Investing in Commercial Real Estate

Dennis Bethel MD

Dennis Bethel MD

[Editor's Note:  Dennis Bethel, MD, is an emergency doctor and a real estate investor.  He submitted this guest post recently.  He is also starting a blog called NestEggRx.com, where he discusses investing, mostly in real estate.  He graciously contributed this guest post.  We have no financial relationship.]

I’ve worked as an Emergency Medicine Physician for over a decade now.  Most of that time, I’ve also been investing in real estate.  Real estate has been good to me and I’ve been asked to share my story and strategy with the White Coat Investor community.

BURNOUT

I finished Residency in 2002 and started my career as an Emergency Medicine Physician.  Chronic understaffing, increased regulation, and the rigors of shiftwork caught up to me and eventually led to burnout.  I began to see earned-income as a trap in which you trade your time for heavily taxed income.  I knew I had to get out, but my options were limited – there is no insurance for burnout.

COMMERCIAL REAL ESTATE

I had been investing for years in residential real estate (primarily four-plexes) and was on the long, hard path to financial freedom.  Since there are no economies of scale in residential real estate, the cash-flow was small and unpredictable.  The rents from my properties would eventually replace my income as a physician, however, that wasn’t going to happen until the 30 year notes were paid off.  In the meantime, I had managed to create a second job for myself managing the properties.

I wasn’t willing to wait 30 years and my second job as a property manager was contributing to my burnout.  That is when I began to look into commercial real estate.  I had four goals in mind:

  1. Capital Preservation
  2. Multisource Income
  3. Minimizing Taxes
  4. Use of Wealth Accelerators

MULTIFAMILY COMMERCIAL INVESTING

I ultimately landed on multifamily commercial investing.  It was a natural fit for me, as I was already investing in and managing smaller apartments.  Shelter is a basic need and people will give up their luxuries long before they give up the roof over their head.

I just needed to go bigger!

Properties with 100 – 250 units and larger had economies of scale that were not available to me with four-plexes.  While I was the only investor with my residential properties, with commercial multifamily investments I could join like-minded investors to invest in these multimillion dollar properties as a fractional, passive owner.

While all investments have risk, the safety profile of commercial multifamily impressed me:

  1. Ability to choose the best markets and submarkets to invest in
  2. Extremely low foreclosure rate for Fannie and Freddie underwritten properties (1% – 2%)
  3. Bulk Buying
  4. Use of Non-Recourse Lending
  5. Ability to insure against loss
  6. Incremental return of initial capital investment through monthly or quarterly distributions
  7. Use of Sole Purpose Entity Structures like LLC’s for Asset Protection

MULTIFAMILY INVESTING = MULTISOURCE INCOME


The commercial multifamily investor can experience financial gain from three different sources: Cash-flow, Principal Pay-down, and Appreciation.

There is a fourth source of income if you count the reduction and or elimination of taxes, but more on that in the next section.

Over the past several years, I invested in multiple large multifamily properties as a fractional investor.  Each property has its nuances, but they have all returned positive cash-flow regularly.  When I factor in the principal pay-down from the tenants and appreciation that comes with increases in net-operating income (NOI), I am obtaining double digit returns on investment (ROI) on each property.

The apartments are managed on a daily basis by professional property managers.  No more tenant headaches, and the scale of the investments have kept my returns consistent.  I am now able to work part-time in medicine and am on track to reach my goal of retiring before I turn 50 utilizing these passive streams of income.

THE POWER OF LEVERAGE

Leverage (the use of fixed bank financing), as a means to purchase a property allows for a larger return on investment than is possible without financing.  For multifamily commercial properties, banks will generally provide non-recourse lending up to 75% loan-to-value on properties with a 1.25 debt-service coverage ratio (annual NOI divided by annual debt service) and higher.  As previously mentioned the safest deals are underwritten by Freddie Mac or Fannie Mae and have a national foreclosure rate of just 1% – 2%.  The better markets have even lower rates.

