Pressing the “Eject” Button: Secure a Viable Real Estate Exit Strategy First

Think back to the Saturday morning cartoons, when Bugs Bunny would get stuck in a tight spot. Whether it be a rabbit hole or quicksand, there is always an “eject” button to catapult him safely out of danger. Relate this to real life, and there’s certainly a valuable lesson to learn – you should always have a reliable exit strategy.

This is particularly important in the context of real estate investments. Having an exit strategy in place before it’s needed saves you the panic of feeling trapped down a rabbit hole when you’re ready to get out.

Your potential real estate exit strategy is best planned in advance before you buy the property in the first place. The strategy then must be tested and modified as conditions change. Ideally, you will also have a realistic fallback position to guide you if your original plan doesn’t work out.

Some investors buy real estate with the intent to hold the property indefinitely, or at least for their lifetime, so they can pass it on to heirs with a stepped-up tax basis. While this may be a good plan if the property generates net income, what if the property becomes a cash drain? Or, what if the next generation is unwilling or unable to manage and maintain the property?

That’s why a real estate exit strategy is important, no matter how long you plan to hold on to the asset.

What to Consider in Your Personal Real Estate Exit Strategy

What constitutes a favorable and realistic real estate exit strategy depends upon your goals and risk tolerance. Relevant factors include:

• Return Expectations – Are you looking for modest or aggressive cash flow? Or, is your primary goal to achieve significant appreciation and profit upon sale? How much flexibility and cushion do you have in your financial projections for a “successful” outcome?
• Time Horizon – How long do you intend to hold the property? Is your strategy to hold long term, to improve and dispose of the property quickly, or something in between?  Are you willing to sell your property at a loss in order to exit at a specific time?
• Need for Liquidity – Is there an upcoming obligation, such as school tuition, that may require you to have a large amount of cash on hand? Do you have other funds readily available to cover unanticipated events, or may you need to exit the investment earlier than planned to free up liquid assets in case of an emergency?
• Changes in Tenancy – Whether your property is an apartment building where frequent turnover is expected, or an office, retail or industrial building with longer lease terms, capital improvements and expenses (i.e., brokerage/leasing commissions) and some downtime for all or a portion of the space may be necessary to prepare the property for a new tenant.  Because the pricing of commercial property is based on cap rates, a commercial property’s value relies heavily on the terms of existing leases and the credit of your tenants. If your commercial tenants do not renew their leases, or if they go out of business altogether, how will you re-lease the space, and how long will that reasonably take?
• Relationship Among Owners – There is a saying that doing business together is a great way to break up a family or friendship. If you own a property with others, do you have a strategy to move forward if the parties want to part ways, or if a partner dies or becomes incapacitated? Do you have an agreement with the other owners to sell or refinance at a certain point in time, or under certain economic conditions? Are your investment goals with respect to the property aligned?
• Financing – If you purchased the property with a mortgage loan, when does the debt mature? Can you extend the maturity date, and under what terms? Is your loan assignable to a subsequent purchaser of the property? Are there defeasance (pre-payment) charges or lockout periods that may keep you from paying off your mortgage early?
• Market Conditions – Are you open to an early sale if you receive a favorable purchase offer? Can you hold on to the property longer than originally anticipated if market conditions are unfavorable on your target sale date?

Sell the Property Outright

The most common real estate exit strategy is a traditional sale, where the property is sold to an unrelated third party through an arms’ length transaction. The primary issue becomes when the sale can and should occur. For single-tenant properties, the terms of the lease may suggest some logical sale dates, such as the date a new lease or renewal term takes effect, a date after certain lease contingencies, such as a tenant termination or purchase option, expire, or a point in time when there is a marketable amount of term left on the lease (such as five, seven or ten years).

Other plausible sale times include:

• The loan maturity date
• Immediately prior to or after significant capital improvements must be made
• In a multi-tenant property, a date after key leases roll
• After significant capital improvements or structural repairs are made to the property
• In the case of a property with operating licenses or franchise agreements such as a hotel, a date that coincides with expiration of such licenses

If your property has a value-add component, you can sell once the improvements are complete in order to immediately monetize your upside, or you may choose to operate the improved property for cash flow for a period of time to enjoy the fruits of your labor.

