Any broker who has worked with Internal
Revenue Code Section 1031 tax-deferred exchange clients knows the
frustration of trying to find a replacement property at the right price
with the correct amount of debt before the 180-day window expires. For
investors in growth areas with healthy residential development,
exchanging into a portfolio of new homes can be an ideal solution.
Investor Benefits
Following are 10 reasons why investors should consider exchanging into a portfolio of new homes:
1. Numerous Choices.
In many growing communities, home builders have been holding land in
inventory for years waiting for the right time to develop it. Most have
many different subdivisions in various stages of construction and
generally are willing to sell homes from within several of the
subdivisions at one time, which allows them to close out projects and
take their sales staff to newer sites.
2. Right Price. Home
builders can hit exchangers' price points right on the dollar by adding
upgrades to certain units, and the more homes involved in the sale, the
easier it is to reach the target. Such price manipulation is almost
impossible with commercial properties.
3. Right Debt.
Home builders also can hit debt requirements by spreading debt among
the homes however the exchanger desires. Many large construction
companies have financing arms and may give breaks for multiple loans,
eliminating the need to deal with commercial lenders.
4. Available Warranties. New
homes and their appliances are usually under warranty for several
years, so exchangers' upkeep costs are minimal for the first few years.
Warranties also eliminate the need for time-consuming and costly
inspections.
5. Ample Tenants. Healthy
rental pools, especially for new homes, usually exist in growth
communities. Investors can work with property management companies to
determine the market rental prices, models, and neighborhoods that
attract tenants.
6. Partial Sales.
If equity is needed, exchangers easily can sell one or two homes out of
their portfolios. The gain on that fractional sale is taxable, but the
tax will be much lower than it would be for an entire portfolio sale.
7. Safer Value Growth.
New home appreciation usually outpaces resale home appreciation, so
exchangers benefit from a quick jump in portfolio value during the
first few years. In addition, the new-home values will continue to
appreciate along with the resale home market, which is usually reliable
compared with commercial property segments. Since appreciation is a
function of more factors than just increasing rents, returns can be
higher and risk is lower. Also, home rental agreements are typically
one year, so investors easily can keep their rates on pace with the
local market.
8. Less Down Time. Replacing
new-home tenants is usually much quicker and less costly than
retenanting commercial properties. Advertising, marketing, and
commission costs are low, and the costs to prepare units for new
tenants are minimal compared with office or retail buildings' build-out
expenses and tenant incentives.
9. Risk Diversification. Investors
can diversify their portfolios by owning homes at several price levels
in different parts of a community. With commercial properties, owners
are at the whim of local market forces that can adversely affect the
capital invested.
10. Return Manipulation.
Investors can determine their returns to a great degree by deciding how
much debt to place on certain homes or by increasing the size of their
portfolios.
Helpful Hints
When assisting clients in exchanging into portfolios of homes,
commercial real estate professionals must keep in mind some caveats.
Be
certain the portfolio contains homes to be built. The building time
usually is about 100 to 120 days, which easily fits into the 1031
window. With new-home appreciation outpacing most other properties', an
exchanger's investment may increase 5 percent to 8 percent before even
taking possession. Exchange tax rules mandate that homes must be
substantially complete, so investors can close even if landscaping or
last-minute touches aren't finished.
When selecting a
builder, pick one that consistently has several communities from which
to choose. Investors stand a better chance of negotiating good prices
and loans if they purchase all of the homes from the same developer.
However, a portfolio's geographic and price point diversities are key
elements in reducing risk; sometimes it may be beneficial to work with
several builders to achieve the right mix. In such cases, builders
should know the other parties involved, as the competition will work to
investors' benefit.
Enlist a good residential broker to
find properties and negotiate the details with the builder. Residential
brokers will know what areas are likely to retain their value, as well
as what amenities attract the highest-quality tenants at the highest
rents. Brokers should prearrange referral fees if their clients plan to
use the same residential broker to sell the homes in the future.
Be
certain the builder understands that this is a portfolio sale and
agrees to the same commission treatment as in a single-home sale. An
ideal setup is for the residential broker to represent the builder
exclusively and the commercial real estate professional to represent
the exchanger exclusively. Otherwise, be sure that dual agency is
permitted in the market and disclose the agency relationships in
writing.
It's also a good idea to hire a reputable
property management company to market the properties, screen for good
tenants, and manage the properties in a manner that maintains their
value. Be sure to include leasing and management fees in the pro forma,
as well as referral fees.
The property manager should
start marketing the homes before they are finished. A brand-new home is
very appealing to tenants, and they may be willing to pay higher rents
as a result. The leases should be treated like any other rentals ?
first and last months' rent plus a security deposit.
The
residential broker and the property manager should be involved in
determining the homes' landscaping, color schemes, appliance mix, and
amenity packages, as they usually have a better sense of what appeals
to residential tenants than commercial real estate pros. Thus, the
builder will know how to finish the homes and price them accordingly.
Other
professionals to enlist include an accountant, a tax specialist, and an
experienced facilitator. Be sure to take the time to explain this
program and ensure these advisers are comfortable with the transaction
reporting and allocations processes.