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Minimizing the Risks of Purchasing Commercial Real Estate

Almost everyone is familiar with the three cardinal rules of real estate investment: “Location, Location and Location.” Although property well situated certainly has fewer risks, an investor must carefully consider other ways to minimize the risks involved in the purchase of commercial real estate.

Focusing the Search

Commercial real estate includes apartment, office, industrial, retail and other income properties. Each of these property types has different advantages and disadvantages, risks and opportunities. Most commercial real estate brokers specialize in a particular property type for a particular area, because it is difficult to stay abreast of the issues and trends in multiple markets and industries. Similarly, most investors lack the time or resources to develop and maintain a thorough understanding of many different types of properties in different areas. Therefore, after conducting some basic research about the current and future strengths and weaknesses of different types of properties for a particular area, using local real estate forecasters, brokerage companies, universities and other sources, it would be wise to focus on a particular type of property in order to develop some expertise as an investor.

Analyzing Financial Information

Although “comparable sales” and “replacement cost” data provide some help in assessing value, most commercial real estate investment property is appraised on the capitalization of income it produces. Generally, this method of valuation is based on the present value of future cash flows, and assumes no growth in the future cash flows. This rate is typically referred to in the industry as the “cap rate.” The cap rate can be described as the investor’s required rate of return based upon the perceived level of risk being accepted. It includes both a return onal,sans-serif;”> invested principal and a return of principal as the investment is amortized over time. For example, a 9% cap rate might include a 6% return on investment, and a 3% return of investment. The choice of the appropriate cap rate is critical to the correct estimate of value, as even small differences in cap rates can lead to large changes in market value.

The purchaser desires a higher cap rate, and thus a better return on and of his or her investment, and the seller desires a lower cap rate, and thus a higher sale price. Although the price (and cap rate) is negotiable, in recent years the cap rates on commercial properties have been coming down considerably, primarily because low interest rates and poor investment alternatives have caused a significant increase in the demand for investment properties, thereby driving up the prices.

Different types of commercial properties, and different locations, may also have different cap rates. For example, apartment buildings may have lower cap rates (e.g., 5%) in areas where tenant demand for apartments is high, and strip shopping centers may have higher cap rates (e.g., 8%) in areas where retail space is plentiful. Retail properties with more national or regional credit tenants like Starbucks and Jack in the Box are generally lower risk investments and thus warrant lower cap rates than centers consisting primarily of less stable or secure “mom & pop” stores. Therefore, cap rates are generally determined by comparisons with other similar properties recently sold. Most active commercial real estate brokers in a particular area can tell a potential investor what the market range of cap rates is for particular types of properties in that area.

Because the cap rate calculation is dependent upon a property’s income and expenses, there are many variables that can significantly impact these analyses. For example, if net income from the property decreases due to more tenant vacancies or increased expenses, then the effective cap rate will diminish as well.

In performing any economic analysis, a potential investor should not take the seller’s income and expense figures and assumptions at face value, as closer scrutiny often reveals that the actual cap rate is lower than represented. For example, the seller’s stated rental income may not be based upon current actual figures, but on future projected figures (after rent increases), or it may fail to include a reasonable vacancy factor, a post-sale reassessment of property taxes that will not be reimbursed by tenants under gross rent leases, a reasonable sum for property management fees, potential percentage or abated rents, or other income and expenses. Thus, the investor should always look for hidden risks (and opportunities) by conducting his own investigation and analysis, which will require a careful review of the rent roll, operating statements, leases, loan documents, and maintenance records.

Contracting

Assuming the property can be purchased at a reasonable price, the next step is to make a formal written offer to purchase, usually through a broker, with the assistance of a lawyer. It should be noted that contract forms vary widely, and there is not much “standard” about them, despite the title or the source of the form. Further, most brokers are not particularly skilled in the art of drafting contracts and protecting buyers. The contract will govern the parties’ rights, obligations and remedies throughout the transaction, and therefore, the importance of it should not be underestimated. Purchasers of commercial property generally have fewer legal protections than homebuyers, as the parties are presumed to have relatively equal bargaining power and sophistication in commerce. Therefore, a prudent buyer should usually have an experienced real estate lawyer review the contract before submitting it for the seller’s consideration.

