Clarus Investor Knowledge Base
| 1031 Exchange | Accredited Investor | Due Diligence | ||
| IRA Investing | Limited Liability Company (LLC) | Property Classes | ||
| REITs | Self-Management | The Real Estate Cycle | ||
| TIC |
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The Short
A 1031 real estate exchange is the sale of existing investment real estate property and the replacement of that property with new investment real estate. When executed correctly, 1031 exchange allows an investor to defer capital gains. The Long The Clarus Take While a 1031 requires both skill and attention to detail, Clarus relishes the 1031. For investors who are investing outside of an IRA, 401(k) or Solo(k), the 1031 is the only way to defer taxes on capital gains. As part of our full-service offerings for clients, we help clients execute 1031s in order to grow their wealth as quickly and responsibly as possible. Whether our clients are transferring wealth into or out of a Clarus project, we work with them to meet their financial goals. The Short
Under the Securities Act of 1933, a company that offers or sells its securities must register the securities with the SEC or find an exemption from the registration requirements. The Act provides companies with a number of exemptions. For some of the exemptions, such as rules 505 and 506 of Regulation D, a company may sell its securities to what are known as "accredited investors." The Long The federal securities laws define the term "accredited investor" in Rule 501 of Regulation D as 1. a bank, insurance company, registered investment company, business development company, or small business investment company; 2. an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million; 3. a charitable organization, corporation, or partnership with assets exceeding $5 million; 4. a director, executive officer, or general partner of the company selling the securities; 5. a business in which all the equity owners are accredited investors; 6. a natural person who has individual net worth, or joint net worth with the person's spouse, that exceeds $1 million at the time of the purchase; 7. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or 8. a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes. The Clarus Take Working with accredited investors offers several advantages. Acquisition fees are smaller because of reduced compliance and legal costs. Projects are more easily financed because of fewer credit concerns. Equity for larger projects is more readily raised. TICs and 1031 exchanges are easier to structure. Personal relationships are more easily established and maintained. Clients are better able to diversify real estate portfolios. For all of these reasons, Clarus works solely with accredited investors. The Short
In real estate, due diligence is the process whereby an investor or asset manager investigates a property, its market and its finances to determine the economic viability of the investment. In order to be successful, the due diligence process must be rigorous and exhaustive; between research and underwriting, numerous inspections, several site visits and frequent interviews, the due diligence period for commercial real estate may take several months. The inspection period, which is stipulated by the terms of a sales contract but is usually 30 to 45 days, is often called the due diligence period. The three main areas of due diligence include research, underwriting and inspection. The Long Research Even before identifying properties, investors must research economic, market and social trends at both macro and micro levels. Much of this data is quantitative: population growth, job growth, cap rates, construction costs, the number of college students in the city, the distance to the nearest coffee shop, etc. The remainder of the data is qualitative: the "feel" of a city or neighborhood, the ambiance or curb appeal of a property, and an understanding of the social tensions at work in a market. The three areas of research--economic, market and social--are not exclusive and frequently overlap. Social research is often the most difficult to perform, and indeed, many investment groups do not factor social research into their assumptions and decision-making process. Underwriting In real estate, underwriting refers to the process of analyzing a particular property's submarket data, financial history and tenant base in order to project and calculate operating budgets and return rates for the holding period, usually 3 to 7 years. During the underwriting period, financing arrangements and exit strategies are discussed. It is also important to understand how the property in question will complement other properties in the investment portfolio. Because of location concerns, portfolio considerations and a lengthy list of other criteria that must be met before an investment occurs, many deals never make it past the underwriting stage. Inspection After underwriting, if an asset manager believes a property is still a sound investment, she will submit a letter of intent to the seller and hopefully enter into contract. The sales contract stipulates the number of days the prospective buyer will have to inspect the property in question. Usually 30 to 45 days, the inspection period is generally the period most associated with due diligence. Because the inspection period is short, inspections must be perfectly coordinated in order to fully evaluate a property. Typical inspections include tenant interviews and an analysis of leases, a general inspection by the investors or their representatives, a