Reversal of Fortunes: Giving Power to the Investor through the 1031 Reverse Exchange

Net Lease Insider sat down for an interview with Stan Freeman, President of Exchange Strategies Corporation, the nation’s only 1031 reverse exchange accommodator dedicated exclusively to providing a full set of reverse exchange processes for all asset categories to qualified intermediaries and sophisticated exchangers. He provided excellent insights into the reverse exchange process, ranging from cost effectiveness to asset security.

1. How do investors take advantage of reverse 1031 exchanges in today’s difficult investment real estate market?

First, it is unfortunately true that many investors’ gains have been seriously eroded over the last 18 months. 1031 exchanges have fewer benefits for these folks. If someone does have potential benefits from a 1031 (either the deferral of gains or renewed depreciation potential), then the issue with making a new acquisition in the context of an exchange will likely be finding a buyer for the old asset.

To that end, reverse exchanges have been used for years by investors to better control the outcome of their investment strategies. At no time in recent memory has this been more important. Using a reverse exchange, an investor can acquire what they really want without the pressure of the standard 45 and 180 day deadlines applied to new assets. Most investors would rather be under pressure to sell what they have and not under pressure to buy something they might really not want. Furthermore, in many situations, reverses can be structured to provide more time – up to a year or perhaps more – to a accomplish a particular strategy. In today’ market, this can make all the difference.

2. How do you use a reverse exchange to get more time?

There are various ways to combine exchanges to get up to two 180-day periods. Generally, this is done when there are multiple properties to sell or buy. As an example, suppose you have an older apartment building to sell and you want to buy two new net-lease properties. If you start a reverse with the first of the new properties, then you have up to 180 days to sell the old property. Once it gets sold, in the context of a forward exchange, you have another period of 180 days to acquire the second new property. This type of strategy can also work if you have multiple old properties and a single new property to acquire.

There are also forms of reverse exchange that allow a new property to be improved prior to title being transferred to its ultimate buyer, thereby increasing its value for purposes of deferring more gain. This can also work with leaseholds. Both forms allow the investor more time to make improvements that bring a property to a full income producing condition.

In addition, there exist non-safe-harbor structures that require a great deal more care to implement. They are more complex and expensive and should be considered when the gains from the sale of an old property are substantial and there is real potential based on a either a series of new property acquisitions over a period of time or a construction project that will require a lot more than 180 days to complete. There are situations in which these structures make a great deal of sense.

3. But, I have the impression that reverse exchanges are very expensive. Isn’t that an impediment to using them as you suggest?

Investors with properties that produce healthy income will almost always find that a reverse is economically sound. The investor can earn the rents from both the old and new properties for up to 180 days if they are using a reverse exchange. So, if this income is greater than the reverse exchange fee plus the cost of funds needed to acquire the new property, the economics are significantly better than in a delayed exchange. Of course, a detailed analysis of the exchange economics for a specific situation is probably more complex than this. But it is always worth doing and we help our clients through the analysis on a regular basis.

4. These days, many investors are hesitant to use 1031 exchanges at all because of the numerous instances of theft and bankruptcy. Is there a reason to be nervous?

A reverse exchange is a title-parking arrangement. There is no cash, per se. And, there are well established methods of insulating assets from liability, bankruptcy and failure to execute. There is really no asset risk in a reverse exchange if it is structured properly.

Regarding the spate of QI failures, it is the accumulation of a large amount of cash proceeds – often following the acquisition of one QI by another – that has proved too tempting for some. The exception to this was the situation involving a large title-company-subsidiary in which securities were purchased with exchanger funds that became illiquid. The motivation was to increase the earnings on the cash it held. When selecting a QI for a delayed exchange it’s important to use one that allows you select the bank where proceeds are parked and is bonded and insured.

None of these issues pertain to reverse exchanges.

Perhaps choosing your accommodator for a reverse exchange requires some additional care in light of these cash-drive failures. If the QI you choose is heavily dependent on delayed exchanges and if their business is under stress because of the decline in exchange activity, then you should make sure that the LLC they form to hold your assets is fully protected from a decision they’d make to seek protection from a bankruptcy court. The entanglement that can occur if the LLCs are not structured right can be lengthy and difficult.

For more visit: http://www.exstra1031.com/

S&P and Moody’s Put on the Defensive: Rating Agencies to Share Liability under New Bill

From Merriam-Webster:

Conflict of Interest
Date: 1843
: A conflict between the private interests and the official responsibilities of a person in a position of trust.

To most, AAA investments are as good as gold and function as a secure reference point with which to steer portfolios. However, they recently served as a false beacon, leading thousands onto the jagged rocks of financial peril, causing billions of dollars to be lost forever. The credit ratings agencies responsible for these guiding lights are supposed to have the interests of the investor and public aligned with their own but it is widely perceived that this is not so. Now under public pressure for accountability, congress is considering a bill that will force liability onto these agencies.

It is commonly known that credit rating agencies such as Moody’s, Standard and Poor’s, and Fitch make their money not from the public who uses their ratings but from the companies who pay to have their securities rated. This would seemingly create a conflict of interest, because the agencies would naturally be more eager to appease those who pay them than those who do not. Thus their official responsibilities (putting out accurate credit ratings) are in conflict with private interests (being paid by companies to rate them). Especially if that company is say, Lehman Brothers, whose financial viability rests upon the AAA ratings of their securities which they know to be worthless. A company in that position would undoubtedly be willing to fork over lots of cash to keep their self-sustaining illusion afloat. Likewise ratings agencies, faced with the proposition of losing business if they are not conciliatory, might be persuaded (through proper monetary investment) to help in that endeavor.

The ratings agencies response to their defaulted ratings is essentially “oops” because they are not liable for the ratings they put out. It is of course natural then that the public would want to strike back at these agencies and hold them accountable for their ratings, to ensure that no future “investment grade on Friday, bankrupt on Monday” ever occurs. But a regulation such as the one proposed is a tricky measure, in need of careful analysis before implementation.

For one, if those giving financial advice are suddenly made liable, to what extent and under what conditions can they be sued? It is possible something could evolve like what currently plagues the medical profession, a multitude of frivolous lawsuits which drive costs unnecessarily upward. Any investor could theoretically have a claim against these agencies, even if the market did take an unforeseen dip. Secondly, the regulation could come out looking like the widely criticized Sarbanes Oxley Act. An act which is generally hailed as being not only a hazardous maze of red tape but essentially a useless precaution. Finally, these agencies may not be liable but they cannot falsify their reports without reproach. Already there are pending law suits alleging major fraud, which could end up securing convictions, penalties or major settlements. These suits could bring about the accountability desired, making legislation unnecessary. Regulation is always more complex than it seems in principle; prudence requires us to be cautious, skeptical and thorough with regards to any proposal.

The net lease industry, like most others, depends upon the validity of credit ratings. One of its most appealing qualities is the promise of long-term viability. Discovering a portfolio of AAA properties is actually not even investment grade would simply be disastrous. Accurate ratings are without a doubt needed but legislation must be properly vetted to ensure it is not harmful, ineffective or unnecessary.

Need Cash? Sell the Capitol Building! The New Trend of Government Sale-Leasebacks.

As reported by Globe St.’s Brian K. Miller, Arizona has approved plans to auction its “State Capitol Executive Tower” in a 20 year sale-leaseback. The tower houses the offices of the secretary of state, state treasurer and Governor and has an estimated value of $40 million. Arizona was forced into this predicament because of its current budget shortfall, which currently stands at around $3.2 billion.

However unlikely, this is just one example of a growing trend of government sale-leasebacks. California plans to sell $2 billion (or 62% of Arizona’s budget deficit) worth of government real estate, including the Attorney Generals Office, in a similar sale-leaseback. The City of Alexandria, VA, is considering the same thing with a host of its properties and Chicago has already performed sale-leasebacks with the “Skyway toll road, downtown parking garages and downtown parking meter system” for $3 billion. Sale-leasebacks make sense for governments because they allow them to get cash now to pay off their debts while retaining the option to buy back the property in 20 years or so.

