by Derek Graham
For companies that own their real estate and are looking to raise capital, reduce occupancy costs or improve their real estate, now is a good time to consider a sale/leaseback or a 1031 exchange transaction.
Current low interest rates and competition in the debt financing markets have created a positive investment environment. As a result, there are more investors with capital in the market seeking quality, well-leased properties.
Many of these investors are in a 1031 exchange situation, where they need to reinvest their capital within a 180-day period. This creates the opportunity for tenants and owner-occupants to attract buyers to their property via a sale/leaseback scenario.
In addition, for corporations that want or need to own their property, now is a good time to consider relocating. Again, the low cost of capital creates a good investment environment, and a 1031 exchange can protect a corporation from any associated capital gain tax consequences.
Trends in 1031s
The newest trend in the 1031 industry is the emergence of tenant-in-common interests, or TICs. In this instance, investors/syndicators are purchasing larger income properties ($6 million and up) and parceling up the ownership of the property into separate divided interests. The investor/syndicator resells those interests to individual buyers who are often 1031 purchasers.
The Internal Revenue Service recently issued rulings that appear to validate TIC purchases as being compliant with 1031 regulations. Hence, the TIC industry is exploding.
What’s the advantage?
A smaller investor or 1031 buyer can invest in assets larger in size and cost than normally possible. For instance, a 1031 investor can purchase a $1 million interest in a $50 million real estate investment via a TIC program. With a separate grant deed, the investor will receive a passive cash flow return of 7 percent to 8 percent on his cash down payment.
In addition, the TIC investor gets the income as a landlord, but the management of the properties and the arrangement of financing are the responsibility of the promoter, thereby creating a passive investment opportunity for the investor.
The challenge in this exploding industry for 1031 buyers is to distinguish quality promoters from poor ones. A 1031 buyer looking at a TIC program must make sure to truly understand the inherent value of the proposed real estate investment, and to be discriminating in analyzing the real returns on the property versus the “projected” or pro forma returns that are commonly used in the marketing materials.
Preparing for a 1031 transaction
1031 exchanges are used to defer capital gains taxes and to create wealth, and any company that owns real estate is a candidate.
While 1031s can be quite complex, there are three professional services that should be considered to ensure a smooth and legal process. First, a CPA should ascertain tax-planning information, such as cost basis and projected capital gains and the potential capital gain tax exposure.
Next, an investment broker experienced in locating suitable 1031 exchange replacement properties can help an investor determine the appropriate type of investment and the preferred geography for the property. A qualified investment broker can also lend critical evaluations and projections of the potential returns from a replacement property investment.
Lastly, an investor will need to obtain a qualified intermediary to take “constructive receipt” of the actual funds from the sale (“downlegg”) and hold the funds until the reinvestment into the replacement property (“uplegg”). In order to not be taxed on the gains, a person cannot take possession of the proceeds from the sale.
Trends in sale/leasebacks
While sale/leasebacks, per se, are not new to the industry, this transaction type is currently more prevalent because of the low interest rate environment. More 1031 investors have cash they need to invest, and more companies (sellers) are seeking cash to invest back into their business or to pay down debt. Conditions are such that sellers are achieving exceptionally high sale prices while locking in low leaseback rents over 10- to 20-year lease terms.
Preparing for a sale/leaseback
The ideal sale/leaseback candidate is a company looking to raise money to grow its business. This could be for myriad purposes, such as technology, business acquisitions, R&D, expansion, launching a new product line or paying down debt.
If a company can get a better return on investing in its business than by keeping the real estate, then a sale/leaseback is a great method to free up capital to make those business investments. On average, real estate provides a return of 5 percent to 6 percent a year.
Sellers should expect a preparation time-frame of from 60 to 120 days for leaseback. This allows time to prepare documents for the 70 or so due diligence items that are required by investors. The entire process typically takes from four to six months.
There are two main components to ensure a successful sale/leaseback transaction: the credit of the seller/tenant and the quality of the real estate. Having both is ideal, but only one is needed to arrange a successful transaction. To assess credit status, private companies can hire an accounting firm to create audited financial statements.
An appraisal company or a real estate advisor should be retained to conduct an appraisal of the property at hand. Keep in mind that the achievable price will depend on the rent that the tenant is willing to pay and the desired lease length. In theory, the longer the lease term, the higher the selling price.
If a firm wants to maximize the one-time cash influx, the tenant will pay a rent that is a small margin above market rates. If a firm needs to minimize operating costs, a tenant will pay a lower rent throughout the term, but will get much less cash upfront.
On average, buyers require a lease term of between 10 and 20 years, which term is driven as much by financing considerations as it is by investors themselves.
Class A properties with a AAA credit tenant will usually result in a 20-year lease agreement. In second-tier markets or Class B buildings, or with less credit-worthy tenants, leases may only be 10 to 12 years in length.
Keep in mind that a sale/leaseback transaction is a much different situation than a straightforward building sale. The seller will not be posting “For Sale” signs or saturating the market with sales materials. Rather, it is a careful selection process, inviting qualified buyers to evaluate the investment that is being offered.
An experienced advisor or broker can help the seller through this complex process and may be instrumental in targeting qualified investors.
One caveat — qualifying a prospective buyer is very important. If a seller gets involved with an unqualified buyer, there is a good chance that the transaction will fall through. Failed escrows, while common, can stigmatize an investment in the eyes of the investment community and significantly add to the sell time for the property.
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