Journey to Multifamily Millions

The Importance of Understanding Market Cycles with Neal Bawa, Ep 63 Part 1

September 28, 2023 Tim Season 1 Episode 63
Journey to Multifamily Millions
The Importance of Understanding Market Cycles with Neal Bawa, Ep 63 Part 1
Show Notes Transcript

This week's guest on the Journey to Multifamily Millions Podcast is none other than the mad scientist of multifamily himself, Neal Bawa! πŸŽ™οΈ

Neal is the Founder and CEO of UGro and Grocapitus, commercial real estate investment companies using cutting-edge analytics to source and acquire (or build) large commercial properties across the U.S. 

He has a portfolio of over 4,800 units, with Assets Under Management valued at over $1 Billion!πŸ’°

This interview was so packed with knowledge bombs we had to break it into two parts! 🀯

In part 1 of this interview, he shares his real estate success story and reveals unconventional strategies and tax-saving gems in real estate. πŸ“

He also dives into data-driven decision-making and how he stays ahead with insights on shifting macro trends. Stay tuned! 

Episode Topics

[01:35]  Meet our guest, Neal Bawa
[02:14 ] Neal Bawa's Remarkable Real Estate Journey
[04:37]  Unlocking Real Estate Tax Benefits
[07:49]  Maximizing Real Estate Tax Benefits
[10:30]   Navigating Real Estate Contrarianism
[15:28]  Real Estate Speculation vs. Investment
[20:33]   Navigating Real Estate Trends: Disinflation, Interest Rates, and Market Cycles

Notable Quotes

  • "I got into real estate in reverse. Most people do a fix and flip or they do a standard single-family rental. I ended up building a 27,000-square-foot building from scratch, and it worked really well." - Neal Bawa
  • "I went from paying 50% of my salary in taxes to paying very little. That turned me into someone who truly understands the incredible benefits of real estate." - Neal Bawa
  • "At the end of the year, you'll notice that what you're actually going to see is none of that cash flow is being credited towards your taxes because we call it return of capital." - Neal Bawa
  • "So it's just strange that when people take advantage of those incentives that were put there for a reason. It's, people act like it's a gray area when it very much is not from a legal perspective, right?" - Tim Little
  • "I think a vast majority of the people that ignored 2008 are also ignoring the opportunity today in multifamily for the same exact reason." - Neal Bawa
  • "Every investor I see out there today is a reverse big speculator. They are a scared speculator." - Neal Bawa
  • "Today, anyone looking at inflation doesn't understand how market cycles work today. You need to look at disinflation or deflation." - Neal Bawa

Connect with Neal Bawa

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https://podcasts.apple.com/us/podcast/journey-to-multifamily-millions/id1634643497

Ep 63 - Neal Bawa (audio) PART 1

[00:00:00] Neal Bawa: I think the biggest single benefit is depreciation So you have the ability to buy an asset and now this asset may be cash flowing maybe it's making four percent five percent six percent cash flow for you But at the end of the year, you'll notice that what you're actually going to see is none of that cash flow is being credited towards your taxes because we call it return a capital. So we say we're returning capital, even though we're giving you money and you can probably use that to run your life. And then in addition to that. Generally in the first couple of years, you see these massive paper losses, right? On 100, 000 investment, you might see 40, 50, and 60,000 in paper losses due to both depreciation and a recent phenomenon called bonus depreciation.

[00:01:22] Tim Little: Hello, everyone. And welcome to The Journey to Multifamily Millions. I'm your host, the founder of ZANA Investments, Tim Little. And on today's show, we have with us a legend in the game, the mad scientist of multifamily himself, Neal Bawa. Neal is the CEO and co-founder at YouGrow and GrowCapitus. commercial real estate investment companies that use cutting-edge real estate analytics technology to source and acquire or build large commercial properties across the US. He has a current portfolio of over 4, 800 units with an assets under management value of over 1 billion. Neal, welcome to the show. Tim, 

[00:02:03] Neal Bawa: thanks for having me on the show. It's great to be here. 

