Chapter 18 | Real Estate Owner Exit Strategies

Overview

Chapter 18 discusses property ownership exit strategies.  Real estate owners sell properties for various reasons.  Developers are in the business of creating buildings and may need cash for new developments.  Additionally, REITs or local operators may have a comparative advantage over a developer in managing stabilized properties.  Another reason to exit is to alter your risk-reward profile.  For example, real estate private equity funds generally exit investments after repositioning a property, as a longer hold decreases the IRR.  There are also old-fashioned reasons to exit, such as estate sales, divorces, and partnership dissolutions.

Summary

The simplest exit strategy is fee simple disposition (an outright sale).  Depending upon the building and market, a “typical” sales process requires 3 to 12 months.  Generally, the sales process will cost an owner 2% to 5% of the property value.  This sum includes fee payments for lawyers, accountants, and brokers.  If you have a trophy asset, the fees as a percentage of value may be substantially less, because the amount of work and value added by the brokers are not large relative to the value of the property.  It also must be noted that a lender may require a prepayment penalty or a yield maintenance fee for repaying a loan prematurely at a sale.

In the U.S., capital gains taxes will be payable upon sale of a property.  Under U.S. tax code, there are two components of the capital gains tax.  The first component is a (currently 15%) tax on the actual gain that you achieve from the sale of the building.  The gain is the difference between today’s sale price and what you originally paid for the building.  The second component is a (currently 25%) tax on the property’s accumulated depreciation.  It must be noted that if you are a non-taxable entity, such as a pension fund, the capital gains tax is zero.

An alternative exit strategy for a real estate owner is refinancing – taking out a new loan on the property.  The refinance process is not free, although it is much cheaper than the sales process as you do not have to pay capital gains taxes associated with selling the property.  You will probably have a 50-basis point loan fee, as well as legal and accounting fees.  If you plan to sell the property soon, the refinancing option makes no sense; however, if you intend to hold the property for the long term, the present value of the deferred capital gains tax liability is effectively zero.

Another exit option is U.S.-specific.  It is the like kind exchange (“1031 exchange”), which allows you to sell your property free of state and federal tax if you purchase a similar property, thereby forestalling the capital gains taxes until you ultimately break the ownership chain.  During a like-kind exchange, you will exchange your partnership interest for an interest in a different partnership.  The exchange is not taxable until you sell your interest for either a non-real estate asset or a property outside of the United States.  In a like-kind exchange you typically have 3 months to identify another property.  There are volumes of ever changing tax laws written around these types of exchanges and the nuances constantly evolve.  Like-kind exchanges are permitted on both improved and unimproved property.

There are two noteworthy ways through which one can benefit from like-kind exchanges.  The first involves selling a stabilized building for a building where there is the opportunity to add value.  This allows an investor to defer their capital gains taxes while capitalizing on a new opportunity.  The second involves selling a property and buying a stabilized building that offers a better refinancing opportunity and little management burden.  Such an example may be a long-term leased building to the U.S. government.  With such a credit tenant, a lender will typically allow you to finance the acquisition with a greater loan-to-value, thereby allowing you to take more money off of the table.

To exercise a 1031 transaction, you will appoint an independent specialist, known as a QI, or a qualified intermediary, to help sell the property.  The qualified intermediary will set up an agreement so that an escrow agent transfers the property to a buyer, and the sales proceeds go directly to the qualified intermediary.  The exchanger must then acquire a property within a set number of days.  It should also be noted that it is nearly impossible to find a property worth the same as yours.  For this reason any excess gain is taxed, with this excess known as the “Boot.”

Another possible exit is to exchange your interest in a property for a monetarily equivalent ownership interest in a publicly traded company.  If this transaction is structured properly you will not recognize capital gains on the transaction until you sell the stock in the publicly traded company.  However, to achieve such deferral of capital gains will require rather complex structuring.  Generally, you receive dividend and voting rights equal to your pro rata share of the company.  Such a transaction allows you to access a larger, more diversified pool of assets and makes your interest more liquid.  A drawback of the strategy is that you will have to give up control of the property and will most likely lose the property management fees that you previously earned.

An alternative to selling to a public company is to go public.  In order to do so, you would need a large portfolio of diversified assets in a particular property type.  The portfolio would also need to have relatively low leverage, predictable cash flows, and institutional reporting.  An IPO takes 12 to 18 months and will cost up to 10% of the total amount of capital raised.  Additionally, you will incur $500,000 to $1 million in fees regardless of whether the IPO is successful.

Determining an exit strategy is critical.  The optimal strategy will ultimately depend on your goals as an investor.  Two people looking at the same sales options may make two entirely different decisions based on their objectives.

Questions

These are the types of questions you’ll be able to answer after studying the full chapter.

1. What are the costs associated with selling a property?

2. You acquired a building for $100MM and financed the acquisition with a $75MM interest-only loan. Three years later, you sold the property for $120MM. Assume 70% of the property was attributed to structure and that the structure was depreciated over a 40-year period. Also assume that capital gains are taxed at 15% and that accumulated depreciation is taxed at 25%. Also assume a 3% sales cost for the building and no prepayment penalty for the loan. What would be your net profits?

3. Why may a refinancing be preferable to an outright sale?

4. What is a like-kind exchange (1031 exchange) and why may it be preferable to an outright sale?

5. Assume you want to sell an asset worth $200MM with a $100MM mortgage in place  and have identified a $200MM U.S. Government-leased office building to acquire via a like-kind exchange. Assuming that you can finance 70% loan-to-value in the U.S. Government building, how much capital will you realize today? Assume a 3% sales cost and a 1% loan fee on the new financing.

Audio Interviews

Owner exit strategies (5:46)

 

The origins of the 1031 Exchange (5:01)

Excel Figures

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Key Terms

To view the definition, click or press on the term. Repeat to hide the definition.

Transfer of title of a property from seller to buyer for monetary consideration to seller.

The negotiated property sale price before any potential deductions.

U.S. tax on long-term gains on capital assets. There are two components which are taxed: 1) the actual gain you achieve on the building; 2) the property’s accumulated depreciation.

The amount of a property’s depreciable cost that has been allocated to depreciation expense since the time the property was acquired.

An investor’s net equity position after selling a property and repaying the loan, paying all fees, and paying the IRS.

The replacement of one debt facility with another.

Ownership of less than 50% of a property’s equity, providing no voting impact and an illiquid position.

A legal process codified in IRS section 1031 through which you sell your property free of state and federal income taxes if you purchase a “similar” property within a prescribed period of time, hence forestalling capital gains taxes until you ultimately break the ownership chain.

An independent specialist who executes a 1031 exchange and helps sell the property.

Chapter Headings

  • Why Exit?
  • How to Exit
  • Disposition
  • Refinancing
  • Like-Kind Exchange (1031 Exchange)
  • Exchange for Public Company Shares
  • Go Public

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