371: Ask Buck June 2023

Catch the full episode: https://www.wealthformula.com/podcast/371-ask-buck-june-2023/

Buck: Welcome back to the show, everyone. And today it’s just me. Like old times. And we’re going to take questions from the audience. There’s actually no audience here in my room, in my office here. But I’m going to take questions from you. And we’ll start with the question from Mike. Mike, here you go. Hello, Buckets. Mike Kaye from Melbourne Beach, Florida.

Mike: I was wondering if you were looking at any opportunities out there in regards to investing in distressed assets. I’ve noticed that rates have gone up in a lot of operators like Western wealth aren’t cash flowing and are actually looking for more capital because they’ve got themselves into trouble. And if rates stay higher than expected, there could be some some pretty good deals as far as bailing folks out.

Buck: So I wanted to get your thoughts on if you were looking for anything out there as far as funds or whatever it may maybe create some opportunity here. Thanks, Mike. Thanks for the question, Mike. The answer well, let’s start with this. Obviously, there’s a lot of distress in the system right now. Interest rates have gone up a the steepest slope in American history.

And as you might expect, that has not been good for operators, particularly those who relied heavily on floating debt. You know, and this is important, I think, to understand what’s going on a little bit, because you might be wondering why in the world would you use floating debt anyway? Well, if it’s a long term hold, it never would really make sense to do that kind of short term debt.

However, and with these larger assets, the problem is fixing debt. If your plan is to, you know, ultimately sell. And, you know, 18 to 24 months, you are going to end up with an extremely high prepayment penalty. And so in those situations, the extremely short hold are the shorter hold models, you know, generally ran on floating rate. So if you’re again, your business model is to get in and out in 18 months, it doesn’t make sense to lock in the rates.

So obviously now they would be better off if we had. But everyone has a plan until they get punched in the face. Right. That is from Mike Tyson, not from me. But that’s that’s kind of what’s happening across the board here, especially for floating rates. And as for looking into creating this fund, which, you know, maybe you got a rescue fund or something like that, that the answer was whether I, I think that that’s potentially something to do is, well, yeah, it’s certainly something to consider.

And I have thought about it. These are essentially these sort of preferred equity positions, essentially become the lender. So there’s not like any tax benefits or anything like that. But so, you know, I have thought about this, but but before doing anything like that, I want to make sure, you know, the economics makes sense for everyone against, again, perhaps one of the most appealing parts of this fund might actually to be getting into some second positions and maybe be first in line if the property fails and you know it or is distressed, it needs to be taken over.

But I really need to think about it because I also want everyone to have as much dry powder as possible. And because, again, it is no fun to be in this environment and those people who are going to make money are going to be the ones that have like nerves of steel that, you know, are okay to feel like, okay, I’m losing some money on one hand, but there’s an opportunity to buy distressed assets on the other side.

And that’s where real money is made. And again, it’s a psychological thing that happens in every cycle. And the key is to try to keep your wits about you and learn, you know, learn whatever lessons you have to learn and move on and deploy. I certainly am not one who is not learned from this experience. Myself, I absolutely have, and I think it’ll make me a better investor going forward.

Unfortunately, we’re still in the midst of this mess right now. But anyway, bottom line is the answer is yes, potentially. I’ve thought about it. And I think like those kinds of preferred equity, essentially debt being in the second position behind the main lender, that is that’s potentially appealing. And certainly as an investor, I think it’s appealing because essentially you’re you’re in a lending position. You’re not you know, you’re not in an equity position, so you’re superior to the equity position. Hopefully that helps. All right. Let’s go on to the next question here. So it’s from John.

John: Hi, this is John Valentino. I listened to your excellent podcast every Sunday morning on my run, walk and find them uniquely interesting and helpful amongst a sea of podcasts that aren’t.

Buck: Yesterday you mentioned Terry Loughlin and your late in life swimming experience. I’m 68 now and at 55 I decided to learn to swim. I researched all of Terry’s stuff and ended up using a local swimming coach here in Fresno, California, who knew Terry and who had a lot of experience. He had me swimming, breathing and flipped, turning very quickly.

Four years ago when we visited Maui, I did a two mile ocean swim with some master swimmers. I now swam about a mile and a half every Sunday with which the swim coach they taught me. And I do that. I listen to your podcast. I’m sure we could get you swimming and breathing properly very quickly. He Fresno’s not too far from Montecito. Good luck with your swimming and let me know if you’d like me to hook you up with Rich. The swim coach.

Buck: Well, John, thanks for that. That makes for a lighter moment in this sea of despair. Ha ha ha. That’s funny, kid at sea of despair. He’s swimming. Anyway, for those of you who don’t know what John is referring to, I’ll just take a minute because, you know, taking questions from all kinds.