Ideally, the contract should include some basic representations and warranties by the seller concerning the condition of the property, as well as some buyer contingencies for such things as approval of title, leases, physical inspections, and financing. At a minimum, the contract should provide for a reasonable “due diligence” period (generally between 15-45 days), during which the purchaser can have the property physically inspected, review the leases, operating and financial statements, rent roll, title report, service contracts and any environmental reports, as well as consult with a loan broker or lender to verify available financing. If this investigation reveals anything of concern during the due diligence period, the buyer should then have the ability to either terminate the contract and receive a full refund of his or her deposit, or renegotiate for additional time, a price reduction, seller repairs, or other concessions.

Inspecting and Investigating

Unless the buyer has some construction expertise, he or she would be well advised to hire a competent inspector. The physical inspection should include the roof, mechanical and electrical systems, as well as the structural integrity of the buildings and the need for any Americans With Disabilities Act compliance work (e.g., parking lot spaces, striping, signage, and ramps) or deferred maintenance work in common areas, such as painting, resurfacing the parking lot, and replacing heating, venting and air conditioning units that are not the responsibility of tenants under the leases. If the property has any potential history of contamination with hazardous materials (e.g., asbestos floor tiles or ceilings, on-site dry cleaners, lead paint, petroleum products from nearby gas stations, pesticides, solvents, or chemicals stored, used or disposed of on or near the property), the buyer should conduct an appropriate environmental assessment, which would include a Phase I report, and possibly a Phase II investigation. This assessment is necessary to protect the buyer from potential cleanup liability after the purchase.

Other basic due diligence tasks should include: (1) early contact with an experienced commercial loan broker or lender for loan possibilities and application, as it generally takes at least 30 days to get formal loan approval; (2) a legal review of (i) the preliminary title report for potentially problematic easements, liens or encumbrances, (ii) the loan documents for things like recourse obligations, lock-out periods and prepayment penalties, and (iii) the leases to confirm that they include appropriate landlord remedies and protections; (3) review of tenant estoppel certificates for consistency with the rent roll and leases; (4) review of service contracts for the maintenance and management of the property; (5) investigation with the city’s development planning department concerning any proposed development in the area that may impact the property (e.g., street widening, competing stores, rezoning, etc.); and (6) some casual discussions with particular tenants about how well their businesses are doing, and any future plans they might have to renew their leases or to expand, close or relocate. Although the broker should help with some of the due diligence investigation, ultimately the buyer should assume responsibility.

Limiting Personal Liability

Prior to closing escrow, and depending upon various other considerations that may involve other investors, potential tax consequences, and the lender’s requirements, the buyer should generally form a limited liability company or other asset protection entity (not a corporation) to hold title and shield the buyer from personal liability for such things as injuries on the property, hazardous materials on the property, and contracts like the loan agreement, leases, and service agreements for the property. Some lenders may still require the buyer to personally guaranty the loan if the buyer uses an entity to take title, but the added liability protection afforded by the entity is almost always worth the extra paperwork and costs. In any event, the buyer should definitely consult with an experienced insurance broker about obtaining adequate coverage for appropriate risks, consistent with the lender’s requirements, and should make sure that policy covers the correct parties upon the closing.

Monitoring the Operation

The buyer should take steps to insure a smooth transition upon the close of escrow and change of ownership by making sure that utilities will be transferred without interruption, all necessary insurance is in place, a property manager has been hired, and all keys and other items needed for operation of the property have been transferred. The buyer and the property manager should promptly visit with each tenant to introduce themselves and to deliver written notice of where to send future rent checks and who to contact with any questions or problems. By promptly addressing any significant deferred maintenance issues such as a leaky roof, the new owner may also engender some good will with the tenants and avoid some future headaches.

Although most commercial properties are professionally managed for the owners, particularly if the leases obligate the tenants to pay for this cost, an owner would still be well advised to periodically inspect his or her property to see how well it is being maintained and to keep abreast of any significant tenant concerns. The owner should also carefully review the monthly financial reports and cash distributions from the property manager for accuracy, as common mistakes or discrepancies include such things as ambiguous expenses and failure to bill tenants for scheduled rent increases or common area maintenance charges. A watchful owner can also make sure that the manager aggressively works to fill tenant vacancies as they occur, in order to maximize the owner’s return on investment and to benefit the remaining tenants with more customer traffic.

