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March 14, 2023

Bonus Depreciation Advantages For Real Estate Professionals With Kyle Kovats [EP144]

Today we have Kyle Kovats on the show! Are you a real estate professional looking to maximize your tax benefits? Kyle Kovats learned the power of using bonus depreciation to help real estate professionals get the most out of their investments.

In this episode you will learn:

  • the amazing impact bonus depreciation has for real estate professionals
  • the tax advantages of investing in real estate
  • the importance of how much you keep vs how much you make
  • the historical superior performance of real estate returns vs the stock market
  • the power of leverage

Table of Contents:

Superior Returns in Real Estate Through Bonus Depreciation

Superior Returns
Photographer: Daria Nepriakhina 🇺🇦 | Source: Unsplash

Darin: Kyle Kovats lives on the East Coast in New Jersey. He grew up around real estate his whole life. He went to college and is an avid fan of Rutgers. He loves to talk about stats and he is convinced that the returns for real estate are far superior than the stock market.

Kyle and I are both members of the same multifamily mentorship group, the Brad Sumrok group. And we met probably, I don't know, it was probably like three years ago. He had just joined the group and he came out and he's a young guy. I'm going to have to ask him his age, but he's a young guy and he is a powerhouse. He just got into it. He is not afraid to get out there and meet people and network. So I'm very interested to hear what he's been having going on for the last few years and we'll go from there. So with that, can you share with the listeners how many properties and how many units you're invested in?

Kyle: Sure. So as a general partner, currently, I'm a GP in four assets, little over 1,100 units, 1,109 units. Was a GP in five assets we had just sold out of one in Phoenix back in November. That was 120 unit property out there. And then on the LP side, I have millions of dollars invested as an LP. So I don't just do all deals on the GP side, on the LP side, thousands and thousands of units. I don't know the exact number of units there. Simply because some of them are fund deals that have multiple properties trading in and out.

Discover How To Save Taxes and Build Wealth

Discovering How Bonus Depreciation Works

Darin: All right. So let me just ask you, how old are you, my friend? Because you're a young guy.

Kyle: Yes, I'm 32.

Darin: So when I met you, you were probably 29. I'm 52, so I'm 20 years your senior, my friend. Not too many people in their 20s really get dedicated to getting into the investing world. So what's your background and what prompted you to get involved?

Kyle: Yes, I guess a big piece of it is my background. I've been in real estate my whole life, it's really all I've known. So my grandfather owned a pre-licensed real estate school in New Jersey that he opened up in 1973. So as soon as I graduated college, I had gotten my real estate license. And while I was a college student at Rutgers University in New Brunswick I would drive up about a half hour up the Turnpike. I'd go to Hoboken and I would try to bang out rentals.

So I really only did leasing when I first got into the business. And I would see on these rental properties, number one, I was making good money doing rentals. But number two, I was able to see what these units were renting for. And I was able to see from year-to-year what the rents were going from. On one property, I would see the rent go from $2,000 the last time I rented it up to perhaps $2,500, the next time it got rented. And I was saying to myself, "Wow, that's a nice jump."

Using Bonus Depreciation for Superior Returns

Kyle: And then I started understanding how investment properties were evaluated when you take the NOI divided by the cap rate. And in my head, I started saying to myself. "Well, if they raise rent by $500 a month times 12, that's going to be an extra $6,000 a year and a 5% cap rate. That's an increase in valuation of $120,000 just by raising the rent by 500 bucks a month at a 5% cap rate."

Darin: On one unit?

Kyle: Yes, on one unit. It started really ringing a bell in my head. So then I decided once I graduated college just to do real estate full-time. A lot of kids who I went to college with, they would work in the city. Rutgers is about a half hour from New York City. So the standard route for a lot of us was to work in the city. But I really liked real estate and I was starting to make good money doing it. I did real estate sales full-time. Within three years, I got named to the National Association of Realtors 30 Under 30.

I was a solo agent selling anywhere between $15 million, $16 million, $17 million worth of homes a year. And I was able to really build up some good income doing so. Throughout that time I was doing subdivisions, Airbnbs, two to four families, and things like that.

But the thing that I was seeing with that is I felt like I kept buying myself a job. I guess, rather than being an investor. I started searching what are ways to invest in real estate passively without having to deal with all the BS that I was dealing with in my other investments if you want to call them that.

Reach Out to People With Common Interests

Reach Out to People With Common Interests
Photographer: Hannah Busing | Source: Unsplash

Kyle: And I came across syndicates, and I started passively investing in syndicates around 2015, 2016. Started really liking how they were. I would follow the monthly reports that would get sent out from the GPs. I would go through the financials, the rent roles, the income statement, the T12. And good GPs were providing a little summary as well of what was going good, what was going bad on the property. And I started making mental notes and then eventually I started making written notes on what's going good, what's going bad.

5 Step Process Ad

I started saying to myself. "You know what, maybe it would make sense for me to try to join a group that has a whole bunch of people doing this. And maybe I could partner up with people. And maybe I can get on the other side of the table and go out and find the deals." Because I think I have a good idea of what to look for now after passively investing in these deals for a number of years at that point.

Darin: Sure. So what year did you join the Sumrok group?

Kyle: I joined late 2017, early 2018.

Darin: Okay. So that was pretty much the same time I did, late 2017. So since then, what's been your experience since you joined? What have you been up to?

Kyle: Yes. So I still invest in deals as an LP. As recently as last month I had a deal that we sold and I invested close to $1 million as an LP into another deal. So I've been doing deals on both sides.

The Importance of Capable Partners

Kyle: I would say every single year, I do anywhere between one to two deals on the general partner side. And on the LP side, it just depends how liquid I am at the time. But I would say on average every single year I'm investing into three to four different assets as an LP and just constantly looking for deals. Over the past, I would say, four years at this point, I've only done deals as a GP with two partners in particular.

We have good cohesion, we work together well, we know each other quite well at this point. And understand what we look for and what we, I guess, ethos and what we look for as far as returns are concerned. We know what our investors want to see. So it's been a good working relationship and just constantly looking for deals. Obviously right now, there's not that much at all available, so it's a little bit of a waiting game.

Darin: It's amazing how a year changes the market cycle. Let's go back to when you first started investing as an LP. The thing is, you did that before you joined the Sumrok group. So how did you even get introduced that? I joined the Sumrok group, it's around the same time as you did and now my inbox is flooded with different investment opportunities. But before that, I didn't get invited into any of those deals. So how did you even know to get into these syndication-type deals?

Initiate Connection With Experienced People

Kyle: Yes, that's a great question. So what I did is on my iPhone, my friends are all listening to podcasts and I'm not into pop culture and stuff like that. I watch sports and I do real estate. So I would just search, like for instance, sports if I needed my sports fix, that's ESPN for me. But for real estate, there's no channel you could turn to for real estate. So I would go on the podcast app and I would type in real estate podcasts. And then furthermore, I really wanted to know real estate investing podcasts.

I came across the Old Capital Real Estate Investing podcast. And they were interviewing people constantly over and over again. So these people who they were interviewing, I would start reaching out to them and say. "Hey, can you put me on your distribution list because I have money to invest. I'd like to invest in deals. And ideally I'd like to invest in deals in the markets that I liked, which at the time were Dallas. I liked the Texas markets in general and I really liked Phoenix. So, anybody who was investing in those markets, I wanted to get on their list.

Ultimately, a deal popped up in my inbox and I'm the type where I kind of do my due diligence upfront on things and then once it comes up, I just act on it. So this deal popped up in my inbox. "Webinar in two weeks out on a Wednesday night, blah, blah, blah." So the webinar comes around, go through the webinar, watch everything, and I'm like, "You know what, let's do it. I'm hopping on in." This was like later 2015, hopped into that deal as an LP.

Finding the Right Timing for Bonus Depreciation

Finding the Right Timing for Bonus Depreciation
Photographer: Who’s Denilo ? | Source: Unsplash

Kyle: And that's at the time when you were an LP where cash-on-cash returns were like 10%, 11%, 12%. I mean it was nuts. Nowadays, we're lucky if you get 6%, that's really lucky if you get 6% cash-on-cash these days it feels like. But at that time it was like 10%, 11%, 12%. So I'm invested in this deal, six months in. I'm getting an annual annualized cash flow distribution of 9% and I'm like, "Wow, this is great." Couple of years later, that deal sells, my $100,000, I put into that deal turns into $223,000 and I'm like, "Oh wow, this is really good."

Darin: It's crazy.

Kyle: And then all the different deals I was investing in as an LP. I started off as an LP investing about $650,000 and within a couple of years, all of a sudden it was like, "Oh wow, I've close to $2 million now." And that's because these deals, at that time, really timing played a big role in it too. You couldn't invest it really a better time, debt got cheaper, cap rates compressed, and everything like that. But I took the leap of faith and I got in the game and it really ultimately did work out for me as an LP.

The beauty of that I believe is that, at first to be honest, I didn't have much interest in ever being a GP. But what happened was I started getting these tax benefits. I started getting these K-1s, I didn't even know what they were when I first started off investing, I had no idea. I got this K-1 back and I read it and it said I lost money. And I was like, "Oh, hold on."

How Bonus Depreciation Can Improve Your Taxes

Darin: That's not what the monthly reports are telling me, right?

Kyle: Right. So I reach out to the GP on that deal and I said. "Hey, I just got this tax document, it says we lost money. And he was like, it's not really a loss, it's a paper loss for depreciation. He's like, talk to your CPA. So I remember I made a Facebook status about it and a kid I went to high school with who was a year younger than me who I was friends with, reached out to me and said. "Hey, yes, since you're a full-time real estate professional too. You can probably use it against your ordinary income from your real estate commission income."

And I said, "Are you sure?" I was like, "How does that work?" I was like, "Where's your office?" His office ironically was a half mile from my office in New Jersey. I said, let's get lunch. We got lunch, we went over everything and he was like, you have well into the six figures of tax deductions here. And I was like, oh, okay, so let's go. Anyway, I went from paying six figures in federal income taxes to next to nothing in some years like overnight.

It was really just a whole game changer and it really widened my mind. And when that happened, I'm selling a lot of real estate at that time. I just started making mention of it to other realtors like, "Hey, do you own any investment properties?" Some of the top realtors in the market who I really looked up to, and some of them would say, "yes, we got one investment property." Or others would say, no. We don't have any investment properties, we just sell property.

Investing in the Right Deals

Kyle: And I was like, "You should buy some investment properties. I mean, you should talk to my CPA because I know nothing about this. But talk to my CPA, he'll be able to really expand upon everything for you. They started talking to my CPA. And they were like, hey, you're investing in these different deals in different markets, how are you doing that? And I was like, well, I just find people who are doing these deals, these syndicate deals. And I just throw money into the deal and I don't do anything.

I literally just put money into the deal and I get a monthly report and I get checks and I called it mailbox money. I get mailbox money here and there. And they were like, well, can you let us know when you come across one of those? And I was like, "Sure, yes, why not?" Anyway, long story short, what it led to is I had enough people. One person would tell another person and I'd have all these people reaching out to me like, "Hey, when you find these deals, let us know."

So I was like, you know what, maybe it makes sense for me to join one of these groups and find people who are doing these deals, partner up with them. The value that I could provide is that I know a lot of people who are looking to invest, number one. And number two, my career started off in leasing. I have experience with leasing, with marketing and things like that. So I could help out on that side as far as tenant retention and things of that sort.

Making Good Money by Using Bonus Depreciation

Kyle: Whereas I might not be the boots on the ground, I could still provide some sort of value to people who were looking for partners.

Darin: That's huge.

Kyle: And ultimately that's kind of how I guess my GP journey started. It really started off as me just being an LP and just randomly talking to people who I was friends with about it.

Darin: Right. And then, have they come back to you and said, "Thank you for getting me involved?"

Kyle: Yes. So funny enough, we just had our first deal as a GP that we bought back in February of 2019, it closed in November. And the equity multiple on it was 3.55, which was quite good. In other words, if somebody put $100,000 into it, they got $355,000 back between cash flow and appreciation. So it was one of those deals.

Darin: $100,000 turns into $355,000.

Kyle: Yes. Now the thing is, and I have to always say this to people, when that deal closed out, I was very sure to make mention to people that, "Hey, just so you know, this is probably the exception and not the norm. I think historically we probably would look to our goal would be to get 16% to 20% annualized. I think that's a pretty solid good return."

But what we did there, we did roughly about 95% annualized over a three-plus-year hold. So the only caution there is does that make expectations unrealistic where people are like, "Yes, Kyle might be saying we'll get 16% to 18% projected returns, but he said that last time and last time we got 95%." So I just want to caution people to not expect that.