[00:02:06] Tim Little: Yeah, and it is great to have you. I'm excited to get into it. But first, I gave everyone a high-level overview of your background. But on this show, we really like to get into the details of how you got started on your journey. So please take us back to the beginning and tell us how you got to where you are today. 

[00:02:23] Neal Bawa: Got there by accident in 2003, I was running a technology company with hundreds of employees. My boss decided that he did not want to rent a new campus and asked me to be involved with him in building a new campus. So by on July 4th, 2004 we opened a custom campus that we had pretty much built from scratch. And so I had, I got into real estate in reverse. Most people do a fix a flip or they do a standard single-family rental. I ended up building a 27,000-square-foot building from scratch, and worked really well massively elevated our business. We ended up building six more, no investors, no syndications, just us. And ended up getting incredible tax benefits. And I went from, I live in California, so I was paying 50% of my salary in taxes. And all of a sudden there were years where I was paying very little. And that turned me into somebody who truly understands the incredible benefits of real estate. And by the time I was, I had enough, I'd saved a lot of taxes in 2004, five, six, seven, eight, I'd saved a bunch of money. And so in 2008, I got into single-family, perfect timing, went out and bought dozen-plus properties and still own most of them. And then started my journey towards real estate data science. Data science is my major computer science Greek geek. And so I started that journey in 2009 when I was buying my single families and that journey went on for about five years before I got into syndication in 2014. So now since 2014 or 15, 36 projects 950 active investors, and about a billion dollars in assets under management, including the new construction projects. So it's been a long journey. So 2003 to 2023, 20 years, but only less than 10 years of that has been as a full-time real estate professional. The rest of it was simply me trying to reduce taxation and reduce the impact of taxiphornia.

[00:04:21] Tim Little: Yeah, and that makes sense. And obviously, we have listeners who are coming from a variety of backgrounds. Some are very savvy in the real estate industry, and others may be listening for the first time, and really trying to understand what all the buzz is about with real estate. So can you help those folks? Can you talk about some of those tax benefits? Associated with real estate investing. 

[00:04:44] Neal Bawa: Of course. I think the biggest single benefit is depreciation So you have the ability to buy an asset and now this asset may be cash flowing Maybe it's making four percent five percent six percent cash flow for you But at the end of the year, you'll notice that what you're actually going to see is none of that cash flow is being credited towards your taxes because we call it return a capital. So we say we're returning capital, even though we're giving you money and you can probably use that to run your life. And then in addition to that, generally in the first couple of years, you see these massive paper losses, right? On 100, 000 investments, you might see 40, 50, and 60,000 in paper losses due to both depreciation and a recent phenomenon called bonus depreciation. And what that allows you to do is to basically write it off against other passive income. If you can also write it off against active income if you or your spouse is actively involved in real estate, or if you're a syndicator, a lot of people that are listening to Tim's show are actually people that got into syndication because then they can be active in real estate. So once they're active in real estate, they can actually write off their other active income as opposed to just their passive income. So it's tremendously beneficial to invest passively in real estate, but it's even more beneficial to have some. It's your leg I tell people to keep their day job at Google or apple don't get rid of that. That's making you money but get into syndication on a path on an active basis where you're a GP or a small general partner in a deal because then you have the ability to basically write off your act use depreciation against your active income one other benefit that only accrues to general partners is that If I buy a 30 million building and it has a 5 million depreciation that I can take in year one as a passive investor, I can only take depreciation to the extent of my investment. As a general partner, we get an additional 30% of that depreciation going towards us. So you can be a general partner with a very small investment in a property, let's call it $50,000, and get depreciation that might be equivalent to $500,000. So obviously this is just an example and it all varies. But being a general partner is extremely powerful. Often people say, why didn't Trump pay taxes in those 15 years? The answer is I'm not really sure he was doing anything wrong there. I think people have been trying to imply that what he did was morally wrong and I won't get into that argument, but I'm not sure he did anything that was legally wrong. He was following the tax code because Trump, as it happens, is a general 

[00:07:14] Tim Little: partner. Yeah, and I think you brought up a bunch of great points there. But just to speak to the perception when people actually follow the tax code, a lot of times we hear the term tax loophole. It's not a loophole. They put these rules and regulations in place in order to incentivize behavior, they want people to invest in real estate and stuff like that, that's why those are in place. So it's not so much a loophole as you're just following the incentives that are put in place by the government.