Investors have shown a great deal of interest in these properties because their tenants (the government and in-effect, taxpayers) have strong credit ratings and in some cases will return twice what the investor pays. Not surprisingly, interest goes beyond political boundaries, as it is reported that international investors are heavily intrigued by these sale-leasebacks. This creates a bit of an irony, because in theory, you could have a U.S. State Capitol building owned by China.

Sale-leasebacks are generally structured as net leases, giving strength to a segment, which as Michelle Napoli pointed out, is already one of the most active in this current market.

Retailers Expecting Lean Santa: Holiday Retail Sales & Outlook

The fourth quarter is typically a time retailer’s look forward to with such glee that even a child would be hard pressed to match their level of expectancy. This is, after all, the time of presents, candy, costumes, decorations, ornaments and lavish meals. Children know Santa is coming to town and retailers know parents are. In-fact retailers are so anxious to begin this cycle of profits; they are often accused of putting out holiday items too early, the infamous “Christmas creep”. However, last year retail was hit hard by the recession; today the economy looks much the same and retail must adapt.

This will be the second holiday season celebrated under our current recession and the retail sector carries no illusions about that. According to a recent survey released by Hay Group, 72% of retailers predict sales this year will be equal to or less than sales last year and 57% are planning on reducing staff levels this holiday season. In comparison, last year 60% of retailers expected an increase in sales and only 29% decreased staffing levels. While these numbers are obviously negative, they are also prudent, reflecting a necessary change in mindset rather than an unfortunate change in the economy.

Additionally, retail is adopting new promotional strategies to better fit the current economy. 43% of respondents plan on “running more promotions and/or deeper discounts” this holiday season and another 43% plan to run promotions continuously from now till new years. This reflects a shift in focus from last year, when 45% percent of retailers ran most of their promotions on Black Friday (this year only 35% will), giving people more time to save up paychecks before making purchases.

These changes may already be having a positive impact on retails outlook. According to Fitch Ratings:

“Many companies across Fitch’s U.S. retail coverage have been managing inventory positions well. Gross margins have rebounded for those companies in the discretionary categories that were hit particularly hard during the 2008 holiday period. This, combined with strong cash flow management and the resolutions of liquidity issues for several companies, has resulted in an improved overall credit outlook”.

Though this may not be the holiday season of our dreams, it will certainly be a reality we are more equipped to cope with. Through tempering sales predictions, cutting overhead costs and altering promotional activities, retailers are becoming leaner and more efficient. Furthermore, in this current market where nearly 50% of net leases are traded as retail, should credit scores and sales improve, the only thing that may be going down are cap rates.

The Party is Over: Net Lease & the Future of Commercial Real Estate

In a very interesting article by Globe St’s Amy Wolff Sorter, the typical real estate investor of the future is predicted to be quite different from the one of our near past. Due to real estates most unfortunate bubble, the new investor will be squarely focused on pragmatic investments for the future, rather than “Real Estate Riches in 14 Days”. If true, it sounds like this “future investor” would be very interested net leases.

Specifically the article states:

“Experts tell GlobeSt.com that, in the wake of the 2008 economic crisis, the real estate owner of the future will undergo a seismic shift from the buy-and-flip investor to one that is knowledgeable about real estate and will stay with an asset for the long haul.”

This description perfectly fits that of a net lease investor. Net leases are primarily characterized by long term leases with stable tenants of investment grade credit. As such, net lease properties are generally considered to be low risk, dependable investments. For a marketplace suffering the effects of a hangover fueled by a lost weekend of high risk binging, net leases could represent that cool cup of tea and handful of Advil in the morning.

Retail Sales Signs of Life: Do Signs Point to Destinations Anymore?