All types of questions here is back in 2016, I think it was 16, I listened to Tim Ferriss podcast about how he spent his whole life trying to swim and unsuccessfully, I’d say, met up a guy, met up with a guy named Terry Loughlin, who taught his total immersion technique or tie. So I decided, well, gosh, you know, basically Tim Ferriss was talking about my story, like he spent his entire, like, you know, didn’t learn to swim as a little kid and then all this and trying to catch up and no one could teach him.

And that was kind of where I was. I do like him numerous, like tries added back in my twenties and thirties, and then I kind of had given up. Then I contacted Terry. He was in New York, upstate New York. So he actually flew out there. I was in Chicago at the time and he taught me to swim in about 2 to 3 hours and it was really unbelievable to me.

And the only thing I didn’t learn how to do during that visit was to breathe. And unfortunately, that was so that was like I was there for like a day and a half. And that was the part I didn’t get to. So now I can swim, but only as long as I can hold my breath because I can’t seem to, you know, I can’t breathe and swim at the same time.

Unfortunately, Terry had, end stage cancer. When I saw him and I believe I was his last student before he died a couple of months later, and he’d actually stopped teaching for a while, you know, before I got to be the lucky one that he decided he had enough strength to go back for. So lucky for me. So but yeah, I would love to, you know, John, shoot me an email, you know, where I am and I get well for Malcolm Connect me to your guy.

And I think Fresno might be a little far, but if he’s as good as Terry, maybe I could. Maybe I could learn to breathe in a day, too. So, hey, anyway, thanks. Thanks for that. Let’s go on to the next question here. All right. This one’s from I think it’s Garima.

Garima: I am looking to become a real professional on studies. We’ve been doing real estate for a little bit but wanted to do this. I really need help. If you can guide me well and see.

Buck: Well, I don’t know. I can do my best about that, Garima. And first of all, I have to preface this as I always do, that what I’m about to say is not legal or any kind of tax advice. I’m not a tax professional. My degree is in medicine. I’m a former board certified surgeon, but that doesn’t qualify me for much. And this in this arena, it’s just my understanding of the tax law, which, you know, I spent a fair amount of time thinking about. So it’s not like what I’m saying should not be listened to, I think.

But on the other hand, the liability issues, I have to make very clear consult with your own tax professional before anything anyway. So again, probably the best thing I can do in terms of guiding is tell you what I know about the qualification as real estate professionals status. And by the way, I should also point out that the benefits that I’m going to talk about, there’s a lot of this similar benefits without having the status in short term rentals.

And that episode, I believe, is 354. So go back and listen to that one. It’s I thought that was a pretty interesting episode. But why is agreement talking about this RFP short for a real estate professional So everyone is on the same page? What is the real estate professional designation? Why is it useful? Well, a real estate professional is not the same thing, is in a real estate agent or a real estate broker, which are basically involved with real estate transactions.

They’re involved as like the middleman. Right. That’s not really the business of real estate. The real estate professional is someone who is who is materially involved with the business of owning and operating business. And the reason that this is important, we’ll get to in a minute, but I’m going to go into the qualification parts of this. And again, I’m not giving you advice and basically telling you what I can gather from the IRS website And basically the material participation is one of the first things.

So you can’t you can’t be a limited partner in a bunch of real estate and call yourself a real estate professional. You have to have some activities that are truly owning and, you know, operating real estate. I mean, you have to be involved in the management operations of your rental properties, right? So the level of involvement is different than obviously if, you know, even if you have a propertyif you have a property manager or whatever, it’s still going to be more active than if you’re just a limited partner.

But another one of the things that you have to qualify for is you have to spend more than 50% of your total working hours in real estate activities. So in other words, if you know, if you’ve got a full-time job, you can’t really qualify as a real estate professional. There has to be more hours than any other profession. Right? Your participation in real estate activities has to exceed anything else that you’re doing in terms of business and employment. There’s also something called the 750-hour test, which you must spend at least 750 hours per year on real estate activities. And some of these things that you can do include property management or rent collection or maintenance or advertising, other related issues, acquisitions, underwriting, etc.

I mean, there’s a lot of things that, you know, once you own real estate, you can be an active owner, right? So anywhere that’s… So why would you want this designation? Because it sounds onerous to go and try to make sure you’ve got all these things if you’re not already doing it. Well, as you may know, the real estate income itself, that real estate income itself is considered passive income.

Right. And similarly, the losses from real estate in the form of depreciation are considered passive losses for most people. Those passive losses cannot be applied to any active income, right? So if you have an income of $500,000 and you happen to have $500,000 of depreciation or paper losses, you couldn’t use those losses to offset your personal active income.

The reason is that one is active and one is passive. So you can’t do that. And unfortunately, unless maybe you or your spouse, rather, with whom you file jointly is a real estate professional. So in this case, what would happen is those passive losses from real estate would become activated, in other words, their active losses. And you can, you know, you can offset anything with active losses, right.