[00:07:49] So it's just strange that people take advantage of those incentives that were put there for a reason. It's, people act like it's a gray area when it very much is not from a legal perspective, right? Like you said, 

[00:08:03] Neal Bawa: Yeah, it's also useful to know that depreciation is not a US concept. You can live in other countries and get depreciation. It's not some loophole that we came up with. 

[00:08:14] Tim Little: Yeah. And I think you talked about multiple different facets of depreciation, and I just want to hit on some of those real quick because Those more experienced among us do understand that you can still get that depreciation as a passive investor. And of course, as an active investor, once you get that real estate professional status, as you said if you're filing jointly like I'm going to write my wife as a regular W2 job worker in tech, she's making a six-figure income. I can help offset her income and put us in a lower taxable income as a couple because as a real estate professional, maybe I got tons of depreciation from those active deals that I'm doing. I think a lot of people just don't realize that as a passive investor they can reap the benefits of depreciation because they, It's just hard for them to imagine if they haven't been exposed to it, right? Say they have one or two single-family homes, they probably get it at that level, but they imagine that if they invest, like, why would they get depreciation passed down to them? But that's exactly what happens. You're getting these distributions, a thousand dollars, a couple of thousand dollars, and then all of a sudden you get a K 1 at the end of the year, which shows the gain or loss and It's depreciation for say 10, 000 when you only receive a distribution for 2000. I think that's surprising to a lot of, especially new passive investors. 

[00:09:38] Neal Bawa: I think so. And then I think the key is that anyone who is interested in learning how to get at depreciation on active income should read on chat GPT the definition of real estate professional, you'd be surprised that you can hold down a full-time job and still get to a real estate professional status 

[00:09:56] Tim Little: as possible. Yeah, absolutely. It's all just a matter of tracking your hours. And of course, consult your seat 

[00:10:02] Neal Bawa: Doing something with those hours, right? You can track but also actually do something with it. 

[00:10:06] Tim Little: Yep, absolutely. No. And you talked about those single-family homes that you started in. And I think you said you started in 2009 with that, which if that's the case, yeah, that would have been an ideal time to get into that market because you came in, right after the bottom fell out. How was your timing? How did that help you in terms of the value that you saw increase in those over time? And at what point did you switch over to more of the multifamily side as a focus for your investing? 

