COVER STORY, NOVEMBER 2005

THE CHALLENGE OF THE EXCHANGE
Successful 1031 exchanges require a balancing act to meet requirements.
David Sobelman

When discussing the aggressive nature of the current commercial real estate investment market, the term exchange undoubtedly is a topic of discussion at some point within the conversation. However, with the widely known benefits of deferring capital gains upon a property sale, rarely are the uncalculated pitfalls ever discussed between the brokerage and principal communities. Section 1031 of the Internal Revenue Code has extreme benefits for the both sides of a transaction, but understanding the true reality of today's market dynamics needs to be a precedent to closing on the settlement date in order to assure a seamless investment.

It is not a secret that a plethora of landlords, developers, and sellers alike are screening the high prices and low capitalization rates and getting the urge to sell their assets in order to maximize investment objectives. Wide eyes and ideas of grandeur commonly overshadow any planning that may be essential in successfully performing an exchange. When the IRS was drafting policy for the 1031 code, it probably did not fathom the thought of today's market climate. What was once thought of as an amenable time period for sellers and Uncle Sam has been unintentionally skewed to the parameters that seem to be favoring the uninvited distant relative that visits in April every year. Investors naively underestimate the challenges that they may incur during the exchange period.

Pressure comes in all forms for an exchange buyer. Once the buyer has closed on what is termed the “down-leg,” the process of searching for properties that fit the appropriate investment criteria begins. If the seller has not been recently active in real estate acquisitions, he or she is typically shocked at the low returns being offered by today's sellers. What is soon forgotten is that the buyer was in the seller's role just moments earlier looking to maximize the value of an asset.

After several attempts of submitting offers to sellers, the negotiating, and in some cases, non-negotiating, begins. This process, which usually takes several days for each property, is finally concluded with an accepted offer in the form of a letter of intent. After both sides agree to the macro terms of a contract, time is needed to draft that contract and make sure it conforms to the negotiated offer. By the rules set forth by the IRS, a buyer generally may identify up to three properties by the end of the 45-day written notice and receipt requirements period. If each property is taking roughly 2 weeks to identify, then the 45 days is the perfect amount of time needed to complete the first task in an exchange. However, in real estate, nothing is perfect.

Due diligence periods begin, third-party reports are ordered, attorneys are retained, lenders are engaged, appraisers try to justify the purchase price, surveyors are looking for a defect in the title, environmental engineers search for site deficiencies, and so on. If the buyer has started this process on multiple properties, then the timing and costs associated with each become complex and considerable. Murphy's Law proves that all of these entities cannot work according to everyone's exact planning guidelines and hence, the pressure. In a typical case, due diligence materials are delivered late, lenders are backlogged for weeks, appraisers are overworked, surveyors are committed to other work, and environmental reports need time to be reviewed and clarified. All of these elements, along with the buying-and-selling entities' personal schedules, fall into the mix of having things done in a, to be polite, non-timely manner. Lastly, if the buyer ultimately chooses a property to pursue and the stars line up properly, then he or she will have four-and-a-half months to settle on the “up-leg.” A lot of this time can be used to continue an evaluation, but typically sellers limit the due diligence period of a contract and buyers need to perform appropriately.

Therefore, how does one try to limit exposure to the intricacies of an exchange? The answer is simple and twofold: start early and work with a competent professional. Both elements are essentially self-explanatory. Months before the down-leg begins, a seller should begin evaluating and discussing the market to understand current cap rates and what types of assets are in within an acceptable price range. Employing a proficient commercial real estate professional is probably the most advantageous strategy for an investor looking to understand market dynamics, streamlining both the sale and subsequent purchase of investment property. Acting as a facilitator in every aspect of each transaction, the advisor is able to spend the time and energy needed to make sure that all aspects are being properly handled with the primary focus of achieving the client's goals and objectives within the restricted time line provided.

David Sobelman is the business development director of Calkain Realty Advisors, the private brokerage division of Calkain Companies, with offices in Massachusetts and Virginia, as well as a coming Florida office.

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