Commercial Real Estate Lending:  What You Don’t Know Can Hurt You!

If there is anything commercial real estate lenders have learned during the collapse of the commercial real estate market over the past five or so years, it would be the danger of “lending blind”.  Commercial real estate lending without fully understanding the project is a prescription for disaster. An original version of this article was first published in 2005.  It is eerie how prophetic the warning signs were. Surely lenders have learned. . . .

I was invited recently to speak at the Illinois Institute for Continuing Legal Education Annual Real Estate Short Course to discuss what every lawyer should know about commercial real estate development agreements. In preparing for the presentation, a developer client suggested it is not only attorneys who need to know about development agreements – developer clients do as well.

So, on that note, the following is my list of the top 10 things attorneys and developers should know about commercial real estate development agreements.

TOP 10 THINGS TO KNOW ABOUT COMMERCIAL REAL ESTATE DEVELOPMENT AGREEMENTS

1.     Development Agreements are not the same thing as Construction Contracts.

2.     There are no “master form” Development Agreements.

3.     Each Development Agreement is unique to the specific development to which it relates, and must accommodate the sometimes conflicting needs, demands and desires of the constituent stakeholders, including the

Of Course We Can Sue Them . . . But Can We Hold Them Liable?

No one knows everything. It’s a simple fact of life. Often, businesses turn to other businesses and professionals to obtain needed information. The range of commercial information providers assisting business owners and real estate investors, developers and lenders gather and analyse information is vast.

The question is: Do we have a legal right to rely on the information they provide? What if the information is wrong? What if we rely on that incorrect information and suffer a loss? Is the information provider liable?

It could be anything from hiring an appraiser to appraise a property to support a commercial loan; hiring a lab to analyze nutrition and caloric content of food products; or engaging a financial consultant to evaluate a company’s assets and liabilities as part of a business acquisition or merger; or seeking out a lending institution to provide information regarding the creditworthiness of a potential borrower. We might hire a structural engineer to evaluate the structural integrity of a building or bridge or other structure; or engage a surveyor to determine the scope and size of a parcel of land, or the location of easements and improvements located on the property, or the existence of rights of way to access the property; or we might retain a person or business holding itself out as a “due diligence” expert to investigate the essential facts necessary to enable us to determine whether to proceed with a particular transaction or project. The list of commercial information providers we rely upon to conduct our affairs is nearly endless.

Another simple fact of life is that people can and do make mistakes. They misinterpret information. Misstate the facts. Fail to discover and disclose all material information necessary to make information they have provided sufficient to enable informed action and decision-making.

What happens when your information provider gives you bad information and you suffer a loss as a result? Do you have any recourse? What if

NOTICE TO MUNICIPALITIES:  If you want economic development, ACT LIKE IT!

Sometimes, municipalities can be their own worst enemies when it comes to economic development. At best, things they sometimes do, or don’t do, evidence disinterest, if not incompetence. Alternatively, it may evidence a breach of trust to the community and local taxpayers.

Here’s the situation:

Recently, in representing developers before a variety of municipal governments, I have been struck by the Jekyll and Hyde  approach many have when in comes to economic development. Often, the city, town or village will have a fully staffed economic development department. It may pay hundreds of thousands of dollars per year, if not millions of dollars per year, to pay economic development staff salaries and to cover associated overhead. It will allocate or approve millions of dollars per year in economic development grants, tax incentives, tax increment financing, real estate tax abatements, sales tax revenue sharing, and other economic incentives to encourage investors and developers to bring private development to the city to create jobs, remove blight, increase land values and otherwise improve the quality of life of the community.  These are all proper uses of public economic development funds.

Then what?

As is necessary, the developer has its architect submit plans to the municipal building department for review and approval to obtain a building permit. There is nothing controversial about that, right? But then, in a remarkably high number of circumstances, the permitting process proceeds at only glacial speed.

How long should it take to review plans and specifications for a modest sized project that will bring jobs and economic opportunity to the city? The city has already confirmed that it wants the project by granting development incentives to the developer for the project. When the developer’s architect is moving forward as quickly as practical to obtain the building permit, should it take the municipal building department 9 to 10 months to issue a building permit on a modest sized structure? I’m not talking about a building the size of Trump Tower – I’m referring to buildings of less than 30,000 square feet. How long is reasonable?  Is a building permit review process that takes 9 to 10 months necessary or reasonable? How is that promoting economic development?

