There are lots of reasons that investors are attracted to the investment opportunities we put together at Wildhorn Capital. Sure, we may like to think it’s our track record. Our conservative underwriting. Our Central Texas markets. And I’m sure those are all important factors.
But at the end of the day, there are just some inherent advantages that come along with investing in Multifamily assets. The safety and security that comes from investing in a shelter business—“people have to live somewhere”. The protection these investments have against inflation—a salient point these days. The depreciation that is generated via our Cost Segregation studies, which results in massive wins (showing up in the form of losses) on your taxes. And, the ability to 1031 Exchange out of one investment and into the next without paying any taxes.
While every individual investor likely has a different stack ranking of each of these benefits, they are all incredibly powerful. Perhaps none more so than the 1031 Exchange.
When you execute a 1031 Exchange, investors are able to take all of the proceeds from the sale of an asset and roll those funds into a new asset—without paying any taxes. You don’t have to recapture the deprecation you’ve taken, and you don’t pay taxes on any of the gain you made during the initial investment. There are rules around what you can and can’t buy and strict timelines you must adhere to, but in general the 1031 Exchange can be a powerful tool for growing your investment and your wealth in a tax-free manner.
We’ve been fortunate to execute a few 1031’s as we’ve sold assets and placed our investors’ funds into a new asset with a fresh business plan. Our investors have always been thrilled with that outcome, as we’ve rolled right into the next opportunity with lots of upside.
The biggest challenge in executing a 1031 Exchange is the timing. From the date you sell your asset, you have 45 days to identify a replacement asset and 180 days to close on the new one. With a limited amount of time to find a suitable investment, it is always an intense period to evaluate as many deals as you can. Often times, we hear of or are competing with groups who have a 1031 winning deals simply because they are willing and wanting to pay more than anyone else. Based on some of the prices tossed around during these scenarios, it becomes pretty clear they have either loosened their underwriting criteria or accepted a lower proforma return—and maybe sometimes both.
Our attitude has always been that every asset we buy is an asset we have to believe in. You hear us use the word “conviction” a lot. We never want to buy an apartment building just to buy it. We have to believe in what we’re doing. The business plan. The investment thesis. The proforma returns. We aren’t willing to change our criteria just because we have a 1031. In our opinion that’s lazy and sloppy—and ultimately will lead to buying bad deals because there is a clock ticking in the background.
Earlier this year we sold two assets, and in both cases planned to execute a 1031 Exchange. On the first one, we executed without issue. Before our sale closed, we had the new asset identified and locked in. It sat adjacent to an existing asset of ours, and was something we’d had our eye on for several years. It was a slam dunk and we had all the conviction in the world. We closed without issue.
On the second one, we did not find a suitable replacement property during the exchange period and ultimately returned all of the proceeds from the sale of that asset back to investors. It is the first time we have not been successful in executing a 1031. But it certainly wasn’t for a lack of trying.
As we communicated this to investors, most everyone understood and appreciated the situation and the challenges we faced during our Exchange window; interest rates skyrocketed, many lenders hit the pause button completely, and deal volume slowed dramatically as both buyers and sellers hit a pause button to understand what was happening in the market. During this period, we actually had an asset identified—and had a fully negotiated PSA with a seller all ready to sign. It was (and is) an asset and business plan that we have a ton of conviction around. A super solid location and very clear value-add story. We didn’t sign that PSA because we were waiting to get an actionable loan application from a lender, close to the terms at which we underwrote the deal. We had 6 lenders ready to provide us a term sheet on a Tuesday. By Thursday, all six said they were on the sidelines and hitting pause on making new loans.
For the record, we were seeking 50%-55% leverage and a fixed rate loan. Given the environment out there (and especially at that time) it seems like the prudent move. But it certainly wasn’t an aggressive ask from a debt standpoint. It was just bad timing.
We looked at a lot of deals during this period, turning over every rock in trying to find a replacement property. We had off-market looks. Conversations directly with owners. We leveraged all our relationships. And there were several deals that actually felt like we were close on.
But at the end of the day, there was nothing we had complete conviction about. Either the pricing ask was too high, the projected returns too low or we just didn’t have conviction about the asset, location or business plan. We opted to return the capital and not execute the 1031.
The asset we had sold to create this 1031 was an overwhelming success, and crushed our initial expectations. We had increased the value of that asset by over 70% in three years, delivering a 35% IRR and 2.5x multiple. Rushing in to buy a deal we didn’t believe in could undo all of that and put those returns at risk. Especially given the volatility in the debt market and economic uncertainty, that is a risk we just weren’t willing to take.
We pride ourselves on being disciplined and good stewards of investors’ capital. It’s a responsibility we take seriously. And we’re never going to buy a subpar deal just because we have a bucket of 1031 capital to place.
Do you think we made the right decision? We do, and we will make it again and again if faced with the same set of circumstances.