Help For Passive Real Estate Investors
In the current search for return on investments many real estate investors are considering non-controlling or passive investments in real estate, often in the form of a limited partnership interest. Clients may be excited by the location of a particular office building or the prestige of a certain hotel. For many these investments have paid well, especially in comparison to the anemic returns recently available elsewhere. However, others have been surprised by their losses and found that they have bought into more than they intended. Below, we will address some of the potential perils and pitfalls involved in real estate investments and how to best avoid them.
When considering a passive investment in real estate, the first step is to coordinate the team necessary to analyze the investment and examine the benefits and risks in the context of the investor’s strategy. A transactional real estate lawyer, tax specialist and accountant all have important roles to play in order to be properly protected and to avoid mistakes.
Once the proper team is in place, the investor is in position to address the significant considerations involved in a real estate investment. The team will also assist the investor in avoiding mistakes which are often made by investors involved in a real estate investment. These mistakes include:
Failure to understand why the investment is available
A review of the current financial statements is insufficient to fully value a property. A property that may have performed well in the past may be in for a significant change, for example:
- A large tenant may be moving out or exercising a sweetheart deal.
- Construction may be anticipated nearby, significantly affecting retail tenants or hotel occupancy.
- Significant litigation may have started or may be anticipated.
- An adverse tax ruling or change in tax law may be on the way.
- A substantial obligation may be expected to become due pursuant to underlying documents.
All of these factors and more can have a major effect on a real estate owner’s balance sheet. Systematic and complete due diligence is necessary, which should include an on-site inspection by experienced real estate professionals.
Failure to fully understand income and expense, gain and loss
If an investor simply looks at the potential for an income stream, they are missing much of the overall investment. Heavily traded are the tax gains and losses that, if not allocated correctly, can lead to unexpected results. Phantom income (where taxable income is recognized but no cash distributions are made) can leave an investor in the position of shelling out large amounts on a very successful project, but with no actual funds to pay the tax. Foreign investors in United States real estate may be required to file US tax returns and pay US taxes. On the other hand, when designed correctly, certain expenses, such as depreciation, can offset certain of the investor’s income thanks to the pass-through benefit of real estate ownership. REITs and stocks do not allow for this pass-through of expenses.
Failure to review and appreciate all of the underlying documents
The operating agreement or partnership agreement is a crucial starting point for review and must be examined by competent counsel familiar with current applicable law. For example, recent changes to the Delaware limited liability company law allow such companies to limit fiduciary duties to members of the LLC. New Jersey has made extensive changes to its limited liability company law which can have significant effects on the rights of members. In many cases, it is not what is provided in the draft agreements that is important, but what is missing from those draft agreements that can have a significant impact on the investment.
However, the investment operating or partnership agreement is only the starting point for review. An investor should understand the impact of various other underlying and related agreements regarding construction, management, sales, operations and brokerage, as well as the underlying leases and financing agreements. If there are related entities involved, as is often the case, distributions, expenses, income and loss can and often will be structured to distribute benefits to these parties unevenly. A tenant may have rights, benefits and renewal or purchase options that can have an adverse effect on the financial situation of the project. If a single investment includes multiple properties, poor results at one property could have a negative effect on the investment in the other property. For example, a lender to the investment may seek to take back both properties, not just the underperforming property.
Additional investment and dilution risk
In many investments, the managing partner may have the right to require investors to invest additional capital (a cash call). This obligation may occur when the property is performing poorly or when there are significant unanticipated costs. If an investor fails to contribute the additional capital, other investors often have the right to cover the non-paying investor’s contribution. This is sometimes done via a loan, often at a high interest rate. However, in some agreements, the other investors can contribute funds and dilute the interest of the non-paying investor.
Failure to fully understand tax and accounting implications
Even investors in other types of limited partnerships may be surprised by the tax rules applicable to real estate investments. Real estate is generally considered a passive investment. This can, for example, limit the amount of losses that can be claimed by an investor. There are also specific state and local taxes applicable to real estate and applicable to the transfer of real estate that must be fully understood, appreciated and planned for. In addition, a Section 1031 exchange (i.e., tax free swap) cannot be performed with a partnership interest and thus an investor is not permitted to sell or dispose of its partnership interest and subsequently defer payment of taxes by acquiring like kind replacement property through a 1031 exchange. However, by using a carefully crafted tenancy-in-common structure, a tax free exchange of a partial interest in a property may be possible. The details of this structure must be carefully reviewed by a tax attorney to insure compliance with the applicable tax laws.
Due to the complexity of applicable tax law and their significant financial outcome, every investor must review the proposed structure with his or her tax professional or tax lawyer and answer at least three questions: (1) Given my tax situation, will there be any problems with this investment?; (2) How can I minimize any adverse tax consequences?; and (3) How can I maximize any tax benefit?
Appreciating conflicts of interest
To save money, investors sometimes rely on the lawyers and experts hired by others involved in the transaction. For some aspects of the transaction, that choice may be appropriate. However, an investor must appreciate that a developer, management company or other investor may have different interests, such as tax objectives, anticipated holding periods, risk tolerance, need for income, etc. A structure for one type of investor may not work for another. An investor must understand these conflicts of interest and determine whether they require independent counsel and experts or if they can rely on the counsel and others providing shared representation to reduce costs.
Failure to plan for an exit strategy
It is imperative that the investor plan for an exit strategy at the inception of the investment. Such investments are usually illiquid and, therefore, the investor must have a full understanding of the method for exiting the investment, including an understanding of how, when and to whom an investor’s interest can be transferred. Typically, the desire to exit will trigger a number of events, including a valuation of the investment and possibly a valuation of the overall property. This will have important tax and accounting consequences that must be understood. Further, an investor should consult with his or her estate planning advisor to ensure that the investment comports with the investor’s overall estate plan.
Buy-sell arrangements are typically used to provide exit strategies, as well as address issues respecting death, disability, expulsion, etc. The investor must understand the triggering events, valuation methodologies, timing, dispute resolution and obligations of other investors.
Finally, an investor should be cognizant of the fact that passive investments in real estate usually are designed to fit under an exception or safe harbor under securities laws. Without the safe harbor, there are significant compliance obligations and potential liability, as well as limitations on an investor’s ability to sell the investment. An investor should seek appropriate counsel which understand the nature of the exception or safe harbor employed.
This brief summary is intended to alert a potential investor in passive real estate assets to some of the major considerations and concerns that should be considered. A competent tax advisor and attorney are crucial to minimizing risk and helping an investor examine an investment. These professionals should be brought into the process at the earliest stages, well before an actual investment is made.
Please note that the scope of this article is limited and that it deals with only general principles applicable to some of the many issues that can arise with respect to passive real estate investments. As with all significant legal documents, the advice of a competent attorney experienced in the particular area of law is recommended. Further, each investment will address unique legal and business issues and a full discussion of all potential issues is beyond the scope of this article.