A lifetime of experience offers a perspective that enables me to see the cause and effect of a human being’s rationalization when making an investment purchase. In other words, I’m old enough to understand why an investor paid too much for a real estate investment when faced with a short time line in a tax-deferred exchange and their perceived need to defer taxes when selling an investment property.
Welcome to my world. I call it forensic analysis into buyer behavior, or why an investor I’ll call John Smith paid $700,000 too much for a property when attempting to avoid taxes.
It’s a well-known fact in commercial and investment real estate a prospective buyer coming out of an Internal Revenue Code Section 1031 tax-deferred exchange will usually pay more to purchase a replacement property than an investor unhindered by a tax-deferred exchange. Think about it. An individual sells a family warehouse for $2 million. His accountant recommends a 1031 tax-deferred exchange so income taxes on proceeds of the sale are deferred into the next investment and there’s more cash for that investment.
After selling the relinquished property, an investor has 45 days from the sales date to name up to three replacement properties he’s considering purchasing. All is fine as a 1031 buyer until you realize:
- It could be difficult to find up to three $2 million-plus valued properties from which to choose.
- Other buyers also are considering the properties on the market.
- Each of the potential replacement properties seem overpriced.
- The broker helping locate the investments could be uninformed about investment real estate valuation principals and negotiation points related to those principals.
All it takes is for one of the considered properties to go under contract to another investor, and suddenly the 1031 buyer is looking at only two potential remaining investments and a short time line to complete the purchase. The pressure the 1031 investor experiences could mean this investor is now poised to make a truly poor investment decision.
Perhaps two years after the aforementioned 1031 investor has purchased the investment, he loses a tenant or tenants and realizes the new investment isn’t performing as well as it should. He hires a commercial broker both to acquire new tenants and inform the investor what the lease rates should be for the new tenancies. At this time, it could become obvious the investor paid too much for the investment based on market rental rates. Moreover, the investor could have to upgrade the property to entice new tenants.
It becomes imperative the investor and his broker develop a plan to both fill current vacancies and to upgrade, where possible, rental rates to strengthen the overall value of the investment. That could be a tall order in times of a slow or slowing economic climate. In a stronger economy, it becomes more an issue of timing: How long will it take?
While on vacation a few weeks ago, I was asked what I do for a living. My answer 10 years ago might have been, “I’m a commercial real estate broker.” Two weeks ago, my answer was, “I provide investment analysis to property owners and help them achieve a greater return on their investments by assisting them in repositioning their property, upgrading the property’s tenancies and creating a greater property valuation so the asset can be sold.” It’s a mouthful, but perhaps a better description of what commercial brokers do.