At some point, all developers of income-producing rental real estate think about an exit strategy for their investors and themselves. There can be any one of several tipping points driving the decision to consider selling, including:
- Valuations: Current capitalization rates may be making it attractive to sell.
- Succession planning: The developer may be getting older and may not have a strong team capable of successfully managing the business.
- Aging assets: The asset base may require substantial costly upgrades and refreshing, and the developer may not want to wait to harvest the resulting enhanced ROI.
- Some of the developer’s stable of longtime investors may simply wish to cash out.
Often, these long-term successful investments have allowed distributions of refinancing proceeds, leaving the owners with significant deferred federal and state income tax liabilities held in abeyance solely because of the property’s nonrecourse financing.
In considering alternative exit strategies, developers almost without exception seek to avoid the phantom gain resulting from triggering those substantial negative capital accounts, typically without regard to the underlying value of the real estate. So, a straight sale for cash or installment sales aren’t the most tax-efficient exit strategy. Additionally, that aversion to triggering phantom gain is one of the reasons developers historically have favored like-kind exchanges to get a “refresh” of geography or asset class.
Clients tell us today that accomplishing like-kind exchange transactions – especially for lower cap rate assets – is very challenging. The number of quality assets is relatively low, and competition for those assets is fierce. Additionally, attempting to replace a portfolio of assets through a series of like-kind exchanges is logistically and administratively challenging. Of course, the 2017 Tax Cuts and Jobs Act’s (TCJA’s) elimination of personal property for qualifying like-kind exchange treatment has made the presence of “boot” in an exchange more problematic. Further, the Biden administration’s proposal to repeal the like-kind exchange provision adds another issue to the mix.
So, what’s a developer to do, both personally and for his or her investors?
The rise of private REITS
Private real estate investment trusts (REITs) are increasing in popularity as an alternative investment strategy as investors continue to seek yield in a lower interest rate environment. For investors, the attraction of private REITs is a relatively high current cash distribution policy (compared to other investment options) coupled with (arguably) a stable share value.
Publicly registered REITS generally file with the Securities and Exchange Commission (SEC) and are generally open to all investors, but some do not list their shares for trading on major stock exchanges. (These often are referred to as “nontraded publicly registered REITs.) Private REITs don’t file with the SEC and generally seek only institutional and so-called accredited investor capital. As of mid-2020, there are 26 publicly registered, non-listed REITs, with these companies and private REITs owning about $1 trillion in real estate.
Given the increased level of interest we’ve seen on the part of sponsors for private REITs for chasing value, developers are getting approached more aggressively to purchase some or all of their real estate portfolio. The strategy is for the developer and their investors to “sell” their investment real estate in a tax-deferred transaction in exchange for operating partnership (OP) units convertible on a one-to-one basis into shares in the REIT. (Note, however, that the conversion of an OP unit to a REIT share is a taxable event.)
The benefits of an OP unit “sale” are attractive, at least at first blush, and easy to understand:
- The investors have diversified their investment, reducing exposure to risk. In lieu of looking to a single asset in one limited partnership, typically they receive a smaller ownership piece of a larger number of real estate projects.
- In the case of a public REIT, the developer and investors have increased liquidity in their investment via the convertibility of the OP unit into REIT shares. Those shares may then be traded on the open market and converted into cash.
- REITs generally seek to provide stable, recurring cash flow in the form of monthly or quarterly distributions, thus – at least in theory – smoothing the “bumps” in distributable cash flow.
- The managing member of the OP or its affiliate assumes investor reporting, property management, and asset management responsibilities, thus making the developer’s life much simpler.
What are some of the key considerations for developers and their investors in evaluating a “sale” to a private REIT?
First, the “sale” really isn’t a sale – it’s a capital contribution. And it generally isn’t a capital contribution to the REIT. Instead, because of that deferred tax liability, the REIT holds all of its assets in a lower-tier limited liability company treated as a partnership for federal income tax purposes. The developer and their investors contribute either the real estate or the partnership interests that own the real estate into that lower-tier LLC, the OP, in exchange for OP units. This is generally a non-taxable event for the contributors. One of the key goals of this structure is to maintain the tax deferral to the contributing partners.
The OP contribution raises a myriad of issues for the developer and their investors to consider – and these issues include not just tax considerations, but also corporate governance and investment analysis. Let’s highlight just a few of these issues.
Selected tax considerations
- The developer and the investors need to assure they have sufficient tax basis to cover those pesky negative capital accounts. The OP needs enough nonrecourse debt allocable to them – not only enough to cover the deferred liability, but also enough “cushion” to cover an allocation of annual loss (through depreciation and interest expense) and the recurring cash distributions. To the extent that there is not enough debt to cover the negative capital account, taxable gain will be triggered. So, an analysis of the OP’s debt, debt refinancing, and liability sharing is a critical component. This issue is exacerbated because the OP generally operates with lower leverage than the contributed properties, especially if those contributed properties were refinanced so that the partners could receive one or more debt-financed distributions.
