You hear the phrase “Cash is king” quite a bit in the finance world. I don’t agree – whether you are concerned about inflation or not, having your money in cash is not the most efficient use of your capital. I prefer “Cash flow is king”. That is why I buy real assets that produce reliable cash flow. I also prefer to invest passively. This means I am generally not involved in the underlying operations of the investment; rather, I trust a manager to oversee and control the investment.
For the first 25 years of my investing life, I was fully invested in the stock market and mutual funds. It’s funny, but becoming a financial advisor is what finally taught me that there is a better way. In my years as an advisor, I spent a lot of time educating myself on finances, markets and how money works.
What I learned surprised me – not many people build sustainable wealth in the stock market alone. Also, research has shown that the average investor earns returns lower than the market (check out this article by The Balance). There are many reasons for this, but mainly I think the system favors the product providers rather than the product investors. Banks, brokers, advisors, and market makers all make money whether the market goes up or down.
This realization ended my financial advising career and is why I started a community called Left Field Investors to help educate people how to invest passively in real estate syndications. There are a multitude of reasons why I invest in real estate – significant tax benefits, forced appreciation, market appreciation, leverage, principal pay down, and cash flow from operations.
One of the main advantages of investing in real estate is multiple opportunities for reliable cash flow. I usually don’t invest in a deal unless I am confident it will provide me with monthly or quarterly cash distributions within the first six months.
Real Estate Investment Trusts (REITs)
A REIT is a company that owns, and often operates, income-generating real estate. You can see Sure Dividend’s full REIT list here.
REITs are popular with investors because they have some of the benefits of both the stock market and of the real estate market. Some of the positives of REITs include higher liquidity than owning physical real estate, receiving regular distributions of cash from operations (average 4-5% yield), ease of investing, leverage, and exposure to the real estate asset class. The one benefit you get that is generally not present in stock market investments is you benefit from the leverage the operator might use at the asset level.
The downsides to investing in REITs are similar to stock market investing: exposure to market volatility; no direct control or influence over the asset; comparatively low cash flow; and you do not receive the tax benefits of investing directly in real estate because REITs are taxed as portfolio income.
Real Estate Syndications
Real estate syndications are typically single-asset LLC’s (some are set up as funds) that buy and operate a real estate asset (multifamily apartment buildings, self-storage, commercial/retail properties, and industrial triple net leases are a few common asset classes).
Some of the benefits of investing in a real estate syndication are forced appreciation, market appreciation, significant tax benefits through depreciation, leverage, principal pay down, and cash flow from operations. The key is to invest alongside the syndicators as a passive investor so that you do not have to find or manage the asset.
With real estate, you are not as reliant on the market for your investment returns. You will receive regular cash flow distributions and can benefit from “forced appreciation” later when the asset is refinanced or sold. This type of appreciation means that regardless of the market cycle, the syndicator can make improvements to the property. For multifamily properties, this could be through unit upgrades, washer/dryer installations, and even dog fences.
Higher rents can be charged because tenants want these upgrades. This, in turn, increases the net operating income (NOI), which directly increases the value of the property. Even if market forces do not allow rent increases to be maximized through forced appreciation, cash flow from these properties will not decrease significantly with a drop in the value of the asset.
Owning real estate through a syndication allows you to earn your share of the depreciation on the property. This type of “paper loss” lowers your taxable income by offsetting gains from cash flow and capital gains from real estate. This is taxed as passive income, which has the lowest tax rate, and any excess losses can be carried forward to future years. One of the best ways to maximize your wealth is through reducing and deferring taxes and owning real estate is one of the best ways to mitigate your tax burden.
Leverage is also a significant benefit of investing in real estate. A typical real estate syndication might finance up to 75% of the purchase price of an asset. That means an asset that is bought for $10 million will only need $2.5 million of cash to purchase the asset. If the operator is able to force appreciation and the asset grows to a value of $12.5 million, the $2.5 million of gain goes 100% to the owners of the equity. The equity owners doubled the value of their investment even though the asset only appreciated 25%.
An additional benefit of a real estate syndication is that the principal on the loan is effectively paid by the tenants in the property. This directly adds to the value of the property and is credited to the account of the equity owners.
Lastly, a real estate syndication typically results in reliable cash flow from operations. It is common to get a preferred return (pref) of 6-8%. The pref is the return the sponsor will pay before they are compensated based on the performance of the project. If the pref is not met during the hold time of the property, then the pref must be paid out of the sales proceeds before the sponsor receives compensation.
You can also receive cash flow in the form of return of your capital if the property is refinanced once some of the improvements have been done. Return of capital is not a taxable event, so you could receive your entire investment back, still own the asset and continue to receive cash flow from operations. This is called “velocity of money” – you can now use the returned capital to buy a second cash flowing asset.
Now you own two assets and have two separate streams of cash flow all from the same initial outlay. The last way to receive cash flow from the asset is when the asset sells. If there hasn’t been a refinance, you receive your original capital plus any gains.
There are many ways to generate regular cash flow from your investments. My experience has convinced me that investing in real assets that produce reliable cash flow is the more consistent way to build wealth. It is not a “get rich quick” scheme, but if you concentrate on regular cash flow from your assets, you will not be dependent on market appreciation alone for the growth of your portfolio.
One final example – if you had $1,000,000 at retirement, most financial advisors would recommend that you withdraw no more than 4% per year and they would recommend you not touch the principal. You could withdraw $40,000 every year. If you are in the 25% tax bracket, your net would be $30,000 from your $1 million nest egg.
Assuming there isn’t a large market correction early in retirement, you could hope to live on that $30,000 for the rest of your life and leave the $1,000,000 in principal to your estate as you can’t spend it down because you don’t know how long you will live.
In contrast, if you invested the $1 million in real estate syndications, you could reasonably assume you will receive at least 7% in annual cash distributions, so you would be receiving $70,000 annually. Under current tax laws, you would likely not pay any tax because you would have a large depreciation loss. Even though you are taking $70,000 in income, the value of the underlying asset is not decreasing – it is likely appreciating through forced or market (or both!) appreciation.
Over time, the value of your assets will grow as will your cash flow through rent increases, debt refinancing, and asset sales. As with the stock market, there is always the risk that asset prices will decrease, but it is unlikely that the operational cash flows will decrease at the same rate, if at all. It seems like a much safer and more reliable approach to retirement. Cash flow is king, so make sure you are investing in assets that produce income.
Jim Pfeifer is one of the founders of Left Field Investors. He is a full time investor living in Dublin, OH. He has invested in over 30 passive syndications in his quest to become financially free through the acquisition of real assets that produce real cash flow. You can connect with him at [email protected].
Nothing on this website should be considered financial advice. Investing involves risks which you assume. It is your duty to do your own due diligence. Read all documents and agreements before signing or investing in anything. It is your duty to consult with your own legal, financial and tax advisors regarding any investment.