VELOCITY OF MONEY

Velocity of money, in its simplest terms, is how quickly a dollar invested returns to the investor to be reinvested.  With traditional stock or mutual fund investing you either buy, hold, or sell.  If your investment goes up in value significantly, you will have to sell it (and likely pay taxes) to access your equity.

With real estate you can keep your performing investment and still access your growing equity tax-free through a refinance.  This is known as equity harvesting and is a way that one property can become two properties and then two can become four over time.

MINIMIZING TAXES

Historically, taxes have been my biggest expense.  My earned income as a physician is taxed at a very high rate.  Developing reliable passive income streams with a minimal tax obligation was a top priority of mine.  Fortunately, real estate investing happens to be one of the most tax-advantaged investments around.

  1. Depreciation and Accelerated Depreciation via a Cost Segregation Study

-gives a K1 paper loss despite actual gain

-generally allows one to take their cash flow tax-free unless they fall into the AMT

2.     Liquidity Events can allow for tax-deferred or tax-free gains

-Starker 1031 Exchange: allows for property sale while deferring the tax on any gain

-Equity Harvesting: refinancing is always tax-free

THE EVOLUTION OF MY INVESTMENTS

I was asked to include a section on how I discovered fractional ownership and the evolution of my real estate investments.

My first deal was a stroke of good fortune and a story of right place, right time.  One of the partners in my group years ago knew I was a real estate investor.  His wife was a real estate agent and putting together a group of investors to buy a 72 unit property in a highly advantageous location.  When a couple of their investors dropped out, I was asked to participate in the deal.

I purchased a 12.68% ownership stake and sold that interest back to the group three years later nearly doubling my money.    I ultimately left over rising operating expenses.  Two of the investors were managing the property instead of using professional management.  I wanted to utilize professional management in better, more stable markets.  Nevertheless, the experience was eye opening.  It was clear that there was money to be made.

REAL ESTATE INVESTMENT TRUSTS

I tried my hand at Real Estate Investment Trusts (REIT’s).  I made money in some REIT’s and lost money in one in particular.  Due to their size, I had less control over the markets that my money was being invested in.  I also had a real problem with what I considered to be a lack of transparency.

However, my biggest problem was the loss of tax savings.  A REIT is a paper asset.  In essence, it is real estate flavored stock.  As such, I lost all of the tax advantages I wrote about earlier.  Over the long-term, direct ownership of real estate has historically outperformed the returns for real estate investment trusts and with a much lower tax-burden.

SYNDICATORS

To avoid the drag of taxes and to maximize my returns, I have moved back to the strategy of fractional ownership of one property, in one LLC, in the markets I deem worthy of investing in, using professional property management.  I do this using a syndicator.  There are many syndicators out there of varying qualities.  Due diligence is important when choosing a syndicator and a proven track-record is of utmost importance.  Additionally, I think it’s important to make sure the syndicator’s interest is aligned with your own.  I personally feel that the syndicator should be paid for performance and quality of the investment.  I have seen deals in which the syndicator gets paid largely up front and regardless of whether the asset performs.  This incentivizes the syndicator to focus on volume of deals rather than quality of deals.

CONCLUSION

In summary, multifamily commercial real estate investing has multiple advantages.  While it may not be right for everyone and you won’t get rich overnight, you can significantly increase your gains while diversifying a portion of your portfolio outside of the stock market.

I’ve watched far too many of my colleagues push back retirement as the stock market and economic cycles ruined their plans.  Many of these same colleagues have asked me about real estate and have considered real estate investing for themselves.  However, the thought of managing tenants and toilets did not sit well with them.  They had no idea that they could enjoy all of the benefits of real estate ownership without having to become a landlord.

I have recently started an educational website intended to demystify the subject of real estate investing.  Our mission is to help physicians and other health care workers find financial freedom through real estate investing and education.