general inspection by an appraiser, and several targeted inspections: roof, HVAC, electrical, structural, etc. Based upon the findings of these inspections, more or different inspections may be required. The Clarus Take The due diligence process is the most important component of the acquisition process. Imprecise or incomplete inspections can result in reduced returns or financial losses. In order to make consistently shrewd decisions, Clarus uses an exhaustive due diligence checklist. As part of our commitment to accountability and transparency, we allow investors to review the due diligence checklist for any property in which they have invested. During the inspection period, Clarus may decide that the project in question will not provide the returns our clients expect or that the risks are too large. Once we reach this decision, we terminate our inspection and incur all costs, keeping our clients’ investment capital whole. In contrast to many of our competitors, we refuse to fee our investors for the due diligence process. Due diligence is always a cost Clarus assumes on behalf of its clients, whether or not we purchase the property in question. This ultimately allows us to put more investor capital into our chosen projects. Due diligence cannot be "quick" or "easy," and any company that describes their due diligence process this way is increasing investor risk in order to increase their profits. The Short
An individual can invest in real estate via IRA, Roth IRA, 401(k), Roth 401(k), Solo(k), Roth Solo(k), SEP IRA, Simple IRA, Keogh, Educational/Coverdell IRA, HSA, 403(b), 457 and 412(b) retirement plans. These retirement plans allow the possibility of tax-deferred or tax-free real estate investing and may reduce the inconveniences and costs associated with other types of tax-deferred real estate investing. The Long In comparison to the traditional IRA, a self directed IRA is unique because of the investment options it allows. The same is true of other self-directed retirement plans. Most IRA custodians permit investments in only stocks, bonds, mutual funds and CDs, whereas a truly self-directed IRA custodian allows those types of investments in addition to real estate, notes, intellectual property rights and other "nontraditional" investment products. If certain rules and procedures are followed, it is even possible to own a business within a retirement plan. For savvy and well-advised investors, the self-directed option allows for increased diversification and increased returns. While the concept of investing in real estate and other assets in retirement plans has existed for more than 34 years, the concept has received little attention because most IRA custodians (usually banks and brokerage firms) focus only on stocks, mutual funds and CDs. Because they make their interests on commissions or load fees, they have vested financial interests in offering only those products to their clients. It is not an uncommon for a trusted financial advisor to have little or no experience with self-directed IRAs, given their relatively undiscovered nature. Certain types of transactions are prohibited via an IRA, and certain assets may not be part of an IRA. Most importantly, the IRS prohibits "self dealing," which includes any investments in which an investor and the investor's family members of lineal descent have prior ownership. The rules governing self-directed retirement plans can be complex, and it is imperative that trusted professionals manage both an investor's funds and any investment proposals. Given the intricate nature of many types of investments, self-directed IRA investing may not be appropriate for all investors. The Clarus Take Clarus does not offer investment or retirement advice, but we are supportive of the ability of taxpayers to self-direct and make nontraditional investments with their retirement accounts. We also believe the investment climate for self-directed investment plans is improving. The number of well-informed and competent investment and legal advisers has increased in recent years, and it is easier for investors to comply with regulations and to find expert guidance. This in turn allows investors to realize better returns with less risk. Clarus has worked with multiple self-directed IRA custodians, and we have been recognized as a preferred and trusted professional by PENSCO Trust Company. We even host our own seminars on self-directed IRA investing. While Clarus will not recommend a particular custodian or financial planner to our clients, we are happy to discuss our experiences and the experiences of our investors. Investors should always consider professional advice before a major investment, and whenever possible, this advice should be documented. While real estate can be an excellent component to a retirement plan, any investment must be executed properly. The Short