[00:10:38] Neal Bawa: Yeah. When people hear this, I bought my first single-family home in late 2008. And then 2009, I just went into a buying frenzy, and did that in 2010 as well. And then 11, 12, I was slowing down and shouldn't have slowed down actually should have kept going for another three or four years, but didn't know any better. A lot of people think, Oh, Neal, you were just lucky. And I want to remind you, I want to remind everybody that this is why people are not successful in real estate because they're like, if I was there in 2009, I would be buying everything. I want to remind you in 2009, we couldn't find if he put 100 people into a room and said how many of them should be buying real estate, almost 100 would say, Are you crazy? There was no one interested in buying real estate. Why would brand new properties that cost 250, 000 to build be available for 100, 000 if people were interested in buying real estate? You could literally walk into a city, a newer city, and you'd see this road. And every single home there was available for sale at 40% of its construction cost, and no one was buying these. So there's this very snooty feeling that investors have that well, if he had started in 2008, of course, we would have made a lot of money. No, we were extreme contrarians. My family, I went and basically was stupid enough to tell my family that my data science was showing that this was the best time in history to buy single-family rentals. I went and explained that for 30 minutes straight without letting anyone know, without pausing at a family event. My family banned me from coming to family events. That was the end result of that. After 30 minutes of what I thought were phenomenally well-practiced math-driven arguments. I was told not to show up at our events because other people are going to lose huge amounts of money because you're such an idiot. That's what was happening back then. So when people say, you got a great opportunity. No, we were shitting in our pants as we were going out there and making cash offers because everyone around us was telling us that we were the biggest idiots of all time. This is pretty normal. So today, again, multifamily properties have dropped 22% and are on their way to drop, I think, to 25, 26%. Larger properties have dropped about 22%, smaller properties, maybe 18%. If I was to ask. 10 investors today, just a random set of 10 investors. Are you investing in multifamily today? Nine would probably say no. Now, if I were to ask those same investors 18 to 24 months ago, nine of them would say yes, and they were buying extraordinarily expensive properties with extraordinarily bullish assumptions, 18 to 24 months ago. But because money was raining down on them, they weren't asking any questions. And today, when things are so much more reasonable. Exit cap rates have gone into the fives. That's great. Rent assumptions have gone into the twos from the threes and the fours. People are paying 22 to 26% less than they were paying before. All of these things mean that this is an incredible time to buy a multifamily. I just can't convince anybody of that because I don't think that investors are investors. I think that they're speculators. And they like thinking of themselves as investors. It's like I'm an investor, an investor invests in assets, and they invest in a market cycle. Speculators put money down when things are good and stop putting money down when things are bad. So I think a vast majority of the people that ignored 2008 are also ignoring the opportunity today in multifamily for the same exact reason. 

[00:14:04] Tim Little: Yeah, no, that makes a whole lot of sense. And I think you're right to point out that the context matters, right? The hindsight is always, 2020, etc. But there's a lot of armchair quarterbacks out there who, to your point now, are saying, Oh I can't believe, someone had bridge debt on these properties, and they should. Yes, we were purchasing off whatever the current environment was. We cannot always try to underwrite to conservative standards always, and I think most syndicators will say that, but, one cannot presume, the Fed raising rates, umpteen thousand points over the shortest amount of time in, in our history. And so it's really easy for people to sit back and say yeah, it should have never done that deal. It had way too much leverage. 

[00:15:28] Neal Bawa: I think on one side, I agree with you on the other side, I completely disagree, Tim. So the part that I completely agree with is there wasn't any data point out there that the Fed funds rate would go from zero at the beginning of, late 2021 to five and a half points today. There, there was no data. I can't find anybody that suggested that would happen. And not even mavericks like people who are constantly gloom of doom have suggested that. So from that perspective, I hold the entire industry to be blameless but what was clear is that prices of properties were completely out of whack during that time frame. And so I'm going to do the me up chalpa first, during that madness period, which basically started at the end of 2020 and went until maybe mid 2022, right? So one and a half years, six or seven quarters of madness. I think the best way to tell who is a good syndicator is to figure out how many properties they bought during that time frame. How many properties? My answer is one and a half. One of those I already owned. I simply wanted more control and my partners wanted to exit. So I basically exited those partners. I don't know if that one counts because it's a property that I've been running for years that I still own, but I'll count it as half a property.

