Real Estate Exit Strategies

Have you been in the real estate investment business for a long time and thinking about getting out?

Have you been pulled into the real estate investment business due to illness or death… and realized it isn’t your “thing”?

If so, I hope this article helps you think through your options.

  • I’ll quickly review the “typical real estate exit plan”,
  • what are the different objectives you have to exit your real estate investments,
  • and then a set of strategies you may use with some very high-level trade-offs between them.

I do start with a story to set the stage… skip down to “Real Estate Exit Planning – Classic” if you aren’t interested.

NOTE: This is new territory (at least for me), so I’d really welcome your thoughts and feedback so I can learn and make this a better public resource… just fill out the form at the end. Thanks – Steve

An After Christmas Story

Everything seemed fine.

It was Christmas in 1996, I had flown out from DC to see my parents and grandparents and sisters, their husbands and kids. My grandfather was a bit under the weather, but other than that, yet another typical family holiday. I flew home (I was probably there 5 days or so – no need to overstay my welcome).

My grandparents drove back to LA.

They got home and a couple of days later, my grandfather had pretty serious jaundice.

A couple of days after that, he was diagnosed with pancreatic cancer.

Today, in 2021, pancreatic cancer is serious, but … treatable, not so in 1997.

  • Just 2 years later, Justice Ruth Bader Ginsberg was diagnosed with it in 1999, surprised everyone, and lived for 21 years.
  • BUT, the actor Patrick Swayze died in 2009 – twenty months after he was diagnosed – considered a “good” run with pancreatic cancer.

(do you keep “cancer” score?.. it has become a weird thing for me with pancreatic cancer)

For a man just about to turn 87 in January of 1997, my grandfather knew he had … MAYBE.. 12 months.

I flew out from DC to LA as soon as I could get a ticket to spend a week with my grandparents, perhaps to see my grandfather for the last time.

It must have been early February, because I think it was my first day there that we went out to collect rent.

Collecting Rent in Cash

My grandfather invested in commercial real estate since at least the 1960s. He owned and managed a number of properties in the LA area. As far as I know, he never worked with property managers. I didn’t have any interest in real estate at that time (probably a disappointment though he never said so).

The one property that day I remember was a small commercial building that had a carpet retailer in front. The carpet store was nothing notable.

The property wasn’t too wide, but it was deep.

Behind the carpet store, was a long row of garage bays.

Each one was rented individually to what seemed like a tall, very fit younger man, virtually all from what I suspected was somewhere in Eastern Europe based on their accents.

I swear, they looked like they were all in the Ukrainian mob.

These guys were installing after market stereos and alarm systems and other “automotive modifications”…. I’m not sure what.

My grandfather was there to collect the rent.

I was along for the ride.

In cash.

I’m sure my grandfather and these immigrant entrepreneurs preferred it that way.

( and I’m sure everyone’s taxes were very accurate)

Most paid their cash rent promptly.

(month-to-month only, no long term leases)

Some had an excuse and would pay shortly.

One guy though… no rent.

No plausible story this time.

“You’re out of here” …

or something similar…

… said my 87-year-old,

5 foot 6 inch (probably 5’4″ by that point),

just diagnosed with pancreatic cancer,

grandfather.

24 years later and I can still see this group of big, hard-looking guys being very respectful to my grandfather as they paid (or didn’t pay) their rent.


This was not a smooth business system to hand off to my 80+ year-old grandmother within a year –  maybe less.


Real Estate Exit Planning – Classic

The standard plan for ‘exiting” an investment real estate business, if there is one at all, seems to be for your heirs to take it over when you die. Stepped up basis and low inheritance taxes makes this plan cheap and easy. A simple family trust or LLC… ask your estate attorney (you do have an estate attorney?).

… as long as life stays easy.

Complications

No battle plan survives contact with the enemy – Helmuth von Moltke the Elder

But, life can get difficult.

  • Your health can decline.
  • Your spouse or partner may be unable or unwilling to take over.
  • Your kids or heirs may be unwilling or unable to take over or even sell your business.
  • You may just be tired and want to actually retire.

And here it is, your long-term, money-making (hopefully) real estate business machine that needs your care, feeding, and support to keep going… and care for you, your spouse, and maybe even your kids (if they stay good).

… and then there are taxes.

