Mabel is a vital, energetic older lady whose husband passed on a few years ago. She has been thinking a lot about how to use her remaining time and energy. “None of us are going to get out here alive,” she tells me. “It is best to make the most of what you have, young man.” (I like anybody who calls me “young man”.)
Mabel has been receiving social security checks for years. She is an energetic grandmother and has been a successful landlady for more than twenty years.
She had twenty three units which are almost paid off. There is no depreciation left. The apartments are worth about $750,000.
“Do I own these apartments, or do they own me?” she asks. “Those apartments won’t love my grandkids or teach them my values, only I can do that. Time is more important than money,” according to Mabel.
The neighborhood is different today than when she and her husband bought there more than a dozen years ago. She used to enjoy visiting with her residents. That neighborhood has declined. She was not yet afraid to collect the rents there, but she knew that she wanted to get away from management of her units fairly soon.
She has had residents who have given her bad checks. It seems harder to get applicants whose credit and work history match her historic standards. In her mind the risk is increasing and maintenance is more of a chore now.
She was through managing real estate. She wanted to at least maintain her cash flow, and actually wanted to increase it.
We discussed three plans: 1) hiring a management company, 2) selling the building, paying the taxes and putting the money into corporate bonds or 3) moving the equity into well secured commercial rental property, which had no management responsibility.
First, we considered property management; there are about 400 property management companies in the county. We identified several which had a good reputation and serve the zip code in which her apartments are located. This solution would have been good enough for many investors. Mabel, however, worried that this neighborhood might decline further. In fact she feared that values were still dropping here and she could not see any trends which made her believe that values would ever rebound in this section. “Cut your losses and get on with the balance of your life!” she concluded. Mabel wanted to dispose of the apartments.
As we talked more, it was obvious that she had no interest in moving the equity into other apartments, even if they were newer or in a better area. Mabel would not lower her credit standards. She wanted tenants with higher net worth and more liquidity.
The next possible solution was to sell the apartments, pay the $180,000 in taxes and to invest the proceeds in corporate bonds. One of her daughters, married to a stock broker, especially liked this idea. Mabel, however, hated the idea of paying $180,000 in taxes. “Do you know how many years my husband worked to make $180,000?! Besides those politicians only waste the money!”
Do you get the idea that Mabel is a person who speaks the truth? She understands Churchill’s idea that speaking the truth is thrilling.
Her daughter tried to persuade her that the bonds had liquidity and were secure. Those facts were true, but Mabel said that the tax money would be enough to pay for a lot of college years for the grandchildren. The daughter recognized that Mabel was right, so we looked for a better solution.
The best solution involved a tax deferred exchange into a commercial property which was leased to a national tenant for 17 years. The tax deferred exchange, also called a “1031 exchange,” allowed her to move her equity without having to pay any taxes now. Mabel exclaimed,“This is like getting a $180,000 loan, interest free, from the government.” We did everything required to satisfy the IRS regulations and completed the tax deferred exchange.
The apartments were sold and the money used to buy a building which was leased by a national company, traded on the New York Stock Exchange. The retail tenant was the only tenant in this free standing building next to major retail mall. The lease required the retailer to pay all the taxes, maintenance, insurance and property management expenses.
Mabel’s only responsibility is to cash the rent check!
This kind of lease is called “net, net, net” because the landlord receives rents net of: taxes, insurance and maintenance. Net, net, net leases, also called triple net leases, are used when the tenant has especially good credit. Typical clients are fast food chains, automotive users, and even day care Centers.
Mabel’s daughter worried that the tenant might go broke or move; a reasonable concern. The national chain, however, had a far higher net worth than all of Mabel apartment tenants combined. The location was so good that a new tenant would probably pay as much, maybe more for the building if the current tenant left. Often that is true with net, net, net leased property. The leases, often written for ten to twenty years, usually carry inflation clauses that give the landlord a bonus when sales exceed a certain dollar amount. In inflationary times the landlord is well protected.
Mabel was able to choose whether she would rather be close to the property or have more cash flow. She discovered that properties like these are in high demand in San Diego. Other investors were willing to pay more for a store building in San Diego than those outside of California. Her daughter wanted her to be able to see the property every week. Mabel decided that she would rather have $6,000 more cash flow. She selected a property rented by the same chain, but in another state.
This solution means that Mabel is receiving more after tax cash flow, because the tenant pays the property taxes, insurance and maintenance she is free from those concerns.
The numbers demonstrate the results:
|Main emotion||Worry||Time with family|
|Property||23 apartments||Free standing retail|
|Tenants||working class families||National retailer|
|Debt||$ 15,000||$ 800,000|
|23 Units||NNN Builiding|
|Gross possible rents||$120,000||$135,000|
|Vacancy & credit loss||(12,000)||(5,000)|
|Taxes, insurance, maintenance other expenses||(43,000)||0|
|Net Operating Income||65,000||130,000|
|Pre-tax Cash Flow||60,000||55,000|
|After Tax Cash Flow||$40,000||$42,000|
* The transaction costs changed her equity slightly.
** Depreciation allows owners to deduct for the wear and tear on their buildings. It is a non-cash expense which reduces taxable income. The tax calculations are best done by a tax advisor. Generally when one buys a property with greater value there are more tax benefits, deductions, available.
In summary, Mabel was able to achieve all her objectives. She saved her investment from a declining area, she avoided paying capital gains taxes, she got out of management and increased her cash flow. She showed that she owned her investments; they did not own her. She is able to use her time and energy in ways that matter most to her.