In short, property managers typically handle numerous properties at any given time and, therefore, do not always give any one property the attention it requires. Therefore, it pays for an owner to monitor the manager and the property.

An Ounce of Prevention

As illustrated above, the process of identifying, evaluating, purchasing and owning commercial real estate is not overly complicated, but a buyer should certainly minimize the risks involved by consulting with a knowledgeable and experienced broker and real estate attorney.

 

* Larry N. Murnane is a licensed broker and lawyer in San Diego, California, emphasizing commercial real property purchase, sale, exchange and leasing transactions.

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Anonymity and Other Benefits of Title Holding Trusts

A Title Holding Trust (“THT”), sometimes referred to as a land trust, holding trust or blind trust, can be a simple and inexpensive method for taking and holding title to California real estate or personal property, confidentially and privately .

A THT can be established by an individual, partnership, trust, limited liability company or corporation. The person or entity that sets-up the THT, the Trustor, enters into a standardized THT Agreement with the Trustee he or she appoints, typically a fiduciary services company. The Trustee then designates one or more Beneficiaries (usually the Trustor) and Successor Beneficiaries (usually the Trustor’s children) of the THT, under the terms of the THT Agreement. The Trustee has no authority to act without specific written authorization and direction from the Beneficiary of the trust. The Beneficiary owns the THT, and retains all ownership rights and complete control over the property, including the power of direction over the trust. The Trustee executes grant deeds, promissory notes, deeds of trust, leases and otherwise manages the property held in the trust, only upon specific written authorization and direction from the Beneficiary of the trust. The trust may be modified, updated or terminated, and additional California real estate or personal property can be added to the trust, at anytime.

The Trustee holds title to the property under its name, in its fiduciary capacity, as Trustee of the trust.  Public records, including the County Recorder’s, County Assessor’s and County Tax Collector’s public files and records, reflect the legal title and ownership of the real estate or personal property in the name of the Trustee, “as Trustee for Trust No. 12345.” The Beneficiary is not identified on any public record, and the Beneficiary’s information is not disclosed to any party unless authorized by the Beneficiary, the trust agreement, or required by law or court order.

When title to real estate is held in a THT, courts have held that the beneficial interest in the trust is personal property. This beneficial interest includes the right to receive any income and any proceeds from the sale or mortgage of the property. The Beneficiary reserves the right to occupy or otherwise possess and use the real estate. However, as personal property, the beneficial interest in the trust can be easily assigned to another party without the need to prepare, sign, notarize and record a grant deed.

Reasons a THT may be desirable for acquiring, holding and disposing of real estate or personal property include:

  1. Anonymity and privacy of ownership;

  2. Succession of ownership and avoidance of probate for California residents;

  3. Partial distribution of property by assignment of Beneficiary interest, without the necessity of recording a deed;

  4. Protection against liens or judgments being enforced against the property, or clouds on title, caused by one investor’s death, divorce, bankruptcy, and debts;

  5. Protection against a partition action by one of the investors to force a sale of the property;

  6. Convenience of conveyance or refinancing, by requiring only the Trustee’s signature, rather than that of multiple owners;

  7. Assignments of beneficial interests in a THT without requirement of any 1099-S reporting, as a transfer of a personal property interest and not a real property interest;

  8. No requirement for a registered agent for service of process, unlike for a corporation or limited liability company;

  9. As a fully revocable grantor trust, the THT is a pass-thru and disregarded entity, so no separate tax returns or other filings are required;

  10. The assignment of a beneficial interest in the THT is considered a valid conveyance of title for income tax purposes, which qualifies for tax-deferred exchange treatment under Section 1031 of the Internal Revenue Code;

  11. The Trustee has no personal liability as Trustee of the THT;

  12. THTs are generally more cost-effective compared to other forms of real estate ownership, with no annual filing fees, tax return preparation fees, minimum annual taxes, Secretary of State filing fees and registered agent costs – requiring only the annual Trustee fee;

  13. The Trustee of the THT remains the insured party before and after any transfer of beneficial interests, obviating the need for costly title insurance endorsements with respect to transfers of beneficial interests;

  14. Real estate investors can acquire real property without tipping off sellers or competitors.  (Walt Disney acquired all of the land for Disney World in Florida through a THT, so no one could take advantage by inflating prices); and

  15. The beneficiary’s interest in a THT can be used as collateral for bank loans without the additional need and expense of obtaining a mortgage, even if a mortgage already exists.