I AM NOT AN ATTORNEY, TAX ADVISOR, OR ACCOUNTANT. DO NOT USE THIS AS INVESTMENT OR TAX ADVICE. TALK TO A PROFESSIONAL SERIOUSLY.

Real Estate Exit Goals

There are options. But, you need to think about your goals. You will also need to think about the goals of your new real estate “partner” – if you aren’t just selling. It needs to be a “win-win” or you won’t find a partner.

Let’s start with a simple model of your real estate investment(s):

Current Cost Basis = land value at time of purchase + building price at purchase + improvements since purchase – building depreciation – improvements depreciation

Current Actual Price = what you think it will actually sell for (no delusions here)

Remaining Mortgage Balance – what you still owe if you have a mortgage… this can be a complicating factor in any of the more complicated options besides a simple sale…. your mileage may vary a lot.

Current Net Value =  Current Actual Price – – Remaining Mortgage Balance – fees and such

Current Net Income / Net Operating Income = what you are taking home after predictable costs (insurance, property management, standard utilities that you pay, taxes)

Current Actual Income = Current Net income – maintenance reserves – capital improvements reserves … things break, roofs need to be replaced, you should be improving the property to keep your customers/tenants happy and your rents moving up instead of down. (we’re going to ignore remaining depreciation as we’re thinking retirement here and  you’ve likely taken most or all of the purchase depreciation)

Current Capital Gain =  Current net value – Current cost basis  … what you are going to see as taxable capital gains

Now, what are your goals tied to your real estate investments (as part of your overall estate plan):

  • Maintain actual income
  • Maximize estate capital
  • Maximize liquid current capital
  • Simplify life

… or some combination thereof.

Options

So, you need an exit plan – what can you do? There are a number of basic options that allow you to balance your income, capital, estate, control, and simplification objectives:

  1. Sell
  2. Sell Slowly
  3. Lease to Purchase
  4. Master Lease
  5. Consolidate
  6. Move in and sell later

These may be familiar to you from when you are on the “buy” side as an investor, but at exit time, you are looking at them differently.

1. Sell

Easy. Selling gets you out of real estate. No muss. No fuss. Yes, you are going to pay taxes (my grandfather hated taxes with a passion. I think he wound up doing some crazy things to avoid taxes. I respectfully disagree, but that is a topic for another day). If you’ve owned your property for a long time, our tax code has done a good job of paying you for investing in real estate with the magic power of depreciation… so, it is payback time.

You’ll pay taxes on your Current Capital Gain. One and done.

2. Sell slowly

One of the cool things about owning your property outright is that you can be the bank as a seller. Now I know that some real estate investors HATE seller financing, but you can use it as a seller to shape your income and taxes as you want. You are the bank. It gives you a lot of leverage in the sales transaction and, if things go wrong, you get the property back through foreclosure.

Your money, your rules. My money, my rules.

You can control the price, payment terms. What is interest, what is a payment for capital. And you don’t pay capital gains until you realize the capital gains.

This is cool.

So, for example, you could get paid your Current Cost Basis in the first year with no tax hit at all.

You can then control how much of the remaining purchase Capital is paid to you each year and thus what your capital gains will be.

Any interest you get paid on the purchase price comes in as ordinary income.

And, you don’t have to pay any taxes, insurance, or any of those other fees (though you may want to set up an escrow account to make sure that taxes and insurance ARE paid… remember all that annoying paperwork that you sign when you take out a mortgage… that is YOUR paperwork now – you really need a good real estate attorney).

So, you can compare your Current Actual Income with your new Interest Income (and capital gains) each year.

You can make the loan last as long as you want. The purchase price what you want. The payment terms shaped however you want.

But, you do have a bit of a “partnership” with your buyer. They need to be able to make the payments, take good care of the property… after all, you don’t really want to go into foreclosure and wind up with a trashed property like you see banks periodically unload at auction. You want them to succeed too.

3. Lease / Purchase

If you are confident you have time or if you want more control, you can lease to your potential buyer with an option to buy. (I’ll talk a bit more about lease terms in the next section).

The purchase option is a payment (or series of payments) to purchase the property at an agreed to price. The option payments can be credited against the purchase price or held in escrow to be returned to the leasor depending on the terms.

You could even set up the lease to continue for many years or until your death … of course, again, this needs to be mutually beneficial – you are trying to simplify your life or avoid taxes.

You get ordinary income from the lease and income from the purchase option.

