Well, first things first, you've got to know your exit strategy before you invest in any commercial real estate investments. If you don't, what you're telling yourself is that it's okay to not maximize your cash flow and it's okay to not maximize your profits when you sell, but knowing only your investment goals is half the story. You must also know how and when to sell the property.
Question for You
What's the commonality between an exit strategy and an astronaut?
NASA astronauts wouldn't dare venture up into space and not have strategically planned outcomes and escape plans. A typical outcome may be to collect moon dust and arrive safely back home or an escape plan may be to eject their space cap in case something goes wrong mid-flight.
Any wise commercial real estate investor should have their desired outcomes and/or escape plans strategically planned as well and well in advance mind you. We call these exit strategies.
Definition of an Exit Strategy for Commercial Property
My definition is this:
An exit strategy is your escape plan for the money you put in and want to get out of the investment
The 2 Types of Investors That Exist Today
Those whose primary exit strategies fall into the short term investment landscape. Their goal is to get the net operating income, the NOI as high as they can, then sell the property. They tend to look for property with a quick upsight that will appreciate quickly such as small retail centers in great locations or an apartment building that has been undermanaged where there's great upsight potential.
Their exit strategy may look something like this:
- One to five years, my property will be a 100% occupied with tenants paying higher rents than when I bought it. When that happens, I will sell it for lower cap rate producing a higher return on my investment.
- Short term, increase the upsight in the property, sell the property, and make a profit.
- Long term holders who want to keep a property for 20 to 25 years. They're also known as coupon clipper investments where these properties provide the consistency of monthly income with limited headaches for the owner.
- The overall returns maybe a bit lower, but they're safer because of the stabilized NOI. These investors bank on the fact that their property appreciates just in the cost of construction over time alone. They increased the return investments by ensuring their property is managed well and professionally. All right. For the keeper, property management is crucial, crucial, crucial, and crucial.
What Type of Investor are You?
Are you a finder, a short termer or are you a keeper, a long termer? Whichever one you are, exit strategy before, during, and after you own a property is crucial.
3 Questions to Ask Yourself Before Investing in Any Commercial Real Estate
1. Why am I buying this property?
It could be for retirement. It could be for personal and wealth creation. It could be to pay for your kids' college tuition down the road. You may want to sell and buy larger, larger, larger properties. That's what I've done. Or you may want to ease out or quit your day job. That's what I did. Or your property buying could be for use as a tax shelter. Those are possible reasons why you are buying this property
2. How long do I plan to hold this property?
Now let me tell you this. When answering this question, your loan terms, the loan that you get on a property will dictate how you answer this question.
If it's a short term hold, like a finder or less than 5 years, then select that type of loan. If you plan on holding for more than 10 years, 20, 25 years, then look for long term loan options. If you end up selling the property too soon, then you may have to pay a very large prepay penalty. If you want to convert your short term loan into a long term loan, the long term loan terms today may not be available tomorrow.
3. How will a sell affect my taxable income?
Very important question, because Uncle Sam will likely get his hands on as much of the income that you earn from a property sell as possible, right? This is the IRS.
Tax planning as early as possible is one major asset to your real estate exit strategy. The sale of a property could put you into a higher tax bracket and take a large buy out of your profits. What I want you to do is consult with a tax professional and organize way to reduce your tax burden at the very beginning.
The Different Types of Exit Strategies
- You could be a long term holder for cash flow.
- You could be the type that wants to maximize and flip the property for a profit.
- Sell outright and pay capital gains taxes
- Sell the property and do a 1031 tax deferred exchange
- Cash out refinance the property, pull out some money and continue to hold the property.
- Sale leaseback. That's a great strategy if you have a lot of equity tied up in a property. You need to pull it out quickly.
- Give the property to your heirs, to your kids.
- Wholesale the property or flip the contract.
Hold Long Term for Cash Flow
- You need to get a good long term loan as long term as you can.
- You need to get really, really good at managing the management. That's where the money is made long term. Managing the management, having good property managers.
- Set up an income and expense budget every single year.
- If you don't know how to do it, what you do is you get your property manager set up for you and they're supposed to do it every year for you. On our properties, our managers have their annual budgets for the following year are due at the end of November each year. If this year is X, so X year that budgets are due at the end of November for X plus one year.
- Get a good real estate tax advisor. Do not use one of those franchise tax advisors. Yes, they're cheap, but let me tell you this. Being cheap can be very expensive. When you're buying commercial property, there's so much money, there's so much taxable income involved.
- Don't use a tax advisor like an attorney or a tax advisor who only does tax returns. Use a real estate-based tax advisor.
- I need you to be anal. That's right, be anal, be a micro manager because no one cares more about your investments than you do.
- You need to watch your numbers. Some people say that commercial property is a passive business. It is not. It is not a passive business. You need to be on top with everything, everything.
Maximize the Value then Flip the Property for a Profit
- You're doing this, if your strategy is to rehab or retain it and to get out, then do it decisively and quickly because the longer you hold the property, the more things I can go wrong.
- Take it from me. If you get close to your strike price, note that the lowest price you want to take, take it and run. Get your profits and get out.
