The “Tourte” of a Real Estate Investment

Most people have heard of Antonio Stradivari, who likely is the most renowned violin maker of all time. Few outside of the violin world, however, have heard of Francois Tourte, who developed the modern violin bow and has been called the “Stradivari of the bow.”

People understand that a quality violin can make a huge difference in the quality of sound produced. Students will spend weeks trying different violins to find the one which is “just right” for them. In the 17th and early 18th centuries, as is the case for many today, the bow was an accessory that came as part of the “violin package.”

Francois Tourte, an 18th century French violin maker, elevated the bow so great violinists now know that finding a bow of the best material[1], weight, balance, and suppleness for the violin and the violinist can make just as much difference in the music produced as the quality of the violin, itself. Indeed, many of the advanced violin techniques found in 19th and 20th century music are not playable using a 17th century-style “Baroque” bow.

Like the violin student, some real estate investors will spend months seeking out the perfect parcel of real estate. After signing a contract, the investor will spend a month or more and thousands of dollars conducting due diligence to be sure that the property meets the investor’s requirements.

Just as the violin student may overlook the importance of the bow, the real estate investor may overlook the importance of financing options and structure. Yet, the types and terms of financing used in the capital stack for a real estate investment, like the violin bow, can make just as much difference in the returns produced by a real estate investment as the selection of the real estate, itself.

In real estate finance, the various components of the “capital stack,” which can consist of various types of debt and equity are comparable to the material from which the bow is made. A simple structure might be one where the purchase puts 30% down as cash equity and obtains a standard, fixed-rate, 30-year mortgage from a bank for the remaining 70%.  More complex structures can contain preferred equity, mezzanine debt, and even multiple tiers of ownership.

However, the types of debt and equity and the balance between them isn’t all that needs to be considered, however.   The terms of the debt and equity also are important.  If the required debt service payments and preferred equity returns are too high, then the real estate investment may not be able to survive even a small, temporary dip in revenue or a small downturn in the economy.

Aside from the interest rate, the terms of the loan can make the difference between a successful investment and a financial failure. For instance, the term of the loan generally should be at least as long as the expected holding period for the property, so re-financing is not necessary.  On the other hand, prepayment penalties should be minimized or avoided altogether, as they may provide economic obstacles to disposition of an asset when necessary.  Further, in times of low interest rates, an assumable loan which, as interest rates increase will have a below-market interest rate, can add additional value to a real estate investment.

While in general increased leverage may improve returns on equity, an unrealistic debt service ratio could lead to foreclosure. Aggressive terms for triggering a lockbox will tie up cash, reduce flexibility in handling the property and very easily spiral into a mortgage default.

A real estate lender may be willing to negotiate some flexibility in the terms to accommodate the specific needs of the investor and accommodate unexpected events. However, once the situation arises all the negotiating power is with the lender. Taking the time and spending the money to have an experienced real estate attorney review and negotiate loan documents up front when the borrower still has some negotiating leverage will save time, reduce friction, and could save a real estate investment from loss.

Finally, capital stack structure can impact the tax consequences of a real estate investment, including the amount of deductions, whether cash flow is taxed at ordinary income or capital gains rates, and whether a Section 1031 exchange will be feasible upon exist from the investment. An experienced real estate attorney can, to the extent the investor’s needs are foreseeable, structure the capital stack optimally for the individual investor.

Just as Francois Tourte enabled violinists to perform at new, higher levels, an experienced real estate attorney can help the real estate investor structure the capital stack and negotiate debt and equity terms which provide greater protection of the investment and help to maximize investment returns.

[1]  Geek Note: Violin bows come in many different materials, the most desirable of which is Pernambuco, the heart of a tree grown in Brazilian rainforests. As modernization has encroached upon the rainforest, Pernambuco has become increasing scarce. Bow makers have turned to “Brazilwood,” which despite its name comes from a completely different tree and may not even be from Brazil. More recently, manufacturers have developed bows made with carbon fiber, which can compete with wood bows in responsiveness and are virtually indestructible, making them good options for young, advancing players, like my 12-year-old son, who enjoy testing bow destructibility. Finally, beginner bows may be made from fiberglass, which is also almost indestructible, but lacks in the suppleness necessary to produce more advanced bow techniques.

© 2017 by Elizabeth A. Whitman

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC.