The Realtors' Advantage in Real Estate

Darin: I've had other syndicators say that it's like it can make investors if they come out of the gate and get some big wins right away. Their expectations could be that they expect that on every deal. So that's interesting.

You've been in the real estate world forever, you had all these people coming to you. Because I personally think that there's a lot of realtors that are not taking advantage of this tax law. And it doesn't have to be the realtor, doesn't have to have made a ton of money off of their being a realtor. It could be the spouse is a realtor and sold one or two homes, but they're a full-time realtor. And then the other spouse is a high-income earner and pays a lot in taxes and how that would help that couple.

Kyle: I mean, you nailed it, Darin. To me, as somebody who is very involved in real estate, I own a real estate school pre-licensed school, the one that my grandfather started. When he passed away nine years ago at this point, I had taken it over and we have about anywhere between 700 to 1,000 agents who come through a year to get their license.

And I always really stress to them like, I know so many realtors who despite being involved in real estate, don't own any real estate outside of the home they live in. And to me, it really blows my mind from a couple of perspectives. Number one, we see these deals before anybody else even sees them, for the most part. Before we list the property, we could always just buy it ourselves directly off the owner. That's number one.

Generating a Tax-Free Wealth Using Bonus Depreciation

Generating a Tax-Free Wealth Using Bonus Depreciation
Photographer: Jingming Pan | Source: Unsplash

Kyle: Number two, the tax benefits side, I don't think a lot of people, to your point, are even clued in on. I don't even think they know about it. Gary Keller says this, the guy who found the Keller Williams, he always talks about gross versus net, how much do you make versus how much do you keep. How much you keep is so much more important. But I know realtors out there who legitimately make like $1 million a year just selling homes on their team. But then you take into account the federal taxes in some states like New Jersey as an example.

The state taxes, the self-employment taxes, and at the end of the day of that $1 million, they're keeping like $400,000 after taxes. However, what if they started learning about real estate investing? They can create passive income for themselves. They can grow their net worth overall and just wealth in general. And they can create assets to leave to their kids and ultimately they can stick a lot more money in their pocket and save money on taxes. So I remember going to an event where Tom Wheelwright was speaking. Tom Wheelwright, for those that don't know him, one of the top tax consultants really in the world.

Darin: Great book out there if you haven't read it, Tax-Free Wealth.

Kyle: Yes, Tax-Free Wealth Second Edition. But with that being said, I hear him speaking and he's saying, "Yes, you could have a doctor who's making $1 million and this doctor's spouse is a realtor making $50,000. But since the spouse is a full-time real estate professional, their combined joint income can use deductions from their real estate investments. So they're combined $1.05 million in income."

A Pie in the Sky Deal

Kyle: "If they have enough deductions, they could potentially wipe the whole thing out." I said to myself, wow. And now in my head, I'm always thinking about, where can this be utilized? And in my head, because I'm always trying to find ways to make Rutgers football better. So I'm like, maybe we could talk the Rutgers football coach into getting his spouse a real estate license. Because although we can't pay as much as Ohio State and Michigan, we're going to have our coach keep more in his pocket because he's going to be able to save all this money in tax. But it is crazy when you think about that.

Darin: Has that worked out?

Kyle: It hasn't worked out though.

Darin: Let's go back to that scenario of that guy that starts with $1 million and he ends up with $400,000. So that's $500,000 to $600,000 worth of taxes. Let's assume that you get to that person to invest where they actually have no tax liability. Which for anybody listening that hasn't done this, it just sounds like pie in the sky, but it is real. So if he took that $500,000 and then invested in a deal and then that $500,000 then doubles in five years, now that's $1 million extra that that doctor didn't have.

Kyle: And I'll give you a perfect example.

Darin: And then he doubles that in year two, in year three, in year four, and year five.

Kyle: Right. So I did this. I'll give you a perfect example. We just talked about that deal we had in Phoenix where 3.55 equity multiple over a three-year hold. 2018, which was the first full calendar year of 100% bonus appreciation, I had $556,000 worth of tax deductions.

Bonus Depreciation Turns Taxes Into Assets

Kyle: Ultimately that saved me in the vicinity of about $200,000 in taxes. That savings for taxes, I rolled into that deal. That deal then produced a 3.55 equity multiple. That $200,000 that I would've otherwise paid to the government turned into $700,000 netted me, when you take that. I would've paid $200,000 without the tax benefit, instead, I took the $200,000 I put it into that deal.

That $200,000 turns into roughly about $700,000. I netted $900,000 over the course of just three years. Literally because I went to a seminar and I learned about this stuff and I talked to a kid I went to high school with who's now my CPA.

I shouldn't call him a kid anymore because we're both, I guess, man now at this point.

Darin: It's crazy. You're 32, I'm 52. There are 20-somethings out there start investing in real estate as early as you can. So it's still a question mark people don't really understand, how do you have a tax loss, a paper loss? What does that even mean? Real estate is really bizarre because you can take depreciation when it's typically an appreciating asset, which doesn't make sense. I started out as a CPA in accounting world, but it's true, and the government does that.

If you read Tax-Free Wealth from Tom Wheelwright and others, they do that because they want you to invest in the economy and keep workforce housing affordable. If we weren't investing in those properties, then it would be very difficult to keep those properties well-maintained because nobody is dumping more money into it. So the working class would be living in very, very poor conditions.

Kyle: Agreed.

Don’t Let Life Push You Around

Darin: So that's huge and congratulations to you, my friend. It takes courage and it takes action to get in. I'm sure you've got your drinking buddies that are like, "Ah, you're lucky, man, you got in at the right time." But you went and looked into it and then you actually took your money and put it in, and look, every investment, there's risk of loss. It turned out to be fantastic for you. But there's a lot of people that just sit on the sidelines and they just let life push them around.

Kyle: Yes. And that's a key. Obviously, timing plays a role, for sure. It definitely plays a role. If interest rates go down and cap rates compress, you're going to make money. But with that being said, you have to be in the game to make money to begin with. To say that, we completely drove the value to get the 3.55 equity multiple, that would be a lie. I think we operated well, we kept occupancy super high, we always had a waitlist and everything like that.