And even W-2 income. So that’s the idea. So, again, theoretically, check with your legal, you know, and tax people and hopefully they know what they’re talking about. But see, if you’re a C, if you’re a doctor, you’re making, again, $500,000. And let’s say your spouse, who’s a real estate professional, generated maybe $50,000 in income, but $300,000 of paper losses, you can deduct that $300,000 from the salary, that is earned income on the doctor’s side.

So basically, that is what the huge, big deal is about this real estate professional status. And again, I’m not a tax professional, but this is something that a lot of people in our group do, and it is, you know, following the tax code, that’s the key. So Garima, bottom line is I don’t know how else I can guide you other than to give you information.

But, you know, I guess what I would do if I were you is, you know, try to figure out how you can actually, you know, get yourself qualified as a real estate professional and make sure that, you know, you fit those criteria and talk to your tax person about it. Okay. Next question is from Mark Hammons. Mark’s question deals with tax law, and I’m not sure it’s appropriate for this forum.

Feel free to pass on if you feel like addressing it. Well, it’s another question. Well, you know how I feel about that. I’ll tell you what I think. But

don’t take it as tax advice in any sort of way. But okay, so here’s the question Mark says. He says, I’m a partner in an LLC that was formed for residential development.

Our project is nearing completion, and this year it will take business income to be taxed at a 20% LLC rate. I will receive income from the sale of raw land and taxed as long-term capital gains. I’m a full-time physician and not actively involved in the business of land development. Can I offset any of this income with accumulated passive losses and leases?

Thanks, Mark, for all you do. Thank you, Mark. And well, as you may have gathered from the previous question and the answer that I gave Garima, you are a full-time physician, my friend, and therefore you do not qualify as a real estate professional, and therefore you cannot use those passive losses against your active income as a physician, and you are stuck in that stratification of income hell, which is that you’ve got these great-looking losses on the passive side and this great income on the active side, and you cannot do anything about it.

So now, if your wife was doing this real estate stuff and qualified as a real estate professional based on the criteria I mentioned earlier, then you would theoretically be able to apply those passive losses to active income, and boom, all of a sudden, you would have what it is you are hoping for. And anyway, but I do have people in our group who are literally, you know, with that spouse set up.

Well, that’s why I brought it up, right, where they literally had a spouse quit their job so that they can switch to real estate professional status. And although their cash flow may constitute a theoretical pay cut from their job, the generated losses, paper losses, are being applied to the larger active income stack. There, in many cases, justifies that because they may make a total gross amount of income that’s less.

But because of those passive losses, they actually get to keep more. So that’s a complicated answer to a simple question. In my non-professional opinion, Mark, you are kind of screwed. Can’t do that anyway. All right. So the next series of questions is from Terry. And let’s see, let’s start with the first one. Is this one. My understanding is there are U.S. dollars held overseas in the United States.

What would be the impact to the value of the dollar if the overseas cash had to be converted to CBDCs, which is central bank decentralized coins? Well, I’m no expert on this, but from what I know, I’m not sure it would have a material effect on anything overseas because as I understand, CBDCs is a little more than using distributed ledgers instead of central ledgers for digital money, right?

Because the thing is, you have to remember that 90% of the U.S. dollars are digital-only already. They do not exist in the physical world already. So what difference does it make if it’s on a single ledger or if it’s on a distributed ledger? I’m not sure that it does. As I understand it, the idea would be essentially to make it into like a software update almost, right, where the new digital currencies would be CBDCs.

But of course, I could be wrong, and my understanding of the plan that the U.S. has there is it could be wrong. I’m sure there’s a larger plan eventually to use this as a way of maximizing tax revenues and tracking people’s spending and that kind of thing. But in the short term, I don’t really see how it has repercussions for money overseas.

But if somebody knows of something that would cause that, certainly email me. But I don’t know that. Okay. This question is also from Terry. He says, “Rising interest rates have had an impact on existing multifamily operators, and it seems like part of the multifamily model relies on interest rate value being lower than cap rates.” That’s correct. “Combined with the multiplier effect of low cap rates for value-add projects, do you see cap rates going up until interest rates come down?”

How high can cap rates go before the value-add model is no longer viable? Are rents still rising fast enough to offset interest hikes? Okay. So yes, I do see cap rates going up. Remember, in order for debt to make sense, the interest rates must be lower than the cap rate. So if your borrowing rate is 5%, then your cap rate needs to be above that in order to have positive cash flow.

Otherwise, you’re amplifying your losses. That said, often, you know, you may have seen in some cases operators buying things and they’ll consider buying things like that. If there’s an obvious thing that’s going to drive up net operating income pretty quickly. But right now we are seeing rising cap rates. Now, as for the value-add model being viable, I would say that yes, the value-add model is viable in all interest rate environments and with all cap rates because remember, folks, real estate was not people didn’t just start making money on value-add.

