When people discover they’re speaking to a commercial real estate professional, the same question is asked: “What hot deal do you have available?” The assumption is that those in the industry have the means to find them the proverbial diamond in the rough – a deal that’s flying under the radar that can offer them astronomical rates of return on their investment, or a building that everyone else overlooked, just waiting to be discovered amid the masses of overpriced properties.
Unfortunately, the question they don’t often ask is, “Should I sell any of the properties I own?” Real estate investors have a tendency to hold on to properties for far too long, waiting for the perfect time to sell. However, we often don’t realize when the perfect time is until after it has passed.
Knowing when to sell is easier said than done. Determining whether the timing is right can be overwhelming. What’s the current market bearing? Is my type of building in demand? What is my current rate of return? Can I achieve a similar return in another property? And on and on. Questions build up without definitive answers, which leads to a lack of clarity, ultimately causing property owners to balk at the prospect of putting their property on the market.
Furthermore, the potential of paying exorbitant taxes on an appreciated property is daunting. The idea of paying upwards of 20 percent in combined taxes on a property is reason enough to question whether or not to sell. As an example, a seller of a property that’s appreciated by $2.5 million is looking at a tax bill of $477,500, according to IPX 1031’s Capital Gains Calculator. However, there are attractive ways to delay paying the tax by utilizing section 1031 of the Internal Revenue Code.
Is there an easy way to determine whether now is a prudent time to sell? When does it make sense to sell a building for less than you may have gotten last year? When does opportunity cost come into play?
First, let’s discuss the cost of opportunity. It is the cost of something in terms of an opportunity forgone (and the benefits which could be received from that opportunity), or the most valuable forgone alternative – the second-best alternative.
Put another way, opportunity cost is the benefit you could have received by taking an alternative action or the difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns 2 percent over the year. In placing your money in the stock, you gave up the opportunity of another investment – say, a risk-free government bond yielding 6 percent. In this situation, your opportunity costs are 4 percent (6 percent minus 2 percent).
Let’s look at how opportunity cost affects those who hang on to real estate for too long. In this example, we have John Landlord. He owns a multifamily property in Charlotte, N.C. The property is valued at $2.5 million with $500,000 in current debt. John originally invested $1 million in the building and is receiving net revenues of $80,000 a year for a return of 8 percent. Not bad. But John is looking to sell. He’s tired of dealing with tenants, trash and toilets. What are his options?
• Sell the property and take the cash. John would owe $300,000 in taxes (20 percent of the $1.5 million appreciation), leaving him with $1.7 million after paying down the debt. Ouch.
• Wait. John feels that conditions will be more favorable in three years. He’ll continue to collect his $80,000 and manage the property. What’s wrong with that? Well, that leads us to the third option.
• Perform a 1031 exchange into tenant-in-common interests. The option has two obvious advantages. John will delay paying capital gains tax by utilizing section 1031 of the Internal Revenue Code, saving him $300,000 and allowing the net equity (sale price less debt) to work for him. Also, by using a TIC exchange, John is able to remain invested in real estate and receive a competitive cash-on-cash return without the headaches of property management.
When one buys real estate as a TIC, they become an undivided fractional owner. The structure allows investors to purchase an interest in a large-scale, institutional-quality real estate asset, typically larger than they could obtain individually. The investor acquires a title and deed interest and subsequently receives their pro-rata share of net rental income while still receiving all the tax benefits of traditional real estate. In addition, the properties are occupied by tenants with net-leases or are professionally managed, allowing TIC owners to eliminate the headaches of day-to-day property management.
The average cash-on-cash return in TIC’s is between 6 percent and 8 percent.
So, returning to our example, John takes his sale proceeds of $2 million (remember, he doesn’t owe any taxes) and exchanges it into one or more TIC properties, which yields him an average return of 7 percent, translating into $140,000 per year in income. It’s an increase of $60,000 a year over his previous property, without the management headaches that come with being a landlord.
What if John didn’t know what a TIC was or that it was even an option for him? What if he waited three years to sell? This is where opportunity cost comes into play. John would have lost out on $180,000 in income by waiting for an opportunity that may never have come. Moreover, John now is a fractional owner of a professionally managed institutional-quality property. The property is being watched over by a team of asset managers who seek to increase value by buying property in high-growth areas and enhancing the building through renovations and capital improvements with the intention of selling the asset at a premium paid back to the investors.
As with other investments, a gain isn’t truly realized until the underlying investment is sold. The same goes with real estate. Appreciation isn’t guaranteed to turn into profit unless you sell. The only way to capitalize on your highly appreciated property is by periodically evaluating your investment real estate holdings objectively and without emotion. You may come to find that now may be as good a time as any. When that time comes, you’ll have the opportunity to unlock your equity, lock in your gains and, more importantly, potentially utilize professionally managed TIC properties to defer the taxes and take a break from active property management.