The early days of September have seen a recent flood of positive news: Retail Sales are Showing Signs of Life. Examples of this include articles entitled “August Retail Sales a Pleasant Surprise” released on Sep. 4th by Globe St. and “Retailers Begin to Show Some Signs of Life, But New Leasing Deals Continue to Pose Challenges” by Retail Traffic on Sep. 1st. If readers from another planet saw these articles, they would undoubtedly think that these were the first reports of good news in a while, as we are just “beginning” to see them. But to an earthly observer, there is something odd about these “Signs”. Namely, that we have been reporting to have seen them for over half a year.

All one has to do is Google “Retail Signs of Life” and they will come upon articles such as Wall Street Journal’s “Retail Sales Show Signs of Life” dated March 6th, Internet Retailer’s eerily similar “Retail Sales Show Signs of Life” dated April 7th and “Signs of Life: Slower Decline May Signal Recessions End” by RIS Media on August 4th.

So how can we be purportedly “Beginning to See Signs of Life” for this long and not yet see the actual Life? The answer may lie in what we are using for signs these days.

Take the opening sentence from the Globe St. article cited above:

“Summer is ending with a pleasant surprise for retail observers, with August US comparable-store store sales declining by a better-than-expected 2% from the same month of 2008, according to the International Council of Shopping Centers Chain Store Sales Index.”

Does this not represent a weird prognostication of good health? We are doing better by doing worse; it is a “pleasant surprise” that comparable-store sales declined by 2%? This is close in resemblance to Orwell’s infamous “Doublethink”, having two contradictory thoughts at the same time. Like, “things are worse but better”. In essence, becoming our own devils advocate.

We can see “signs of life” for as long as we want if we simply make the predictions worse than what actually happens. An actual show of improvement will be a trend in which sales do not decline, or even perhaps go up. Those will be the real signs and hopefully we’ll see them soon.

It’s the Loans, Not the Land: The CMBS Refinancing Crisis

It seems to be a generally accepted fact that Commercial Real Estate is about to hit the ground like a ripe watermelon thrown off a ten story building. Stories abound about how its impending collapse will send systemic shocks rattling through our weakened economy, delivering a rude kick to the face just as it is trying to get up. Investors stand quivering on the sidelines and banks are trying to find out how they can hire Jimmy Stewart (aka It’s a Wonderful Life) to perform some crowd control once their money evaporates with the popping of this last bubble.

And you know what? These predictions, dire as they are, may not be totally off base. If recent reports are to be believed, things are not all well with the world. The delinquency rate for CMBS rose to 3.14% in July, which is more than six times as high as the level last year and by 2012, $100 billion of the $153 billion worth of CMBS loans (65%) will face difficulties being refinanced. With this kind of information, it’s easy to see why so many are pessimistic.

The thing to be remembered, however, is that this is all the result of massive artificial inflation. There is nothing inherently wrong with the land; there is nothing inherently wrong with commercial real estate. There was something horribly wrong with the way people behaved between 2004 and 2007. Essentially, taking a Louisville Slugger to the figurative credit piñata and declaring “come get it!” resulting in drastic overpricing and horrible loans. The land itself was the innocent victim of this all and today faces the repercussions of our malfeasance.

In-fact, the cash flow from most of those properties whose loans expire in 2012 is enough to “pay interest and principal on their debt”. Even in the midst of this deep recession, commercial real estate is still producing wealth. The problem is that its values have inevitably fallen from their inflated highs, making it almost impossible for borrowers to extend their existing mortgages or refinance with more debt. But is this necessarily a bad thing? Clearly the market was flooded with bad credit, so is it wise to take out more debt, or in the case of government action, tax payer funded debt, to refinance bad loans? Perhaps it is best just to let the market clear itself of its toxic waste.

We collectively went on a binge of epic proportions and today have to face the consequences. But we never destroyed or devalued assets, we overvalued them. When the dust settles it will be found that commercial real estate is still a great investment, still capable of building wealth and in reality, still is today. If the economy does get hit by a wave of CMBS foreclosures, it’s not because of the land, it’s because of us.