Why apartment owners are transitioning into net lease
- Mehdi Star
- Mar 27, 2018
- 4 min read
John Smith exchanged out of his San Francisco apartment building and purchased three (3) single-tenant net lease investments. By doing so, he increased his net operating income by 44%, moved away from management responsibilities, and achieved his estate-planning goals.
Studying the nuances of a 1031 exchange and exploring single-tenant net lease investments can be overwhelming. In an effort to make abstract concepts more concrete, it is helpful to review case studies of past clients who took the plunge and successfully completed their 1031 exchange.
The first of our case studies is a great example of a savvy investor who carefully reviewed his options before committing to exchange out of his San Francisco apartment into three (3) single-tenant net lease investments across the US. The decision did not come easy, and was thoughtfully arrived at after years of consideration and counsel.
For the privacy of our client, we will refer to him as John Smith in this post.
Motivation of the Investor
Several factors motivated John to trade out of his investment in San Francisco. In no particular order: estate-planning, constant managerial responsibilities, and the city’s limitation on his ability to adjust rents to compensate for rising operational costs were key factors that ultimately informed his decision to leave the San Francisco market, and seek a different product type all together.
Estate-Planning
Family limited partnerships, limited liability companies, and revocable living trusts are a few of the tools used by real estate investors for estate-planning and liability protection. Owning real estate has serious tax implications, certainly if the real estate portfolio is sizable. Tax savings realized from sound estate-planning advice from your attorney or CPA can be immense, and are always worth exploring further.
In this particular situation, John owned his apartment building under a general partnership, whose members included himself and his sister. Both siblings had reached an agreement that they should split up the investment, for estate-planning reasons, as their children would come to inherit the apartment building, making management decisions difficult for their children in the future.
Therefore, a key benefit in favor of the exchange was their ability to move the equity that was tied up in a single asset—their San Francisco apartment— on a tax-deferred basis into three (3) separate real estate investments. This met their estate-planning goals of having properties set aside that each sibling could then will away at their discretion.
Less Management & More Cash flow
The relinquished property comprised thirty-one (31) units with a mix of studios, one and two-bedroom units. At around 34K rentable square feet, the units were very large and because it was built before 1979, all tenants took advantage of rent control. We determined that there was about 55% upside in our client’s current rental income, as many of the units were paying well below market rents.
Estimated gross income for 2016 was approximately $760K. The expenses for that year totaled about $245K, resulting in net income of around $515K.
James Devincenti and Brad Lagomarsino of Colliers International were able to obtain a bona-fide offer for $20M for John, of which $1M was made non-refundable and passed through escrow in favor of John’s exchange accommodator, which allowed him to begin looking at trade opportunities and make offers to satisfy his exchange.
At an offer price of $20M, which constitutes our clients equity position since there was no loan on the property, his return on equity was approximately 2.6%—unsurprising, since values have greatly increased in San Francisco, while cash flow stays somewhat depressed due to rent control.
John allocated nearly 85% of his exchange funds towards single tenant net lease investments across the United States. The tenants included Wells Fargo Bank, Bank of America, and BMO Harris Bank located in CA, TX, and IL respectively.
At a total purchase price of approximately $16.1M, John was able to increase his net operating income to almost $742K, which is a $228K increase from the income realized on his apartment building—a 44% increase. It is important to note that since all three investments were absolute triple net leases, John has absolutely no expenses in the course of his ownership. By undergoing a 1031 exchange, he increased his overall return on equity from a 2.1% to a 4.61%, a significant improvement from his previous position and all thanks to the ability to defer capital gains under IRS Sec. 1031.
An added benefit to increasing his overall return was the ability to eliminate management responsibilities all together. The need to constantly visit his apartment building due to maintenance issues or unexpected capital expenditures made his San Francisco investment time-consuming and sometimes stressful. By moving into net lease investments, John was able to reduce the pressures of management, and enjoy the freedom of truly passive income.
Conclusion
For Mr. Smith, the decision was not easy. San Francisco is on the world map. Owning an investment in one of the best neighborhoods in one of the best cities in the world is hard to give up. The considerations are important, and the consequences are dire should the exchange not successfully close.
Conversely, the results attained as a result of a successful exchange speak for themselves. John has diversified his investment position across three (3) properties, in three (3) geographically different markets. Any risk associated with having a majority of his net worth in a single asset is now mitigated. Moreover, when the time comes to plan for his estate, it will be much easier to divide the interests among his beneficiaries. Additional benefits highlighted include a marked increase in overall cash flow, as well as a move away from the drudgery of apartment management.
Our clients are entering a stage in their lives where they have created immense value in their current investment position, and are now considering how best to enjoy the fruits of their labor. These decisions are by no means easy, but our team endeavors to give you all the facts, so you can make an informed decision for yourself and your family.
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