Do you have an investment exit strategy?
An often-overlooked element of owning investment property is having an exit strategy. Most private investors seem not to have one, so I thought it might be helpful to explore potential strategies in this column.
Buy and hold
This is essentially a default exit strategy. Investors will buy a property and state that they intend to hold on to it for an undetermined period, perhaps until death. While there are some tax benefits to holding property until death, not the least of which is the step up in basis that can eliminate or dramatically reduce capital gains taxes, this approach fails to take advantage of opportunities that may arise to maximize the value of the investment, or to recognize changes in the market.
Definite time horizon
We have been talking to an investor recently who tells us that his strategy is to buy investment property and hold it for three to five years, at the end of which he plans to sell it for a profit. Unfortunately, the market is not always in synch with the goals or plans of investors.
This particular investor likes to buy “value-add” properties that perhaps have high vacancies or are in need of substantial renovations, and thus can be bought at below-market prices. His assumption is that he can acquire it, make whatever improvements are needed to attract tenants, sign up those tenants, and then turn around and sell it at a substantial profit three to five years down the road.
This plan assumes that there is a healthy market for the types of tenants he needs, and that rents and property values will continue to climb high enough to provide a profit at the end of the five-year period. Maybe all of that will happen, but this approach is probably too rigid.
Outright sale vs. 1031 exchange
The best clients for our brokerage practice are the ones who are highly motivated to sell (or buy), whether because of some “life event” like retirement, death or divorce, or because there is another opportunity they would like to take advantage of. In either case, time constraints enter the picture, and these clients are faced with a decision to either sell outright and pay the capital gains tax, or to exchange the currently held property for a replacement property that qualifies for a 1031 tax-deferred exchange. Here again, an exit strategy is important.
I had a client who owned an investment property and wanted to sell it to generate funds for a construction project he was getting into. The transactions probably would not have qualified for 1031 treatment, but he didn’t care. He had amassed significant tax losses from previous transactions, and had plenty of tax credit available to him to absorb the capital gains from the sale of his investment property. He was willing to work with any buyer who acquired his property as part of a 1031 exchange, but didn’t need one for himself.
On the other hand, I had a client who was selling a strip center and definitely wanted to acquire an investment that qualified for a 1031 exchange. He was retiring and didn’t want another property that would require hands-on management.
In his case, a Tenant in Common, or TIC, property was the best solution, and he initiated dialogue with a vendor well in advance of his closing so that he could meet the time deadlines required for a successful 1031 exchange.
In both of these cases, the clients had a strategy based on their own situation. I doubt they had established these strategies when they acquired their properties, but they developed them well in advance of selling them. And they worked with their legal and tax advisers as well as our brokerage firm to develop and implement the strategies.
I have not been directly involved in such a transaction, but for a property owner who wants to sell, has no mortgage and is willing to be “the bank,” this strategy can offer continuing cash flow and reduced tax liabilities over the life of the loan to the buyer.
While it is beyond the scope of this article, there are estate planning strategies for investment real estate that can secure income for property owners and transfer the property to either family members or a charity, often at substantial tax savings. Advice from competent legal and tax advisers is critical.
In summary, planning for your investment real estate holdings is very similar to estate, legal or financial planning. It’s important to develop a strategy to cover current and near-term circumstances, and the strategy should be reviewed every three years or so to make sure that it meets the client’s need and the realities of the marketplace.
Ideally you’ll develop the strategy when you acquire a property, but if not, it should be done at the earliest possible opportunity.
Dan Scanlon is a retail investment adviser with Grubb & Ellis|Coldstream Real Estate Advisors Inc., Bedford. He can be reached at 603-206-9605, or email@example.com.