And we treated the tenants really well too, which definitely played a factor in the renewal rates that we were able to obtain there. But to your point, you have to get in the game because if you're not in the game, you can't get any of these home runs. Not that we swing for the fences. I always say we swing for singles and doubles, but if you swing for a single or double and you really connect, well, it might go out of the park and that one went out of the park.

Bridge Debt and Floating Rate Debt

How Bonus Depreciation Reacts to Bridge Debt and Floating Rate Debt
Photographer: regularguy.eth | Source: Unsplash

Darin: Yes, that's huge. One of the significant things that's happening in a lot of these deals right now is you were talking about cash-on-cash earlier and a lot of deals are either holding back on distributions or cutting distributions. Because over the last two or three years a lot of deals have been financed with bridge loans and floating rate debt. So talk about pausing distributions or cutting back distributions altogether. What are you seeing?

Kyle: Yes. So pretty much every deal I'm in both as a GP and LP. Distributions have been paused any deal that is on bridge debt. And the reason is because if you look at the Fed dot plot, the one from this time last year. The most recent Fed dot plot at that time was the one from the December Fed meeting. The Fed's own dot plot projected that in 2022, the rates would not go above 1%. Oh, they went way above 1%, they ended the year at about 4.5%.

Their Fed dot plot at that time for 2023, they projected they would never get above 1.5%. That was their number 1.5%. 2024, they projected that at that time they would get rates to 2%. So now what has happened? Rates have gone significantly higher. Now the market is thinking that the Fed will probably get up to somewhere between 5.25% To 5.5%. And perhaps their last hike, instead of being in March, the bond market teams will be pricing in. They will hike also in May and perhaps even June as well. So what that leads to is deals that are on bridge debt who have floating rate debt.

Floating Rate Debt

Kyle: And have rate caps that they bought upfront perhaps for two years or three years or even one year in some cases. Those distributions that they would've otherwise paid out are getting paused so that this way the general partners can build up cash reserves in order to buy future rate caps. Just to keep the cash position strong. Because it doesn't matter, I guess, what the data perhaps says, at the end of the day. If you look over at the Pensford studies.

Pensford does great studies with JP Conklin, and what it shows is that floating rate debt is better than fixed rate debt 90% of the time on a five-year hold. Number two, if the fixed rate debt was better, it's only better by 0.9%. If the floating rate debt is better, it could be as close to 5% better rates-wise, which is huge when you think about it that way. But when you're going through it, when we're at the point that we're in right now.

Darin: It's painful.

Kyle: It is. It's almost like one of those things where you see a good employment report and it's like. Well, good news is bad news, but bad news could be good news. It feels weird. When you see a hot employment reading of 500,000 plus new jobs and you're like, ugh, the projection was like 200 and now the Fed is going to maybe raise even more and things like that. So until there's really clarity on what the Fed is going to do. When are they going to pause their rates, when might they start cutting the rates?

Building Up Cash Reserves Is the Smart Way to Go

Kyle: I understand both me as a general partner and also deals that I'm invested in as an LP with those general partners. When they're pausing their cash flow distributions, I understand it. I also think it's a smart thing to do because as they say, "You'd rather have the cash and not need it than to need it and not have it." So I think building up cash reserves is the smart way to go right now.

And then once there is clarity on what the Fed is doing, once inflation does eventually come down, then the spigot can be turned back on as far as cash flow distributions are concerned. And if it's a case where you are just kind of socking that money away in reserves, it's not like that money disappeared, it is still there. So when the Fed does eventually pause, and when they do eventually start cutting rates when inflation does come down that money at that point, that would be the time where it makes sense to put it out there.

Because rule number one is protect your LPs. You never want to risk the loss of capital invested, and you want to do everything you can to prevent a situation like that. So I think the pausing of distributions right now, both as the deals I'm in as an LP and also the deals on the GP side, I think that is definitely the prudent measure right now.

The Balloon Feature in Bonus Depreciation

Darin: Absolutely. So all that is fantastic information for the listeners. Some listeners understand all of that and some don't really understand the financing piece of it. So I'm going to delve into that a little bit. On these multifamily deals, you can't get a 30-year fixed-rate mortgage like you can on your house. They all have some kind of balloon feature. And what does a balloon mean? It just means that the loan is going to come due at a certain period of time and you either have to sell the property or refinance at that point in time.

So the longest term you could probably get in these multifamily deals is 10 to 12 years fixed, and that would be with Fannie Mae and Freddie Mac, the agencies. Banks like to be in that five-year max timeframe. And then over the last several years, bridge financing was a big popular way to finance these deals. And the typical structure on a bridge loan would be a one or two or three-year typical plus two, one-year extensions. So three years to the reset with two, one-year extensions.

And like Kyle was saying, that is floating rate debt. So as interest rates went up, the debt service went up, the interest rate went up. So more of the cash flow is getting paid to pay that debt service. But then the second thing that was happening is that some of these lenders were requiring say maybe it was a seven-year floater with the agencies. And then you bought a three-year cap and then you're done with two years of it, you have a year left to buy.

The Importance of Keeping Cash Available

The Importance of Keeping Cash Available in Bonus Depreciation
Photographer: Andre Taissin | Source: Unsplash

Darin: The lender requires you to start reserving to buy a new cap. And so, that's going in as reserves into a reserve account similar to how your property taxes and your insurance might go into your mortgage payment, it's going into that account. And a year from now when you actually purchase that cap, if it's lower, you're only paying the actual cap cost. The lender is just being conservative to require you to reserve for that cap.

If you were to sell the property before that, all those reserves would go back to the investors. But I think that that confuses some investors where they just see the combination of increased debt service and the reserves. That's a big jump. It's not like 10% or 20%. I mean, you could see a property up paying $30,000 a month and then all of a sudden paying $70,000 a month and you're like, "Holy cow, what's going on?"

Kyle: Yes. To your point, the escrow reserves for buying future rate caps too. I've heard some stories of that number being, in some cases, in excess of $50,000, $75,000 a month.

Darin: A month?

Kyle: Yes, for interest rate cap reserves.

Darin: Right. That's crazy. It really is. So a lot of things are going on and I agree with Kyle that it's prudent to keep the cash available. And I'm older than Kyle, but I'm still not counting on that cash flow as paying for my daily living. Now, if I was an investor that was counting on that money for my daily living that would make it much harder because that would impact how I live.

Bonus Depreciation as a Way to Build Wealth

Darin: I look at these deals as being a combination of cash flow and the backend capital gain. And the two combined is much more attractive than investing in the stock market from my perspective and has huge tax advantages. So I'm okay with them holding off and waiting for a better time to reinstate distributions.

