MetLife Inc. had an ulterior motive when it purchased the 1.5 million sq. ft. One Mellon Center in Pittsburgh earlier this summer for $185 million: The insurance giant wanted to defer capital gains taxes from an earlier real estate sale.

MetLife is just one of an increasing number of investors intent on avoiding hefty tax bills by rolling their proceeds into the purchase of another “like-kind” property. The burgeoning 1031 exchange market attracts a wide range of investors, from corporations and real estate investment trusts to individuals selling condos or other rental properties

The frenzied real estate investment market is funneling billions of dollars into the 1031 exchange market. Statistics on 1031 exchanges are sketchy at best, but industry experts estimate that 1031 exchanges currently account for about $90 billion in annual transactions.

Enormous demand for exchange properties is resulting in a dramatic shortage of quality options. “There are 10 buyers for every good property out there,” says Sterling Champ, a senior vice president in the Glendale, Calif., office of CB Richard Ellis. The intense competition for 1031 replacement properties — and commercial real estate in general — is driving buyers to pay more for properties. Cap rates have dropped about 150 basis points in the past two years.

The shortage of quality investment real estate is prompting buyers to become more creative in their search for viable like-kind replacement properties. In addition to competing on price, some buyers are willing to offer the seller the incentive of a quick closing. Still other buyers are willing to enter different markets, venture into other property types, or even commission build-to-suit properties.

One question is whether the intense competition for real estate coupled with the strict time limits of an exchange are prompting 1031 investors to make poor choices. Investors planning an exchange have 45 days from the date the relinquished property closes to identify potential replacement properties. After the 45 days have passed, exchangers may not change their property identification list and must purchase one of the listed replacement properties, or the exchange fails. The purchase of the replacement property must be completed within 180 days after the close of the relinquished property.

“Earlier this year, the heavy demand was making it difficult for taxpayers to successfully complete their exchange into a property which made economic sense,” says Cecily Drucker, Esq., president of San Francisco-based Independent Exchange Services and executive vice president of Reverse Exchange Services. “There just was too much 1031 money chasing too few properties.” For example, Drucker recently represented a 1031 client who spent about 200 hours identifying a single replacement property.

Double-edged sword

Buyers continue to be aggressive on pricing in order to land deals. Sale prices on commercial properties sold in August averaged $136.79 per sq. ft., up from $119.73 during the same period a year ago — a 14.2% increase — according to New York-based Real Capital Analytics.

A 1031 exchange puts the taxpayer in the unique position of both seller and buyer. “As a seller, the taxpayer is very happy to sell its property at an unbelievable price. However, when the taxpayer now becomes a buyer, they cannot believe what unbelievable prices other sellers are asking for their properties,” Drucker says. “So, the real estate investor is their own best friend and worst enemy.”

Finding even a single property that constitutes an attractive acquisition is tough in a frothy investment market. But exchangers typically identify multiple properties to ensure a closing within the allotted time frame. “If you find a property that you like, nine times out of 10 there are other folks looking at that as well,” says attorney Aasia Mustakeem, a partner in the Atlanta real estate finance and development group at lawfirm Powell Goldstein Frazer & Murphy LLP. “Investors are finding that if they don't move quickly, they are ending up buying properties that are not their first choice,” Mustakeem says.

Some investors end up paying the capital gains tax because they are unable to find a replacement property at a desirable price. Duke Realty Corp. of Indianapolis recently sold a $1 billion portfolio of office showroom properties, and in the short term the company does not plan to enter into any 1031 transactions.

Instead, the REIT is using the proceeds to pay off short-term debt, provide a special dividend to shareholders and buy back shares of its stock. “We think buying back shares is good or better than many of the real estate transactions we're looking at because the properties are very highly priced,” says Matt Cohoat, Duke's executive vice president and CFO. “It's difficult to find an economic exchange.” Duke's management team believes that its stock, which has been hovering at about $32.80, is not fairly valued. The REIT also plans to pay its special dividend of 90 cents to $1.20 per share in the fourth quarter.

Unconventional pursuits

What's clear is that many 1031 investors are becoming more creative in order to secure a like-kind exchange and defer the taxes. For example, CB Richard Ellis closed two significant 1031 deals this year with large commercial real estate developers who were willing to be flexible in order to lock in a 1031 exchange.

One developer purchased 77 KFC properties after selling an office building in West Los Angeles for $110 million. The 1031 investor viewed the KFC restaurants as an opportunity to buy a large portfolio at a discounted rate with the potential to turn around and sell individual stores for a higher price at a later date, Champ notes.

