AMA - Tax Adjusted Returns?

Today is another AMA Episode (Ask Me Anything) Carlos from Los Angeles asks,

We have a single investor who capitalizes most of our deals. He has recently been very focus on investment multiples in our investments and not as much on cash-on-cash returns, IRR, etc. He comes from the private equity world.

We have recently tried to highlight our overall returns once you factor in the tax benefits from depreciation. Since we are all in different tax brackets, this is a little tricky to do (in my opinion). Is this something you try to quantify for your investors?

Below is an excerpt from our investment memo highlighting the "tax-adjusted" cash yield and IRR. We worked with our CPA to quantify this.

This is a deal that our investor is not too excited about. We are using 1031x funds and are trading for a lower-risk property.

Carlos, this is a great question.

As a general rule we don’t stray into the realm of offering tax advice for the simple reason that everyone’s personal tax circumstance is different. I’ll give you a simple example. Let’s imagine for a moment that an investor is using funds from their retirement account. Any income received within the retirement account would be tax sheltered. In that scenario any tax benefit that would accrue to the investor from depreciation would be zero since they’re already in a zero tax situation for that specific investment.

On the flip side of the argument, we do point investors to educational material that may help them in the arena of making a decision on how best to structure their investment. They might decide to use cash funds instead of retirement account funds for that specific investment in order to take advantage of

Investment multiples are a very simple way of evaluating the quality of an investment. But of course they neglect time. If a project is delayed, it has the effect of lowering the annualized rate of return.

Of greater importance to the more sophisticated investors I speak with is the return of capital, rather than the return on investment. This involves a deeper assessment of risk.

I have to agree with your investor that the returns being offered by the proposed project are rather thin. Thin deals by their very nature represent higher risk. It often takes only a small change in circumstances for a thin deal to go sideways. If you have two things go wrong, now you’re underwater. I like the inherent safety of high profit margin deals. High margin deals provide ample financial cushion for problems to occur.

Risk assessment is extremely difficult to objectively quantify. After years of stable market conditions you might but a buffer for increased lumber costs. You might argue that a 20% or a 30% increase in lumber or a 3-5% increase in the overall cost of construction would be reasonable. No rational risk manager have predicted a 300% increase in the price of lumber. If your project had not pre-purchased and warehoused the materials, or if you didn’t have the financial cushion to withstand the material price increase, your project would be in trouble.

The impact of the tax sheltering creates the illusion of a better investment that is not necessarily real. I personally would rather find another vanilla investment that offers a stronger IRR without relying on the tax structure to make it viable.

We take the attitude that an investment should stand on its own. If the tax structure offers an even better return, then that’s icing on the cake. I find that most investors I speak with prefer to separate the tax consequence from the investment decision. Even for a single investor, their tax circumstance can change from one year to the next. What might be advantageous one year, might be of marginal value the next.

Thank you Carlos for a great question.