1031 Exchange Checklist: This is a gift from the government that only a select few are lucky enough to take advantage of
I have seen many of my clients get amazingly wealthy in less than 10 years by doing 1031 exchanges. Section 1031 of the US Internal Revenue Service tax code is one of the greatest gifts around to property investors. It's almost as if someone at the US Treasury Department woke up one day and said, “What is the best way to make personal wealth grow? Let's have people invest in a property. As that property grows in value over time, let's allow them to sell it at a profit. And let them invest that profit tax deferred into a property of greater value. Then let's allow them to repeat the process over and over.”
A 1031 tax-deferred exchange enables owners of real estate to sell a property and use the equity from the sale to purchase a replacement property while deferring federal and state capital gains tax on the original property to a later time. Here is a checklist to use if you are thinking of doing a 1031 exchange:
As-Is Clause: This clause in the purchase and sale contract protects the seller
By putting an as-is clause in the purchase and sale agreement (PSA), the seller is establishing that the onus of determining the physical and financial condition of the commercial property being sold is on the buyer. Often sellers have had the property professionally managed and they might not be totally informed on every aspect of the property's physical and financial condition. So it's up to the buyer when they do their due diligence to determine the condition of the property. The as-is clause protects the seller and states that they are not making representations and warranties of any kind, that the buyer is purchasing the property subject to any information they find while doing their due diligence, and that any due diligence items provided by the seller may or may not be accurate.
When a buyer does their due diligence thoroughly, they will likely find things out about the physical and financial condition of the property that the seller may not even been aware of. This is especially the case when sellers have had the property professionally managed. If the buyer's real estate agent or attorney prepares the first draft of the purchase and sale contract, it may state that the seller is making many representations and warranties. It is an acceptable and recommended practice for the seller to tell the buyer about major replacements that are needed such as roof replacements. It should then be mentioned in the purchase contract that the buyer is buying the property as is including these major replacements.
Broker Cooperation Agreement: Get 10 times more exposure for the property being sold when you get your real estate broker to agree to network with other realtors
As the seller, be sure to choose a listing broker who is willing to share their fee by signing a broker cooperation agreement with the buyer's real estate broker. Most brokers will do this but some will not. They will insist that the buyer's real estate broker collect their fee from the buyer. Well, not many buyers are expecting or willing to do this. You will be greatly limiting your exposure to buyers if your listing agent is not willing to share their fee. If your real estate agent networks with other realtors, your property can get 10 times more exposure. Listing brokers most often split their commission equally with the buyer's broker, but some pay a flat fee of 1–2%.
Cap/Capitalization Rate (Seller's Perspective): Be sure to put an accurate cap rate that is based on actual numbers in the marketing flyer
The cap rate shown in your marketing flyer is one of the most important factors motivating a buyer to be interested in purchasing your commercial property. Remember when you were a buyer searching for the right property to buy—looking on LoopNet or through multiple listings? You likely looked at the sales price first, then the cap rate, and if those two looked attractive, you went through the property photos. If you liked a property, you then looked for verification of its value from cap rates shown for other, like properties for sale.
If your property has a lower cap rate than most of the others, the buyer will think it is priced too high and likely pass on it. Listing brokers know this and sometimes put pressure on sellers to mix actual and potential numbers to come up with a cap rate in the marketing flyer that is higher and will get the buyer's attention. In this case, though, say a buyer makes an offer on your property based on the higher cap rate. When they do their due diligence, they'll find out the cap rate is lower than what they were told it was. The buyer will now feel at best that the deal was misrepresented and at worst that they were lied to.
The cap rate that your property is marketed at will be heavily scrutinized by the buyer, the buyer's real estate broker, the buyer's lender, and the appraiser. If this group is convinced that you inflated the cap rate, they will not only have the data to prove it but the professional knowledge to use as ammunition in lowering the sales price.
Commercial Real Estate Buyer Types: Think about what type of buyer will be most interested in your property and then put yourself in their shoes
Have you thought about how important it is to know what type of investor will likely be buying your property? Will it be a fix-and-flipper or a buyer who will hold the property for the short or long term? What is it about your property that will motivate them to make an offer? Prior to putting your commercial property on the market, talk to several real estate brokers to get their opinion on this. Then decide on the most likely profile of the buyer. From this you can determine the highest sales price on the current market comps for your property type. Then put yourself into the buyer's shoes and ask, “If I were buying my property with this goal in mind, would I pay that much for it?
