high cost and scarcity of industrial land.
For existing property owners still in the wealth creation phase of their lives, it may be wise to hold on to their current real estate, despite the windfall they would receive on a sale.
These investors already own a virtually irreplaceable asset, and have the time to hold through on until the next peak in the cycle, which could move prices to even higher levels than we see today.
However, if existing facilities are inefficient or may require substantial additional investment for deferred maintenance or to cure functional obsolescence, then it may be a good time to trade up to something more suitable for the long term, despite having to pay a premium to do it.
Working through your real estate strategy
for the next 3, 5, and 10 years?
We recently had a conversation with a good friend of ours that we believe is a good example of being in the wealth creation mentality.
Rob owns several industrial buildings in Anaheim with an aggregate value of nearly $12 million at today’s market value. His adjusted basis in the property is just $1.6 million. Currently, there is less than $500,000 in debt against the properties and they are fully leased at slightly under today’s current market rate.
Rightfully so, Rob sees the opportunity to refinance the properties to free up cash for the purchase of additional industrial real estate in another state where yields are running as high as 7%, as compared to the 4% cap rate for Orange County properties.
Given his relatively young age and the current low interest rates for long term real estate loans, the “refinance and buy more” strategy is a sound one. If he were to execute this strategy, he would control as much as $24 million in assets by leveraging each to 50% of current value, all producing monthly cash flow and subject to further price appreciation.
Clearly, his net worth would rise much faster as long as the markets the properties are located in keep moving higher. He would be in good position to weather a correction if one occurred, and he is young enough to patiently wait out a complete real estate cycle before moving out of the wealth creation phase of his life.
However, there’s a catch.
Rob owns the property with his father and title is vested in a family trust with Rob and his dad as trustees. Dad is now approaching 80 and he has a different plan, one that reflects the different place he is in life.
He would rather pay off the remaining debt and stick with the current assets, which he believes will produce consistent cash flow for the remainder of his life. Increasing net worth is no longer a priority for him. He has enough money to live his life style of choice and likes the safety of owning quality assets with little or no debt.
The worst case scenario for him is to lose a tenant or two and have to spend the money to secure new ones. Without debt, he can lease them at whatever the market rate is at the time and still have positive cash flow.
Both Rob and his dad have valid investment strategies that reflect their respective positions in life. Rob is still interested in creating wealth while his dad is more focused on preserving wealth, which is phase 2 of the wealth cycle.
Part 2: Wealth Preservation
At his age, Rob’s dad has accumulated enough wealth to enjoy his current lifestyle. Unlike Rob, he isn’t willing to take on the risk of refinancing the property, reducing his cash flow and taking a chance on feeding the property if tenants are lost with debt to service. This posture defines the wealth preservation mentality, and that is to take a safer and more defensive approach to managing our investments.
In the case of Rob and his dad, neither of them wants to sell their properties. They just have different uses for them. They both understand the underlying value of the buildings and both have good historical perspective on owning industrial buildings in Orange County. So, their respective strategies have those common elements. Chances are good that they will reach a compromise and find some middle ground that gives Rob a chance to parlay his ownership into a bigger portfolio without putting his dad’s cash flow at risk.
They are talking things through now, and we don’t yet know what the outcome will be. But, no matter what they decide, we see the opportunity to learn a good lesson that we can pass along to all of you.
Now, let’s take a harder look at wealth preservation. In the case of Rob’s dad, he chooses to maintain ownership, which still, even in the best of circumstances, involves risk. We all remember the 40% to 50% decline in property values that resulted from the biggest recession since the Great Depression. They didn’t name it the Great Recession for nothin’.
It was ugly and let’s hope the next down cycle is kinder to us all.
Our team was on the front line back in 2008, and we are not fond of the idea of a do-over. But, what we hope for has nothing to do with what will happen the next time the market hits the brakes. Hopefully, it will be orderly and less severe, and that hard-fought gains will not disappear as they did the last time around. We will be weighing in soon on current events that may or may not be indicative of the next correction, but this is not the time.
