Buyer Beware: Purchasing Investment Properties in Today’s Market
Michael Kovacs, CPA and Christie Gricius, CPA
In today’s real estate market, you can still pick up investment properties at bargain-basement prices. But what may seem like a good deal could cost you much more than you expect… especially for class C properties. Several factors should be considered in addition to the purchase price.
The demand for certain kinds of rental space, including office and retail space, has not recovered to pre-crash rates in most markets, so a bargain property may come with a high vacancy rate. Finding new tenants can be time-consuming and costly, especially if you need to renovate the vacant space first.
Even if the property has a decent vacancy rate, you will need to examine existing leases for any troublesome terms and evaluate the financial standing of every tenant.
Before purchasing a multi-tenant property, review existing leases and compile a current rent roll that includes such lease terms as:
- Tenant names;
- Move-in dates;
- Expiration dates;
- Security deposits;
- Escalation clauses;
- Options to extend or purchase; and
- Outstanding rent balances.
Watch for tenants who are behind on their payments, leases nearing expiration and rent rolls that differ greatly from the seller’s income statement.
Maintenance and Carrying Costs
If the property is distressed, it is likely that routine maintenance and repairs have been neglected. In that case, you will need sufficient capital to bring the property up to speed and make it attractive to tenants. Depending on the property’s condition, you might be unable to market vacancies for some time.
Regardless of the property’s vacancy rate, you must pay its carrying costs — property taxes, mortgage payments, insurance and so forth. If a building is off the market because it needs maintenance or code compliance work, you could shoulder carrying costs without offsetting rental income for a while.
To minimize hidden costs, hire an inspector for pest infestation and to review wear and tear of the physical structures. Also evaluate the adequacy of parking, signage and drainage before you buy.
Judgment, Claims and Liens
The seller of a bargain-priced property may have fallen behind on obligations to contractors and other third parties. In such cases, you may incur costs to locate lien holders and obtain releases. Code enforcement fines could also come into play.
You will also need to verify certain contractual obligations of third parties. Are the warranties, guarantees, indemnities and rights under the original construction contracts assignable? Would the contractor’s additional insured endorsements apply to you as a successor buyer?
Clean-up costs and liability for lurking environmental issues can pile up quickly. Often, anyone who has owned the property may be jointly or severally liable for clean-up. In this case, determine the applicable federal, state and local environmental regulations, including those that could limit future uses. Review any environmental reports, notices of violations and pending litigation.
Lenders typically require a Phase I Environmental Site Assessment, which requires an analysis of a property’s past and current uses, looking for environmental conditions that could create liability for the buyer. The assessment generally covers underlying land and any physical improvements to property.
Platting and Neighborhood
Unplatted commercial property must be platted before it can be developed. So, you may need to deal with right-of-way dedications, utilities installation, impact fees, and restrictions on access and levels of development.
The nature of the neighborhood will significantly affect its current and future value. Check the crime rate, median income of tenants, rental rates of comparable properties and unemployment rate for the past few years to help estimate the neighborhood’s future property values.
Although you cannot change a property’s location, you can change the perception of the property. If you make certain improvements and upgrades to the property, you can improve the classification of the property from a Class C property to a Class B property. If you put competent property management and oversight procedures in place, you can improve tenant quality. With the added value and stronger tenant base, you will also increase your ability to obtain more favorable refinancing terms which may help make the deal worthwhile in the end.
So before you snap up a bargain-priced property, make sure you take the time to consider all the issues and plan ahead. You may feel as if you need to move fast, but failing to take the time to perform thorough due diligence could put you on the hook for far greater costs than you originally anticipated, while reducing your expected operating income.
Understand How a Qualified Intermediary Works
Anita Wescott, CPA and Tamara Partidge, CPA
Under Internal Revenue Code (IRC) Sec. 1031, you can exchange business or investment property for property of a like kind without recognizing any gain or loss until you sell the replacement property. Most of these transactions are deferred exchanges — the seller has 45 days to identify a like-kind property and 180 days to invest the sale proceeds in that property.
But the IRC prohibits a taxpayer from gaining actual or constructive receipt of the property’s proceeds when relinquishing property. The parties in a deferred exchange rely on a Qualified Intermediary (QI) to hold the proceeds until they are transferred to acquire a replacement property.
Unfortunately, QIs are not required to be bonded or insured or carry a minimum equity capitalization. Anyone can start up a QI and start administering Sec. 1031 exchanges.
Years ago, after several high-profile incidents involving QIs that declared bankruptcy or otherwise were unable to fulfill their contractual obligations, the IRS warned real estate professionals and investors to exercise caution when selecting QIs. Problems with QIs can end up disqualifying the transaction for the gain deferral.
Do Your Research
To protect your interests, make sure that the QI you select has a thorough knowledge of the stringent requirements for Sec. 1031 exchanges and their interplay with other aspects of tax law. The QI should also work on your behalf to help you achieve your wealth management and business objectives. Confirm that the QI can handle all of your exchange needs — some QI firms lack the tax expertise to execute more complex exchange structures. One mistake in legal documentation could disqualify your Sec. 1031 exchange.
Also, research how the QI handles its clients’ funds, including what measures it takes to protect funds and ensure liquidity, as well as whether you will have any influence on how the funds are invested. Find out if the QI “commingles” or segregates funds. The IRS considers commingled funds to be held as a loan to the QI for tax purposes, and clients are considered general creditors. Segregated funds are also treated as a loan to the QI, but they will not become part of the general asset pool in the event of the QI’s bankruptcy.
You may prefer to go with a QI that permits you to decide where the funds are deposited and in which types of accounts. Regardless, insist that the QI disclose how it holds funds and earns revenue.
Also inquire about the QI’s internal controls and other fraud prevention efforts, such as internal audits and employee screening. Choose a QI that carries sufficient Errors and Omissions (E&O) insurance coverage to protect against loss from human error.
Lastly, make sure you fully understand the QI’s fee schedule from the beginning. It may include transaction fees, hourly exchange consulting fees and interest-sharing arrangements.
Perform your due diligence when deciding on a QI. Going with a larger QI does not necessarily guarantee success. If you complete the due diligence suggested above, you have a better chance of signing up with a QI that is rock-solid and ready to help you through the process.
Finally, be sure to consult your real estate and tax advisors for further guidance. If you would like additional information or have questions, please contact Anita Wescott at firstname.lastname@example.org or Tamara Partridge at email@example.com.