To Your Success!

Dennis Bethel, M.D.

 

 

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Comments

Investing in Commercial Real Estate — 28 Comments

  1. This was a great post and certainly very interesting. I did have a few quick questions:

    1) When you initially invested within your first commercial real estate property (you said 12.5%) roughly what percent of your portfolio was that initial payment?

    2) When you purchase a fraction of commercial real estate, did you take out an individual, personal/business loan for your 12.5%? Or is that 12.5% your down payment, and the group (all of the investors) took our a loan to purchase the property?

    3) While I know this will be covered more in your blog, as a somewhat novice towards purchasing commercial real estate, how did you initially evaluate safe/unsafe investments? Is there a journal, or newsletter in particular that you studied?

    Once your blog comes out I certainly will add it to my to-visit list. I appreciate your taking the time to post here.

  2. Hello Neil,

    It looks like the link above is broken. My website is up and can be found at http://www.nesteggrx.com.

    My first fractional deal cost me a little over $60K. We put 20% down as a group, so the raise was just under half a million. We financed the rest. I made a nice profit on that deal, but made a few mistakes. In those early days, I knew very little about market and submarket analysis. I got lucky in that I invested in a reasonably good market, and the submarket was outstanding. It was a full recourse loan and I was a guarantor which was a mistake. Nothing bad happened, but non-recourse lending is the way to go. That removes a lot of risk.

    There is a lot more on mitigating risk and the safety profile of multifamily commercial real estate on the website. Feel free to post more questions here or drop me an email at dennis@nesteggrx.com.

  3. Is it more that you regret going to medical school in general, or was it ER specifically that burnt you out?

    I long for the day when i don’t have to practice as well.

  4. Great post. Love the idea of being an investor rather than a landlord. Are there good books or other educational materials you recommend on this topic?

  5. z…..Great question. Hard for me to answer. There are things unique to emergency medicine and things in general that I dislike. Too many to list here.

    On the other hand, medicine has been good to me and I truly am appreciative for all of the people I have been able to help. It has provided for my family and gave me the money to start investing in real estate. Being able to work part-time and have more control over my schedule has been a blessing.

    Steve, stay tuned to the website. More to come. I’m not aware of any books on fractional passive investing. Most books are written for the active investor who wants to roll-up his or her sleeves and get to work. Many recommend residential real estate and having done that myself, I’m not a fan.

  6. For years my family owned several apartments. We tried to manage them ourselves but found it too difficult to keep up. The smartest move we made was to turn all of the management over to a company. They were able to keep the apartments occupied and well maintained. It was at that point that we actually saw a positive cash flow.

    This sounds like a great opportunity, when you go to most financial advisors they do not offer fractional investments as a way to diversify.

    • One key to getting a positive cash flow is putting enough money down. Unless you can get a screaming deal on a buy or have ridiculously low financing costs, it can be pretty tough to have positive cash flow until you get ~30% equity in the property. You can get that either by putting money down, or waiting a few years until rents (and thus the value of the property) go up. I have a slightly negative cash flow (although a positive return thanks to amortization and depreciation) on my rental property, but I probably only have an 80-85% debt to value ratio. This is why getting the often-discussed 0% down positive cash flow property is so hard.

      • I agree with you that 0% down positive cash flow is difficult– but probably not important for most of the high income investors you are targeting here. The primary purpose of debt in a real estate investment is to increase Return on Equity by giving up the “safe” portion of the cash flow to the creditor.

        This is important for low net worth folks but for investors with more income the added risk due to the added leverage is probably not worthwhile.

        We have 10% ROI investments available with no leveraging at all– the investor money is in first mortgage position which means that the investor captures the “safe” portion of the cash flow and gets a better than average return without the risk of leverage.

        How did we do this? We found an under-served niche, in essence we found a market segment where we can get a lot of “screaming good deals”. Within a couple of years this niche will evaporate but the good news is it will evaporate on the buy side first so we will know its time to quit when we can no longer buy on our numbers.