Types of Investors
I have a client in Portland, Oregon, who had a $28,000,000 office building that I did a construction and permanent loan on in 2013. His plan was to hold onto it for retirement and then pass it on to his kids. But soon after it was stabilized with great long-term lease tenants, a REIT offered him $34,000,000 for it. The offer was too good to refuse.
Commissions, Commercial Real Estate Brokers: What is the going rate for a real estate broker's commission?
Commercial real estate brokers are salespeople, so of course their commissions are negotiable. But keep in mind that the buyer's real estate broker will be splitting the commission with your broker. If you negotiate a commission that's too low, both realtors might show other comparable properties before they show yours. You will likely get more realtors working hard to sell your property if there is enough commission to share.
Confidentiality/Nondisclosure Agreement (NDA), Sellers: Be sure to protect yourself with this before disclosing confidential financial and operational information to buyers
As the seller of a commercial property, you will be providing the buyer with confidential financial and operational information that could be used against you by one of your competitors or tenants. To avoid this, be sure to have the buyer sign an NDA. This enables you to disclose sensitive information about the property's finances, leases, property management, service contracts, and more to the buyer. When signing this agreement, the buyer is obligated to keep all information confidential. Anyone that the buyer provides the documents to, including lenders, must also sign the agreement.
Contingency Clauses in Sales Contract (Seller's Perspective): Make sure you give the buyer enough time, but not too much time, on these
Can you imagine selling an automobile and having the sale contingent on seven or more contingencies? Contingency clauses in the purchase and sale contract are escape clauses designed to protect the buyer. Yes, this does seem to put the buyer at an unfair advantage. But then, you have to remember that the buyer is buying the property as is, so maybe this is fair. The burden of finding out what's wrong with the property falls on the buyer. They have the right to know what they are buying. But using the faults they find to lower the sales price can be sport for some buyers. Unless the property is practically new and the financials are in stellar condition, you can bet they will do exactly that. Although there can be dozens of contingencies, here are the most popular:
Contingencies in the Purchase and Sale Contract
Don't be shy about asking for advice from a commercial mortgage broker or from your banker about what it will take for a buyer to qualify for a loan on your property. Make sure the buyer has a letter of interest from a direct lender or a letter of preapproval from a commercial mortgage broker.
It will take between 30 and 45 days after you provide the buyer with all the financial due diligence items for their loan to be approved. So 45 days is a good time period for a financial contingency.
Depreciation Recapture: This is how the government gets its due
While you owned your commercial property you were given this great gift from the government called depreciation. This has lowered your taxes for each year you've owned the property. But did you know that upon the sale of the property the government is going to take this gift back? Sellers know that they will be facing capital gains taxes if they sell a property and do not do a 1031 exchange. But often they don't know they'll also owe depreciation recapture taxes. “Depreciation recapture” refers to the taxable event that occurs when you sell an income property and are taxed on the total amount of depreciation you wrote off during the period you owned it. Only buildings can be depreciated, so there is no depreciation recapture tax on the sale of undeveloped commercial land.
To determine the amount that will be subject to a capital gains tax upon the sale of your commercial property, take the price you are selling the property for and subtract from that the original price you paid for it. This will give you your gross profit on the property. Now subtract from that amount the total cost of all the capital improvements you made to the property over the years you owned it. The balance is your adjusted net profit, which is the amount that is subject to a capital gains tax of 15% or 20%, depending on your income. Now add up all the depreciation you took since you owned the property. The depreciation recapture rate amount will be 25% of this total. Ouch! To avoid this you will need to buy a replacement property and do a 1031 exchange.
