My team at Progressive Real Estate Partners recently had the opportunity to help a client successfully accomplish his 1031 exchange goal of selling a Southern California multi-tenant retail center that he owned for 20+ years and trade into 3 absolute triple net single-tenant fast food properties in other states.
Although our team has helped a number of clients acquire their upleg properties, this was the 1st time we had done a multi-property upleg. During the course of this process, we agreed on 7 letters of intent, went under contract on 6 properties and successfully closed on 3. Mission accomplished.
We all learned a lot through this experience and, as my readers know, I like to share knowledge and I hope these tips will make your 1031 exchange transaction easier to navigate.
Tip 1 – Seek Advice from Your Legal & Tax Team Prior to Starting the Process: Anyone who intends to execute a 1031 exchange should have a professional tax and legal team to rely upon for guidance based on their own specific situation. I assure you it will be money well spent. Although, this blog addresses some tax and legal considerations and provides some general info to help navigate the process it is NOT a substitute for getting advice from your own team of experts so please don’t rely on this blog for any tax and legal advice.
Tip 2 – Read Broker Offering Memorandums Carefully: I have been creating and reading property offering memorandums for 30 years and even I fell for what I will affectionately call “brokerisms”. In one case, the broker indicated the tenant was a “strong franchisee” that “operated over 50 locations.” This was sort of true. The franchisee was strong and did operate over 50 locations, BUT the tenant did not. The tenant was an entity the franchisee had set up and it only operated 4 locations. By the time we dug through the financials, waited for more information and tried to negotiate a more secure guaranty, all to no avail we decided to move on. In another case, the memorandum stated the building size and that it had a drive-thru and we assumed that it also had indoor seating. It was only as we were conducting the due diligence that we realized that wasn’t the case. Based upon this and the price per square foot, we became very uncomfortable with the ability to re-tenant the property if the tenant vacated so we chose to not move forward.
Tip 3 – Be Careful of Sale/Leasebacks Especially with Franchisees: In one of the escrows (the same one with the “strong franchisee”), we realized the challenge of dealing with a tenant/seller that writes their own lease that the sale is based upon. The challenge with franchisee sale/leasebacks is that you generally don’t get to review the lease until you negotiate a letter of intent and purchase agreement. We found that inevitably these leases had provisions that were either intentionally written in the tenant’s favor or just poorly written. We did close on one of these properties, but it was only because it was the 1st property we had put under contract so we had plenty of time to resolve the issues. When a developer negotiates a lease with a tenant, the developer knows that they are negotiating a lease for a potential buyer and if they don’t do a good job it will be much more difficult to sell. As a result, a developer negotiated lease is preferable to a sale/leaseback lease.
Tip 4 – Give Yourself Time to Close the Downleg: The property you are selling is your downleg. Often the parties involved will structure the closing to occur something similar to “15 days following the buyer’s waiver of contingencies.” Remember, you have 45 days from the time you close the sale of your downleg to identify the properties you are potentially purchasing in your upleg. Many people who poorly execute the 1031 exchange process have gotten one or two properties under contract by the time day 45 arrives. Our goal was to have completed due diligence AND waived contingencies on all the properties we were purchasing by the 45th day. To give ourselves time to start this process in advance we utilized language substantially similar to the following in the purchase & sale agreement for the downleg:
- “Closing shall occur no sooner than 30 days and no later than 90 days from the Buyer waiving contingencies. Seller shall have the option to cause the Closing to occur upon 15 days notice to the Buyer.”
Our client closed the sale about 45 days following the buyer waiving contingencies which in turn gave us a total of 90 days to identify the potential upleg properties. As a result, we closed escrow on 2 of the 3 properties prior to the end of the 45 day identification period and had 2 other properties mostly through the due diligence process.
Tip 5 – Identify Specific Search Parameters for the Upleg: The upleg is the property you are going to purchase after selling your property. If you view your upleg as the equivalent of going to the mall with $1,000 in your pocket and you just wander around until you find something you like, your 1031 will likely not be successful. BUT if you go to that same mall knowing you are looking for a suit/dress for your child’s upcoming wedding, you are much more likely to be successful. Despite the fact that our client knew exactly what he wanted, the search was still challenging (just like trying to find a suit/dress for your child’s wedding). Our client knew he wanted absolute NNN properties in tax free states. You must know what you want within a fairly tight range or you will be chasing too many horses and won’t be able to catch the one you really want to acquire (instead you might just end up with the slowest horse).