  7. Hey WCI,

    So what do you think of commercial multi-family real estate investing vs. paper assets like stocks and bonds?

    Thanks.

    • I don’t own any commercial multi-family real estate. I’m not an expert in it by any means. I like the idea of having a portion of my assets not tied to the stock and bonds markets. I also like the idea of getting solid returns without having to personally do property management chores. I’m confident I don’t understand all the downsides, which is pretty important when it comes to investing in something.

  8. I like the post and comments! I am looking at purchasing an 8plex in a good rental market…have not made the plunge to fractional realestate investing. I am currently looking at financing options. I have another commercial loan (that I am trying to refinance) and I do not like its terms. (5 year rate reset, etc) I want to lock in the low rates for most or all of the loan term…any suggestions on commercial lenders that offer fixed rates over a longer term? (like 15 year fixed rate on 15 or 20 year amoritization)

    • That mix of terms is going to be pretty much limited to FHA approved multi-family loan. On the small number of units the fees are going to appear high but you can lock a rate for up to 30 years and borrow non-recourse.

  9. I like the idea of not being a landlord better if the same returns are possible but I suspect that there will be more downside and the only think you will get out of it is diversification and not better overall returns.

    I think real estate in general can be a good investment, but I also don’t think it is for everyone. I have never done commerical property but I have done residential property because I figure no matter what happens in business, whether companies outsource call centers to India or new environmental regulations drive some companies out of business, everyone needs somewhere to lay their head at night.
    So then I start looking at the numbers. For a single family house the numbers that seem to make sense are where you are getting as large a rent to value ratio as possible. Most real estate investors strive for the somewhat mythical 2% rule. I think it could happen if real estate investing is your profession, but this is a website for incredibly busy people that don’t have time to rehab a rental property and make the connections necessary to buy properties for $50,000 and get $1000 a month rent. I think it is more realistic to buy a property for 80K-85K and rent it for $1000 a month. Lets break down some numbers. lets say you buy a home for $80,000. You put $20,000 down and pay $5000 in closing costs. Total $25,000. I know it is 25% down but after 4 loans Fannie and Freddie start making you put 30% down anyway. Lets say you get a 30 year mortgage at 4.5% and pay the minimum payments for the next 30 years. A good rule of thumb is that after expenses (property management, maintenance, taxes, vacancy, etc) you will keep half of your rent over the long haul and then you need to subtract principle and interest payments. This is backed up by data from apartment complexes. I’m not sure if it is true for SFH but I think it is a reasonable assumption. Lets say that rents keep pace with inflation at 3% per year and the house appreciates at 3% per year as well over the next 30 years. Total rent payments for the property are $570,905. Half of this is $285452.50. The total of payments on a $60,000 loan for 30 years is $109,444.03. The total cash flow would be $176008.47. The home would be worth $194,181.00 at the end of 30 years if the home kept pace with inflation. Total from the investment of $25,000 is $370189.47.

    That is a total return of 9.4% per year.

    That is not too shabby, but I would say it is a lot more work and a lot more liability exposure for that return, considering an 8% return is possible with a well diversified asset allocation in the stock and bond markets. I didn’t put in the tax savings which could be significant or the legal fees needed to set up LLC’s and umbrella policy insurance and little extra expenses that can decrease the total return.
    I just mainly wanted to write this so my colleagues have an idea of what they are getting into and see if it is really worth the extra percentage point a year for the time and effort to manage a rental.

    • Tom,

      Nice analysis of a “typical” real estate transaction and I agree with you that the “average” high-income earner would be much better off in something more passive and spending the time billing at their higher “day job” rate.

      That said there are a lot of private placement investments out there that are no more active than the work to keep your diversified stock portfolio tuned up. Personally I’m offering some 10% annual rate 5 year annuities backed by cash-flowing property that requires no management by the investor.

