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Triple-Net (NNN) Leased Real Estate – Ideal For Section 1031 Exchanges?

Posted on June 26, 2017 in Uncategorized

Section 1031 exchanges allow real estate investors to sell their investment properties and exchange them for similar or like-kind investments and defer the tax on the accumulated capital gains. Real estate is by far and away the most exchanged asset class allowed by the code. Triple-Net (NNN) Leased Real Estate could be a suitable replacement property when conducting an exchange. A Net lease refers to a tenant paying all or some of the properties’ operating expenses plus the rent. Before getting into the specifics of the NNN lease, one must know that there are several types of leases:

*Bond lease – The tenant is fully responsible for operating expenses, maintenance, repairs and replacement cost.

* Triple Net (NNN) lease – There are usually limitations on capital expenses. Lessee is responsible for property expenses including tax, insurance and maintenance.

* Net Net (NN) lease – Similar to NNN lease, except that landlord may be responsible for structural damage such as roof or bearing walls.

*Modified Net lease – The tenant pays utilities, maintenance, repairs and insurance. Landlord is responsible for property taxes and everything else.

Investors seeking suitable replacement property for their 1031 exchange look to NNN properties for following reasons: the structure may provide relief of management obligations, such as multi-family apartment complex owners that are looking for relief but still need the income, want to defer their tax responsibilities, and no longer want intensive landlord responsibilities. Investors may also consider NNN properties for assured income, pride of individual ownership and preservation of capital. NNN leases may also interest investors that want to provide a relatively easy estate asset for their heirs.

While NNN properties appear to be easy to own and operate, they can be a challenging type of real estate investment if the investor does not fully understand lease structure, such as lease term, which can be as long as 50 years. Even more so than typical commercial real estate, there is significant value in the lease; the lease can be more important than the building and/or the land to determining value of the real estate.

Due Diligence

It is important that investors understand the variations in different NNN properties before investing. One should review the investment, lease document, tenant, the real estate itself, and the type of seller. After finding potential property, one needs to obtain a copy of the lease and review thoroughly before getting into other due diligence aspects, which also include inflation, local tax risk, credit worthiness and type of use.

An investor must take inflation into consideration when deciding upon an NNN lease to invest in. Frequently, rent increases are not included in the lease. This is particularly prevalent with large publicly traded retail drugstore leases. . Leases that call for rent decreases are actually prevalent in older NNN lease. The theory was that the loan would be paid off so the landlord’s spendable income would be reduced. These leases are not common today, but careful consideration should be given to the affects of inflation on these two structures.

Secondly, there are tax risks to be considered with NNN real-estate. Local laws may affect the lease values. Taxes may increase during reassessment after sale, creating additional tax burdens that may not be covered in the lease, shifting responsibility to new landlord.

Furthermore, consider the credit worthiness of the investment. Again, there is considerable value in the lease so tenant quality is a critical factor of pricing NNN leased assets. Property price should reflect the tenant’s ability to meet the terms of the lease. Capitalization rate (annual rent divided by purchase price) should adequately indicate this variable risk factor. If there is a higher risk that the tenant should become insolvent over the long term, the capitalization rate should accurately reflect the increase in risk absorbed.

It is easy to find information on publicly traded companies but it is considerably trickier for privately held entities. Many were caught off-guard by Vicorp Restaurant, Inc.’s Chapter 11 filing, which is a private corporation. However, there are investigation options for potential purchases also through fee-based tenant underwriting services and they should be considered. In an ideal situation, your broker will provide some of this research for you and at least give you an opportunity to weed out poor credit risks prior to investing significant time and energy in the due diligence process.

Even with a substantial credit rating, one needs to consider how the type of business may affect investment value. General purpose properties that are easily converted to multiple tenant needs are more desirable than a single purpose property. Manufacturing facilities are prime examples where investment or building is designed specifically for that tenant, frequently without consideration for the market as a whole.

It is not unusual with Triple Net leased properties for the purchase price to exceed replacement costs and comparable sales on a per square foot basis. Be wary of over-market rent that can’t be achieved with another tenant in the future, particularly if the tenant’s credit quality is weak.

Types of NNN Sellers

NNN sellers fall into 3 categories – Investor Owner, Owner User and Build to Suit Developer.

With an Investment Owner, the primary lease has a limited amount of time remaining. Pay careful consideration to base rent, payment/expense history, and sales volume history to determine the likelihood of the tenant remaining in the property.