SIZING UP IN VIOLINS AND INVESTMENT REAL ESTATE

If you have ever attended an elementary school instrumental music concert, you may need your parental pride to outweigh the general cacophony that is inflicted on your ears. Sometimes, however, you may find a group of violins that sound pretty good. Why is that?

Well, for technical reasons, string players can start younger[1]. As supply meets demand, violins can range from a 1/32 size up to full size.  Therefore, a child can start playing the violin on a tiny instrument at a very young age and “size up” on violins as he/she grows.

There are two strategies for obtaining violins for a child: rent or own. If you rent, you just pay each month for your child’s entire career.  If you choose to buy the violins, you will keep buying and disposing of increasingly more expensive violins.  I looked at the math and decided to buy my son’s violins.

My son started at age three playing a 1/32 size violin, which with an eight-inch body looked more like a toy than a violin. At age five, when he moved to a 1/10 size, we also found a need to move up a step in quality (and therefore, price) with each size increase.  A few months ago, my son traded in his ¾ size violin for a 7/8 size instrument, which is valued at 20 times the price we paid for that original 1/32 size violin nearly nine years before.

When we made the most recent violin purchase, I realized how our “investment” in violins is like real estate investment. A real estate investor might start small, with a single duplex.  That duplex might be sold and the money reinvested in a four-plex, and the four-plex might in turn, be sold and the proceeds reinvested in a more expensive three-story office building.  Eventually, through a series of purchases, sales, and reinvestments, the real estate investor may own multiple large apartment complexes, office buildings, or even high-rise mixed-use buildings.

Unlike with violins purchased for my son, a real estate investor has to think about taxes with every “trade up.” There are two ways that an investor might owe taxes upon sale of investment real estate – increase in value (i.e. the property is sold for more than what is invested in it) or a “recapture” of depreciation expenses that the investor took while he/she owned the investment real estate.  Although land cannot be depreciated, buildings can be, so there can be a significant tax liability upon sale of the investment.

One thing that helps real estate investors accomplish growth in is to use a Section 1031 exchange to defer taxes each time they sell an investment property and reinvest the proceeds in another “like-kind” investment property within 180 days.

When it was first created in 1921, a Section 1031 exchange required a literal swap of the two properties, as would occur if my son were to literally trade in his small violin at the violin shop for a larger sized violin.   For a direct swap, tax deferral makes a lot of sense.  It can be difficult to determine the “sale prices.”  Plus, unlike a sale and reinvestment, a sale doesn’t result in a cash payout from which taxes could be paid.

Therefore, over the years, Section 1031 exchanges have evolved so that they are more useful to real estate investors.

For instance, another option with violins, is to sell the smaller violin to another student and then use the money to buy the larger sized violin from the violin shop. Likewise, a real estate investor might choose to sell that duplex to Company A and use the proceeds to buy the four-plex from Company B.

For the past 30+ years, the tax law has allowed real estate investors to use what is known as a “qualified intermediary” to do the real estate equivalent by for instance, exchanging an apartment building sold to Company A with an office building purchased from Company B.   Without going into the detailed rules for this 1031 exchange, this would roughly equivalent to selling the smaller violin to another student, then putting the proceeds of the sale in a special savings account that could only be used to buy a new violin, once the desired instrument was located.

1031 Exchanges, however, are seen by some as a tax loophole for real estate investors. The Republican tax proposal “A Better Way” would significantly change the tax laws, including those on investment real estate. The proposal includes a full and immediate expensing of investment in place of depreciation.

Although this proposal might simplify the tax laws, it is likely to complicate the tax situation for many real estate investors. 1031 exchanges are not specifically mentioned in “A Better Way,” but some believe that 1031 exchanges might be abolished along with depreciation.  If that were to happen, real estate investors likely would be taxed on their proceeds upon sale of their real estate.  This would limit available cash for real estate investors’ to “trade up” and potentially could slow down the recovery of the real estate market.

Therefore, although it seems likely that there will always be a crop of younger violinists in need fractional-sized violins as you “trade up” to larger instruments, tax laws may not always make it as easy to “trade up” your real estate investment.

© 2017 by Elizabeth A. Whitman

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[1] Geek fact: A partial explanation is that strings of different length can reach the same pitch by changing the tension, while wind instruments require a certain length of the air column to produce a pitch.  So if you want to start your five-year-old on a bassoon, you may need to stretch him a bit first. Also, wind instruments require a developed mouth and certain number of permanent teeth, which are not required for string instruments.

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC.