How to Invest in Commercial Real Estate

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Episode #044 - How to Create Financial Freedom in Commercial Real Estate with Passive Cash Flow!

by Criterion, Braden Cheek, Brian Duck
January 11th 2022
00:00:00
Description

"Millionaires are trying to make more money, & billionaires are trying to save money on taxes." - Warren Buffet

Today our hosts Brian Duck, Braden Cheek & Joel Thompson from The Cri... More

uh and then you get to you can literally fund your lifestyle with the overflow without ever having to to sell or get rid of your nest egg. And then the more you invest, the more you grow that nest egg and the more that nest egg throws off that cash that you get to spend every quarter. And some of the investments I've done with precision, I've made all my money back through through distributions and now I'm still yeah I'm still getting paid that money and I'm in for no money. Alright hey everybody and welcome back to how to invest in commercial real estate. And today we're talking about the cash flow. So one of the most important things when investing in commercial real estate or really investing in anything is getting a cash on cash return. You know just cash flow in your mailbox, the passive income, that's what's most important here. Yeah. So how does that differ from most people's idea of investments? Because I would say 90% of people, they just put their money in the market through their 401K. And they're not they're not getting any cash on cash, all they just put it in there and they just hope it grows and when they're 65 they get access to it. And then the problem is once they want to sell it then they're like well I don't want to sell it because now I've got to pay taxes on it.

So they just let it sit there at least that's pretty much much what I've done with my stocks. Yeah. And then the key to income is really shifting as much as you can from active income when you're working for it. You're trading time for money to passive income where you're trading money for more money and not time. And that's what we're trying to talk about today is the idea of investing money and cash flow and commercial real estate and the ability to rely on that cash flow is huge and can be amazing. Yeah. I think the big point about distributions is we are sending people checks every quarter. And so, you know, it's one thing if you give me your money and then in 10 years, I promise you a certain return and maybe in 10 years that return comes and maybe, it doesn't. but by me sending you money every quarter, I'm reducing your basis in the investment. So effectively we're reducing your risk. And the great thing about distributions is like you said, you get money working for you, not only is your initial investment driving distributions that we pay, but then you can take those distributions and you can reinvest those and so now you're earning double on your invested dollars. Uh, and so for me, I think it's a great way to invest, is not just putting money in the market that could be a strategy, but the power of real estate distributions, every single quarter has been amazing for us and for our investors.

Yeah. And, and how many people have you talked to that said, Hey, I don't, I don't want the cash flow. You just keep that. I don't know if I've talked to any of our investors that have said that. No, they love getting, they love getting the checks because it's a sense that the investment is working. They don't have to guess every quarter what's happening with it. No, we send the cash, the xX cash that the investments throw off. We send it right to them and they can spend it. They can reinvest it. It just gives them peace of mind. Yeah. So just just last quarter, the third quarter of the year we have, we have a few months here. Just last quarter. How much did precision equity and criterion send out in distributions? Well, what I want to say first is, uh, these are my favorite times of the month that comes out of the year. It comes around four times a year. It's the end of quarters where we evaluate all of our investments and we get to decide how much money I'm gonna send my friends, family, co workers, relatives, anybody that's trusted us that's invested with us. I get to send them money back. So it really is the best thing about what we do. But this quarter I sent out about 150 checks over $600,000 in that cash flow that we sent out to investors.

That's the time. That's incredible. Yeah. It's my favorite time of year two, I find myself as an investor, I find myself, let's see what month is this? Okay, so man, 30 days it's my next round of checks. I can't wait. And then when they come I'm like well now I gotta wait another 90 days. But anyway. Yeah. But at least it's paying, at least it's paying you and a lot of people, you know, we're on the phone with an investor, a prospective investor the other week. And he was saying, hey, I'm just really, you know, I'm a high W two earner, I make decent money but I'm just trying to build up some passive income for retirement, you know, eventually I don't wanna have to work and I'm not going to be making this act of money And I need to invest in something that's gonna pay me every few months. Because even though 90 days may seem like a long time, you can you can live off of getting paid four times a Year. People, I mean a lot of people do it. Yeah, basically replaced my W2 money with my with those quarterly checks. So and that's what you know you were talking about this investor, that's what he's wanting to do. Yeah. Well so how many investments for people listening do you get to spend some of your earnings without having to sell the investment because with stocks, that's that I mean there are some dividend paying stocks.

Okay. but if it's just a typical IRA account or a four oh one K. Account or a Roth account, you can't get to the money. And even if you did, you have to sell the asset or parts parts of the asset to get cash flow. But here uh you can get cash flow but your money is still invested, it's still earning, we're still paying down that mortgage, the the assets still going up in value. Uh And then you get to, you can literally fund your lifestyle with the overflow without ever having to to sell or get rid of your nest egg. And then the more you invest, the more you grow that nest egg and the more that nest egg throws off that cash that you get to spend every quarter and some of the investments I've done with precision, I've made all my money back through through distributions and now I'm still paying, yeah, I'm still getting paid that money and I'm in for no money. Yeah. So so let's talk about that. Obviously when you go in and buy a long term cash flowing deal, you know, we're buying a lot of shopping centers. You could be buying an apartment complex, very similar structure. The sponsor is going in with the business plan, they're gonna say, hey, we're, we're gonna kick out quarterly distributions and they're probably gonna rise over time because we're going to increase the rents or or yada yada yada.