Kyle: I would agree with that. And to your point, for the full-time real estate professionals, when you account for the cash flow, appreciation and depreciation, I mean, when you look into the net effective returns, it's pretty damn good.

Darin: Yes. I mean, your example alone, you would've paid $200,000 instead you ended up with close to $700,000, so that's a $900,000 swing. That's only one year, if you do that for five years. I mean, obviously you're not going to get that 3.6 multiple on all your deals. But you end up getting that compounding effect where each year you're saving $100,000 or $200,000 in tax, you're putting that into a deal that doubles over time. It makes a massive difference.

And that's probably why people say that 90% of millionaires are created through real estate. I mean, I don't know about you, but when I got involved with this group, I met a ton of people and people get to the net worth discussion pretty darn quick. And I couldn't believe how many multimillionaires there were. I've asked people that I know that are wealthy like, "Do you know anybody that's wealthy just by saving?" And I was told, "No. I don't know what your experience is."

Kyle: Yes. There was a study done between 1870 to 2015 looking at, let's call the geometric mean of different returns of equities.

Why Real Estate Has Superior Returns Than Stock Market

Darin: 1870 to when?

Kyle: 1870 to 2015. And what it showed was that equities, the stock market during that time when accounting for volatility, the average annual return was 4.64%, 4.64%. Post 1950, it was 5.1%, around 5.1%. For real estate, from 1870 to 2015, the average annualized return from just appreciation alone was 6.61%. Now with that being said, you got to remember that if you buy it 100% all cash, 6.61%. Most people who buy investment properties buy it with 25% down. So if you buy that with 25% down, we take 6.61% multiplied times four, and your average annualized leverage return.

If you are buying with 25% down, would be about 26% from just appreciation alone, not even accounting for cash flow, not even accounting for the tax benefit. So when you compare 4.64% in the stock market from 1870 to 2015. Again, this isn't even accounting for the 2015 to 2022 crazy run up in real estate prices. But from 1870 to 2015, the stock market, 4.64% real estate, if you bought with 25% down, the leverage return would've been about 26%. That's a little over five times more on the return profile.

Darin: That's crazy, I've never heard anybody say that. That's huge.

Kyle: It's crazy when you think about that, especially when you plug it into a compound interest calculator and you see what the difference is over time between 4.64% and the stock market. Because the stock market, the average annual return, not accounting for volatility is something like 8% to 10%. But when you actually account for the volatility that it goes down, it goes up, it goes down, it goes up.

The Leverage Returns

Kyle: Because if you have a stock as an example and you put $100 into the stock market and it goes up by 20%, that's now worth $120. But then if it goes down by 10%, the average annual return there you would say is 10%. But it's really the overall return goes down because if you have, again, this example, $100 you put in the stock market, the stock market goes up 20%.

Darin: Cut to $108, is that right?

Kyle: Yes, it's $108. But the thing is, over the course of two years, your average annual return, most people would say, "Well, that's 10% total, which is 5%." But really what it is your $100 turned into $108 over two years. Your $100 did not turn into $110. So when you account for actually the volatility of it, that's where the real returns, that's how you really have to analyze the returns in my opinion. And again, leverage returns is buying with 25% down, which is kind of a standard down payment for an investment property. Again, real estate is beating the stock market by a little more than five times.

Darin: I mean, leverage is a huge piece of real estate. So before I got involved with the Sumrok group and got involved with large scale multifamily, my wife and I bought a new construction duplex and I still own it. And that was partly because of mindset, I didn't know how to buy these larger deals. But just even with that duplex, it was a $300,000 purchase. My wife and I put in $50,000, we got a loan for the remainder from a bank, personal recourse.

An Early Start in Bonus Depreciation

An Early Start in Bonus Depreciation
Photographer: Serghei Trofimov | Source: Unsplash

Darin: I don't know, that was maybe five years ago and I don't know what I could sell it for, but the tax roll on it now is valued at like $430,000. So I really didn't do anything. I've owned the property for five years and the two tenants are paying my mortgage, my property insurance, and my taxes. So I'm positive cash flow a little bit, but it went up by 120,000. I didn't do anything just by owning it, owning an asset. And it would've taken a long time to put 10% away and have it grow to that $110,000.

Kyle: The crazy part when thinking about that, and it's something I always try to stress to people, is that you took $50,000 out of your pocket to buy that, and the property went up in valuation from $300,000 to$420,000. Your $50,000 in equity is now $170,000 in equity. So you went from having $50,000 to now $170,000. So when you really look at it that way, your return on your equity there is huge.

You made an extra $120,000 just by having a roof over your head, which is insane when you think about it that way. But I think oftentimes people don't look at it in that sense. That's why I personally think when everybody first starts off, if you first graduated college and you just got your first job. The first thing I think everybody should do, and I wish I did this in hindsight, was buy a four-family using an FHA loan, live in one unit, house hack it, 3.5% down.

Darin: 3.5%. Perfect.

Kyle: Yes, it's nuts. It's crazy.

Darin: I love that you said that.

Bonus Depreciation Makes Assets Pay For Themselves

Kyle: Yes, that's a great way to start. For somebody who's just graduating college, they just got their first job, use an FHA loan, buy a four-family, 3.5% down, they'll qualify you with a higher debt-to-income ratio. They'll allow you to take roughly about 70% of the other three units' rent roll, and use it towards your income when applying for that loan.

Most people can get a loan larger than they think because they don't realize that the bank doesn't just use their income for that loan. They also use the income of the other units for that loan when you qualify for it. You've probably lowered your monthly living expense because you have three other people helping you pay.

Darin: You only have to live in it for a year, is my understanding. And then you can move out and put somebody else in that fourth unit and then you have that property forever.

Kyle: Exactly. You could hold it forever. Think about somebody who bought, let's use round numbers, a $500,000 four-family. For that $500,000 four-family as an example, or let's even use $1 million because I can do the numbers quicker in my head. For $1 million four family, you took $35,000 out of your money for down payment plus whatever the closing costs were. But for $35,000, once you eventually move out of that, you're going to be cash flow positive on it. So now, you have this asset that is paying for itself, on top of that, you're probably getting passive cash flow.

