Over the last three to four decades, many successful real estate developers, sponsors, syndicators and operators have built substantial portfolios of commercial real estate using high-net-worth investor capital. Through careful acquisitions, development expertise, market appreciation and operational oversight, these sponsors have amassed portfolios worth tens or even hundreds of millions of dollars.
While this success story is one that many real estate entrepreneurs aspire to achieve, it often creates an entirely new set of challenges later in life. Ironically, some of the industry’s most successful real estate developers, syndicators and operators eventually find themselves facing one of the most difficult decisions of their careers: how to transition out of highly appreciated real estate without creating significant tax consequences for themselves and their investors.
The Hidden Challenge of Success
For many sponsors, years of success have resulted in a substantial portion of both their personal net worth and their investors’ net worth becoming concentrated in a relatively small number of assets. What began as a strategy for creating wealth can eventually become a concentration risk.
A real estate developer may find that the majority of their wealth is tied up in a handful of apartment communities, retail centers, industrial properties, hotels or other commercial real estate assets. Likewise, many of their investors may have significant portions of their investment portfolios tied to the same properties.
This creates a dilemma. On one hand, the assets have performed extremely well and continue to generate income. On the other hand, the sponsor and investors may have become heavily concentrated in a single asset class, geographic region or investment strategy.
The Tax Trap
The obvious solution may seem simple: sell the properties and diversify. Unfortunately, it is rarely that easy.
Many of these assets have appreciated substantially over decades of ownership. In addition, years of depreciation deductions have created significant depreciation recapture liabilities.
For many real estate developers and their investors, an outright sale could trigger capital gains taxes and depreciation recapture taxes that, depending on their tax situation and state of residence, may consume 30% to 40% or more of their equity proceeds.
Faced with that reality, many sponsors begin considering a 1031 exchange. However, a 1031 exchange often introduces another challenge.
The Aging Real Estate Developer Problem
When these properties were originally acquired, the sponsor may have been in their 30s or 40s. Today, many of these same sponsors are in their 60s, 70s, or beyond.
The question becomes: do they really want to continue operating, managing and overseeing large real estate portfolios for another decade or two?
Many no longer desire the day-to-day responsibilities that come with active real estate ownership. Leasing, property management oversight, lender negotiations, capital projects, tenant issues and operational challenges can become increasingly burdensome. At the same time, simply selling and paying the taxes may not be an attractive option.
As a result, many sponsors find themselves caught between two undesirable outcomes:
- Continue owning and managing increasingly demanding assets; or
- Sell and incur substantial tax liabilities.
The Capital Expenditure Challenge
Adding to the complexity, many long-held assets eventually require significant capital expenditures: roofs must be replaced, parking lots resurfaced, mechanical systems upgraded, interiors renovated and brand standards maintained.
For aging sponsors, writing large capital expenditure checks while simultaneously managing complex projects can become increasingly less appealing. The assets that once generated wealth may now require substantial reinvestment simply to maintain competitiveness.
A Real-World Case Study*
Kay Properties recently worked with a large real estate operator facing this exact situation. Over several decades, this client had successfully developed and acquired a portfolio of approximately 20 hotels throughout the Midwest. The portfolio had been built using high-net-worth investor capital and had generated significant wealth for both the sponsor and his investors.
However, time had changed the equation. The sponsor was well-advanced in age, and many of his investors were also nearing retirement or already retired. The portfolio had appreciated significantly, making an outright sale highly unattractive due to the substantial capital gains and depreciation recapture taxes that would result.
At the same time, another major issue was looming. The hotels were approaching the point where they would need to complete Property Improvement Plans (PIPs) to maintain their national hotel brands and flags. Depending on the property, these PIPs were estimated to cost between $1 million and $4 million per hotel. Across approximately 20 hotels, the required capital infusion represented an enormous financial commitment.
The sponsor ultimately tasked his CFO with identifying a solution that would address the following challenges:
- Avoiding a substantial tax burden
- Reducing concentration risk
- Eliminating the need for active management
- Addressing aging ownership concerns
- Avoiding massive upcoming capital expenditure requirements
- Continue generating potential income for investors
Exploring the Options
After extensive discussions with the Kay Properties team, along with the sponsor’s CFO and legal counsel, the group determined that selling the portfolio to a large institutional buyer and completing a 1031 exchange into a diversified portfolio of Delaware Statutory Trust (DST) investment offered a compelling solution.
Following the sale, approximately $65 million of 1031 exchange equity was exchanged into a portfolio of roughly 30 different DST investments sourced from multiple DST sponsor companies.
Rather than remaining concentrated in one asset class – hotels – the sponsor and investors were able to diversify across multiple property sectors, including:
- Multifamily apartments
- Industrial properties
- Medical real estate
- Retail properties
- Student housing
- Other institutional-quality commercial real estate assets
The result was exposure to thousands of underlying units and properties across numerous markets and asset classes.
Solving Multiple Problems with One Strategy
The suggested investment strategy addressed several major concerns simultaneously.
First, it significantly reduced concentration risk by moving from a portfolio concentrated entirely in hotels in a limited geographic area to a broadly diversified portfolio spanning multiple property sectors.
Second, it allowed the sponsor and investors to defer a very large amount of capital gains taxes and depreciation recapture through the 1031 exchange process.
Third, it eliminated the burden of active property management that the developer had borne for many years. As passive owners in DST structures, the developer no longer had responsibility for day-to-day operations, leasing, maintenance oversight or capital project management – those responsibilities now rested with the DST sponsor companies.
Fourth, it addressed the looming capital expenditure requirements associated with the hotel portfolio’s Property Improvement Plans.
Finally, the DST portfolio provided the potential for ongoing monthly cash flow distributions from a diversified collection of institutional-quality real estate assets.
The Bigger Picture
As the real estate industry continues to mature, more real estate developers are likely to face this same exit strategy conundrum. The challenge is not simply about selling assets. It is about balancing taxes, diversification, legacy planning, investor relationships, operational responsibilities and lifestyle considerations.
For many aging real estate developers and their investors, the question is no longer how to build wealth through real estate. The question becomes how to preserve that wealth, diversify it, simplify ownership and transition into the next chapter of life without unnecessarily sacrificing a significant portion of their equity to taxes.
*Past performance is no guarantee of future results.
Dwight Kay is the CEO and Founder of Kay Properties and the Kay Properties Team.
Kay Properties and Investments is a national Delaware Statutory Trust (DST) investment firm. The www.kpi1031.com platform provides access to the marketplace of DSTs from over 25 different sponsor companies, custom DSTs only available to Kay clients, independent advice on DST sponsor companies, and real estate research and analysis on each DST (typically 20-40 DSTs). Kay Properties team members collectively have over 200 years of real estate experience and have participated in over 30 billion of DST 1031 investments. Past performance does not guarantee or indicate the likelihood of future results. Securities offered through FNEX Capital, member FINRA, SIPC.
Please visit www.kpi1031.com for more details, call them at 1.855.466.5927 or email [email protected] for more information.