And once the building permit is issued, and work begins – how often should work have to stop because city building inspectors fail to show up for scheduled inspections?

Private investors and developers cannot afford – literally – to sit around and wait extended periods of time to move a project to completion. Market conditions change. The cost and availability of money changes. Commercial tenants choose other options.

The Point?

The point here is that municipalities need to get their act together if they want to promote economic development in their communities. Not all cities, towns and villages are guilty of dragging their feet or sending mixed messages, but there are many more than you may think. For developers, time really is money.

It is counterproductive – and more than a bit silly – for local governments to “give away” economic incentives to promote economic development, and then have their building departments drag their municipal feet in facilitating completion of the project. Economic development staff and their building department siblings need to get on the same page and follow the same agenda if a municipality truly wants to promote economic development.

Promoting Economic Development

Promoting economic development is not merely a matter of handing out economic incentives. That can be useful – and sometimes necessary – to promote economic development in your community, but it is not the whole story. To get the economic development engine running, local governments need to take a holistic approach that fully embraces and encourages desired economic development. It needs to walk the walk.  It needs to expedite services to facilitate development. It needs to get its collective act together – in all municipal departments – to genuinely do what is in the best economic interests of the community.

Commercial developers and their prospective commercial tenants and users have choices as to where to invest their money to build new projects that promote economic growth. Most development opportunities are regional, if not national or global. If your town will not do all it can reasonably do to truly promote economic development in a meaningful way, some other town likely will.

This is not a threat – it is a practical reality. If you are in local government and genuinely want economic development, I suggest, with all due respect, that you act like it.

Thanks for listening.

Kymn

This is the second installment of a three-part series on Section 1031 like-kind exchanges. Part 1 explained WHY you should consider use of a Section 1031 like-kind exchange when selling commercial or investment real property. Part 2 covers the key rules for HOW to implement a Section 1031 like-kind exchange. Part 3 will cover special issues applicable to a Section 1031 like-kind exchange when a Tenant-In-Common [TIC] interest is being acquired.

KEY RULES FOR SECTION 1031 EXCHANGES

The following is an outline of key rules applicable to Section 1031 exchanges. Become familiar with these rules. Unless you intend to completely cash out of real estate investing, a Section 1031 exchange may work to your benefit. If you intend to keep investing in real estate or using real estate in your trade or business, a Section 1031 exchange will maximize the capital you have available to reinvest.

Key Elements of a Section 1031 Exchange*

What is Section 1031?

Section 1031 refers to Section 1031 of the Internal Revenue Code of 1986, as amended.

What does it do?

Section 1031 permits a taxpayer (the Exchangor) to dispose of certain real estate and personal property and replace it with like-kind property without being required to pay taxes on the transaction.

What property qualifies?

To qualify for a Section 1031 exchange, the property being disposed of (the Relinquished Property) must have been used in the Exchangor’s trade or business and/or must have been held for investment purposes. The property being acquired (the Replacement Property) must likewise be acquired for use in the Exchangor’s trade or business or for investment.

What property is considered like-kind?

For real estate, to be like-kind means simply that real estate must be exchanged for real estate. The rules related to personal property are significantly more complex. Personal property is any property that is not real estate.

Real estate exchanges are fairly straightforward. A warehouse may be exchanged for another warehouse or for any other qualifying real estate including, for instance, a factory building, office building, shopping center, single-tenant store, parking garage, or even a parcel of vacant ground so long as it qualifies as being acquired for use in the Exchangor’s trade or business or is to be held for investment. This is not a difficult test to pass. Similarly, a qualifying parcel of vacant ground or a shopping center or office building or factory or other parcels of investment real estate may be exchanged for any other qualifying real estate investment.

Personal property exchanges are not so straightforward. For personal property, the property must be substantially similar and of the same type or class. For example: a car can be exchanged for another car; and a bull can be exchanged for another bull; and a cow can be exchanged for another cow; but, a bull may not be exchanged for either a cow or a car.

Although personal property exchange rules are substantially more technical and complicated than real property exchange rules, generally speaking, depreciable tangible personal property held for productive use in a trade or business can be exchanged for other depreciable tangible personal property held for productive use in a trade or business so long as they fall within the same NAICS classification code.