So how do you as a sponsor go about evaluating what amount to kick out? Because obviously you're not just sending out all of the cash that that business has, you know, the business still has money left, right. But yeah, a couple of things we do is we always want to have a certain amount of money in the account in case we have issues, maybe maintenance issues that aren't covered by the tenant's. Maybe we have tenants that move out the occupancy and apartment complex dips all those factors can adjust cash flow. And the last thing I want to do is to go back to the investor and have to do a cash call and effectively reduce people's ownership. That if they don't participate in that. Well, you probably don't want to reduce the check that they get right. If they get one check for this amount, one quarter, you don't really want to go backwards either. Yeah, it's consistency is really key. It gives them peace of mind. Exactly. You definitely don't want to ask them for money, but you probably don't want to go down in your amount either. So what we try to do is, uh, number what I do, maybe some other sponsors don't do is I pre raise, um, potentially a five year capital expenditure outlook. And so you know what I don't want to do, like you say, is to have a capital event where I need some cash and I haven't raised for it.

And now I've got to stop distributions in order to raise that capital and do a project. So for me, if there are projects that are going to be done, I'm going to raise that up front and put that into a safety account for the property so I can still distribute the cash that the property is generating without having to re raise any money for capital. And I raise capital expenditure money in addition to operating capital. So depending on how large the deal is. Just with the fluctuations of cash flow and things that might happen, leasing commissions and T I and things, I'm also raising a decent amount of operating capital where it can ebb and flow with the monthly expense cycle, we're, we're never in jeopardy of of, you know, not distributing what I've told them, we're going to distribute or having to raise a little bit of extra and you kind of have that operating income number sort of in your head each each quarter when you're distributing. So that you say, okay, I'm gonna keep that amount in here all the time. So if we get xx cash and it's, it's well over this, uh, this amount that I need for operating then now it's time to consider raising the distribution. So if I get like we've done a village south shopping center, we have here in Tulsa where the the Capex I over raised and then the property keeps exceeding expectation.

So that Capex budget just is getting too big and too to the point where it's excess, I don't need that much money in the account. That's when we start raising the distributions and paying even more money out to the investors. So in essence, you know, quarter over quarter were literally just distributing the prophet really that that property made, because you said we kind of go in and and pre raise Capex or T. I. Or tenant improvements is what T. I means leasing commissions, um, your, your pre funding that. So it's really just, hey, the property made This much or all of our properties I guess last quarter alone made like $700,000. We were able to distribute that to, to the investors. Yeah, that's, that's a ton of money. Yeah. For I mean to be able to shut off for us over 600,000 and criterion is growing um, every quarter and be able to pay that money out. It means we have a lot of profitable projects and I would say we typically would, would distribute slightly less than whatever the prophet is. Um, just because it's once again, I want to be consistent and so if I have a dip next month, I don't want to be always dropping it and having people ask me why did you drop it?

So we just distribute maybe slightly less than than the the ny that we made that way, I can keep it consistent and then if the account builds up, we increase it. So you'll go a few quarters before you decide, okay this is definitely on the way up, so now it's time to maybe go ahead And go to 12% return to maybe a 14% return. Alright, so it's the end of the year, you know, I'm filing my taxes and and brian, you mailed me $100,000 last year. Do I just emailed my accountants say, hey I got $100,000 worth of distributions from criterion through brian and uh Like what what what do I do? I'm assuming the $100,000 in distributions I got is all taxable, right? No, no it's not. So this $100,000 of course you're gonna get a K. One and it's going to reflect how much uh your income or your loss was and uh the income is offset by the depreciation. So uh and other costs. I mean we have, when we um operating account, we have our gross income and then we have all our costs, you know, utilities, maintenance, everything else.

And then we're gonna have a net income. And then that net income is kind of what's dis distributed but then um depreciation is taken off of that. And so we typically do uh what is it accelerated depreciation, right? Because A straight line, what is it? 27.5 years that normally you can depreciate. And that's what I think it maybe maybe 40 years. I don't know if there's a couple different times different ways. 27 a half. 39 years. But yeah, right now you can accelerate that. Yeah. And we're gonna operate or we're gonna own a property for, I don't know, 5 to 10 years. So we'd rather take depreciation as quickly as possible, right? And in those first few years, you know, you may have gotten $100,000 worth of distributions, but you may have gotten a negative K one, right? I mean, that's huge and zero taxes on That $100,000 of tax free cash flow and you're actually doing the right thing. Yeah. So, so people, if you're gonna high tax bracket getting $100,000 in distributions and let's say that first year or two, it's offset by depreciation to you. It's like getting $200,000 potentially with federal tax, state tax, Social Security, Medicare, 7.5% or whatever you're paying.

