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45 Properties For 1
| | Tuesday, June 06, 2006 @ 08:09 AM EDT
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Contributed by: Ed Meyer
Ed Meyer Properties
Read more archived articles about Tax Strategies
I recently completed a 1031 exchange where I relinquished one 3 bedroom, 2 bath house for 45 separate properties. This project had been in the works for about seven months. The relinquished house is in Stockton, CA and the replacement properties are in Oklahoma City.
This was a project with many interesting challenges. The two that presented the most challenge were lining up the financing and conforming to the 1031 tax deferred exchange laws.
Stockton
First, the house in Stockton is one that I acquired by foreclosing on a note that I purchased over 20 years ago. I paid about $6,000 for the note. The house had the same tenant for over 17 years (I never met her until after 15 years!) and then I rehabbed the house and rented it out for the last 3+ years. I netted about $315,000 when it sold last September (buying and holding ain’t so bad!).
Oklahoma City
I traveled to Oklahoma City with the idea that I would trade my house for an apartment building and found one that I wanted to check out that was advertised as 70 units on 10 acres. While I was intrigued by the property, the actual income was about half of what was in the pro forma. My last day in OKC I walked into a realty office and the agent told me there were 49 properties (mostly houses) he had listed for about $3M. The light went on with the thought that a 10% down purchase might be a possibility. Four properties were discarded because they had lease options on them.
An Alignment of the Planets
There are several factors that enabled this to take place or make this an attractive deal. First, they were all owned by one owner. This was important because of the 1031 exchange. The only exchange rule that was available is the 95% rule that places no restriction on the number of replacement properties or their total value, but requires that you close at least 95% of the total value of the identified replacement properties. The identification must be done within 45 days of the sale of the relinquished property(ies). The replacement properties must be closed within 180 days of the sale of the relinquished property(ies) (some modification depending on the time taxes are filed). With more than one seller means more negotiations and more risk that one seller may pull out.
Second, the seller has a property management company and wanted to continue managing the properties after the sale. This had great appeal to me. I have had very good experiences when former owners manage my new properties. They know the market, they know the tenants, they know service people and there is a near seamless transition after the sale. Since the seller and new manager is the same person, the management contract became part of the negotiation.
On inspection and discussion it became clear that the seller takes very good care of the properties and tenants. This was a definite plus.
Financing
My concern here was not about coming up with clever means of financing but to come up with any means of financing. Initially, I set a threshold of 6.5 % interest rate and was looking for 30 year, fully amortized loans. I went through 3 loan brokers before finding one that I thought had a chance of pulling this off. One reason for the 30 year horizon is that I do not want to re-finance 55 loans in five years when a loan product goes adjustable. Furthermore, it is difficult to predict what interest rates will be or what the real estate market will be if it is necessary to sell.
One problem is the Freddie/Fannie restriction on having 10 or fewer real estate loans show up on a credit report. This means that I was definitely going to need many non-conforming loan. We examined the possibility of blanket loans (loans secured by more than one property) but there were restrictions on number of properties and the lenders wanted more than 10% down. The other constraint is that there is a limit to the number of loans one person can have with a given lender. There are seven different lenders involved. I have some properties with 90% loans, some with two loans (80—20) and some that are 100% financed. My blended rate is somewhere near 7.5%.
Negotiating Ideas
There were a few interesting ideas in the negotiations. For giving the seller close to his price I was able to get management at 1% for the first two years. This increases and winds up at 6% at the end of six years. This seemed like a good trade for me since whatever incremental price I paid is financed over 30 years. Another idea was to lower the price of a six unit building in order to assume a private loan with 10% down. The prices of the remaining 44 properties were raised slightly so that the offering price is the same. The note holder backed out and I had to go with a local bank. The good news is that there was enough equity for me to get the bank loan (commercial loan since over 5 units) yet my overall down payment was less than 10%. Also I have a lot of equity in one of the properties should I need to sell for cash.
Expensive Transaction
Yes, I had to dig into my pocket for cash to complete this transaction. Loan fees were over $45,000. Appraisal fees were around $18,000. There was also initial interest on some loans, initial escrow funds for escrow accounts (taxes and insurance). I did get a bargain on the exchange costs. The Qualified Intermediary charged me only $1500 for all 45 of them.
Where Am I Now?
My mailbox is often stuffed because of the number of loans and insurance policies. Keeping track and handling transactions and information is certainly a challenge. One continuing issue is that lenders sell their paper to others so there are new loan numbers that need to replace old ones in my record keeping. I am continuing to refine my record keeping to produce information I can use to help stay on top of everything.
On the plus side my house grossed $1175 per month where my new acquisitions have a scheduled income close to $35,000 per month. Since most of these are houses there is good possibility for increasing cash flow using lease options. Keep in mind that the genesis of most of this was a $6000 note purchase 20 years ago. Again, buying and holding is not a bad strategy!
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