For instance, Limited Service Restaurants such as fast food restaurants, pizza delivery, sandwich shops, etc. fall within 2012 NAICS Code 722513. Accordingly, the assets of one can be exchanged for the assets of the other under Section 1031. But, note that the NAICS Code for a bar, tavern or nightclub is 722410, and the NAICS Code for a full service restaurant is 722511, so an exchange of assets of either of these for the assets of the other, or the assets of a Limited Service Restaurant (even though otherwise physically identical), may not likely be considered “like kind”.

The point, for purposes of this post, is that exchange rules for personal property are substantially more complex than exchange rules for real property. Accordingly, if you are exchanging personal property – either in conjunction with an exchange of real property or purely as a personal property exchange – great care must be taken to comply with the personal property exchange rules to receive the benefits of a tax deferred exchange under Section 1031.

What property is excluded?

Some types of property are expressly excluded from tax deferred exchange treatment by statute, rule or regulation The following types of property do not qualify for aSection 1031 exchange: stocks, bonds, partnership interests, limited liability company interests, personal residences, stocks in trade or inventory, and certain other intangible property.

Are there timing issues?

Section 1031 exchanges can be simultaneous, but they are not required to be. In fact, most exchanges made pursuant to Section 1031 are not simultaneous. There are, however, strict timing rules that apply tonon-simultaneous exchanges and strict rules prohibiting access to funds.

What are the time limits?

The Replacement Property or properties must be identified, in writing, not later than forty-five days after the Relinquished Property is transferred (the Identification Period). The Replacement Property or properties must be acquired not later than the earlier of (i) 180 days after the Relinquished Property was transferred, or (ii) the due date for the Exchangor’s tax return, including any extensions (the Acquisition Period). The Identification Period is included within the Acquisition Period.

How many Replacement Properties may be identified?

There is no fixed limit to the number of Replacement Properties that may be identified, but there are two primary rules that apply: (1) the Three-Property Rule, and (2) the 200% Rule.

1. The Three-Property Rule allows you to identify up to three (3) properties as potential Replacement Properties, regardless of value. You need not acquire all three properties, but as of the end of the Identification Period, not more than three properties may be identified. This is the most commonly used identification rule.

2. The 200% Rule allows you to identify any number of potential Replacement Properties so long as the aggregate value of all identified properties does not exceed 200% of the value of the Relinquished Property. You need not acquire all identified properties.

Generally, if you identify more properties than permitted, you are treated as if you have not identified any properties. However, there is one more rule that might save the day. The 95% Rule allows you to identify any number of potential Replacement Properties, regardless of value, so long as you actually acquire within the Acquisition Period at least 95% of the value of all properties identified. Use of the 95% Rule is rare, and is generally considered more a safety valve rule than an intentionally used exchange rule

Must all exchange proceeds be used?

There is no requirement that all proceeds received upon sale of the Relinquished Property be used to acquire the Replacement Property. Any exchange proceeds not used, however, are taxable.

What constitutes exchange proceeds?

Exchange proceeds means the net sale price of the Relinquished Property, including all net equity and the amount of any mortgage encumbering the Relinquished Property, whether paid off at closing or assumed by the purchaser. It is not sufficient to merely reinvest the net equity received upon sale. The purchase price of the Replacement Property must equal or exceed the aggregate of the net equity received upon sale of the RelinquishedProperty plus any mortgage encumbering the Relinquished Property at the time of the sale closing.

Example: If the Relinquished Property is encumbered by a $700,000 mortgage and is sold for $1 million as part of a Section 1031 exchange transaction, to defer all taxes, the purchase price of the Replacement Property must be at least $1 million, not merely $300,000.

When can the Exchangor obtain access to unused proceeds?

Proceeds from sale of the Relinquished Property may be accessed only when the exchange is completed, fails, or expires. If no potential Replacement Properties are identified within the Identification Period, the exchange fails, and the Exchangor may receive the funds. Those funds will, however, be taxed in the year received. But note: If a mortgage was paid off at the Closing of the Relinquished Property, and the amount of the mortgage was greater than the tax basis of the Relinquished Property, the amount paid to satisfy the mortgage in excess of the tax basis of the Relinquished Property is taxable in the year of Closing of the Relinquished Property.

If all properties identified within the Identification Period are acquired within the Acquisition Period, the exchange is completed, and any remaining funds may be received by the Exchangor. Those remaining funds are taxable. If less than all identified properties are acquired, but the Acquisition Period expires, all remaining funds may be received by the Exchangor, but are taxable.