The second developer opted to fill his exchange requirement with 16 Walgreens stores after selling an office building in Beverly Hills, Calif., for $100 million. “I think the liquidity of his investments are the key to what he's trying to accomplish,” Champ says. Even though the Walgreens stores are pricey at cap rates of 6.2% to 6.4%, they are in high demand because Walgreens is a strong-credit tenant.

If either of those developers could have found a quality, reasonably priced office building in their marketplace, they would have likely bought it, Champ says. But because they couldn't, both investors pursued alternatives that would provide flexibility and liquidity in regard to their future investment strategy, he adds.

That type of maneuvering for a temporary fix rather than a long-term hold does raise concerns. Industry experts are wary of investors who are buying simply to satisfy exchange requirements. “Will people get burned? Yes, I think so, because pricing tracks interest rates, and people may get caught paying too much for these properties,” Champ says. Paying high prices for properties not only reduces returns, but it also puts owners in a position where they are carrying more debt than a property is worth.

Old favorites

Net-lease properties occupied by investment-grade tenants such as Walgreens or KFC are a favorite among 1031 buyers. Net-lease properties, often purchased via a sale-leaseback, are popular with investors because they typically involve a single tenant that is committed to a long-term, triple-net lease. These properties are known for providing steady cash flows and long-term appreciation in value.

Net-lease properties appeal to corporate and individual investors because they offer stable income, minimal management responsibilities, and they are highly liquid. “One of the beauties of a net-lease property is that you can buy it, sit with it, and sell it. It is very much a commodity,” says Bruce MacDonald, president of Boston-based Net Lease Capital Advisors.

Net Lease Capital Advisors recently represented a client who sold his West Coast apartment portfolio and ended up buying $73 million worth of net-lease industrial and retail properties, including CVS drug stores. However, the client is not a retiree and was not necessarily searching for a more passive investment. “The driving factor was that he could count on the certainty of closing the sale, and he was confident that he could resell the net-lease properties in the future. And if not, he's confident in the purchase as a long-term investment,” MacDonald says.

Net-lease, or credit-tenant, deals are underwritten based on the credit rating of the tenant who has committed to a long-term net lease. But while net-lease properties are often treated as a commodity, MacDonald does not advocate buying net-lease assets with the intent of turning around and re-selling the properties. Net lease properties should be purchased for long-term investment purposes, he says.

Still, some investors are venturing into the net-lease arena for the first time because traditional opportunities have dried up. “They're saying, ‘Let me buy something that I feel secure about. If I hold it forever, great. If not, I may sell it and buy something else,’” MacDonald says.

Attractive TICs

Intense competition for freestanding properties is one factor driving the growth of the tenant-in-common industry. TICs allow investors to acquire a fractional interest in real estate. “What TICs have done is open up larger investment properties to the smaller investor,” Champ says. For example, investors with as little as $50,000 to $100,000 in some cases can buy a stake in a high-rise apartment building in Manhattan or a shopping center in Atlanta.

Not only do TICs qualify as like-kind property, but TICs also are relatively simple to buy into, which makes it easy to meet the time constraints of a 1031 exchange. Other TIC incentives include stable cash flow and the chance to own institutional-quality assets without the headaches and time commitments of managing the real estate.

“Because it is harder to find stand-alone properties, TICs offer more options and flexibility for individual investors,” says Patrick Dowdall, managing director of the Boston-based Atlantic Exchange Co. “Certainly, more of your individual investors are buying TICs than they were three to four years ago,” Dowdall says. Dowdall is the current president of the Federation of Exchange Accommodators, whose membership jumped 29% over the past year to 345 members.

The booming TIC market is expected to raise nearly $4.2 billion in equity this year — more than twice the $1.8 billion TICs raised in 2004, according to Salt Lake City-based Omni Brokerage Inc. Omni tracks data from 59 securitized TIC sponsors — those sponsors that sell TICs as securities in accordance with U.S. Securities and Exchange Commission regulations.

“One thing the TIC market has done is magnify acceptance and awareness of 1031s for the whole real estate market,” MacDonald says. “TICs have made 1031s much easier and much more available to smaller individual investors, and that is just fanning the flames of 1031 activity.”

Reversing the order

Another option for 1031 investors is a reverse exchange. Essentially, a reverse exchange allows the taxpayer to acquire a replacement property, and then proceed with plans to sell the existing property. “In the last three to four months, we have seen an increase in the number of reverse exchanges,” Dowdall says. “Part of that phenomenon is that people want to make sure they can nail down the replacement property.”

In a reverse exchange, a 1031 investor will identify or sign a contract to purchase a like-kind property, and then use an experienced accommodator, such as Drucker's Reverse Exchange Services, to structure and execute the reverse exchange on their behalf. “This gives the taxpayer the time to sell their relinquished property in a favorable transaction, without having the time-bomb ticking for the identification and closing of their replacement property,” Drucker says. The taxpayer still has to complete the exchange within the IRS' 180-day time period, but it can relieve some of the pressure of identifying a replacement property.

