Two years ago, when the first threats to real estate limited partnerships began to trickle out of congressional tax reform talk, the wise guys started selling “economic” deals, as opposed to “tax” deals. Well, today, with tax reform silling in our front yard and three-to-one write-offs a thing of the past for many investors, some of the so-called economic deals aren’t looking so economical . As for the tax deals, well, the problems with those started back when the words “tax shelter” became a noun. You see. “tax shelter” should be a modifier an adjective to describe one aspect of a real estate investment. The problems with real estate limited partnerships, it can be argued, began when people started investing in tax shelters as opposed to real estate.
You read about them on the front page of the daily paper. Dallasite Donald “Grand Prix” Walker’s S168 million real estate syndication empire went bankrupt last year. This year’s headline-grabber is Dallas resident Craig Hall. In the aftermath, names like Hall and Walker strike fear into limited partnership investors large and small. Behind that fear are a lot of questions, the most obvious being. “Will my limited partnership be tomorrow’s bankruptcy headline?” The answer to that question is between you and your syndicator. Following, some experts and industry observers field some of the variables that can help you ask your syndicator the right questions.
What’s at the root of these syndication bankruptcies?
Most industry observers agree that the lax incentives applied to real estate limited partnerships are at the crux of the overbuilding problem. In a typical, tax-oriented private real estate limited partnership offering a three-to-one write-off, investors get a three-dollar write-off for every dollar paid in, accrued as losses on the property. Pavments are in stages, generally large annual payments spread out over three to five years. In publicly offered partnerships, payments are in full on the front end. Naturally, many people jumped on these investments and their sweet write-offs. But that meant the market was being driven by artificial forces, the tax write-offs, rather than by demand for the space being built. It paid to lose money; deals were structured with no economic basis for existence, and investors could write off the losses on their tax returns. When tax reform began to threaten those write-offs, the salesmen pushed deals that made more economic sense, that would be worth something down the line or would immediately generate income. But by then, the overbuilding had gone too far. There was just too much product on the market.
How can I remove myself from the mess?
Most advisers say that if you have invested in a real estate limited partnership, public or private, and your initial reaction to the new tax legislation is to dump that partnership, don’t do so immediately. Wait.
There is a growing secondary market for the resale of limited partnerships (about which more later), but if you rush into a sale, as many other investors are likely to do, the competition to sell is going to force prices down, down, down. You probably won’t get much for your piece of the syndicated pie.
And, if you are a large investor in real estate, the tax changes regarding limited partnerships may not affect you that much. In brief, and extremely simplified: the changes would be made in laws related to “passive” losses generated by real estate limited partnerships and would eliminate deductions for such losses taken against other kinds of income. So the larger investor who may have many investments in real estate, some producing income, others losses, can still take deductions for limited partnership losses against similar income. This change is devastating to the smaller investor who was taking his limited partnership deduction against income from, say, his salary, which is not “passive” income. Now his loss has no tax value, and if the tax incentive was the only value in the deal, well, tough luck.
Wait, the experts say, and explore your options. Each private limited partnership deal differs from another and the options differ depending on how the partnership was set up, and depending on the investor’s individual circumstances. (Who said the simplified tax law would make less work for accountants?)
How do I know if my limited partnership is in trouble?
Before tax reform, there weren’t many choosy buyers in the marketplace. But since the real estate syndication bubble has already burst, there are wiser investors in the market. A sharp investor can reduce his risk. Limited partners have always had the right to visit the purchased property if they wanted to, but in the past, most investors have relied exclusively on investment information presented by the syndicator on paper. Now, first-hand inspections have become commonplace. One real estate limited partnership property manager in the area says the frequency with which the limited partners are inspecting the properties has increased geometrically. Another property manager says investors are making trips to Dallas to look at properties and are complaining about trash in parking lots, dirty windows, potholes, and other minor flaws that would have gone unnoticed several years ago. Although keen-eyed investors make a management company’s job harder, many in the industry think the changes are positive.
The present market conditions have also prompted investors to take closer looks at the partnership agreements. In the heyday of syndication, the late Seventies and early Eighties, tees tor the general partner, the syndicator, on the front end of the deal, and profit sharing at the back end was typically heavily in favor of the syndicator. Limited partners were so happy with their two-to-one, three-to-one, or four-to-one write-offs that they really didn’t care what the general partner took out of the deal. In some cases, the general partner got as much as thirty cents out of every investor dollar up front for fees, and then 50 percent of the profits in the end. The word among the less reputable syn-dicators was that fees and profits were “whatever you could get away with.” No more. Today’s investor has more on his mind than a tax break and is more likely to seek independent counsel to scrutinize the fees and profit-sharing arrangement of a syndication.