Tip 6 – Line up Your Team: We initially intended to utilize CA legal counsel for properties in other states but quickly realized that most were not comfortable “practicing” on out of state properties. As a result, we ended up retaining legal counsel in the states where the properties were located. Fortunately, through our office’s affiliation with Retail Brokers Network we were able to quickly get some good recommendations. Also, you need professionals to do property inspections, surveys and environmental reports. There are a couple of national firms that can be utilized to make this process more efficient. We used National Due Diligence Services. These national vendors will frequently be more expensive than a local vendor, BUT when you are going fast and furious through this process it is a lot easier to be able to make one phone call for all these services. By going online, we did dig up a few local vendors but this was very time consuming. If you are dealing with a lender keep in mind they will likely want their own team including the appraiser.
Tip 7 – Third Party Reports Cost Time & Money: I am so grateful that our client recognized that “you win some and you lose some.” He recognized quickly that 3rd party reports were going to take time and time was not on our side. As a result, he was immediately willing to order 3rd party reports knowing that we might end up throwing some of these reports into the electronic trash bin. He recognized that when you are trying to buy $8M in property, “wasting” $10K to $20K on 3rd party reports and legal fees was worth it.
Tip 8 – Line Up Your Debt Beforehand: Fortunately, our exchange was all cash. Debt would have added a whole additional layer of complication. This is another reason why you need to know what you are shopping for before starting the process. I would recommend working with a quality mortgage broker/banker for your debt as not only will they save you a lot of time, but they should have a lot more leverage than most people doing a 1031 exchange. The lender has more incentive to perform for someone who has the potential to channel a lot more business in their direction compared to a buyer who may never need another loan again.
Tip 9 – Have Excess Cash or a Line of Credit Available: You would think that when working with $8M of cash and no debt it would have made everything really easy, but because we were trying to purchase 3 properties, we quickly realized that wasn’t the case. At times we were focused on 3 properties that added up to $9M and other times they only added up to $7M. The goal was to try to use as much of the cash as possible without going too much over. Fortunately, our client had additional cash he was prepared to utilize if we went over, but it made me realize that for others, it would be best to have a line of credit if they did not have the cash.
Tip 10 – Work With a Reputable & Professional Broker: This one is difficult for both parties. In general, a quality listing broker will not take on an acquisition assignment. It is just not productive for them since they are focused on being a listing machine. Also, the seller/buyer is often concerned that their broker will not uncover every stone to find all the upleg possibilities, nor will the broker stick with the client until the end. There were certainly a couple of times during my client’s exchange when I questioned my sanity of taking on this responsibility (especially when I had to tell him to cancel a deal that I had done a lot of work procuring because it was just a bad deal). In my opinion, the best way to solve this dilemma is for everyone to have a sincere conversation. The broker needs to know exactly what they can and cannot do for the client. And the client needs to tell the broker how exclusive OR not exclusive they are going to be and how they might reward the broker even if they purchase the property through another broker. The benefits of working with a reputable and professional broker not only include the expertise that comes from that broker’s knowledge, but also the credibility that a buyer receives from the brokers who are listing the upleg properties.
Tip 11 – Use Technology But Go Kick the Tires: We used a lot of technology to analyze each deal. We used Costar, Crexi and email marketing for finding properties. We used Sites to Do Business and Sites USA for reviewing demographics. We utilized Google Maps for analyzing competition. We used Yelp for reading reviews on the particular restaurant and the other restaurants operated by the same franchisee. We used AirTable for keeping track of all the opportunities we were evaluating. We used Craigslist Gigs to hire photographers to photograph the properties and the surroundings before making a decision to go visit the properties. Ultimately, my client and his son went and visited the properties just to have that comfort level that all was what was expected. I am a huge believer in seeing sites in person as I have frequently found that not everything shows up on Google. Freeway sound walls, homeless problems, a vacant anchor space that looked occupied on Google, and similar situations are good reasons to go look at the real estate before waiving contingencies.
Tip 12 – Pay the Price if Necessary: At the time of this transaction, the single tenant absolute NNN market was very competitive. It took us about 2 weeks of writing offers 5 to 10% below the listing price to realize that this was a mistake and shortly thereafter we started writing offers at full price. We realized that getting properties under our control was a lot more important than saving $50K to $100K per property. Our client had no basis in his downleg so his tax implications were huge, especially because California does not recognize the concept of long term capital gains. In California, long term capital gains are taxed as ordinary income. As a result, buying the right properties and deferring all the capital gains was much more important than a few basis points of return.
Summary:
A 1031 exchange is a great tool to defer capital gains taxes while growing your commercial property portfolio and hopefully these tips are helpful in making the process as smooth as possible.