Who loves paying taxes? Not you? We don’t either.
Yet President Joe Biden has proposed a top federal tax rate of 39.6 percent on long-term capital gains and qualified dividends. Factor in average state taxes and a 3.8 percent federal surtax, and the wealthiest Americans could face a tax bill as high as 49 percent in 2022.
This potential change in policy, assuming a successful passage through Congress, would affect owners of commercial real estate with long term capital gains that they expect to realize in the next few years. Much like other classes of investors, real estate owners desire the highest possible return on investment, and a part of that return includes how much Uncle Sam requires in his tax bill.
As a result, many real estate owners are looking to sell as much of their holdings as is practical by the end of 2021. Often, selling and reconfiguring portfolios is done on a biannual or more infrequent basis. Yet some of these companies that completed such a cycle in 2020 are choosing not to wait the extra year.
If you or your company are considering such a selloff, you must plan strategically before you ever close on—or even market—your buildings with the goal to close by New Year’s Eve in case that capital-gains tax hit blasts its way into 2022. Here are two leasing considerations to be keenly aware of as you prepare for a sale.
- Revisiting and shoring up all existing leases
You need to ensure that everything aligns with the expectations of your prospective buyer. That said, you may not want to push a sale if a building’s largest or most important tenant has few years remaining on its lease term. If possible, you will be better off selling after you have renegotiated and extended the term.
How this goes depends on the nature of a building you intend to sell. For instance:
- Is it space in a retail “shadow center” location like a strip mall? Generally, if that space rests next to a Walmart, a Kroger, or another big-box retail operation, the return will be higher, and thus the stakes will be higher, too. Retail leases are typically short and might run five to seven years. As we all know, retail was significantly hampered by Covid, but well-placed centers can still bring a good return.
- Or is the space in or around a medical center? Leases with medical tenants tend to be longer (sometimes 12 to 15 years), more secure, and have higher values as a result.
- Focus on what you can pay upfront in lease negotiations with your tenants
You should focus acutely on your buildings’ net operating income (NOI) and how it is listed or presented when you get ready to approach the market with a sales listing. Simply stated, NOI is just the amount of cash flow the building provides after the expenses are paid. It is also how the sales price of a commercial building is typically calculated.
Tenants, in a quick-turnaround context like a this one, where they know you want to sell portfolio assets by the end of the year, will likely require some kind of tangible benefit to them before they will renegotiate their terms.
In the course of these negotiations, you will likely face a decision on whether to offer an abatement of monthly rent for a specified period of time during the extended term or provide an improvement allowance in cash once the new lease is executed. Expect a tenant to put both of these asks on the table. You will push back against one or the other.
Remember, then, that a rent abatement will reduce your NOI during the period in which the abatement is granted, but offering the tenant improvement allowance will not affect your NOI. Thus, you may increase your return on investment by providing the upfront allowance rather than weighing down your NOI with rent abatements.
Here is a concrete example: If you grant a three-month rent abatement in the new lease terms at $10,000 per month, you will lose $30,000 in NOI from your balance sheet. However, if you pay the tenant a lump sum of $30,000 toward an allowance as essentially an “extension bonus,” it helps to better define the sale assets.
If you decide to sell some of your holdings, it may seem like five months is a long time between now and the end of the year. When you factor in all you must address to properly set up a sale, that cushion will evaporate quickly.
So now is the time to accelerate your planning and due diligence if yours has yet to begin in earnest. For the considerations mentioned here and others, draw on a network of professionals to guide the process ably. Consult with all accountants, attorneys, appraisers, brokers, managers and other would-be teammates accordingly.
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Considering a sale of commercial real estate assets? Contact our expert attorneys today.