This has been around for some time, right? There are plenty of people who got rich off of value-add real estate in the eighties despite double-digit interest rates in double-digit cap rates. So what has created so much distress in this system is not the absolute interest rates. It’s the pace at which the interest rates went up.

They’re the moving goalposts. You see, every time you underwrite a property, you have to model in interest rates and reversion cap rates. And if rates are not stable, it’s very difficult to underwrite. And that’s why these real estate markets right now have been so illiquid. There really are no stable variables to underwrite with. Rightly, you got to have the goalposts, you got to know where the goalposts are so you can play the game right.

Once you have that stability, though, you can underwrite again, and in value-add real estate, the money isn’t made based on interest rates being high or low, but it is made by ultimately creating a positive delta in the net operating income. And that can happen in all interest rate and cap rate environments. So I don’t see it being an end to value-add real estate at all.

In fact, one could argue that if you’re, say, you’re buying real estate, which hopefully we are in the fall, and you’re getting great deals on it, you know, the rates are high, but the numbers are making sense. You do your normal net operating income, you do your normal value-add program, you try to increase NOI, and you get lucky.

And by the time you’re ready to sell, interest rates have actually come down. Well, in that case, you’re going to actually probably get, you know, more for your property than you would otherwise if rates were stable. So I actually don’t see this as something that is ending anything. In fact, I think those who, again, take advantage of a higher-rate environment and buy into assets that make sense at high interest rates could seriously make money in the next, you know, several years.

So let’s see, the last question from Terry is, “What are your thoughts on portfolio allocation between real estate stocks, cash value insurance, gold, crypto, and cash?” Well, I might not be the best person to ask about portfolio allocation because I think my portfolio would make most money managers think, right? I’m about 75% real estate, maybe 5-7% crypto, mostly Bitcoin, Ethereum, and the remaining investments are things that I believe are uncorrelated.

The most stable thing is, you know, I’m a big fan of cash value life insurance in part because, I mean, it is so stable. I mean, seriously, it is incredibly stable. If you look at the environment that we’re in right now, it makes you, again, think you should be buying more cash value life insurance. It’s extremely stable.

And this is why it was such a big deal during the Great Depression. People lived through the Depression and had no faith in anything except for cash value life insurance, which is what they were buying. But anyway, I think, in particular, I’m talking about these strategies that we’re calling, wealth formula banking or various leverage dials, wealth accelerators, things like that.

So there’s that. You know, there’s also things that we’re doing, like I’m invested in things like, you know, cargo ships that are delivering essential oil and gas to the country, things like that, where again, it’s not something that is significantly correlated with the rest of the markets.

And I think that’s one of the things to really make sure that you’re not… I mean, listen, I guess in my case, being 75% real estate, I mean, it’s not a good time to be 75% real estate right now. Right. I probably… I mean, if I did the numbers, I’m probably less than 75% real estate now because I probably lost quite a bit of value in the real estate.

But I’m not even going to look at that right now for this purpose. But ultimately, though, you know, listen, personal finance should be personal. I don’t own stocks, although I’m not against stocks. I’m just, you know, not a guy who really owns stocks except for some big, really, you know, asymmetric plays in the energy space, you know, through Mercatus and things like that.

I don’t own any physical gold, although again, I’ve talked about possibly wanting to do that. I don’t really want to right now, but I’m hoarding cash right now because I think there are going to be tremendous buying opportunities in real estate with distressed assets, and I think that’s going to be the name of the game in Q4. So but again, I do not think it’s a good idea to listen to me about portfolios.

I think I think it’s if you want those kinds of things, you probably should, you know, talk to others, talk to, talk to, you know, our RIA’s, things like that. But to me, again, personal finance is really personal. And for me, I’m, you know, I’m pretty aggressive on some of the things that I have a lot of belief in.

So, okay. Well, I guess that’s my last question. Before I go, I want to remind you that there’s another actually, there’s actually another podcast that I do now, which is, you know, it’s kind of just taking something that I was spending a lot of time learning about and and and trying to process myself and turning it into another show so that I could share with you.

The show is called CPO, CPO. You can find it on pretty much all of the ways that you find this show and

hopefully on YouTube soon too. We haven’t quite gotten to YouTube, I think, but the show is, I think, very interesting because, you know, we talk about wealth on the show, but I mean, you know, what do what is more what’s more coveted than, you know, actually having health because then your wealth is actually useful.

So a lot of Sabio is really about various types of longevity and wellness type stuff on the science that we know out there. Really interesting stuff to me and would love for you to check it out again at Sabio with Buck Joffrey. Check it out and let me know if you like it. Give me a positive review. That’s it for me.

This week on Wealth Formula podcast, this is Buck Joffrey signing off.