Conclusion:

These are the basics. As tax rates rise, Section 1031 exchanges become increasingly valuable.

A Section 1031 exchange is not a new and exotic tax shelter scheme. Tax deferred exchanges of like-kind property have been recognized by the Internal Revenue Service as a valid tax deferral strategy since the early 1920s. The structure and effect of a Section 1031 exchange were specifically authorized by Congress by enacting Section 1031 of the Internal Revenue Code of 1986, as amended, and the Internal Revenue Service has promulgated extensive regulations for its implementation.

Use Section 1031 to your advantage, but be sure to strictly comply with the Section 1031 rules.

* Special Thanks to my tax partner, James M. Mainzer, for consulting on this post.

_________________________________

As required by the Internal Revenue Service under Circular 230, you are advised that any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this article.

This is the first installment of a three-part series on Section 1031 like-kind exchanges. Part 1 explains WHY you should consider use of a Section 1031 like-kind exchange when selling commercial or investment real property. Part 2 covers the key rules for HOW to implement a Section 1031 like-kind exchange. Part 3 covers special issues applicable to a Section 1031 like-kind exchange when a Tenant-In-Common [TIC] interest is being acquired.

Why Consider a §1031 Like-Kind Exchange?

What if I told you that you could get a hefty 0% interest loan from the federal government to invest in commercial or industrial real estate? Would you be interested?

Better yet, what if that loan has no fixed monthly, quarterly, or annual repayment obligations and does not show up on your credit report or balance sheet as an outstanding liability?

Still better yet, what if the terms of the loan provide that it may never have to be repaid? Are you interested now?

In effect,* that’s what a Section 1031 like-kind exchange can do for you.

Here’s how:

Section 1031 of the Internal Revenue Code permits

 Tips on Selling Commercial Real Estate

Sellers are funny people. Not “ha ha” funny, but funny in the sense that they sometimes have an odd way of looking at things when they are selling commercial real estate.

This is not an indictment against any unique class of people. Let’s face it, sooner or later virtually all commercial real estate Buyers become commercial real estate Sellers. It is simply a recognition of an odd twist that occurs in the mindset of many commercial real estate investors when the tables are turned and they become Sellers instead of Buyers. If you are selling commercial real estate, or are a listing broker representing a party selling commercial real estate, here’s what you should do.

MONEE, ILLINOIS IS IN SEARCH OF A COMMERCIAL REAL ESTATE DEVELOPER – AND WILL PROVIDE ECONOMIC INCENTIVES

This post is intended to serve two purposes:

1. To give any interested commercial real estate developer a heads up that there is an opportunity in Monee, Illinois to obtain meaningful economic incentives as part of a public-private partnership with the Village of Monee;
2. To help Monee, Illinois attract the commercial development it wants and needs – including particularly a grocery store.

Let me first say that I am not a real estate broker or real estate developer, I don’t own land in or near Monee, I don’t represent Monee, and I have no other specific connection to Monee.

WHAT IS THE POINT OF THIS POST?

I do represent commercial real estate developers (mostly property turn-around specialists and redevelopers) and commercial real estate investors. Developers often tell me they are looking for development opportunities

ICSC RECon 2014 is in full swing as the largest retail real estate convention in the world. Every year, retail owners, investors, developers, lenders and other commercial real estate professionals converge on Las Vegas, NV to network, discover, promote their projects, look for development opportunities and make new deals. This year is no exception. There are an estimated 33,000 real estate professionals in attendance for this action-packed three day convention at the Las Vegas Convention Center.

Once again this year, members of the International Council of Shopping Centers are recognizing and acknowledging the need for public-private partnerships with local communities to promote economic development. The extremely difficult economic conditions over the past several years have taken a toll on communities and developers alike. Now, more than ever, they need each other to facilitate mutually beneficial development.

To help local governments establish and promote much needed permanent, beneficial economic changes for their communities, ICSC in cooperation with other development groups and agencies continues to

Albert Einstein:           “Everything should be made as simple as possible, but not simpler.”

Commercial Real Estate Due Diligence – the Four Areas of Inquiry

I’m a big fan of Albert Einstein. He’s one of my intellectual heroes.  He could see and understand what others could barely imagine. His greatest gift, I believe, was his ability to find answers to questions others didn’t even know existed.

Real estate due diligence requires insight as well. To find the answers, you must