Bonus Depreciation in the Long Run

Kyle: If that person holds that forever, 30 years down the road and it's fully paid off, if that appreciates at the rate of roughly a little over 6% a year, that $1 million property you bought 30 years ago on average using the rule of 72, you just take the return divided by 72 and that's how long it would take to double in value. That would mean that property is worth about 2.5 X more, that $1 million property is worth $2.5 million in 30 years when that person is now in their 50s. After they graduate from college, they now have $2.5 million in assets free and clear. That's good for retirement money, right?

Darin: It's amazing. I would say that one of my number one advice to young people is you're only a first-time home buyer once, don't waste it on buying a single family. If you can afford a fourplex. I love the idea of using the income from the other three to help qualify, that's huge. Then if you can think to yourself, I'm just not going to sell anything. I was in Florida in January, my wife and I went down and we met with a couple, we used to live in the same neighborhood as them.

They're like, "Darin, you know what your house is worth now?" And I think when we bought the house, it was on the East Coast of Florida for $364,000. And when we moved to Texas, we sold it for, I don't know, $430,000 or $440,000 or something like that. Well, now it's worth $1 million. Had I rented it and just held on, I would've had $600 and some odd thousand of extra equity that was built up just by holding on and owning an asset.

The Infinite Return Aspect of Bonus Depreciation

Kyle: Right. And that's something I always think about. I always think, should I try to one day buy deals with the thought process being and being transparent with LPs that this will be a legacy asset. This will be an asset that we buy, that we intend on really holding forever. And throughout the term of holding this forever, we will perpetually keep re-leveraging and refi-ing. Because if you put $100,000 into this deal upfront, our goal would be within five to seven years, to get your $100,000 out of there by refi-ing and leveraging.

And now you get, excuse me, what we call the infinite return, the infinite return, you have no money at risk, but it's continuing to pay you. And you still got that percentage of ownership. Maybe that's an asset that we hold for 20 or 30 years. So when we hold that for 20 or 30 years, we keep refi-ing, and here's the beauty of that, refi proceeds are tax-free, so you're getting your money back. You got the tax benefit when you put the money in, but you're getting your money back tax-free.

Then you're taking your money that you're getting back and you're using that to invest in more properties. You're getting more tax deductions, you're building more wealth, you're getting more passive income. For me, if I could find a fund like that, I would start investing a ton of money in a fund like that. I don't know, again, because I've never really spoken in depth to other people about this, but to me that's always been something that really does intrigue me.

The Velocity of Money in Bonus Depreciation

The Velocity of Money in Bonus Depreciation
Photographer: Martin Adams | Source: Unsplash

Kyle: Just the benefits of being able to hold something forever, just the infinite return aspect of it. So it's something that I think sometime down the road I'll certainly look into and feeling people out to see if it would be something they'd be interested in.

Darin: Yes. I think that the approach makes sense. I think you have what the piece you have to look at is the velocity of money. If you were to be able to sell that and then roll that into another deal that is going to return more on your capital at that point in time than if you had left it in there, that's the piece that you have to look at. I was in syndication, they did refi out all of the investor money, and it is infinite returns and you're getting that nice cash-on-cash with no money left in the deal, which is nice.

But the question is, okay, every time they refi, there's still, whatever, 25% equity still left in the deal. If you took that equity and you put it into another deal that was a value add deal that had capital to improve the property. Or maybe this property, they've already done the value add and they don't have any more money to make it better. So they're not going to be able to really juice up the returns and get the rents up that much higher. It'd be slow and steady. So that's the piece that I think you have to measure it up against.

Affordability Gap

Darin: I know some people that are really good about doing all of the above. They buy some deals on their own, they do syndications, and they have some deals that they consider legacy assets. So that may be the play is to diversify into those different categories.

Kyle: Sure, definitely.

Darin: Oh, man. So talk about affordability gap. You're a stats guy, so I can come to you on stats.

Kyle: So affordability gap is big right now. It is significantly cheaper to rent versus own in this country right now. I always do this. Any deal that I invest in, both as an LP and a GP, I do basically a three-mile radius around the property and I look at the single family homes, I want to see what their values are. Because I want to see what is the alternative. Because you would assume that your typical renter, if they're buying a house, they're going to be putting down not like 50%, they historically will be putting down somewhere close to 10%, even 5%, even 3.5% in some cases if they go at FHA.

Darin: Texas is 20%.

Kyle: Yes. Well, you could still go FHA with a lower down payment, but yes, to your point, it is common that people will put down 20%. So you could run the number that way as well. But either way, what I try to figure out is, okay, in this three-mile radius, if somebody wanted to buy versus rent, what's the difference going to be as far as monthly cost is concerned? It's funny enough you say this, because I didn't know we would talk about this, but I was literally doing that this morning.

Renting vs Owning

Kyle: I was looking at one of our properties and I was seeing nearby complexes, nearby subdivisions, what are the homes selling for. And what it comes out to with where rates are right now on single family home sales right now. the average nationwide rate as of today, it's gone up 75 basis points in the past 10 days but it's 6.75%. So 6.75% if you buy with 10% down. And that means you're going to pay PMI, private mortgage insurance.

The cost of that in a lot of cases could be close to $750 to $1,000 more than it is to rent. And there's also really good indexes put out by services like Black Knight, John Burns Consulting, and they'll show you the affordability gap. Right now, yes, it is significantly cheaper to rent versus own. And on top of that, we have the second-lowest amount of inventory ever in this country to begin a year in 2023. The lowest ever was last year, 2022.

So we have super low inventory, we have high rates, we have high demand for housing. So it's one of those things where people naturally will want to buy, but can they buy is really the question. The thing is, in recessionary times, not that we're in a recession right now, we could be perhaps in the future, who knows, but during recessionary times when household formation goes down, most people think that the people who aren't buying are just going to rent.

The Fugazi Loans

Kyle: But what it actually shows is that people historically will just renew in place wherever they happen to be. They won't move or they'll move in with family. Or they'll continue to live with family if they've been living with family and kind of push off buying or push off household formation in general for a little bit. But the affordability gap is huge right now. As far as rents are concerned, we saw historical rises in rents over the past couple of years here, that is tempering down now.

We're getting back more toward historical norms, I mean, there is an enormous affordability gap, it is significantly cheaper. You could probably look at this across almost any apartment complex in the whole country. I can guarantee you, it is significantly cheaper to rent at an apartment complex within a three-mile radius of what you could buy.

Darin: Do you see that changing?