Secondly, the Owner User type of seller indicates that the NNN lease is well-suited for sale/lease back. Why would the owner want to become a tenant? Simply, the seller frees up capital and makes it easier to grow his/her business. Generally, real estate returns are lower than the returns the business is generating, so selling the underlying real estate and leasing back the property enables the owner to free up cash held in the real estate to invest in the more profitable business that occupies the property. Also, sale/leaseback leases are highly flexible, but investors should be particularly aware of any stipulated methods of rent increases and the possibility that the seller over improved the property to meet the company’s needs.

Finally, the build to suit developer is probably the most straight forward form of seller. They are professionals who have set up a system for the building and disposition of assets and readily have standard information available in packages for potential purchasers. Typically, their leases are more standardized, reducing contractual surprises. However, the downside to purchasing from a developer is the lack of or limited amount of performance history for the site. It is valuable to look at developer’s past projects to see how they fared.

Summary

In conclusion, when carefully structured and underwritten, NNN investments are a terrific, viable option for Section 1031 replacement property. They can help investors reduce their management responsibilities and hold a long term lease with a strong credited tenant. Due to long term nature of this type of real estate investment, however due diligence may be even more important than with other types of real estate investment.

Some critical factors to be observed when considering a NNN lease are:

*Is the lease actually NNN?

* Will the tenant succeed in the location?

*Are there any additional local tax issues?

*Is there adequate inflation protection in the lease?

Triple Net Leased Investments

Real Estate and the New Series LLC

Posted on June 23, 2017 in Uncategorized

There is a national trend developing. Today, more LLCs are being formed in the USA than corporations.

Necessity, it is said, is the mother of invention. Given the simplicity, protection and flexibility of the Limited Liability Company (‘LLC’), some states have begun to adopt the new ‘Series’ form of LLC. Starting 10 years ago with the concept of ‘cell’ captive insurance companies used offshore, the states of Delaware, Nevada, Oklahoma, Iowa, and now Illinois have embraced the new ‘Series’ LLC. It may be very well-suited for certain types of business and investment holdings — such as multiple income-producing real estate, aircraft leasing, container vessels such as tankers and cargo ships, franchise business enterprises (i.e. multiple fast food stores), trucking and transportation fleets, and companies having operating divisions that need to enhance the liability shield to better protect one portion of the business activity from another.

THE CONCEPT MAKES SENSE.

Use of multiple LLCs for property owners is a conservative and safe way to go. However, instead of registering a traditional LLC, forming a new ‘Series LLC’ may be a smarter way to go for real estate investors. The concept is simple. It’s based on the model of the Cell Captive Insurance Company used in other countries.

Even though one LLC ‘mother ship’ entity is formed, each separate cell within it (called a series) can be separately accounted for, and each can own assets and operate as a separate business enterprise. The idea behind the legislation is that the liability of one cell does not infect the others so long as guidelines are followed.

So now, instead of using land trusts or numerous traditional LLCs, a less expensive option may be to hold several rentals or fix-and-flip properties in one Series LLC -giving each cell within it a separate business designation, i.e. ‘Valley Properties LLC Series I or Series II or Series III’ or ‘Valley Properties LLC Series A or Series B or Series C’ for example. This simplifies formation and reduces legal and tax costs, since only one registration is made with the state and one single consolidated tax return is prepared. To keep the paperwork clean, each series will need to separately identify itself as distinct from the others in all business and tenant transactions — including lease and rental agreements, deposits, bank accounts etc. in the name of that particular series as opposed to the ‘mother ship’ LLC or any of the other series. Of course, it will need to register as a ‘foreign’ company in any other state in which it holds properties – but only once.

WORKING THE NUMBERS.

Real Estate investors ‘work the numbers’ every day. Acquiring an investment property, doing fix-up, advertising and insuring the property, attracting stable tenants, maximizing the tax advantages and working the cash-flow management are all part of how you build a portfolio of income-producing real estate. To save costs, rather than paying for multiple ‘traditional’ LLCs, consolidating through a single ‘Series’ LLC can offer significant cost savings.

Let’s consider one case example. If an investor has 20 properties and uses the new Series LLC, even if the franchise tax is applied the savings in multiple entity formation costs and tax preparation may be significant. The difference could be better spent on acquiring more income-producing rental properties and marketing for new paying customers, don’t you think?