It should be noted that, although THTs provide many benefits to real estate investors and property owners, they will not serve to circumvent income and property taxes otherwise payable. Nor will they circumvent a due-on-sale clause contained in a promissory note secured by the property, if 100% of the beneficial interest is transferred.

Though a THT can be established at any time, in order to take maximum advantage of the confidentiality and privacy benefits of the THT, the trust should take title to the real estate or personal property when it is first acquired, so the Beneficiary never appears on any public record tied to the property.

 

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Choosing the Best Form of Business

Starting a new business involves several difficult decisions. One of the most complex of those decisions, with significant consequences, is choosing whether to operate the business as a sole proprietorship, partnership, corporation, or limited liability company (“LLC”). This decision should be based upon careful consideration of a number of factors, and a comparison of the advantages and disadvantages of these alternative business forms.

Sole Proprietorships

A sole proprietorship is simply a business conducted by an individual rather than a separate entity such as a partnership, corporation or LLC. Key advantages to this form of business are: (1) it is relatively easy and inexpensive to form and operate; (2) it requires only one owner; (3) there are no separate franchise taxes or corporate formalities; and (4) there is no double taxation on income because the business profits and losses are simply passed through to the owner.

The primary disadvantage to a sole proprietorship is that the business owner has unlimited personal liability for the debts and obligations of the business.

Partnerships

A partnership is an association of two or more persons who co-own a business for profit. Partnerships may be general or limited in form.

In a general partnership, each partner can bind the partnership by contract, and is personally liable for the obligations of the partnership. California does not require filing of a certificate or articles with the Secretary of State to form a general partnership. Although oral partnership agreements are permitted, the agreement should be in writing, and specify all the terms of the parties’ business relationship. A general partnership is dissolved upon the death or withdrawal of any partner, absent a written agreement to the contrary.

A limited partnership is a partnership with one or more “limited partners” (partners who contribute capital but do not participate in the control of the business and who are not personally liable for the obligations of the partnership), and one or more “general partners” (partners who actively engage in the management and control of the business and who have unlimited personal liability for the obligations of the partnership). General and limited partnerships are usually not subject to federal or California income tax, (although limited partnerships are subject to an annual franchise tax, and are required to file a certificate of limited partnership with the Secretary of State).

The primary advantages and disadvantages of a partnership are similar to those of a sole proprietorship, in that profits and losses may be passed through to the partners, thereby avoiding double taxation on the income if the partnership is properly structured, but the general partners have unlimited personal liability. Limited partners generally have no liability beyond their partnership investment.

Corporations

In contrast to a sole proprietorship or general partnership, a corporation is a separate entity that protects the business owner(s) from personal liability for business debts. In order to maintain the liability protection afforded by the corporate entity, the corporation should be adequately capitalized, and the officers and directors of the corporation should strictly adhere to the formalities of holding regular meetings and keeping accurate minutes and records.

The income of a standard “C” corporation is taxable at the corporate tax rate, which may be lower than the individual’s rate, but may also cause the owners (shareholders) to pay double taxation — once on the corporation’s income, and again on the shareholders’ dividends or distributions. In theory, a highly profitable corporation may actually save taxes for its shareholders by operating in C form, assuming the corporation’s profits can be reasonably paid to the shareholders as salary or other compensation.

