Robert Smith, The Daily Record Newswire
One of the few bright spots in our economy today appears to be housing. Many analysts believe housing in the U.S. may be undervalued by as much as 19 percent. With the housing market finally finding a bottom, 1031 exchanges will increase.
Such exchanges are named because of the Internal Revenue Code’s Section 1031, which provides an alternative strategy for deferring the capital gains tax that may arise from the sale of a business/investment property.
In its simplest form, one property is exchanged for another of equal or greater value using a qualified intermediary. In so doing, the investor does not take constructive receipt of funds. Therefore, a true “sale” does not occur and capital gains tax liability is not triggered.
This is how wealth is created in real estate. Investors never “sell” a property. They simply exchange it. In so doing, they can avoid paying capital gains tax indefinitely. Unlike stocks and bonds, it isn’t two steps forward and one step back.
In anticipation of an uptick in exchanges, I want to caution investors against rushing blindly back in. John Maynard Keynes famously said, “The financial memory is remarkably short.” This implies that as soon as conditions change, investors dive back in and make the same mistakes again.
In our case, with regard to property exchanges, this is investors chasing yield and ignoring the creditworthiness of an asset and management strength. When this occurs, investors inevitably lose both cash flow and principal.
The reasons for this are quite simple. If an accredited investor were to decide to “trade up” and exchange into a larger commercial property like Target, Kohl’s or Disney, the person would likely use the DST (Delaware statutory trust) format. In so doing, the investor would own part of a much larger asset that is managed remotely and not 100 percent of a smaller, self-managed asset.
In so doing, investors are assuming a passive role in regard to both principal and income. However, because real estate is a tangible asset, it must be actively managed by someone somewhere. Long term, the integrity of both principal and income depend on this.
Because management is so important to the long-term profitability of a property, this should be done as close to home as possible. Therefore, the property syndicator should also act as manager. After all, the syndicator’s due diligence process should generate an intimate familiarity with all of a property’s strengths and weaknesses.
For this reason, investors must have a company of sufficient size. A large management company, having weathered multiple market cycles over decades, is the wisest choice for managing, protecting and growing a commercial property investment.
Unfortunately, most companies providing DST properties for 1031 exchange are small. Therefore, they outsource property management. The problem with outsourcing is a lack of accountability. When something goes wrong, responsibility is shifted from one entity to another. The problem is effectively ignored until a situation reaches crisis proportions and investors lose money.
Investors should take heed to not make these same mistakes. The only way this can be accomplished is to avoid new syndicators and brokers like the plague. They are opportunistic. The next down leg in the market cycle will wash them away.
Stick with those entities that have been through multiple ups and downs and are still standing — the “last men standing,” if you will.
There are good reasons why large, experienced management firms continue to flourish in the most challenging environments. Their longevity provides them with the necessary resources and insight to protect and manage assets.
When it’s time to exchange, stick with the “heritage” players who are “still standing” despite volatile markets. They made the right choices the last time around and are likely to do so again.
As the housing market bottoms, and 1031 exchange opportunities increase, think long and hard about whom to perform business with. Size matters in real estate when it comes to protecting principal and building cash flow.
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Robert Smith is president of Peregrine Private Capital Corp. Contact him at 503-241-4949 or at www.peregrineprivatecapital.com.
