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5 Secrets to Find Profitable 1031 Exchange Properties

At the end of the day in a 1031 Exchange, you're buying real estate, so you need to understand the actual underlying property involved in the offering. Here are a few factors to consider:

  1. How is the market and sub-market?
    • Generally avoid Texas and areas with over-supply of land. They often promise higher yields, but you risk depreciation and risk of re-tenanting.
    • What is the population and job growth
    • What is the trend with the local lease rates and occupancy?
  2. How credit-worthy are the tenants?
    • Are the tenants public or private companies?
    • Are the companies growing or declining, profitable or not profitable?
  3. How attractive are the leases?
    • When do they come up with renewal?
    • Are there any rent escalators?
  4. How hard would it be to re-tenant if a major tenant left or declared bankruptcy?
    • What is the general quality of the building/ location?
    • How specialized is the building, how broadly appealing is it?
  5. What is the promised yield?
    • Cash on cash vs. cap rates: Some firms advertise "cash on cash yields" which are really returns to your equity. Others advertise capitalization rates which are returns to equity and debt. Generally a cap rate = a higher cash on cash yield due to positive leverage.
    • How are the rents secured? Avoid master leases. Many offerings have rents guaranteed by a master lease (a shell company that takes rents in from the tenants and then guarantees a return to the investors). Often times these shells are thinly capitalized with no recourse to the sponsors, so your "guarantee" is a false promise.
    • What are the fees? Have a 1031 TIC firm lay out on paper their entire fee structure. Many times they will list the fees as a percentage of assets rather than a percentage of equity. For example, a large firm quoted us fees of 10% of the asset purchased which sounded reasonable. However, when you consider that the building was being purchased with 50% debt, the fees equated to 20% of equity exchanged which is higher than the national capital gains tax.
    • What is the leverage level? From what we've seen, 1031 syndicators underwrite their purchases from 0% debt all the way up to 80% debt. Obviously, the lower the debt, the less risky. We generally think that around 60% debt makes sense. With higher debt levels, there's greater chance that firm will not be able to cover debt service and deliver their guaranteed return. Even worse, they are not able to cover debts service and will make a capital call which requires you to put more money in.
  6. Also pay attention to how this debt is structured. Many firms will use interest only debt in the early years. They do this to increase their yield to investors at the cost of big principle payments and lower returns (and potentially capital calls) in the future.