- Have you thought about the tax consequences?
- Talk to your tax advisor before closing.
- I don't know why you want to do that, but you maybe forced to do that for some personal reasons.
- Just remember this, it takes 12 months to plan a good exit and it takes 3 months for the sale to actually happen.
- If you want to sell your property, you should plan to sell it a year in advance to set up the numbers, to make sure everything is good, the NOI is good.
- Then when you decide to sell it, it takes 3 months for actually to happen, so planning is very important. Next, be prepared to pay capital gains taxes.
- Tax that either a short term rate which is 25% up for investments held under year or for long term, it's 15% for investments held one year or longer.
- Twenty-five percent tax it for investments held under a year and 15% for investments held one year or longer.
- Talk to your tax advisor on those specific numbers. Again for the person selling outright, what are you going to do with the profits? You may want to research if there's a better way to get the profits out of their property before selling outright.
Sell and Do a 1031 Tax Deferred Exchange.
- According to the IRS rules, you can sell your property and not pay capital gains taxes as long as you move forward all of your equity into a more expensive property. Obviously you would do this to buy a larger property with more cash flow, right?
- You can indefinitely do this as long as you teach your kids or heirs the same thing.
- In my opinion, this is the best way to build long term wealth is the best way, is to buy property, increase the value, pay down the mortgage. Then when you sell it, buy a larger property and do this over and over and over and over again. This is what I've been doing for years.
Cash Out Refinance and Then Hold the Property
- I would say 80% of the properties that I've held, we've done this.
- In this case as the property has increased in value, you can pull out cash and then hold on to the property. It's called a cash out refinance loan.
- With the additional cash, you can buy more properties to fix up or you can just fix up the current property you have to make it more valuable and then pull out more cash later, right? Beautiful thing.
- By the way, most commercial lenders allow cash out refinancing. Look into that.
- To free up money tied up in your property, you can do what we call a sale leaseback.
- You would sell your property to an investor for cash, then lease it back for a long period of time as an agreed upon price, rent price.
- If the seller or a tenant that's you, you're very strong financially, then your investor can get good financing. That's a win-win.
- This strategy not only frees up cash, but the seller that's you retains use of their property with the long term lease.
- This is ideal for doctors and attorneys that own their property in which they practice their business. They're ideal candidates for sale leasebacks.
- Just to let you know, typically the price of the sale leaseback should be set by an independent appraisal.
Give the Property to Your Heirs
- I call it gifting it to your heirs. If you wish for your children to own a portion of your commercial real estate while you are still alive, you can gift portions of the real estate to them each year in the amount of the annual gift tax exclusion which I believe today is about $13,000.
- Every year you can give them $13,000 worth of their property and you can gift it to them.
- Here's one caveat. Unlike inheriting real estate in which the heirs' basis is a fair market value with their property as of the date of the inheritance, a donee's basis from a gift is the same as the basis of the donor.
- Your children may wish to consider a 1031 exchange or another options when they sell the real estate to avoid a big capital consequence.
- In a nutshell when you gift this to your kids, make sure they get a tax advisor before they decide to sell those property because they could be in for a big surprise if they do.
- If you have an excellent property under contract and you decide that you don't want it for yourself but you would still like to make money from it, consider wholesaling your property to a qualified buyer. Basically what you're doing is you're assigning the contract, you're flipping the contract to another buyer for a fee. Okay, that's called wholesaling in commercial property.
Real life example of having a razor sharp exit strategy can do for you.
There's this LLC which owns a property that's called Goshen Investments LLC. They purchased a 112-unit apartment building and they called it Goshen Villas. They bought it more than 15 years ago. That 3 partners' investment objective was to pay themselves a certain cash flow every month and they end up doing this for several years quite successfully so it worked out really well. However, the partnership as a whole decided to sell Goshen Villas and part ways, but 2 of the partners faced huge capital gains consequences at closing if they did sell. They were really concerned about that and they consulted their advisors which was me. I advised them to refinance their property, payoff the third partner, continue to sell the property, and then perform a 1031 tax deferred exchange.They end up doing that and exchange their "tax" re-profits into another property that had even greater cash flow. It was a win-win for everybody.
Here's a lesson in this. If you don't have a razor sharp exit strategy when you sell a property, be prepared to pay Uncle Sam heavily. Okay.
Tips for Exit Strategies for Long Term Success
1. Don't be married to your exit strategy. Allow yourself some flexibility due to market changes, market timing, and personal situational changes.
2. Have more than one exit strategy at a time. Ideally you want to have an exit strategy going in the investment, during investment, and as you come out of the investment. At that point, there maybe 3 different types of strategies there.
3. If you don't have an exit strategy thought of, you are telling yourself that it's okay to lose your investment or that you're not looking forward to any profit. That's how important an exit strategy is.
4. The best exit strategies come from wise investors. You will limit yourself and your options and you may leave thousands if not hundreds of thousands of dollars on a table if you don't get help in designing your exit strategy. Don't try to be the expert or the know it all here. You are not the expert on exit strategies because you don't have experience.
You need to talk to a person like myself, to a real estate-based tax advisor, both actually because I'm not a tax person. Get help on that.