One benefit of being a long-term owner of real estate is the flexibility on capital decisions at the time of loan maturity. Another is the tax advantages afforded to strategies deferring liquidating sales. This article will explain both, in addition to why they are often utilized by Timberland Partners in lieu of the liquidating sale preferred by many, if not most, real estate sponsors.
Many real estate investments are made on a deliberately short timeline, typically three to five years. The idea is that after some change is affected at the property, ranging from full development of the site to minor repositioning of the property, the sponsor will have increased the operating income and thus the value of the property, and can then sell it at a profit for both the sponsor and the investors. This can work well, but it does come with some disadvantages.
One risk is simply that market conditions may not align well with the sale of a property. Investors or investment managers operating on a short timeline have less flexibility in terms of a window to sell. If the market happens to contract during their sale window, they may be forced to sell when capitalization rates expand, and values fall. This can lead to sub-optimal returns, or worse, a loss of investor capital. An investor with a longer time horizon simply has more discretion to act when market conditions are more favorable.
A second way long-term owners have flexibility is through the method of capital transaction. They can choose to either sell or refinance a property. An owner would choose to refinance if they believed that further value can be captured by additional income growth at the property, either from more market growth and/or a capital infusion into strategic improvements. Electing to refinance a property is essentially the same as choosing to buy it again at the current market (appraised) value, but the difference is that the current owner has the equivalent of the right of first refusal. In other words, there is no competition from other buyers.
Finally, and perhaps most important, is the tax advantage of a refinance versus either a liquidating sale or a 1031 tax-deferred exchange. Oftentimes, the value of the property has risen enough at the time of its loan maturity that when it is re-levered to the allowable limit—usually up to 60-70% of appraised value—the additional proceeds beyond what is required for capital improvements are available for distribution to the owners.
Critically, these proceeds are not taxable in the year they are distributed. This scenario is referred to as a tax-deferred debt financed distribution. It is a mechanism for the owners to convert the equity in a property to cash without paying capital gains or ordinary income taxes. Like all distributions, however, the amount distributed will reduce the partners’ capital balance, which will increase the gain subject to tax at the time of a liquidating sale. Still, the opportunity to put your money to work on a tax-deferred basis can be a powerful wealth building tool.