A Limited Liability Company (LLC) provides lawsuit, tax and foreclosure protection for its members/owners. It combines several features of corporations and partnerships and has replaced the limited partnership (LP) as the preferred entity for real estate investment. The Long An LLC shields its members from liability in the event of a lawsuit, so although a lawsuit may target the assets owned by an LLC, the LLC's members, like a corporation's shareholders, are not personally liable for the debts or liabilities of the company. An LLC also provides pass-through tax treatment. This means the LLC is not taxed on its profits; all profits of the company pass-through to its members. Unlike a regular C corporation, taxes are not levied at the corporate level, so an owner's return is taxed only once, usually as income or capital gains. This tax can be deferred via a 1031 exchange; it can be deferred or even eliminated using self-directed retirement plans. It is thus possible to invest in real estate with few or no tax consequences. Furthermore, in the rare event of foreclosure against an LLC, members will not have personal liability unless they signed the loan personally. Before 1997, when the LLC was adopted by all 50 states, the LP was the preferred entity of many real estate investors and their legal and financial advisors. Unfortunately, the general partner of an LP has personal liability. This problem was often solved by using a general partner which was a corporation, but this tends to increase both expenses and paperwork. The Clarus Take When appropriate for our investors, Clarus uses LLCs to structure our projects. Despite their slightly higher costs, we prefer to use Delaware LLCs because of the state's favorable LLC laws. We work hard to ensure our investors are shielded from risk and loss, and while it is impossible to eliminate all risk, Delaware LLCs reduce risk exposure. Clarus also creates LLCs for all tenants-in-common to ensure TIC members have shielded themselves from liability and have eliminated or reduced tax and legal consequences. The Short
Multifamily real estate professionals organize apartment properties into three main classes: A, B and C. Each property class brings class-specific financial risks and rewards, and each requires different asset and property management approaches. The Long The uppermost property tier includes Class A properties. Typically new, these properties feature state-of-the-art amenities and occupy prime locations. Class A properties are usually leased to tenants with high incomes and stable rent histories, and this allows for increased cash flow. However, because many Class A properties are purchased directly from developers, they may not be fully leased, and vacancies may prove difficult to eliminate because of high rents. Class A properties are also the first properties negatively affected by new market supply. Furthermore, Class A properties are always fighting a losing battle against time. Depending on construction materials, maintenance policies and changing community demographics and economics, a multifamily property can slide from Class A to Class B status in as few as five or as many as 15 years. Class B properties are exactly what one might expect: Class A properties that have lost their luster and glory. They may require one or two minor capital improvements to improve curb appeal or raise occupancy, but in general they are sound properties that experience very little credit loss. Unlike Class A properties, Class B properties may experience recurring maintenance problems, and there is always a danger that as neighborhood demographics shift, Class B properties will suddenly find themselves in undesirable submarkets. Class C properties are often properties that can no longer command high rents or attract premier tenants. They may appear old or need significant repairs. Many properties in this class have problems retaining tenants, or tenants are often delinquent in rent. They can be located in dangerous or decaying parts of town. With significant and expensive rehab work, Class C properties can sometimes show dramatic rent and occupancy rates. Each property class requires different asset and property management strategies. For example, the purchaser of a Class A property may hope that high rents generate strong cash flow with minimal maintenance expense while the neighborhood’s property values appreciate. The owner of Class B property, on the other hand, may hope to make several capital improvements and raise rents in order to increase an eventual disposition price. And the owner of a Class C property may be happy to maintain the status quo and sell the property to developers who have targeted the area for redevelopment or rejuvenation. The Clarus Take While each class offers unique challenges and opportunities, and while we've successfully acquired and managed Class A, B and C properties, we tend to target Class A and B properties because the tenants and physical structures provide a sound basis for growing wealth responsibly and securely. We often consider Class C properties if we like the submarket, the acquisition price, or believe there is a significant value-add component to the project. It is necessary to understand the risks involved with each property class, and it is important to have the ability to recognize the traits that enable buyers and sellers to grade their properties. If you have questions about diversifying your real estate portfolio or about the types of properties in your portfolio, contact a professional who can offer you advice as well as expert opinion. The Short