Letter of Intent/Interest (LOI) (Seller's Perspective): How some buyers are experts at misleading sellers with LOIs
A letter of intent to purchase can be a useful tool for both buyer and seller, as it quickly identifies the buyer's offering price, earnest money, contingencies, and closing date. But far too often the buyer's purpose is to get their foot in the door and tie up the deal. When speaking at commercial real estate seminars about financing, I have sat through many great presentations by commercial property investment gurus. They usually teach buyers to send out dozens of one-page letters of intent offering full price and great terms. The idea here is that one will stick to the wall. Some of these buyers are not acting in good faith. They really intend to get control of the property so they can buy time while they raise the down payment. Worse yet, they are taught to dump the property if they cannot find enough wrong with it to get a much better price.
If you receive an attractive LOI it is important to let the prospective buyer know that you will be screening their experience, financial strength, and proof of down payment extensively. Be wary of any buyer that is short on funds but tells you that they have a high-net-worth investor coming on board. Tell them you need to talk to that person.
Listing Agreements/Contracts: As the seller, you are holding the cards. You decide what type of listing agreement to have with a broker
Top-producing real estate agents will tell you they are only willing to sell your commercial property if you sign an exclusive right-to-sell contract with them. Often they will refuse to discuss any other type of listing. Is this in your best interest and should you be bullied into it? Look at the types of real estate listing contracts below and decide which one fits your needs and those of your property best. As the seller, you are holding the cards. Most real estate agents would rather list the property with the type of contract you prefer than not at all.
Loan Assumption: What about the buyer assuming your mortgage?
If you need to sell your commercial property and your loan has a high prepayment penalty, it might be a great benefit to have the buyer assume your existing mortgage. Check your mortgage note and see if your loan is assumable. When selling your commercial property, having a great, low-interest rate loan that is assumable may be of great value to a buyer if rates have gone up. Most often sellers think about having their loan assumed when there are three years or more remaining on a declining prepayment penalty. But sometimes they will not be able to sell the property at all unless the buyer assumes their loan. This will be the case if they have a yield maintenance or defeasance prepayment penalty (see Encyclopedia Topic H, Financing) and rates have gone down a lot since they took out the loan. In this case the prepayment penalty will be humongous. But here's the problem: if rates have gone down, the buyer will do much better to take out a new, lower-rate mortgage than to assume your higher-rate one. So to persuade them to assume your mortgage you will need to have an irresistible property or to give them some incentives.
Community bank loans are almost never assumable, but loans from regional banks and capital divisions of major banks usually are. All securitized loans, including those from Fannie Mae, Freddie Mac, and HUD, as well as commercial mortgage-backed security and life company loans, are assumable. To assume your loan, the buyer will need to qualify under similar guidelines that you applied under. They will also need to pay an assumption fee, which is usually 1%, plus the cost of whatever third-party reports are needed (for sure a new appraisal and often a property condition report).
Negotiating Repairs with the Buyer: How much the seller pays for repairs is based on supply and demand in the market and two other factors
Remember that you are not making any representation in the purchase contract as to the condition of the property. If the buyer has a property inspection done that shows major expensive repairs, they will almost certainly ask you to pay either half or the total cost. How much each party pays is based on three factors:
Last year one of our clients lost an $8,200,000 apartment complex he was in the process of buying in Sacramento. This property was exactly what he was looking for. The property inspection report found over $700,000 in needed replacements or repairs. The buyer first tried to get the seller to pay for all of this, and then tried to get the seller to split the cost with him. It was a seller's market. The seller knew this and also knew there were no fixer-uppers left in the neighborhood. He was selling it as a repositioning opportunity. So he refused to budge on the sales price, period. Because our client was going for maximum leverage with an 80% loan, there was no room for us to finance the repairs with the mortgage. So the buyer backed out.
So if supply is low and the property is in a dynamite location, the seller can likely hold firm on not paying much or anything toward repairs. The buyer may be thinking that if they don't buy now, prices are going to continue to go up and they'll end up paying full price anyway. Also if they can refinance the repairs with their loan, they can recover the renovation money and more over time. On the other hand, if it is a down market and there is a high inventory of similar properties for sale, you as the seller should consider offering some reduction in price. If you put the property back on the market, the next buyer will likely come up with the same list of repairs and you will be back to square one.