Let’s assume for the moment that the market will begin a correction in Q1 of 2023. And, let’s also assume that market values pull back roughly 25% during the correction, a reasonable assumption based on our own experience. That means a building worth $400 per square foot at the peak will be worth $300 at the bottom of the next cycle. A decline of that magnitude is worthy of any investor’s attention.
Now let’s assume that the owner of a certain 20,000-square-foot building in Anaheim is 68 years old, has owned his own business since the 1970’s and bought his building 25 years ago for $75 per square foot. That means he paid $1,600,000 for a building that is now worth over $350 per square foot or $7 million. Good for him, and good for you if this hypothetical scenario resembles your current situation. But, a 25% correction would equate to a $1.75 million loss of equity. Ouch. If you were this investor, what would you do? Good question.
If we assume the peak of the next cycle to be 10 years from the peak of this cycle, our building owner would have to hold the building until age 78 to recoup the value lost during the correction. However, if he sold the property before the correction, he could realize a massive gain, stash a pile of cash in insured cash accounts and not put himself at risk of losing hard-fought gains. After all, he worked hard to get where he is today, and he took risks in the wealth creation phase to get to where he is.
This is an owner profile that is very common today, but most of those in this situation refuse to sell because they either see the market as having more juice in it, or are loathe to pay the taxes associated with realizing such enormous gains. This may be something you are wrestling with yourself. While we agree the tax hit may take your breath away, it may be just what the doctor ordered if you are an investor in the wealth preservation phase of your life.
Each of us has his or her own reasons and methods of acquiring wealth. The term “wealth” in itself, has many definitions. Some measure it mainly in dollars as a gauge of success, others by the opportunity to pursue personal interests and help others.
Wealth is relative and unique to every person who pursues it.
For our purposes, we look at the accumulation of monetary wealth through savvy real estate investing.
Rob wants to leverage the properties they hold in an effort to buy more properties that can appreciate in value and generate more cash flow. Because they carry very low debt on the property, they will be able to withstand vacancy and avoid losing the building due to foreclosure in extreme market conditions.
If they were very conservative investors who anticipated a change in the market cycle, they would be more inclined to sell, suffer the heavy tax burden and convert their equity to cash in insured cash accounts, annuities or other liquid investment instruments. Cash flow might decrease, as in these days of low interest rates, yields on savings have decreased accordingly.
This amounts to making the decision to “pay” for a higher level of safety. By selling, the tax consequence of the gain is done with and Rob and his dad would have free and clear ownership of the sale proceeds. For some, it’s okay to leave some money on the table, knowing that what they walk away with is truly theirs to keep.
You may be in a similar situation and find yourself becoming more willing to trade maximum returns for greater safety. You may also be invested in multiple properties, along with your investments in other asset classes like stocks, bonds and residential real estate. As such, an important aspect of successful wealth preservation is portfolio balance, both in terms of the real estate own and your other investments.
As far as your real estate is concerned, diversifying into other property types might be a good move. Let’s say you own an industrial building that is leased to a local business that doesn’t have the financial clout of a big corporation. You may be getting your rent on time now, but that income stream might be at significant risk in tougher economic times.
To preserve your equity, it may be wise to exchange your highly-appreciated asset into a rental income stream backed by stronger credit. In recent years, this strategy has become very popular with investors in the wealth preservation phase of their investment lives. The single-tenant net-lease (STNL) market has been booming during this economic recovery. These properties are leased on a long-term basis (usually 15 to 20 years) by major corporations who use retail, office and industrial properties.
Returns are lower, but the integrity of future cash flows is at a much higher level.
So, if you exchange your industrial building leased at today’s market lease rates into one of these investments, your return may lower, but so will your risk of losing equity due to a correction.
Some investors believe that even STNL deals are too risky because they focus on what the underlying property will be worth when the lease ends and the tenant decides to move on. This is a legitimate concern and should be taken into consideration. Given the popularity of these transactions, there are not enough of them to go around, and buyers are forced into small markets that bring another type of risk into the conversation.
There are many other examples we could give you as to how investors are managing their risks, and we would welcome the opportunity to share them with you. However, only you know what your tolerance for risk is, and it will be up to you how to manage it. We favor balance even if it means slightly lower returns, as we’ve seen what can happen to fortunes when markets head south.