        • We are purchasing condominiums in the Chicago metro area for cash and selling them on long-term fixed rate Land Contracts. In order to to recapture our cash and use it to buy more condos we are allowing private investors to invest in that cash flow by making new first mortgages secured by the title of the Condos.

          5 to 7 years of the Land Contract payments (discounted at 10% rate) is enough for us to recoup our costs so that is the portion we are offering to investors. Our profit lies primarily in the cash flow for the remaining years of the Land Contract debt.

          So a $33,000 investment, for example, would produce $700 per month for 60 months or a total of $42,000.

          Risk is mitigated by funded reserves of 6 months payment held in escrow by an accounting firm not related to me.

          Each investment is secured by a single property. $30,000 minimums.

          A Disclosure Document is available outlining risks and structures for those who are interested.

          Mark@blackhallpartners.com

  10. I agree with the WCI, that understanding risk is important before investing in anything. My website is focused on education and my next post will be on the risks.

    Spencer…The two commercial multifamily lenders that have been used most on my properties are Berkadia and Walker Dunlop. I do not know if they would lend on a property that small, but it may be worth giving them a call to find out. You may have to shop around with local lenders. If the 8 units are divided into two buildings and or addresses, you may be able to qualify for residential lending by calling them two 4plexes. You would have to get two loans instead of one and consequently more fees. However, you could then lock in the low interest rate for 30 years.

  11. Tom…I agree with you that residential real estate (1-4 units) is tough. I’ve been there done that and its not fun. Its the long, hard, path to wealth. If you buy enough of them and you pay the notes off (upto 30 years) you can accumulate a significant net worth and cash flow. I do NOT recommend it. By going bigger and using economies of scale, you can achieve far better returns than what you’ve described without the headaches. I will never do residential again.

  12. In regards to multifamily commercial investing, my newbie questions are -

    1)Can it be suitable for a 57yr old Doc, close to early retirement, i.e the time span for the returns is short vs a 30yr old. What do you think ?

    2)How much money are you talking about for initial investment ?

    3)The question of Trust, how much can you trust a General Partner/ CEO , whom you do not know vs say, Manager of Vangaurd Index Funds, where there is a Board (I presume) with some built in checks and balances. How are they(All coats and suits)kept accountable.

    4)The newness of this kind of investing does make you anxious(Maybe I was anxious 25yrs back too, when I initially started with the Mutual Funds).

    5)In theory, it makes a lot of sense though.

  13. Hello Raj,

    Let me answer in generalities as I don’t know the specifics of your situation and ultimately only you can decide whether an investment is right for you or not.

    1) Is this right for a 57 year old? They way I invest in real estate is for the long-term. I buy in the best markets and hold primarily for yield (cash-flow) and secondarily for growth. In my mind, this works well for all age groups. The advantage I see for someone your age is that multifamily real estate tends to be much less volatile than the stock market. I have a partner in his 60′s and one who is 59 that wanted to retire in 2009. They both were heavily in the stock market and are both still working. The trade off for less volatility is less liquidity. So if you are going to do this, you will have to decide what percentage of your portfolio you would be comfortable having in less liquid assets.

    • Also, if you are looking to leave a legacy, it is nice for your heirs to inherit the real estate on a stepped up basis.

      2) Every syndicator is different.

      3) Like all investments, due diligence is important. I think you start by interviewing the executive team, scrutinizing their track record, and speaking with several of their investors. What I like about real estate is that you can do even more due diligence than that if you wish. It’s a physical asset, so you can fly out and visit the asset. You can speak with the property management company and or onsite manager. You can speak with the lawyer who drew up the contracts, the insurance company who is providing insurance. You can speak with the lender, the title company…..heck, you can even speak with the gardener if you like. I’m not suggesting that you have to do all of that, but you can if you want. It is very transparent that way.