Uh So, so it's really, really powerful and you say, well Joel, I have to catch that back up. You do, but worst case, whenever we sell the property and you get that we have to catch all that back up, you're you're only gonna pay maximum about 24, on that money, which is a lot less than like uh you know, a single, a single male surgeon, let's just say, I mean that's probably a 35 40% tax bracket easily. But then with all the state and FICA tax and everything, it's a lot more. So it's probably almost half of a high income earner. And so it's not only do you get to pay half of the taxes, but you get to pay it years in the future. So that $100,000 you can be investing and earning 12, 15, 20% on that for 12345 years. And so you've made enough profit to pay the tax that you're going to go on that money even when we sell. And that's a huge benefit. And people have to understand how depreciation works and how offsetting your taxes, how powerful it is to push that into the future and then pay on a 30% or on a half, you know, 50% level that you would have otherwise paid.

There's a famous quote out there that we may have quoted several times in the show, but millionaires are trying to make more money and billionaires are trying to save money on taxes because 3% that they didn't pay, that you're on taxes on their income is is tens and tens of millions of dollars. I mean, you've, you've got to pay attention to taxes at some point in your life. You're gonna have to pay attention to, Hey, this is a more favorable tax environment to make money in and I can actually keep more of my money. Yes, that's a good point. I have a lot of friends that are high income earners and so they're in the highest tax bracket And uh you know, they may work hard at getting better at their career and trying to increase their their income, okay? But even if they increase their income 5% a year, 10% a year, which is a lot uh if they're paying half in taxes, the biggest uh bang for the buck on their time would be to educate themselves on how to pay less in taxes. We're not trying to evade taxes. We're just trying to to get depreciate able assets and other things to help offset that.

And of course you're gonna have to consult a tax uh professional in order to understand how to do that because there are, there are limits to how much uh depreciation losses you can apply to your personal income, your active income. So you have to kind of segment a segment your incomes and into active income and passive income and passive losses can be uh can be claimed against passive income. Okay? But very little passive loss can be claimed against active income. So uh you know, one suggestion and we won't get into it today is that I always suggest that people have the opportunity to have one family member be a real estate professional on a joint return that will enable them to take unlimited passive losses against active income if they can qualify as a real estate professional, at least one of them can. And they're finally jointly. Yeah, we we literally just made a facebook post about this about how at some point your real estate investing career may be advantageous to get a real estate license. And that was one of the key indicators is I think a real estate license gets you that designation. I don't I wouldn't say, let's say you're spending 60 hours a week as a project engineer.

I don't think just having the real estate designation gets you there. I think you have to spend a certain number of hours a week. Uh once again though, if there's if there's a stay at home spouse or maybe a spouse as a part time job and they start doing real estate, they can qualify. And since it's a joint return, I you know, once again get some advice. But I think that's how you can really take advantage of the passive losses. Well and the RRS is very specific on that. So if anybody wants to look look it up, you can you can find out what the I. R. S. Says you have to meet what qualifications you have to meet to to be a real estate professional. Yeah, but we're getting off on that today was about distributions. Yeah. So there's there's another one. Um you know, net net operating income like brian discussed earlier isn't always what you're distributing out to the investors because typically you're going in and you're leveraging the asset with some sort of debt. So you're taking this net operating income, you're kind of gross profitability, you're paying your debt service and then you have the distributable cash to your investor in a big way we structure our deals is getting long term Amateur ization schedules and that really just gets the cash and our investors pocket instead of the lenders pocket, then you have to wait until it sells to get that money back.

And I mean that's because your your your debt payments on a monthly basis or lower or lower allowing you to keep so more bottom line income. Yeah. Which Is that cash flow? So I mean that that's the difference in paying out a nine or 10% return and paying out a 12 or 13% return. It's just the the am schedule and how long your lender is taking to get paid back. And if you've got a strong enough asset which most of the time we do they'll allow you that longer and schedule which is huge. Absolutely. Yeah. So the advice I want to give people today is uh get yourself earning passive income as soon as possible, your number one goal as as a worker should be to convert earned income into passive income. So every dollar you make if you can save and get invested wisely then that money will earn you money without working. And pretty soon you'll build up the passive income to where you'll be like okay I'm spending all year Working for 50,000, a year, you know 40 50 hours a week over 2000 hours. And and this now I'm getting an almost an equivalent amount from passive income and I'm not working at all for that.

What am I doing at my day job? Right? Maybe I should stop and focus 100% on driving this this passive income and that's the day your life changes when you when you can substitute passive income for your earned income, you pay less taxes on it, so you don't need as much of it uh and you get freedom, you get your freedom back. I think we have to end it right there because that poses some great question um at the end of the episode, I mean that's that's huge, That's great. Alright guys, we'll see you next time on how to invest in commercial real estate. Yeah.

Episode #044 - How to Create Financial Freedom in Commercial Real Estate with Passive Cash Flow!
Episode #044 - How to Create Financial Freedom in Commercial Real Estate with Passive Cash Flow!
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