Financial Poise
real estate exit strategy

An “Eject Button” is not a Viable Real Estate Exit Strategy

If you ever watch Saturday morning cartoons, you may notice that every time a hero like Bugs Bunny gets stuck in a tight spot, there is always an “eject” button to catapult him safely out of danger. Not only is this entertaining to watch, but it also offers up a valuable lesson for adults: You should always have a reliable exit strategy for a variety of situations. This is particularly important in the context of real estate investments, which are not easily and quickly liquidated. Having a real estate exit strategy in place before you need one can save you the panic of feeling trapped down the road when you’re ready to get out.

You should always have a reliable exit strategy for a variety of situations

Some investors buy real estate with the intent to hold the property indefinitely, or at least for their lifetime, so that they can pass it along to their heirs with a stepped-up tax basis. This may be a good plan if the property is generating net income, but what if the property becomes a cash drain? Or what if the next generation is unwilling or unable to manage and maintain the property? A real estate exit strategy is important no matter how long you plan to hold the asset.

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Potential real estate exit strategies are best planned in advance, before you buy the property in the first place, and tested and modified as conditions change. Do you really want to wait until you are careening off the cliff before finding out whether your “eject button” provides a parachute for a gentle landing?

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 may 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 – Because the pricing of commercial property is based on cap rates, your 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-let the space, and how long will that reasonably take? 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.
  • 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? 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 (prepayment) 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 onto 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, or a point in time when there is a marketable amount of term left on the lease (such as five, seven or 10 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
  • 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 may plan to sell once the improvements have been completed 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

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 your building, or sells its business or assets to another company, or if a lease guarantor dies or becomes insolvent, you will likely need to adjust your exit expectations until replacement tenants or guarantors are found.

Additionally, if you own the property with one or more partners, your timing for a sale may be hastened by a disagreement among the parties, a transfer of a partner’s interests, or a partner’s need for liquidity.

Financing 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, or
  • use equity invested in the property for some unrelated purpose.

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

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If you currently own a property free and clear of any mortgage, a loan will allow you to take some of the equity you have invested in your asset and use it to make improvements to the property, or for other purposes unrelated to the real estate. An added benefit is that proceeds from a refinance are not immediately taxable.

Refinancing an existing loan can also achieve the same result. Depending on the lender, the terms of the loan, the credit of the tenant(s), and then-current interest rates, commercial loans may be extended for short periods of time, say 1-2 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 are able to 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. A mortgage lien will have to be either satisfied or assumed and assigned before the borrower can receive proceeds from a sale of the property. Financing should therefore be used only with careful planning, taking your investment goals into account.

Reposition your Real Estate Investment

If the market is not favorable for a sale or refinancing at the time you want to exit your investment, a repositioning or repurposing of your property may unlock value. For example, if you own an apartment building, you may 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 your property, as will making capital improvements to increase the longevity of your building.

Changing the use of a property (or a portion of it) typically 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 into a residential space (or vice versa), or adding or eliminating parking areas; are all examples of repurposing that potentially could better position your property for a sale.

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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 can increase the value of the property and its appeal to purchasers who won’t have 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 in the property. One significant challenge of changing your investors is how to value the property interests being transferred. If you have multiple owners, you must establish how the property will be managed, and how proceeds will be distributed going forward. Note that if you have a mortgage on the property, you will need the lender’s consent for this type of transaction. 

Undertaking capital improvements to building structures and systems can increase the value of the property and its appeal to purchasers who won’t have to do that work themselves in the future.

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

You may also like the Financial Poise webinar, “Due Diligence in Real Estate Deals

Hopefully, your real estate investment will not prove as eventful as a day in the life of Bugs Bunny or the Road Runner. With careful and creative advance planning, you can give yourself several viable exit strategies so that you can transition profitably out of property ownership.

Read more: Real Estate Partnerships – the Good, the Bad, and the Ugly

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About Tracy Treger

Tracy is a Principal at Syndicated Equities where she helps high net worth individuals and family offices to profitably invest in real estate. She also assists investors in identifying appropriate replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code. Drawing upon her 20 years of legal experience in the areas…

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