This may be particularly useful if you own single-family home(s) where your tenants/customers don’t have the cash or credit to buy. Remember, your goal is a successful sale at some point, not to extract option payments from someone who can’t afford the home.

If you have multi-family or commercial properties, you may want to think about a master lease…

4. Master lease – think like big-guy commercial real estate

I haven’t invested in classic commercial real estate, I have a portfolio of small (and slightly above small so far) multi-family properties.

True commercial leases work differently from apartments. They are often for longer terms, and they can be structured as “Triple Net” leases – where the tenants pay all of the taxes, insurance, and even maintenance.

Your lease income winds up being lower, but all of the costs are shifted to your leasor. So, if taxes go up, that is their problem. If insurance goes up, that is there problem. If there are ordinary maintenance costs, those can even be their problem. What you do wind up paying more for is improvements. Again, your leasor is your partner. You want them to be successful, so they keep the lease and you wind up with a property (or portfolio of properties) that is going up in value, not down.

From an “exit” strategy perspective, you likely do this to consolidate a your portfolio into one Master lease. You can still consider the lease to purchase option described above. The key benefit here is simplification of management and variable costs. You are going to want a more experienced partner here that you can rely on.

5. Consolidate

As long as we have 1031 exchanges, you can either split or consolidate purchases and sales and roll them over into another property. I’ve seen a number of “smaller” real estate investors who have accumulated 10, 20, or even 50 properties or more over their career….and then they want to get out or simplify (this scenario was the one that actually spurred me to think through this issue).

So, sell all of the little properties in one transaction and roll them into a single big one.

Turn 30 ( or even 4) single-family homes into an apartment complex.

… or something.

Simpler management and you “reset” your depreciation opportunities.

You’re still in the real estate game, it is just much simpler. You can even consider changing markets to where you are buying more units or fewer (as a person who lives in the SF Bay Area where condos can cost over a million dollars vs. where I invest in South Carolina where I bought my first money-making duplex for the price of a Lexus).

6. Move in and sell in a couple of years

This only works for one residential property at a time. Move into it. “Convert” it back into residential real estate after 3 years (double check the tax code). Then sell or do the residential real estate “thing” with all of its tax benefits and limitations.

More?

I’m sure there are other options… shoot me a note so I can add to the list.  You could consider turning a multi-family property into a condo… the sky’s the limit. You can also mix and match things to meet your own objectives.

Next steps

I didn’t get into real estate until I was almost 50, seven years ago now. I’d been an individual stock investor since my grandfather had gotten me started back in the late 1980s. I love real estate. It is like value stock investing with a super illiquid market, often limited competition, and the ability to “buy on margin” with your customers/tenants paying for your option over 30 years… and a tax code that subsidizes your business.

WOO HOO!

But, I’m an older guy and my experience watching my grandfather’s estate (and my estate planing for my wife and kids) has made me think more seriously about “The End”… my exit strategy as I know that I’m going to “exit” with or without a strategy.

So, I’m looking at Real Estate exits from both sides – as a buyer today and a planner for my own eventual exiting (hopefully not any time soon)… I’d love your thoughts on the form below:

[contact-form-7 id=”10″ title=”Contact form 1″]

And they all lived….

So, my grandfather made it until September of 1997. I actually got to see him one more time for a week in late August. He was still alert and not in too much pain. He had gotten to see and say “Goodbye” to everyone and, equally importantly, everyone who wanted to had a chance to say “Goodbye” to him. A “gift” of his diagnosis that I only appreciated when he was gone.

He went into a coma shortly after my visit and died a week later.

He lived a good life on his terms and did his best to take care of his family and friends.

I don’t know all the details of his estate. I did look at his stock holdings shortly after his death. He was a much more active and aggressive investor than me with stocks that I would never have touched (I think there was some sort of new-fangled medical equipment company with the symbol BONEZ????) and his perennial favorite Cooper Tire. Not surprising for a man who was renting garages month-to-month for cash in his late 80s.

My grandmother was well-provided for as were my father and his sister. I learned some estate planning lessons along the way… but it all worked out.

I have no idea when the property with the garages was sold or what happened to the Ukrainian entrepreneurs… I’m sure it was sold at a good profit.


Dedicated to:

My grandfather – Harmon Benjamin Davis and My grandmother Ruby B. Davis


 

 

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