We encourage all of our clients to be in a constant state of portfolio evaluation, and to always be ready to make a move when the situation calls for decisive action.
What should you do to preserve your wealth? There are many questions that need to be answered first. Among them: What do you need to pursue and maintain your lifestyle of choice? How are your assets allocated? Do your investments produce the cash flow you need to live that life style? Does the income from any single asset you own produce a disproportionate share of your total income.
Is income from your investments likely to keep up with rising operational costs? How liquid are your assets should you need to access your wealth in the event of an emergency or new opportunity? The list goes on, but you see the point. To safely navigate the wealth preservation phase of your life, these and other questions need answers that support your objectives.
Working on your real estate strategy
for the next 3, 5, and 10 years?
Part 3: Wealth Distribution
Deciding what will happen to accumulated wealth after we are gone is perhaps the most difficult, frustrating and complex business challenge you will face.
Rules, regulations and taxes are only part of the problem.
There’s also the personal side of the equation, which brings in family dynamics and the relationships with business partners, lenders, shareholders and others, all of whom have their own plans for the assets that flow from our estates.
Then, there is the mountain of paperwork associated with each and every agreement we’ve ever made, much of which we haven’t even looked at for years. Just the idea of having to sort that all out will bring out the procrastinator in just about anybody.
Before getting into a serious discussion about distributing wealth, we need to make clear that we are not the go-to experts when it comes to establishing a comprehensive wealth distribution strategy. You will need legal and financial professionals who specialize in this complicated area of the law to help you work up a plan that is best for you.
However, we know a thing or two about commercial real estate and we interact with clients every day who are making real estate decisions driven by their own wealth distribution strategies.
So, we decided to share some of that experience with you in the hope that it will get you thinking about your own plans for the future. It could be that you decide to make some moves now that will streamline the process of distributing your assets in the future, as the more simple things are structured, the better the chances are for the outcome you desire.
Understanding Your Assets
A good place to start the process is to take a look at all of your assets, including your real estate.
Like most other successful business people, you have probably invested in a variety of asset classes that include real estate, blue-chip stocks, bonds, mutual funds, whole life insurance policies, partnership interests in other companies and your share of the business you own. Each of these investments has its own risk profile and level of liquidity and complexity.
The stocks are easy. You own them yourself and they can be traded in a fraction of a second.
Partnership interests in real estate or your business is a whole other story, and we can tell you from experience that it’s a story that doesn’t always have a happy ending.
Hypothetically speaking, let’s take a partnership interest in a building that you and your business partners purchased as individuals to serve as a facility for your company. This is a very common practice in Southern California, as merchant developers have been focused on building freestanding industrial buildings for sale to users since the 1970’s.
Let’s also say that you bought the building in the name of an LLC with you and your partners as the managing members. That agreement describes your interest in and responsibilities for the property.
But, it may or may not define your exit options should you decide that selling your interest in the property is in your best interests.
You and your partners may have all been on the same page when you bought the property many years ago, but life is full of surprises and things change. If something happened to you or one of your partners, having your heirs or their heirs become a partner in the property may not be best for all concerned.
In such a case, it may be more prudent to sell the property before the fact and have each partner exchange his or her proceeds into an investment of their own, which has the effect of simplifying several estates at the same time. We see this strategy being executed with considerable frequency.
The takeaway in this scenario is that you and the other original players make the decisions and the heirs get what they were intended to have in the first place. It also allows for the investors to go in different directions. One may wish to exchange to defer capital gains and depreciation recapture taxes, while another may choose to cash out, pay Uncle Sam and buy a big boat or second home to enjoy with the grandkids.
Without a cohesive plan and clear path to achieve that plan’s primary objectives, things can go sideways in a hurry.
We recommend that you look at each property you own from every angle possible and decide if continuing your ownership serves the interests of a sound wealth distribution strategy. Dedicating a little time to the topic may just be the best investment you’ll ever make.
