In last week’s post The Hazards of Static Decision Making, we expressed how important it is to adjust your disposition strategy to changing market dynamics. In the past year, the run-up in industrial real estate values topped out, land sales for new projects came to a screeching halt, and commercial property mortgage rates doubled to nearly 7%, which slowed investment and owner/user sales.
Owner/users, in particular, often include their highly appreciated industrial assets as an integral component of their retirement plans, but even those approaching or are beyond that age have been reluctant to sell and pay the massive tax bills that go along with making a killing on their property investments. In doing so, they overlook the potential of delaying the decision to sell even if that means losing equity in a down-cycle of undetermined duration and depth, which could put their retirement plans at peril.
As we have said many times in these pages, the aversion to taxes and lack of a sound strategy on what to do with significant gains on exit are the two big barriers to action for most owner/users. The installment sale just might be a good alternative. Let’s take a closer look.
In an installment sale the owner of a property with little or no existing debt sells to a buyer and becomes the lender. Two goals are accomplished in the process. The first is the fact that capital gains taxes are paid over the life of the loan in proportion to the amount of the gain realized in a given tax year instead of all up front. For some this is a less painful way of dealing with the inevitability of taxes. The second is the fact that it solves the problem of what to do with the proceeds. The owner converts his equity into an injection of cash via the buyer’s down payment and an income stream to fund retirement through monthly mortgage payments. The rate and terms on the loan are up to the buyer and seller; no bankers required.
The seller also changes his risk profile in this process. He trades the risk of a loss in equity as an owner for the risks associated with becoming a lender. His loan is secured by the property, which he can take back through foreclosure in the event of default. And, the down payment he receives at the point of sale is correction protection of a kind. If he accepted 25% down at the point of sale and pays his taxes on that portion of the gain, he is insulated from a mild market correction should he have to take the building back in a market down-cycle. Clearly, the creditworthiness of the buyer is critical, and the terms of the promissory note secured by the deed of trust must be carefully crafted to protect the seller/lender.
The installment sale also offers a very important benefit to the buyer that he may be willing to pay a premium price to get; no bank underwriting, no bank fees and a chance to set loan terms that work for him. With a bank it’s take-it-or-leave-it on their terms. In an installment sale the rate and terms of the loan can be crafted to benefit both parties. If a seller is fixed on the highest price he may offer a lower rate on the loan to achieve it. If a buyer is fixed on his monthly loan payment, he may be willing to pay more to get a longer amortization period or lower interest rate.
This aspect of the installment sale is becoming even more important today due to higher interest rates and the greater difficulty in finding a lender who will make the loan at all. As you may have heard, regional banks do most of the commercial property lending and many of them are under intense scrutiny right now as a result of the meltdown at Silicon Valley, First Republic and Signature banks. Even well-capitalized banks operating within regulatory guidelines are at risk of losing deposits quickly if we see other regional banks get into obvious trouble. And we won’t know which ones are really in trouble until it’s too late. The run on Silicon Valley Bank took just a few hours, as depositors scrambled to get their money out with their smartphone apps. It was astonishing to say the least. So, it’s no wonder that banks have become much stricter in underwriting loans, even for very strong borrowers.
We believe the installment sale model is a great option for buyers and sellers in the right circumstances. For a buyer with enough cash to make a substantial down payment, the installment sale can give him access to reasonably priced capital under tightening conditions. For the seller, it provides management -free cash flow at rates well above US Treasury yields and the loan is secured by a tangible asset they know better than anyone else-their own property.
Is this for everyone? No. But could it be right for you? Maybe. If you like the idea of having steady income at a competitive yield, and you don’t relish the idea of holding onto your property through a potentially damaging corrective cycle, it may be worth some serious thought.