Online and Multiple Listing System (MLS) Marketing: Yes, you do want to choose a listing agent who will market your property on MLS and websites like LoopNet
With all the online commercial property listing websites these days, such as LoopNet, is it necessary to choose a listing agent who will list the property on MLS? Well, this is one way you will know whether they are willing share their commission with another agent. Only other real estate agents can view MLS listings. Today, MLS is still a very viable and proven way for realtors to network and find buyers for each other's listings. Why not have as much exposure as possible? The argument against this is that the majority of real estate agents on MLS are residential agents. This is true because there are a lot more residential than commercial agents. But, although few residential realtors understand commercial real estate, they likely know people who invest in both residential and commercial properties. Most importantly, commercial buyers certainly don't seem to care if a realtor is residentially oriented.
Today more buyers find their commercial properties online than any other way. This is a bonus for listing real estate agents and for sellers. For listing brokers, the bonus is that buyers call them directly and are seldom represented by a buyer's agent—so they won't have to share their commission. For sellers, the bonus is that when a buyer works directly with the listing realtor who represents the seller, there is really little representation for the buyer. This can give the seller an advantage in negotiations. LoopNet is the number-one online marketplace for selling commercial real estate. There is also CoStar Group (which owns LoopNet), RealNex, CityFleet, Rofo, Craigslist, and more.
Owner's Title Insurance Policy: It is really worth it for the seller to purchase this
Although not mandatory, it is highly recommended that you purchase an owner's extended title insurance policy. This protects the owner against any claims brought against them for defects in the title and pays for all legal fees.
Private Sale: Do this if you do not want your tenants to know you are selling the property
If you do not want your tenants to know your commercial property is for sale, it is best to sell it through a private sale. A seller needs a private sale when they are negotiating longer-term leases with tenants to increase the value of the property prior to a sale. If tenants know you are selling the property, they will be in a position to negotiate much better lease rates and terms. When a private sale is conducted, there are no signs on the property and the listing does not appear on the Internet or MLS. What makes this approach work is using a top-producing commercial real estate broker who specializes in your property type. They will likely know many investors that will be interested in your property. They can also make the listing available to a few select real estate agents in their company who will keep it confidential.
Property Condition Inspection Report: Wouldn't it be great to know before you put the property on the market what it needs in repairs?
Sure, your buyer will be ordering a property inspection as part of their due diligence. Wouldn't it be great to known prior to putting your property on the market the approximate amount the buyer will ask you to take off the price due to the defects they found with their inspection? If you do not want to go through the expense of a property inspection report, consider walking the property inside and out with an experienced licensed contractor and taking notes on all needed repairs. Then get a ballpark quote for them. A definitive knowledge of the work your property needs and its cost will give you a competitive edge. Once the buyer completes the property inspection due diligence, they will want to negotiate lowering the sales price with you to pay for the repairs. Doesn't it make sense for you to determine what you are willing to pay for well ahead of time?
Realized Gain: How to calculate what your capital gains taxes will be when you sell the property
If you are not going to do a 1031 exchange after selling your commercial property, wouldn't you like to know what your capital gains tax will be? You will be taxed on your realized gain. To compute your realized gain you have to first compute your cost basis. Start with the purchase price and add to it any other closing costs that are on your settlement statement that are not related to your loan, taxes, or insurance (look up IRS Publication 551). Next add to this amount any capital improvements you have made since owning the property (these are not repairs and maintenance, which show as expenses). This will give you your adjusted cost basis. Next subtract this amount from the sales price. This will give you the amount that is subject to capital gains tax.
Don't forget to allow for depreciation recapture tax (see Encyclopedia Topic E, Selling) on top of capital gains taxes.
Time Is of the Essence Clause: Take this a step further by enforcing time frames for contingencies
Most boilerplate purchase and sale agreements have a brief “time is of the essence” clause or statement, but it can be very vague. This needs to be strengthened, stating that each contingency period time frame is to be enforced. Write in an addendum as to under what circumstances the seller is willing to extend more time for contingencies and due diligence, and what those time periods will be.
For example, the financing contingency clause might state: “This offer is subject to the buyer obtaining satisfactory financing within 45 days. The financing contingency period may be extended for up to 14 days if required by the lender, with the buyer giving notification to the seller prior to the expiration of the financing contingency period. Or it can be extended for an additional 30 days with a $10,000 nonrefundable deposit should the purchase be canceled as a result of the buyer not closing on time.”