- Another key issue is planning for the contributing partners’ allocable share of losses from the OP. At the time of contribution, the partners will have a built-in gain to the extent the fair market value (FMV) of the contributed assets exceeds the adjusted tax basis of those assets. That built-in gain (so-called “Section 704(c) gain”) generally is amortized by shifting depreciation deductions from the contributors to the original OP owners. Conversely, the existing assets in the OP also are revalued to FMV, creating a book/tax difference that likely pushes depreciation to the contributing partners (so-called “reverse Section 704(c) gain”).
The only way to thoughtfully evaluate the impact of these complex rules is to model them out, considering some sensitivity analysis. What happens if the “seller” skips this step? The contributing partners likely will have a nasty surprise when they receive their Schedules K-1 from the OP – and by then it likely is too late for any easy remedy.
- A third fundamental tax consideration for the contributors is how the contributed property fits into the OP’s longer-term plans. In addition to the business imperative, there are substantial tax considerations for the contributing partners. The reason is simple: A disposition of a contributed asset triggers any unamortized built-in gain to the contributors. And that rule applies both to taxable sales and the OP’s like-kind exchange of a contributed property.
- To help mitigate this complication, indemnification agreements are usually set in place between the contributor and the OP, intended to prohibit the OP from selling the contributed assets and triggering the built-in gain before a specified number of years. If the OP sells the property before that number of years, then the OP must indemnify the contributing partner for taxes due on their built-in gain.
All of these issues – basis through sharing of nonrecourse debt, built-in gain amortization, and the deferral of subsequent dispositions of contributed property – are critical negotiating points for the developer and their investors. Often, a tax protection agreement may exist to cover tax liabilities produced from any foot faults on the part of the OP.
Some corporate governance considerations
One of the benefits of a “sale” of a portfolio of real estate in exchange for OP units is that the developer frees themself from daily real estate or asset management responsibilities. But those responsibilities often help determine the ultimate value of the underlying assets. Thus, the developer truly needs to understand how the OP – and the REIT – do business. Some of the fundamental corporate governance considerations may include:
- What is the quality of the management team, both from a real estate and an organizational perspective? Do these people have a history of creating value or destroying it? Is there deep bench strength in management? Is there a cogent management succession plan?
- Does the developer want a mechanism of oversight? Is a seat on the board of directors a reasonable request?
- What is the REIT’s history in treating other “sellers”? Do other sellers hold positions with any influence? What has been their view of the relative success of the relationship, post-closing? Should this matter to the developer and their investors?
Don’t forget the underlying investment analysis
The developer and their partners aren’t selling for cash, but instead are receiving units in the OP. Granted, those OP units are convertible to shares in the REIT, but are those units and shares a good investment? Selling into an OP should entail the same financial and investment diligence any thoughtful investor would undertake before making a meaningful investment in any stock or security.
- For the developer and investors with a significant portion of their respective personal net worth in the current real estate portfolio, does this transaction provide a path to true financial diversification (i.e., reducing their overweight position in real estate to an eventually more balanced portfolio model)?
- The dividend yield and distribution policy of the REIT may be key considerations. How stable and secure is the current level of distributions (looking at things like payout ratios)? Are there foreseeable events that might alter that analysis, such as debt refinancing, material Capex, or brokerage commissions?
- Shares in a private REIT (as compared to a public REIT) fundamentally aren’t liquid. How important to the developer is that liquidity? (Hint: It should be really important!) What are the path, timing, and obstacles before the developer and their partners have clarity as to that liquidity? Are there better options with easier access to liquidity, perhaps at a cost of “selling” price?
- What are the growth prospects for the REIT? How do those prospects compare with those of the REIT’s competitors?
Build a strong team of advisors
As you see, these OP transactions can have deep and long-lasting implications. Most developers will only “sell” once in a career. This makes the careful selection of advisors a critical exercise. A well-rounded team will include thoughtful tax advisors (both accountants and attorneys), experienced securities counsel, specialized investment banking resources, and valuations specialists with expertise both in real estate and real estate securities.
Selling into an OP – whether a private REIT or a publicly traded REIT – is complex. Identifying and addressing all the potential tax pitfalls requires expertise, creativity, and financial analytical tools. We’ve seen these transactions create the proverbial “win-win” for both buyer and seller. But identifying risk areas early in the process is a critical success factor.
Subject matter expertise
CRE, FRICS, Director
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