[00:16:50] And then I bought one, but I was lucky with that property. That property was in a very small market that most people would not like. It's called Killeen, Texas. It's a military market, but I was able to buy it for five caps because a lot of people don't want to buy military properties. And I said, instead of buying three and a half caps in Austin, I can go 52 miles outside of Austin and buy five caps. And I'm pretty pleased with what happened there. So I, on the one hand, was able to buy a very rare five cap property on actuals. On the other hand, it was a property that I already owned that I wanted to leave my partners. But other than that, during that 18 month timeframe when money was reigning on us, I didn't buy anything. And so a lot of it really came from just this fear, somewhat irrational fear that things would, something would go wrong because everything was so expensive. Something did go wrong and I didn't anticipate it. I didn't anticipate interest rates. But when you are priced for perfection, anything less than perfection hurts you, whatever it might be. So my rationale for staying out was this is priced for perfection and perfection is just an impossible thing to achieve. So I think that there was a lot of irrational exuberance amongst syndicators in that 18 month timeframe. I think a lot of it is reflected. In the syndication industry, primarily being formed in 2014 and later, the jobs act in 2012, democratized syndication, democratized investing. And by 2014, a lot of shops had formed. A lot of them have formed in the last three or four years, right? Syndicators, basically some big syndicators, their first property was purchased in 2016 or 17 or 18, right? We were buying properties in 2014, but I can't say that I've had more experience than that. I think that this is good for the industry. There's a humbling process that the industry has gone through in the last 12 months. There is not a bulletproof process that the industry has gone through. And I think that our millions of investors are going to benefit from it in the next 10 years from what has happened in the last 12 months. This is good for investors, but what's bad for investors is. That they're using the past to predict the future. It's a very dumb mistake because clearly if in 2009, you wanted to predict, use the past to predict the future, no one would have bought any single families. I bought dozens, right? Because obviously the last 24 months had been truly disastrous for pricing, right? So never use the past to predict the future. And by the way, in certain cases, it makes sense to look at a 10 year or a five year run. But if you look at the last year before that. Why would, why don't you look at the last two years from the end of 2020 to the end of 2021, the United States experienced 15 and a half percent hike in rents. Why not use that? You shouldn't because the following year, they can come down to 5%. Today they're down to 1%. That averaging of three years still shows you that rents grow faster than inflation, because if you average the inflation over those three years, rents are higher. If you look at it in the last 12 months, rents are lower than inflation, and that's not the way to look at it. So averaging is useful as a, but looking at just the experience of the last 18 months, the, and only cherry picking the distress timeframe and making your decisions based on that is not investing that speculation. And that's what's happening with investors. Every investor I see out there today is a reverse big speculator.  They are a scared speculator. 

[00:20:11] Tim Little: Yeah, and I think a big part of that being a speculator is that they don't have the time or desire to go into the details to really do the due diligence and dig into it. And as someone who focuses on data, what are some of the key data points or macro trends that you're seeing right now that people should pay more attention to? You talked about some of the trends leading up and how that's important context in and of itself so that it informs what you can predict will happen in the future, but what data points or macro trends are you seeing right now that people just need to pay more attention to?

[00:20:50] Neal Bawa: I am not looking at inflation. 18 months ago, inflation was important. Nine months ago, inflation. Even three months ago, inflation today, anyone looking at inflation doesn't understand how market cycles work today. You need to look at disinflation or deflation. The industrial index has been negative for five months and it's accelerating. Its negative status is accelerating. M2 or money supply has dropped by a trillion dollars in the last four months. Container shipping costs from China to the United States are now cheaper than they were in 2019 even if you don't adjust for inflation, demand is dropping in the United States very quickly. We were at 400, 000 jobs a month, we're now at 188. So today that the fear is, has the Fed overdone it? There's people who still like inflation. You don't understand that when you see a 4. 7% annualized number, the last two months have been 0. 2 and 0. 2. So if you just annualize the last two months, we're at 2.4, not 4.7. An annual number is good to look at in a normalized market. The last 12 and the last 24 months have not been normalized. If you look at the annual number for inflation in, 24 months ago up now down. Normalization is really good when you have a market that moves inside a narrow band. That's clearly not the case for the last 24 months. So while you're looking at the last 12 months, always know the number for the last three, because now you're going to know what the trend is. The trend for the last three months for either headline inflation or core inflation is much lower than the newspapers are telling you That the real concern is that if inflation continues to trend at this rate, it could go below zero That's called disinflation now a few months of disinflation is awesome More than a few months is something that the Fed has no tools to fight Remember the all of the Federal Reserve's tools that they have in their book are basically designed around simply Getting rid of inflation. So quantitative tightening, raising interest rates, all of these work, right? And you might say they can drop interest rates and that boosts inflation. Actually, no, it doesn't. Hiking interest rates kills inflation very quickly. And you've seen that 9. 1 to three in just 12 months, but the reverse effect actually doesn't go quite that same way because if demand isn't there, because you've killed it with high interest rates, then dropping interest rates, doesn't. Instantly create that demand. It actually takes months or years for the demand to return. So it's not an on/off switch. Just like Hiking interest rates immediately cuts down inflation and we've seen that hiking interest rates immediately increased in cap rates and we've seen that The reverse doesn't actually quite happen as well. So here's my prediction. We are in early August or mid August. My prediction is within the next 30 days, you will hear several fed governors talk about disinflation or deflation and that they're beginning to get worried. That's the trend that you should be watching today. And if you're watching inflation as a trend, you're late on that trend. So get your mind away from that. 