      • Lastly, I believe you should not invest in something until you understand it well. Real estate has been good to me and many people that I know. However, that doesn’t mean it is right for everyone. Unfortunately, many people write it off because they don’t understand it or know someone who failed as a weekend property manager. They are missing out on some incredible opportunities.

        In my mind, it is better to educate yourself on the investment (and that goes for any type of investment) and then you can make an informed decision as to whether that investment is right for you or not.

  14. First time on the website, what a great resource. I am not an MD/DO but I have worked in the medical field for a several years and have seen the squeeze of physicians and have several newly minted physician college friends. With that said, IMHO there is only one way to buy your SFR (single family residences) and that is to buy them directly from wholesalers or brokers as pocket listings. You need to be able to your properties at a price that would qualify for “hard money lending” or at least 70% or less of ARV or after repair value. There are several reasons for this 1) You build instant equity into your property once you rehab it 2) You finance most or all of the repairs into the deal and don’t pay for them out of your pocket 3) Your major repairs are done and you don’t have to worry about a single HVAC, roof, foundation problem to wipe out your entire return for the year 4) great positive cash flow due to low PITI (principal interest taxes and insurance) 5) Once you have a few properties you sell them to cash in your equity and roll it into a multifamily property TAX FREE with a 1031 exchange.

    An example,
    3/2/2 House 1,200 sq/ft
    bought at $52k
    ARV $96k
    Repairs $12k (new sheet rock, paint and condenser)
    All In Price $64k
    Hard Money Loan plus closing costs $10.5k
    PITI- $791
    Rent-$1,200
    Cash Flow- $409 x 12= 4,908
    Cash on Cash Return- 46.7%
    Equity- $32k, I know, equity is subject to markets, but either way you will have actually “forced appreciation” on a SFR investment
    Outside Management Costs- $80-$100 a month, but if you have a perfectly rehabbed house and a strong lease with the tenant paying the first $200 in repair costs outside of large capital expenditures (roof, electrical, etc) you will have a quality investment that won’t cost you much if anything in time. If you want to stay in the SFR realm plan on expending pretty large capital expenditures every 7-8 years and set aside money accordingly. However, I suggest you get out of the SFR game as soon as possible and cash in that equity you have built and invest into properties that you can perform “value add” techniques to build large amounts of forced appreciation to be refinanced out or sold and reinvested into more stable, long term passive properties.

    If you are serious about real estate, make darn sure you aren’t going about it as a “hobby” and more like the business that it is, or invest your money with folks like Dennis. If you don’t, you will be the burnt out landlord that sells for a song. Everything is a system, you need to have an exact answer to every facet of the business, for sourcing, renting, selling, dealing with tenant issues, etc.

    If you are interested in more, check out.
    “Investing in Apartment Buildings” Matthew Martinez
    “Multifamily Millions” Dave Lindahl
    “ABCs of Property Management” Ken McElroy

    Please let me know if I can make any of my ramblings more concise, thanks for the great website. I will send my MD friends this way.

    Trevor

  15. What would the difference between investing in a REIT and fractional ownership be? I understand, maybe incorrectly, that REITs invest in large properties and pass profits in the form of dividends to investors and then these shares of dividends are bought and sold. Fractional ownership seems to be pooling your money with several people to buy a share of future rents or “dividends.”

    So wouldn’t the investment Denise is proposing be similar to a privately traded REIT?

    I think the key difference would be that Denise is suggesting LLC instead of REIT for tax structure which does make a difference but I’m not too sure what that would be.

    Thanks for the help!

  16. Hello Stan,
    REIT’s are real estate flavored stock. In other words, they are paper assets and not physical assets. They follow the market cycles and as such correlate closely with the stock market. Ownership of actual real estate (whether whole or fractional) follows population cycles and is not correlated with the stock market. Additionally, real estate investing has some of the best tax advantages available to investors. Unfortunately, those tax advantages are not available to REIT owners.

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