Established in the 1960s, real estate investment trusts (REITs) are securities that sell likes stocks. The companies issuing the securities pool the investor's capital to invest in real estate, either through properties (equity REITS) or real estate debt (mortgage REITs). REITs often specialize in a particular type of real estate (residential, industrial, office, etc.) or in regions (cities, states, nations, etc.). Many financial advisors recommend REITs because they have usually performed independently of the stock market. REITs can be highly volatile. The Long Because of the high financial and time costs of direct real estate investing, many investors--particularly small investors--turned to REITs as a way to diversify portfolios. REITs have traditionally paid high dividends, and coupled with rising share prices, many early REIT investors experienced rapid wealth growth. REITs, like any other publicly traded security, can be volatile, and they can be easily overvalued. Throughout its short history, the REIT industry has shown repeated signs of distress. In the latter half of 2007, for example, REITs were paying their smallest dividends in history and had their highest historical P/E ratios. It can be difficult to determine what types of assets REITs actually own: many REITs own other REITs; many REITs own high-risk, variable interest debt; and because the laws governing REITs stipulate that only 75 percent of a REIT assets need to be related to real estate, many REITs are heavily invested outside of real estate altogether. The Clarus Take Clarus cannot and does not offer financial planning advice to investors, but we believe in diversification, and REITs may contribute to a stock or mutual fund portfolio. That said, investing only in REITs will decrease diversification. While a REIT's individual properties may do well, a REIT's per-share price and dividends can still tumble or rise based on a host of factors completely unrelated to the assets owned by the company. In addition, at least from our conservative perspective, REITs appear to underwrite their deals aggressively. Many investors don't realize this, however, and by believing that their REIT investment is a real estate investment, they lose out on opportunities to grow their wealth and to diversify risk via real property investments. Consider the apartment market of the first half of 2008. The single-family housing slump increased apartment returns in most markets, meaning that rents should have risen, concessions should have decreased, and profits should have climbed. Yet apartment REIT prices plummeted, in part because they had over-leveraged and overpaid for properties, and in part because falling investor confidence reduced share prices. While these factors had little to do with the value of the underlying real property assets, REIT investors lost significant value in their portfolios. While we believe investors should consider all investments as they develop and improve their portfolios, we also believe investors should compare the costs and benefits of both REITs and real estate investments and decide what balance best meets their investment goals and needs. The Short
A self-managed property is one with day-to-day operations that are organized and administered by its owner(s). In the commercial real estate industry, few properties are self-managed. Instead third-party management companies control the daily operations. The Long While investors often manage small properties directly, few investors want to spend their days as full-time property managers at large properties. Hands-off owners prefer the time- and energy-saving services that property management companies provide. In addition, property management companies tend to have more and broader expertise than individuals, and they may be able to better capitalize on efficiencies and economies of scale. Third-party management also enables an owner to own properties in multiple geographic locations. Because efficiencies and economies of scale are essential to the profit margins of property management companies, these companies are generally built on business models that emphasize quantity over quality. Fee structures--usually a flat rate with no performance bonus--tend to reinforce these models. The Clarus Take Although the real estate industry has historically used third-party property management, Clarus considers self-management better for its communities, its employees and its investors. For these reasons, Clarus Project Management (CPM) manages Clarus projects. We made the decision to form CPM after learning important lessons from our experiences with third-party management companies. 1. A third-party manager does not need to emphasize the health of an individual property. Because of business models built on quantity, most third-party property managers prefer to have two average properties rather than one exceptional property. While many real estate investment companies are content with mediocre returns, Clarus considers such results untenable. By managing our own projects, Clarus is able to boost net operating incomes and thus the disposition price, increasing investor returns. 2. Third-party managers tend to provide infrequent feedback. Monthly or fortnightly reports cannot adequately detail the day-to-day maintenance and turnover that large properties experience. It also becomes difficult to track and monitor investor dollars when other companies are writing the checks. With our own management company, we receive immediate and updated information about a property and its financial health and can maintain complete financial transparency with our clients. 3. It is often difficult to form meaningful relationships with the employees who work for another company, and it is nearly impossible to incentivize or reward them as they perform their duties. Clarus feels employer-employee relationships are some of the most important for maximizing investor returns and building vibrant apartment communities, and we would not want to leave the relationships in the hands of companies that do not share the Clarus vision. With competitive employee salaries and benefits, we can attract the best talent in a market and thus raise our investors’ returns further. Ultimately, having our own property management team reduces costs and increases our revenue, providing a superior return for our investors. The Short