The importance of having a cohesive plan cannot be overstated. In a perfect world, each of our assets will flow to the intended parties and the appropriate professionals will already be engaged to lend assistance in their respective specialties. Those receiving portions of our estate will know what they are getting, when they will get it and have a clear understanding of their role and responsibility as it relates to each asset they receive.
Making sure that your heirs know what to do with what they get is critical, especially when it comes to commercial real estate.
If you hand off real estate assets to heirs that lack the experience and depth of real estate knowledge that you have, the results could be disastrous. Industrial business parks, retail shopping centers and office buildings are complicated investments, all requiring a high level of expertise in multiple disciplines.
You may be quite comfortable negotiating a tenant improvement package with a prospective lessee, but the person inheriting that asset may not know where to start. Real estate decisions are complex and markets are in a constant state of change. So, if you will be passing along real estate investment properties to your heirs, either make sure they can fill your shoes or engage the appropriate professionals to act in their interests.
As we mentioned in our last post, keeping things simple may be the best strategy.
If you have assets that are management intensive, maybe you should consider exchanging into simpler properties that require less hands-on experience to manage. Also, you may own assets that have elements of functional obsolescence or have deferred maintenance issues that need attention. If so, trading into more modern facilities might become part of your wealth distribution strategy. Planning ahead means that you get to make the important decisions. Without a good plan, your heirs may find themselves overwhelmed, and you won’t be there to help. Please excuse the morbid reference but, let’s face it, there is no escaping reality.
We recommend that you evaluate all your assets and visualize the simplest transition of each one to your heirs.
If your current distribution plan comes up short, now is the time to come up with one that will get the job done. We can help you with evaluating your real estate in terms of its value and relative position in the market, but you’ll need advice from attorneys, accountants, financial planners, insurance professionals and others depending on the size and complexity of your estate.
If all your assets will flow through to just a few who understand your assets as well as you do, that’s one thing. But, if there are children, grandchildren, brothers, sisters and charities all receiving shares of your estate, the need for simplicity becomes more important.
Let’s also not forget Uncle Sam. The tax implications alone can be enormous, as federal estate tax rates run as high as 40% on the net value of individual estates exceeding approximately $11.7 million. If your estate is worth more than that, then some of your assets may need to be disposed of to generate cash to meet tax obligations. That’s where life insurance can come in handy, as cash proceeds from life insurance can be used to pay the taxes, so that other assets don’t have to be liquidated for that purpose.
We could go on, but we want to be careful not get too far afield in terms of our area of expertise. However, we do want to pass along one more idea before we close, and that’s the act of distributing your estate while you are still alive. The truth of it is, you can pass your estate along to your heirs while you are alive, giving you the opportunity to see them enjoy their inheritance.
Of course, there is the usual mountain of paperwork and menagerie of rules and regulations to follow. Plus, your heirs will inherit your basis rather than get a step-up, but it can be done. Maybe one of your heirs needs capital to start a business or another needs to pay for law or medical school. Perhaps you’d like to make the down payment on your son or daughter’s first house as a wedding gift or start college trust funds for your grandchildren.
In simplest terms, you can use up to the limit of your estate tax exemption to distribute your estate without incurring tax liability.
You can also gift up to $14,000 per year to each of your heirs without even having to file a gift tax return. By doing so, the taxable value of your estate will be reduced and your future heirs receive their gifts tax free.
For example, if you gifted the maximum to ten heirs for ten years, that could reduce the federal tax on your estate by as much as $672,000 (40% of $1,680,000). You can even establish trusts that restrict and protect the distribution of those gifts to heirs too young or otherwise unable to handle their own financial affairs.
Whatever you decide to do with your assets, the sooner you focus on the issue the better. Planning ahead cannot work against you. It’s your plan and you can change it any time you want to. You can be totally transparent with your heirs or hold all your cards close to the vest. You earned your wealth and only you should decide what happens to it and who benefits from it.
This series is meant to get you thinking seriously about this important final phase of the wealth cycle.
We are real estate market experts, and know just enough about estate planning to know that only trained professionals in the field of estate planning should be relied upon for specific advice. But, if we have you wondering if your wealth distribution plan truly serves your interests and those of your heirs, then we consider that to be another “mission accomplished”.