“We are talking with several exchangers who will neither sell nor begin their exchange until they are sure they've found an attractive property to acquire,” says Kate Gallivan, vice president of product management at Rockland, Mass.-based J.P. Morgan Property Exchange Inc.

For example, J.P. Morgan Property Exchange represented a REIT that sold 20 properties last year and was able to complete like-kind exchanges on 15 of those transactions by using both forward and reverse exchanges. The REIT's tax director worked closely with the acquisition and disposition department to know what was in the pipeline. Essentially, the REIT created an “inventory” of replacement properties that could be timed with dispositions.

What's ahead for 1031s?

Several factors will continue to drive 1031 activity, including a hot real estate investment market and increasingly sophisticated investors. “Investors are becoming more knowledge in terms of what they can do with 1031s,” says Todd Williams, an attorney and vice president of marketing at Argus Realty Investors LP in San Clemente, Calif.

For example, investors are using 1031 exchanges to move between different types of investment properties, as well as to diversify real estate portfolios by region and property type.

Two factors that could impact 1031 activity are changes in tax laws or a significant hike in interest rates. The 10-year Treasury yield registered a relatively low 4.39% in mid-October, and many industry experts believe interest rates will have to rise 150 basis points before they begin to negatively impact real estate investment activity.

Yet some believe a rise in interest rates could turn out to be a good thing for 1031 investors — and the real estate investment market in general — if it helps to cool an overheated sales market.

And while the IRS has announced plans to examine 1031s as they relate to the exchange of intangibles such as patents and copyrights, there is no indication that the IRS is planning on changing 1031 law related to real estate exchanges in the next year or two.

As a result, many industry experts expect the thriving 1031 market to not only sustain its current pace, but also to gain even more momentum. “The 1031 activity is extremely strong,” MacDonald concludes. “We don't see any slowing down whatsoever.”

Beth Mattson-Teig is a Minneapolis-based writer.

1031 Exchange Hazards

Deferring capital gains taxes can lead to costly mistakes.

Banking on continued appreciation in their residential properties, many 1031 exchange buyers are in for a rude awakening, industry experts warn. The hot investment sales market has led individual investors to cash in on residential properties that have appreciated dramatically and reinvest that money in even more expensive properties.

It's easy to understand why. The median price of a home in California reached $568,890 in August, up 20.1% from a year ago, reports the California Association of Realtors. Nationally, the median price of existing homes rose 9.3% in 2004 and is projected to rise 5.6% this year.

“I think that there will be some of these 1031 investors who will rue the day when they decided to do an exchange, rather than pay taxes at the historically low 15% capital gains rate that we have now,” says Cecily Drucker, Esq., president of San Francisco-based Independent Exchange Services and executive vice president of Reverse Exchange Services.

Tax law changes lowered the capital gains tax by 5% in 2003. Although most taxpayers pay the 15% rate, capital gains taxes can range between 5% and 35%, depending on income levels and how long an investor has owned a property.

Investors disappointed with dismal returns in the stock market have been turning to real estate investments, oftentimes purchasing single-family homes and condos and renting them out. The concern with that practice is that, in the short run, the rental income doesn't usually cover the entire carrying cost, which includes the debt service, homeowners' dues, taxes, insurance, and possibly some utilities. Many buyers are willing to gamble that property appreciation will offset any negative or nominal cash flow.

Additionally, many properties have been purchased with adjusted rate mortgage (ARM) loans, and as interest rates rise, the carrying costs will increase faster than rents. Since June 2004, the Federal Reserve has raised short-term rates 11 times, driving the prime-rate benchmark for adjustable home-equity loans from 4.25% to 6.75%, its highest level in four years. “Will the taxpayers be willing, and able, to continue to feed their real estate?” Drucker questions. “If not, when the investor wants to sell these properties to get rid of the drag on their cash flow, will there be a market to buy these properties at prices which result in the taxpayers getting what they consider a decent return?”

Those concerns resonate with Federal Reserve Chairman Alan Greenspan, who continues to warn investors — particularly homeowners — about a potential decline in home values. Indeed, some markets have already begun to see a decline in their housing values. Sacramento, for example, saw its median home price decline to $394,450 — down 4.5% compared to a year ago.

“Everyone is looking for the next hot market or the next dot-com,” says Todd Williams, an attorney and vice president of marketing at Argus Realty Investors LP in San Clemente, Calif. “That in itself should be cause for tremendous caution. Housing should never be something that fluctuates in value like a stock.”
— Beth Mattson-Teig