The double taxation of a corporation can be minimized in certain cases by paying salaries to the shareholders or by making an “S” corporation election. Upon making a valid S election, all corporate profits and losses are simply “passed through” proportionately to the shareholders in a manner similar to a partnership. If the S election is made upon formation, shareholders can also avoid two levels of tax on the sale or distribution to them of the corporation’s assets upon liquidation, as the gain or loss will simply pass through to the shareholders to be taxed once. S corporation shareholders might also be able to reduce employment taxes by paying themselves some corporate profits in the form of dividends above their “reasonable” salaries. However, there are important restrictions on the ability to qualify for an S corporation election (e.g., 75 or fewer shareholders, with further restrictions on who can be a shareholder). Additionally, S corporation employee-shareholders do not receive tax-favored treatment for fringe benefits (other than retirement plans) if they own more than 2% of the outstanding stock. Benefits such as life, health and accident insurance will be currently taxable to such shareholders and may not be deducted by the corporation.

Although a corporation is fairly easy and inexpensive to form, it is usually required to pay a minimum State annual franchise tax of $800. However, Assembly Bill 10, which was chartered on July 6, 1999, exempts every corporation that incorporates or qualifies to do business in California on or after January 1, 2000, from the minimum franchise tax (prepaid to the Secretary of State) for its first taxable year; however, the corporation must still pay income taxes on the income from the first year (if any).

Other advantages of a corporation over most partnerships and LLCs include the free transferability of corporate shares, and the continuity of business even upon the withdrawal or death of shareholders.

Limited Liability Companies

LLCs are a relatively new form of business organization that may be treated like a partnership for income tax purposes, and like a corporation for liability purposes. Formation and operation of an LLC that is organized, registered, or doing business in California requires filings with the Secretary of State, and payment of an annual franchise tax of $800, for the privilege of doing business in California.

Unlike S corporations, LLCs may have an unlimited number of owners (referred to as members), which may include corporate or non-resident owners. Additionally, as of January 1, 2000, California no longer requires LLCs to have a minimum of two members.

Since most business owners desire to avoid personal liability for business debts, and double taxation of the business income, an LLC may be the best alternative. A properly structured LLC provides protection against personal liability of its members, much like a corporation does for its shareholders. Although LLC members, like corporate shareholders, can be personally liable under certain limited circumstances, they cannot be personally liable for failure to hold meetings or to observe formalities pertaining to meetings, as shareholders can. An LLC is also typically treated as a partnership for tax purposes, allowing personal deductions for business losses, and thereby avoiding double taxation of the business income and distributions.

While an LLC has many advantages, it is not always the preferred choice of business entity. An LLC may have certain restrictions on the transferability of interests, and on the continuity of the LLC’s life. In addition to California’s annual franchise tax, LLCs are required to pay an annual fee based on total income from all sources reportable to this state for the taxable year, ranging from $900 for total income over $250,000, to $11,790 for total income over $5,000,000. Therefore, an LLC may not be economically practical for a business with large gross receipts and narrow profit margins. An LLC cannot deduct medical expenses for members, and the receipt of this benefit is considered income to the people insured, unlike for shareholder-employees of C corporations. An LLC might also be less desirable than a corporation when most income is going to be reinvested in the business.

On the other hand, an LLC would almost always be preferred to a general partnership. LLCs are also the preferred entities for real estate investments, because they combine limited liability and flexible management with the ability to pass through losses and deductions, to make special allocations, and to avoid double taxation on the sale of appreciated assets.

Conclusion

Deciding on the best form of business requires careful consideration of such factors as ease of formation, transaction costs, liability of owners, tax consequences, ease of transferability of ownership interests, and the continuity of business, among others. The decision can have profound and lasting consequences on both the business and its owner. Therefore, before forming or starting a business, the owner should invest some time and effort, or consult with qualified professionals, to determine the most advantageous form of business.

Larry N. Murnane is a real estate lawyer and broker in San Diego, California, emphasizing business and real property matters.

Copyright Murnane 2009-2017

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The Meaning of Life

What is the Meaning of Life – our purpose for being here?

In a word — the purpose of life is to be happy.

So the question then becomes, how do we find true and lasting happiness?

Happiness is a choice and a process that we engage in every moment of every day, by thinking positive, expressing gratitude, living healthy and harmoniously, loving each other, giving generously, forgiving munificently, pursuing our passions, and accepting full responsibility for our lives, without blame, and regardless of circumstances.

Consistently choose happiness to live a meaningful life!

 

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