Investors are also checking up on syn-dicators’ experience and prior partnerships, talking with present investors, and visiting other properties owned by the syndicator and his limited partners. They are taking a closer look at the financial strength of the syndicator and checking credit ratings. Are mortgage payments made promptly? Any lawsuits? Are offices plush and running over with employees; who pays the overhead?
These tactics of the new “wiser” investor may sound obvious, common-sensical. They are. You’d be surprised how many people didn’t ask those simple questions, but just blindly followed the cow path.
What should I do with my investment dollars that were slated fur another limited partnership?
Just to make the situation supremely confusing: this is a great time to buy real estate, and some of the basic benefits of buying real estate through a limited partnership are still shining through dark clouds of negative press. It’s a great time to buy. for those who have cash, because prices arc depressed. There are good deals out there on the open market and in the secondary market. For that reason, there are new salesmen in the business every day.
Hoyt R. Matise, a firm recognized for real estate brokerage and development in Dallas, is just one of many firms that has recently created a division to sell real estate syndications. Why is this a good time to buy? Says John T. Wear, president of Hoyt R. Matise Securities Inc.. “The proposed tax legislation is going to decrease the amount of new development in commercial real estate. Gradually, the vacant apartment, office, and retail space will fill up, and as that happens the cash flow and rental income on these properties will increase and, therefore, the property value increases.”
Disregarding any tax incentive, limited partnerships public or private still offer the investor benefits: financial leverage-a group of investors is pooling money that allows them to buy larger and better properties; economies of size-there is greater cash flow from larger properties clue to economies of size; expertise of the syndicator (that is not a joke)-the lone investor does not typically have the knowledge to put together a deal that will yield the greatest benefit for the least dollars; limited liability-the investor’s liability is typically limited to his initial contribution only; property management-the syndicator takes responsibility for day-to-day management; and a broad investment base-an investor with $100,000 to invest has the ability to invest in five $20,000 deals vs. one $100,000 deal.
If I still want to sell my limited partnership, who wants to buy swampland?
If you can’t wait to get rid of your limited partnership, there is some hope for you in the secondary market. A number of companies specialize in buying or brokering the resale of real estate limited partnerships. Raymond James & Associates Inc. of St. Petersburg, Florida, has been actively buying publicly registered real estate limited partnerships since October of last year and the firm has been brokering (he resale of limited partnerships for four years. Senior vice president of corporate finance J. Davenport Mosby said the firm is presently evaluating getting into the private partnership market sometime next year. Liquidity Fund Investment Corporation of Emeryville, California, is another firm that buys real estate limited partnerships for a group of investors. Brent Donaldson, president of Liquidity Fund, said his firm is interested primarily in modestly leveraged, publicly offered partnerships. In other words, those selling tax deals need not apply. “We have had a number of inquiries from people who have invested in tax shelters, which we do not buy.” George E. Hamilton, president of National Partnership Exchange Inc. of St. Petersburg, said his firm (also in the public-only market) gets an enormous number of calls from people who have invested in limited partnerships in the last two years and who still have one or two annual payments coming up. “I really feel for them; they have limited options,” Hamilton says.
But the large number of calls to these various partnership exchange firms is provoking the firms to take a look at the private, tax-oriented deals. Ronald T. Baker, president of Partnership Securities Exchange Inc. of Oakland. California, says his firm is “researching that area at this tune.” although presently il will only broker the resale of public partnerships.
What if I just quit making payments on my partnership?
The real estate industry estimates that some $10 billion of payments is still owed to partnerships. A big chunk of that money will be due this January when the next big round of payments into the investment pools is scheduled. Many people in the syndication business are afraid to say the D-word (DEFAULT), but they are still wondering: without the lure of tax breaks, will investors rebel and refuse to make their payments?
Steve Kurth, a partner with the accounting firm of Kenneth Leventhal & Company in Dallas, warns investors that there are some very distasteful side effects of default. ’To begin with, they can count on being sued by the general partner,” he says. And then there are tax recapture problems since defaulting on payment will trigger the back-end catch to the limited partnership: when the tax benefits are over, a portion of those write-offs come back and haunt the investor as phantom income. (For instance, in a two-to-one write-off deal, for every dollar you invest, you get two dollars to write off, one of which goes into a “negative capital account” that is taxed as income at the end of the deal.)
Kurth’s best advice is of the wait-it-out variety. He warns: “Don’t panic. People should not hurry to divest. And remember, this is all cyclical, Some of the properties in trouble today are going to be some of the best properties in the country down the road.”