WHAT ELSE TO CONSIDER?

o The Illinois-type Land Trust (sometimes called the ‘Real Estate Privacy Trust’) is effective for protecting privacy and avoiding probate, but it is not a liability shield. It is only a ‘privacy mask’. Some real estate investors in the past have used multiple real estate privacy trusts built around LLCs to save franchise tax fees but now that the Series LLC has arrived, that practice will fade away as did the 8-track tape and the Beta video system. With the Series LLC you can have privacy and protection in one entity.

o Using the Series LLC won’t make sense if there are a large number of un-related parties – because the flow-through considerations might be quite a burden to your accountant. After all, simplicity is what’s behind the new Series LLC. Real estate investors will want to take advantage of the Series LLC as a preferred form of property ownership, particularly where the LLC members are single owners, married couples, maybe a family trust or a family limited partnership.

o After your Series LLC is registered and the Members have signed the Operating Agreement, be sure to then sign separate ‘Series Agreements’ for each cell they choose to use. All future transactions should reflect that particular series’ name so that you reinforce the ‘separate’ quality of each of the series units or ‘cells’. As long as the revenue and expenses are separately accounted for (perhaps using Quicken® or QuickBooks®) and one single consolidated tax return is prepared, the fact that multiple properties are under the umbrella of one ‘mother ship’ (sub-designated as Series One, Series Two, etc.) it makes it easy to track revenues, costs, tenants, fees, property taxes and profits of each Series.

WHERE SHOULD I FORM MY SERIES LLC? About seven (7) states so far have adopted the Series LLC. However, four (4) other states have adopted legislation which strictly limits creditors of LLCs to a ‘sole legal remedy’ known as the ‘charging order’ (a passive lien on distributions). However, of all the 50 states only Nevada has done both. Once your new LLC has been formed, if you’re going to use it in another state, simply register it as a ‘foreign’ (out-of-state) company with that secretary of state’s office. Once it is registered to do business, we can show you the smart way to guard your liability risks and lawfully manage your tax costs so that you have more to put into your retirement accounts for the future.

Afterwards, in your business transactions, be sure to have each individual Series clearly distinguished from the others. Treat it as a separate business. Consider having each series use separate brokers, separate lenders, and maybe different banks just to make it clear they are separate. Rental agreements and all other paperwork will need to reflect the series designator so that it’s clear the tenant is not doing business with the LLC ‘mother ship’ but rather with one particular Series as a distinct business enterprise.

LOOKING AT THE ‘BIG PICTURE’.

Forming an LLC to hold investment property is a positive step in the right direction. However, it’s one step. Keep the ‘big picture’ in mind: what are you trying to accomplish by investing in real estate in the first place? You’re trying to build – and preserve – secure wealth that gives you cash flow and a future for your loved ones. Keep in mind that each property you acquire is part of a building process that is dynamic. You are using a system to find, acquire and finance each property. Use the tools that empower you and don’t be overwhelmed by the small details that can sidetrack you if you let them. Use professionals for tax preparation, property acquisition and finance, and keeping adding to your portfolio with focus and discipline. Use professional advisors as a support system but remember they work for you so that you can enjoy what you do best — acquiring more income producing real estate.

Real Estate Investing In Mexico

Posted on June 19, 2017 in Uncategorized

Mexico is CHEAP! But its getting more expensive. As property values rise, especially in resort areas, investors wonder how they can profit from this.

Compared to major US cities, Mexico is still very very cheap. But compared to 5, 10, or more years ago, values have really risen.

There are some particulars to pay attention to with Mexican property purchases. For instance, Mexico forbids foreigners from owning land in resort areas. This is worked around by shares in a development, partnerships, or strata arrangements.

Foreign ownership is limited only in the “restricted zone,” land located within 100 km of the Mexican borders, and within 50 km of the coastline.

Instead, a real estate trust must be set up to hold title for the foreigner. Since foreigners are not able to enter into contracts in buy real estate, they must have a bank act on their behalf, much as a trust is use to hold property for minors because they also can not contract. Potential buyers should always get advice and have all real estate transactions overview by a licensed Mexican attorney.

Mexican real estate transactions are not carried out in the same manner as United States real estate transactions. The buyer must retain professionals to assist in the transaction. Mexico has yet to regulate real estate transactions. Real estate agents and brokers are not legally licensed in Mexico. Consequently, a foreign buyer cannot always depend on the normal safeguards that would be applied to real estate transactions in the United States. The old saying “let the buyer beware” is very appropriate. Anyone can set up a real estate company in Mexico. There are no special requirements or brokerage licenses to obtain. A would-be real estate agent merely has to establish a Mexican corporation, obtain a work visa, and he is in business.

As a rule, a foreigner should assume nothing. Was THAT enough of a warning to make sure to get good legal assistance in your transactions??

The best part about investing in Mexico is the proximity to North American investors. You can vacation and view your property, even stay in it if it is not occupied. Mexico has become North America’s playground, so it is likely that you would return every few years.

Anywhere in Mexico that there are tourists, there are vacation properties and property management companies. And realtor’s to re-sell your property when you wish to take your profits!

Your best bet is to travel to Mexico, find an area that YOU really like, and will return to again and again, happily. Then you get a two fold benefit from your investment – it draws you back to your version of paradise as well as hopefully making you money!

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