The vast majority of real estate markets in the U.S. follow a typical pattern: expansion, equilibrium, decline and absorption. Using this general information, it is often possible for investors to determine a property’s future value or to time the market. The real estate cycle suggests that the opportune moment to make investments is just after a market emerges from a recession. The opportune moment to sell occurs just before equilibrium. Because of these fluctuations, the real estate cycle increases the risks and rewards of real estate investments.  Click the image for a larger view. The Long Each asset class has its own real estate cycle, and only seldom are multiple markets synchronized. For example, the cycle for single family housing usually differs from the multifamily cycle. Furthermore, each market experiences its own cycle. If the Houston cycle resembles a roller coaster, the Tulsa market is a nice, leisurely drive across Oklahoma's rolling hills. Indeed, even submarkets or neighborhoods may experience their own individual cycles. In general, each real estate cycle lasts 7 to 8 years. As a whole, however, the U.S. experiences one major real estate cycle every 17 to 19 years and several larger cycles in intervals of 30 to 50 years. Whenever these larger or major cycles slip into a decline, the entire American economy suffers. When economists or analysts speak about a real estate correction, they are talking about the declining periods occasioned by various real estate cycles. The Clarus Take Many pundits and analysts call the real estate cycle "natural," but we at Clarus feel that poor city planning, overzealous developers, weak underwriting and swarming investors are anything but "natural." Accepting the real estate cycle as an investment standard is both dangerous and irresponsible. The mortgage and liquidity concerns of 2007 and 2008 reveal the pitfalls of cyclical markets. When many markets experience a synchronization of their real estate cycles, the result is a run-up in profits followed by large losses of capital and homes. We recognize the cycle exists, however, and we use it to our advantage. Our research identifies markets on the rise and those on the wane, and we invest accordingly. We also use our understanding of cyclical markets to avoid volatile and risky markets. Clarus also seeks to identify international markets in which American-like cycles are unknown or not yet fully developed. The Short
The tenants-in-common (TIC) structure, also known as tenancy-in-common, is a way for two or more individuals or entities to own property. As a member of a TIC, a co-tenant owns an undivided fractional interest in an entire property and shares the net income, the benefits of tax shelters and any appreciation of value according to their percentage ownership. The Long Rather than owning particular units, shares or apartments, TIC members own percentages in an undivided property. Each member receives a deed that identifies his or her percentage ownership. Because a TIC ownership interest is fractional, TIC members may invest any amount of capital into the property, although minimum investments are often required. A popular vehicle for 1031 exchanges, the TIC allows investors to diversify previous investments into more than one property and to participate in potentially larger, institutional quality properties. Thus 1031 investors in one area of the country may diversify in industrial, commercial, and residential property investments throughout the country, all while reaping the benefits of deferred taxes. A TIC differs from joint tenancy in several ways, the most important of which is survivorship. In the event of a TIC member's death, the title can be passed to a beneficiary of the owner's choosing, whereas in the event of a joint tenant’s death, the title passes to the other tenants/owners. TICs are complex investments and are only available to accredited investors as defined by Regulation D of the Securities Act of 1933. TICs have long-term holding periods, limited liquidity and no active secondary market for the sale of TIC interests. In addition, TICs have unique fees and expenses including sales loads that are different from other real estate investments. These fees may impact cash flow rates and investment returns. Furthermore, the rules, fees and risks associated with TICs have come under increased scrutiny from various government and private regulators. The Clarus Take Legal and filing fees are generally larger for TICs than for other ownership structures, and because most TIC investors are also executing 1031 exchanges, coordinating timetables can prove both stressful and complex. For these reasons it's generally not practicable to organize TICs with more than about 35 members. Because of a lack of regulation and oversight in the TIC industry, many early TIC investors experienced significant losses while investing with unethical individuals and organizations. Moreover, the TIC market often lacks transparency, and investors may not be aware of how firms and sponsors dilute investments. Current TIC practices may ultimately lead to serious tax and legal consequences when regulating bodies take a closer look at the TIC industry. Clarus not only complies with FINRA, IRS and SEC guidelines, but we ensure investors are aware of all fees and expenses before they make TIC investments. Clarus provides complete transparency to help investors grow their wealth safely and securely. |