[00:23:49] Tim Little: Yeah, no I'd be interested to see if that comes to fruition, because I agree with you that demand is dropping but that's primarily a demand in goods. We've seen that your demand for services has actually remained pretty robust and it's impressive. How much the American consumer is willing to put up with and keep spending despite their personal circumstances, as we see with credit card balances starting to rise again after they had gone down to their lowest levels in a while. So some of that was revenge spending on stuff like travel and everything else, but it seems on the services side, going out to restaurants, et cetera, people are still spending money. So I don't know how much that's going to dip. And then I, with as long as it's going to predict 

[00:24:38] Neal Bawa: because services, inflation is tied to the percentage of the economy that owns jobs. Keep in mind that today's services economy is based on job gains from three or four months ago, which were at 400, 000. So remember in June, we added 209, 000 jobs in July. We added 187,000 four months before that, we were at 400, 000 jobs. So the inflation that you're seeing in the services economy is not in real time. It's based on what happened three or four or five months ago, because there's a lag, right? So if you want to know what the services economy inflation looks like, You've got to extrapolate the jobs numbers from the last two months and move them forward another three months And that's what's going to give you the true picture and once jobs drop below two hundred thousand a month Which is basically equilibrium point then you start to see some weakness in the services economy And I believe that you will see that weakness in 90 days 

[00:25:33] Tim Little: And so at that point when the Fed chairs start to be concerned about this, do you think they will lower interest rates given that it's one of the only leverages that they have?

[00:25:45] Neal Bawa: I have absolutely zero belief that the Fed either will or is forced to drop interest rates. I just think that they will reach an equilibrium point. And we've, my belief is I'm going to say this. I think the last hike in this cycle was in July. Or June, whichever one was the last one. I think July they might've hiked it or maybe it was June, but that was it. So here we are in August. I do not believe that the Fed will hike again, but keep in mind that the Fed doesn't have to hike to reduce inflation. We're at 550 basis points in the Fed funds rate or 525, depending upon which number you use, because it's a range that's enough. That's an enormous rock that's a thousand pounds on the chest of the economy. You don't have to keep adding hundreds more pounds. It's already there It's already clearly showing an impact you know in jobs is clearly showing an impact in inflation The fed will hold and the fed has really no incentive to drop interest rates until next year I just don't so I don't think that there's any movement in the interest rates for the fed funds rate this year you should start to see interest rates, which we call mortgage rates. So whether it's mortgage rates for multifamily, you should start to see those start to drop by December because mortgage rates are a forward looking predictive interpretation of the Fed funds rate. So what we've seen in previous cycles is when the Fed pauses mortgage rates because they're a forward looking interpretation of the Fed funds rate. So you start seeing that drop maybe in December or January and we'll see continuing drops in the bridge market, which obviously is highly predictive in nature. We'll start to come back maybe around July and August because you'll start to see bridge rates go down. The bridge market probably wants to see the Fed drop a couple times before it starts to come back So they're not going to be satisfied with a single drop. So Again, the market will start to improve over the next 9 to 12 months, but it's a slow improvement process. I don't think 2025 is the year for real estate. I think it's a recovery year. Things will get better every month in 2025. I really think it's 2026 and possibly 2027 where you start to see some good trends in real estate. I never think we're going to see what happens in 2021 again. That was a bizarre data point that was tied to a bizarre event called COVID and we will never see it again.