Kyle: It's tough to say. Because here's a problem, rates being this high is a problem as far as monthly debt service is concerned for a single family home purchaser that's going to buy a house. The bigger issue is though if rates do go back down towards the fours, like Mortgage Bankers Association of America believes that by Q3 2024, single family mortgage rates will be 4.4%.

If that happens, there's so much demand on the sidelines. Last year we went from 6.5 million annualized home sales all the way down to 4 million, that matched 2008 as far as level of demand is concerned. 2008 is a totally different market than what it is now. I'm from New Jersey, so we always say fugazi loans, had all these fugazi loans, where basically you're breathing a mirror and you get money essentially.

Increasing Rates

How Will Bonus Depreciation Fare on the Increasing Rates
Photographer: FilterGrade | Source: Unsplash

Kyle: Well, we don't have that this time, the lowest delinquency rates of all time. So if rates go back down, these people who are waiting to buy, we have the most 30 to 35-year-olds of all time in this country ever before, it's the baby boomers kids. They had a lot of kids, apparently. Especially this five-year gap here. So with that being said, if the rates do go back down, there's going to be a rush of buyers and that's probably going to send single family home prices higher.

Because people buy the monthly payment, they don't buy the price of the house, they buy the monthly payment. So if people are qualifying at this monthly payment right now, when rates go down, they still can afford the same monthly payment, but that same monthly payment affords them to buy it for more money. And ultimately that increases down payments, which therefore affects people looking to buy that house. This is a very long way of saying that, I don't know if that affordability gap is going to get solved anytime soon.

Maybe the only way it gets solved is if rents just go so high that they start getting close to the monthly mortgage payment of what it costs to own a home. And what a lot of people, unfortunately, especially first time home buyers, don't realize when you buy a house, you're not just buying that monthly payment, you're buying the maintenance too. Because what happens if your air conditioning system goes, your heating system goes, things like that.

Buying a House Is a Liability

Kyle: Your hot water heater goes, you got to replace windows, things like that. Not everybody takes that into consideration when they buy a house. So when that happens, all of a sudden your heating system and cooling system goes, it's five figures out-of-pocket to replace those things. How many people have that? So it's an unfortunate thing, but I don't really see this affordability gap getting closed significantly, at least anytime soon.

Darin: Yes. The other thing that I think about is you have so many homeowners that finance their home and refinance their home and they're sitting on a sub 3% mortgage rate. And unless they have to move or they're retiring to a different state, why are they going to sell? Because if they put their house up for sale, they're going to move down the road into a different house and they're going to have a much higher mortgage rate. And so it's going to be so much more expensive. So I just don't see a lot of homes coming up for sale because you've got a lot of people sitting on low-interest rates.

Kyle: Yes. I mean, I did a webinar on this on Monday night for State of the Market. Here's a perfect example that I gave. For somebody who bought a $500,000 house five years ago in 2018, the Case-Shiller index is the number one-cited index for home prices in the country. The Case-Shiller index shows that from today, when we're shooting this in February of 2023, from January of 2018 to February 2023, home price have gone up by 50%.

A Costly Purchase

Kyle: Now, what that means is that somebody who bought a $500,000 house in 2018, that $500,000 house is now worth $750,000. Furthermore, the US Department of Commerce says the average interest rate for a homeowner today is 3.47%.

So if we use the 3.47% number on somebody who bought a $500,000 house, and we just assume a 20% down payment, that means that their monthly payment on that home is roughly about $1,750 between principal and interest. Now, today, for them to buy their same exact house they bought five years ago would cost $750,000.

And if we use rates, the example I gave on the webinar, if we use rates of 6.5%, they would have to put down $150,000 instead of $100,000, and now their loan would be $600,000. A $600,000 loan at 6.5% interest would increase their monthly payment by $2,000 a month between just principal and interest.

Darin: About $3,750?

Kyle: About $3,750, a little more than that. I think it was about $3,789. So it would go up by $2,000 more per month. Now, Darin, historically, your move-up buyers, they buy a house worth 50% more than their current home. So for that person to become a move-up buyer and buy that next-level house, they would've to sell their now $750,000 house, and that would imply they buy a house for $1.125 million.

Now, if they buy a house today for $1.125 million with 20% down, that would be 20% down payment, that would mean alone a mortgage of $900,000. A $900,000 mortgage at a 6.5% interest rate would increase their monthly payment by $4,000 a month.

The Dilemma of Selling a House in Today's Time

Kyle: And Darin, that doesn't even consider their increase in tax and insurance. If you take that into account, you're talking about an increase of monthly payment by $5,000. And when we really think about it that way, an increase in monthly payment of $5,000, that's $60,000 a year. To clear $60,000 a year, you have to make probably about $90,000 after you take the taxes out of your paycheck.

You have to make an extra $90,000 a year at work just to break even on affording that increase in monthly payment. So what are these people doing? They're not selling. They're going to say, "You know what, $1,750 on the monthly payment, that's a whole lot better than $6,750. We don't really need that extra bedroom, we don't need that extra office." So what they're doing is they're staying in place, and that's going to suppress inventory for a long time, I think.

Darin: I think so too. For a long time, I think the biggest potential to change is we've seen it in a tech sector layoffs. If that continues, if people lose their job, even if they're paying the $1,750, and if they can't afford that anymore, then they're like, "Hey, now is the right time to sell. I'll book my gain and I'll rent."

Kyle: Yes, that's definitely possible.

Darin: I don't think that that person is going to be able to go and buy another house, like you said, nor would they want to. It's a matter of, "Look, I lost my job. I don't have the cash flow coming in. Our house has appreciated a ton, I'll sell the house and I'll rent." So I think that supports rental prices.

The Three Things to Worry About Owning a House

Kyle: And one thing on that too, I think speaking of somebody selling their house and things of that sort and what are some other things that could perhaps help prices, help affordability, it would be new construction. The problem is it's just gotten so expensive to build. Between the red tape before you stick a shovel on the ground that you have to deal with all the cities, labor costs, material costs. Everything has gone so high.

That realistically building these days, it's tough to build unless you're building something expensive. So that traditional $200,000 to $300,000 first-time home buyer house, it just doesn't really exist anymore, unfortunately. John Burns Consulting put out a good stat on that.

Darin: If they could figure out where to buy land and build to make housing prices affordable again, $200,000 to $300,000 with today's interest rates, then people would flock.

