Creative Methods of Structuring Real Estate Acquisitions
Creative Methods of Structuring Real Estate Acquisitions
By Bryan Mashian
It is not possible to survive in the real estate business today using the old, common methods of structuring real estate transactions. To succeed, real estate professionals must be creative. To that end, this article will provide a brief summary of the advantages and disadvantages of some of the alternative methods of structuring real estate acquisition.
1. Seller Financing
If the buyer is unable to obtain a new loan, the seller should consider providing the financing. One advantage of seller financing for the buyer is that the seller usually does not charge any points, origination fees or other costs customarily charged by institutional lenders. Also, seller financing is very flexible and the parties can structure a loan to meet the mutual needs of buyer and seller by, for example, selecting a variable or fixed interest rate, having an interest-free period, deferring interest payments, increasing or decreasing the term of the loan, using an interest-only structure, or fully amortizing the loan. If the buyer is cash poor, the seller can choose to finance a larger portion of the purchase price than would be done by an institutional lender.
Through seller financing, the seller may be able to obtain a higher purchase price in exchange for deferring receipt of the purchase price. The seller can charge the buyer an interest rate higher than the rate the seller would earn from depositing the sales proceeds with a bank. Also, by using the installment method of reporting the gain from the sale, the seller can defer payment of taxes over the term of the purchase money note.
2. Shared Appreciation Mortgage
Using a Shared Appreciation Mortgage (“SAM”) is another method of structuring a purchase money loan by a seller. A SAM has a bifurcated interest structure. The buyer pays to seller a non-contingent amount of interest. As additional interest, upon sale of the property or maturity of the loan, the buyer pays to seller a stated percentage of the appreciation of the value of the property.
Since the lender/seller shares in the increase in value of the property, the non-contingent interest is usually at a rate slightly below market rates. Therefore, a SAM has the advantage for the buyer of providing initially lower fixed payments. A SAM may be suitable in a transaction where the seller is reluctant to sell in today’s depressed real estate market because the seller believes that the values will increase in the future. A SAM has the flexibility of providing the seller with a share of the up-side, if any, and a definite amount of interest.
3. Retaining Existing Financing
The amount of many of the previously placed real estate loans would be considered to be generous today since the property values have generally declined. It is often difficult, if not impossible, to replace such loans. Retaining the existing financing may be the only means to finance and consummate some transactions.
One advantage for the buyer of retaining the existing financing is that this structure saves the buyer the costs of obtaining a new loan. One advantage for the seller is that if the loan is assumable, the transaction will not be contingent upon the buyer obtaining a new loan, which will simplify the transaction and shorten the escrow period. However, most loans from institutional lenders will have a due-on-sale clause which will necessitate the lender’s consent prior to consummating the transaction.
One common misconception is that by using a wrap mortgage or an all-inclusive trust deed (“AITD”), the parties can avoid a due-on-sale clause. The fact is, however, that usually the due on-sale clause is triggered by virtue of the sale and transfer of title. The parties should be careful not to inadvertently violate the due-on-sale clause.
In a sale-leaseback transaction, the owner sells the property to the buyer who concurrently leases the property back to the seller. This structure allows the seller-lessee to generate cash from the sale while continuing to use the property by leasing it. A sale-leaseback allows the seller-lessee to recognize any gain or loss on the sale, and to deduct the rental payments. The sale-leaseback is especially suited for a seller-lessee who wants to increase its working capital by selling the property and thereby improving the balance sheet and credit worthiness of the seller. The buyer-lessor in a sale-leaseback transaction will be able to depreciate the building and deduct any mortgage interest payments. Furthermore, by adjusting the purchase price and the rent payments, the buyer-lessor may be able to obtain a high rate of return and enjoy a management-free investment.
5. Ground Lease
In a ground lease, the landlord usually leases unimproved property to a tenant for a long term, i.e., in excess of 50 years. The tenant will improve the property and then sub-lease the building to occupants who conduct some sort of business from those premises. The long-term ground lease is essentially a financing device to facilitate development of the land into a commercially viable project, where the leasehold interest will be the security to develop or refinance the project.
A ground lease allows the tenant to further leverage a project since the tenant does not have to tie up cash for the down payment to buy the property. The tenant will also be able to deduct the rent, taxes. and other appropriate expenses, and to depreciate the improvements. One disadvantage is that there are few lenders who will loan money on a leasehold collateral.
This vehicle may also be suited for an owner of unimproved land who does not have the expertise, money or ability to develop the property. From the landlord’s perspective, a ground lease may be preferable to a sale because the landlord avoids capital gain taxes due on a sale. Another advantage for landlord is that the tenant develops the property and usually pays a steady rent to the landlord. The disadvantage is that ground leases are very complicated and time consuming.
6. Lease with Option to Purchase
Many property owners have been sitting with vacant properties that they have been unable to sell in this declining market. At the same time, there are many would-be owner-users who wish to buy (instead of lease) a property, but are uncertain whether their business will generate enough profit for them to afford buying a property.
A lease with an option to purchase has the advantage of providing the lessor-seller with rental income until the property is sold. The tenant-buyer also gains from use and occupancy of the property without tying up cash that can be used in the business until the property is purchased. Also, this structure allows the tenant to actually determine if the property meets the tenant’s business needs.
If the option price is fixed, then the ten-ant-buyer has the advantage of being able to buy the property at the same price, even if the value of the property increases. Usually, however, the landlord will require that the option price be increased by stipulated amounts or in accordance with increases in the CPI. Alternatively, the landlord may require that the option price be the fair market value of the property to be determined when tenant exercises the option.
7. Tax-exempt Bond Financing
A potentially significant source of savings on interest expense can be obtained by acquiring financing from tax-exempt bonds (including certificates of participation). Tax-exempt financing is only available for limited purposes such as infra-structure financing, construction of certain apartment housing projects that include a low and moderate housing element, and nonprofit corporation projects.
If a project is financed with tax-exempt bonds, the borrower must work with a governmental agency or a Mello-Roos District. The major advantage of tax-exempt financing is the lower cost of financing. The disadvantages include limitations on the types of projects for which tax-exempt financing may be obtained and conformance with federal tax law to obtain and maintain the tax exempt status of the bonds.
8. Real Estate Investment Trusts
A Real Estate Investment Trust (“REIT”) is an entity (either a corporation or a trust) that receives most of its income from passive real estate investments and receives “pass-through” tax treatment for income distributed to its shareholders. This structure allows a REIT to raise money without the “double tax” drain of operating in a corporate form.
A REIT can raise large amounts of money, with each individual investor having the freedom of investing small or large amounts. A REIT must have at least 100 owners. Thus, large numbers of investors can pool their resources. The REIT ownership interests are usually freely tradable and therefore much more liquid than most other real estate investments. A disadvantage of a REIT is that it is usually expensive to form because the sale of interests in a REIT constitutes the sale of a “security” with all of its related costs and expenses.
These methods and others, such as tax-deferred exchanges and shared equity arrangements should be considered to creatively structure transactions in these trying times.