A potential danger of relying on these traditional exit points is that the market does not always cooperate with your plans. Cap rates, interest rates, tax laws, or the local or national economy may be unfavorable for a sale at the time you originally planned to exit the investment. If there is a significant change in the tenancy of the property, such as if a substantial tenant goes bankrupt, stops operations in the building, or gets acquired by another company, or if a lease guarantor dies or becomes insolvent, you will likely need to adjust your exit expectations until you find replacement tenants or guarantors. Additionally, if you own the property with one or more partners, your timing for a sale may be hastened (or delayed) by a disagreement among the parties, a transfer of a partner’s interests, or a partner’s need for liquidity.

Finance the Property to Get More Capital or More Time

While a loan will not enable you to immediately exit an investment, financing may provide a way to unlock capital invested in a property, or buy yourself more time to sell. This can be helpful if you want to:

• Delay the timing of a sale until market conditions improve
• Make improvements to the property to create more value and upside
• Use equity invested in the property for some unrelated purpose

Adding leverage may also increase cash flow, but it also increases overall risk, since the loan will have to be repaid before you can pocket the proceeds from any disposition of the property.

Refinancing an existing loan may allow you to take some of the equity invested and use it for other purposes. It also helps that proceeds from a refinance are not immediately taxable. Depending on the lender, the terms of the loan, the credit of the tenant(s) and duration of their leases, and the then-current interest rates, commercial loans can be extended for short periods of time, say one to two years, or for an entirely new term.

Note that some types of loans may be assignable to a subsequent purchaser of the property, which can be attractive if you lock in a low interest rate for the long-term. Loans may also have defeasance charges and lockout periods, making an early exit more challenging because you will either have to find a buyer that will assume your loan, or you will have to pay the penalty amount from sale proceeds. A borrower cannot receive proceeds from the sale of a property until the mortgage lien is satisfied or assumed. Therefore, financing should only be used with careful planning, taking investment goals into account.

Reposition a Real Estate Investment

If the market is not favorable for a sale or refinancing at the time you want to exit an investment, a repositioning or repurposing of the property may unlock value. For example, if you own an apartment building, consider converting the property to a condominium and selling the units individually instead of trying to sell the entire building at once. Leasing space to new or different types of tenants and filling vacancies can also help improve the marketability of the property, as will making capital improvements to increase longevity of the building.

Changing the use of a property (or a portion of it) will require additional capital, and may require zoning changes as well. However, converting commercial spaces to residential ones, adding ground-floor retail to a residential or office building, turning a hotel or shopping center into a residential or office space (or vice versa), or adding or eliminating parking areas are all examples of repurposing a property to potentially better position it for sale.

In other instances, interior remodeling, modernization of a façade, or improvement to landscaping may increase the “curb appeal” of your property, making it more attractive to prospective buyers or tenants. Undertaking capital improvements to building structures and systems adds appeal to purchasers who can’t or may not want to do that work themselves in the future.

If some, but not all, of the owners of the property wish to exit, or if a sole owner wants to reduce his or her ownership percentage without selling outright, you may be able to bring in new equity investors through the sale of ownership interests. One significant challenge of changing investors is how to value the property interests. You will need to establish how the property will be managed, and how proceeds will be distributed. Note that if you have a mortgage on the property that will be kept in place, you will need the lender’s consent for this type of transaction.

Depending on the nature of the property, it may also be possible to sell a portion of the physical asset while retaining the rest. This can be done in a variety of ways:

• If the property has multiple buildings, sell some buildings.
• If the property has a large parking lot, sell part of the lot as a development outparcel, or all of the lot as a paid parking facility.
• Divide the property into individual condominium units.
• Create a ground lease, which enables the ownership of the land to remain separate from that of the structures.

Hopefully, your real estate investment won’t trap you in a rabbit hole. With careful and creative advance planning, you can ensure several viable exit strategies in order to transition profitably out of property ownership.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Real Estate Investing 101 – 2019 and Real Estate Leasing Dumbed Down 2019.]