Kyle: Yes, definitely. And I could tell you this, I mean, I see that I think it's also something that people don't take into consideration with their multifamily properties, with their apartment complexes, the new supply risk. There's three things I worry about that are kind of out of your control a little bit. If new supply comes online that was not permanent prior to you purchasing.

Insurance every single year, it seems like it's going up an insane amount that you can't even project how much this was going to go up. And number three, in a state like Texas in particular, property taxes. It gets to the point where I believe that they just sit in a room and they start throwing darts at a board and saying, "All right, that's going to be your tax bill this year."

The Three-Mile Radius

The Three-Mile Radius
Photographer: Karsten Winegeart | Source: Unsplash

Darin: What can we get away with.

Kyle: Yes, what can we get away with. This is really been their piggy bank for a long time, but can they keep increasing taxes when valuations go flat as they are right now, or even in some cases declining. So it'll be interesting to see what those tax bills come out at.

Darin: So do you think the new supply is a risk on B, C assets or just on the A?

Kyle: I would say more on A side for sure as opposed to B and C. Yes, definitely more on the A. I'll give you a perfect example. So we bought a property last year in April, and at least what I always do is always look around the three-mile radius, is there any new permanent new construction being built? There wasn't. However, there was one about five, six miles away. Well, we didn't really think that would be a competitor for us, but it turned out to be a competitor for us because you know what a community like that will do.

It's frowned upon but people do it, they'll drill your community's mailboxes and say, "Hey, we got this new complex, it's five miles away. We're offering two months of free rent." Well, how do you compete with that when they offer two months free rent and they'll pay moving costs and things of that sort. So what we saw, and it definitely affected us, our occupancy was lower than we anticipated, it was in the low 90s%. Now we're up to 97% because they've pretty much got those units leased up over there so we're not dealing with as many issues with that anymore.

Can Real Estate Maintain Its Tenants

Kyle: But it's one of those things where historically you always think that your competition is a one to three-mile radius. Now, this has totally kind of changed my mindset like, "Okay, maybe we have to change our thought process on this. Maybe we have to look out five miles." Because maybe within five miles as a competitor, because you never know, maybe they'll just start drilling your resident's mailboxes and saying, "Hey, are you up for renewal?"

And it could be somebody who just moved in 10 months down the road. But for instance, they might hit a mailbox where the renewal is in two months. And we send a renewal notice and they're like, "Hey, we just got a two months rent-free offer and paid moving expenses from this community. Can you match that?" Well, it's hard to match that. It's hard to match essentially what equates to three months free rent. So you wind up losing people that way.

Darin: Absolutely. So you've been in the real estate world for a long time. I've been in real estate, purchasing real estate, investing only for the last five years. But I've been trading loan portfolios since 2002, residential, multifamily and commercial. And my viewpoint is that real estate prices will continue to increase residential, multifamily, commercial over time.

And yet every investment is cyclical. You need to figure out and plan to figure out how to get through the tough times. Because there will be tough times in real estate also just like every other investment. But over the medium to long term time, I don't see another investment that is as attractive because of the leverage and the tax efficiency. What's your take on that?

Kyle Kovats’ Take on the Prices of Real Estate in the Future

Kyle: I would agree. I mean real estate, they always say, it's not get rich quick, it's get rich for sure. And what they mean by for sure is over the long haul. They don't say, wait to buy real estate. They say, buy real estate and wait for a reason. Because over the long term, the fundamentals, you're going to be able to replace a lot of things in this country, in this world with technology. But what you ultimately can't replace is shelter, a roof over your head at the end of the day.

So fundamentally real estate is in a really good spot depending upon where you look. We're around like 5 million housing units short in this country right now. So when you have a shortage of housing and especially for the next 15 years or so, you have a very large amount of people hitting peak household formation age, the fundamentals really do ultimately work out.

And as we talked about earlier, it's getting more and more expensive to build. So it's hard to build anything that's "affordable" these days. And I don't mean affordable with capital A, affordable meaning government-mandated affordable. I mean like market-rate affordable. So over the long haul, yes, definitely. Now obviously there could be blips, like right now as an example, when you have this rate shock where rates go from overnight, essentially zero to where they are now, you're going to have rate shocks.

What Kyle Kovats Like to Do for Fun

Kyle: You're going to have events like this where prices do go flatten and in some markets they even decline. But over the long haul, everything ultimately does balance out. And real estate, historically, again, we talked about this earlier, 1870 to 2015.

Darin: That's so crazy.

Kyle: The geometric mean when it counts volatility.

Darin: So Kyle, what do you like to do for fun outside of work?

Kyle: I love sports.

Darin: Rutgers football.

Kyle: Rutgers football in particular, Rutgers basketball. Rutgers basketball gives me a lot of high heart rates at times. Because one night they could beat the number one team in the country. Which they did this year they beat Purdue who was number one in the country. A few weeks later they can lose to one of the worst teams in the whole conference in Nebraska, which we did recently as well. And I like hockey, I like the Rangers. I'm a New York Rangers fan, so we're having a really good year this year. So pumped up about that. And yes, I like skiing. I play a lot of sports. I still play basketball.

A Plethora of Information

Darin: East Coast skiing or Colorado skiing?

Kyle: So East Coast Ice as they say.

Darin: Yes, right.

Kyle: So yes, East Coast Ice. And I was in Colorado.

Darin: Freeze as you go up the chairlift with the man-made snow.

Kyle: Yes, exactly. So I was skiing in Colorado last week and I'll be skiing in Vermont this week.

Darin: Yes, Colorado is much more favorable in terms of the temperature.

Kyle: It certainly is.

Darin: So hey, how do people reach out to you if they want to get to know you more?

Kyle: Yes. If people want to reach out to me, they can go to our website, which is Kovatsmultifamily.com, or they could simply shoot me an email. My email is very simple. It's just my name, kylekovats@gmail.com.

Darin: Kyle man, you are a plethora of information. I don't know how you keep up with it all, but I appreciate you coming on and sharing with everybody. I learned a ton. So listeners, I hope they enjoyed that one. Until next week, signing off.

How To Reach Kyle Kovats

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Darin Batchelder

Wealth creation through real estate provided me with a new passion to get the word out and let others know that they have an alternative to investing in the stock market.

If I can inspire and educate just one person to take action that results in life changing wealth creation then the work to launch and grow this podcast is well worth the effort.

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