This is the fourth piece in a five-month series of REIT Advisor that provides a high-level overview of the advantages and disadvantages of individual strategic alternatives for private real estate portfolios. This month’s REIT Advisor focuses on the ultimate exit from the portfolio through sale to a third party. The sale alternative may be structured as a sale of the underlying portfolio itself or equity interests in an investment vehicle. The primary benefit of the sale transaction is the realization of the proceeds previously invested in the transaction. Each of the following issues are key considerations that a company should take into account in determining if a sale transaction is the best path to pursue.

Timing

The pricing of the portfolio is certainly central to the selection of the sale alternative. When determining the sale price of the portfolio, many factors will contribute to the calculation of an expected or desired price. While some of these variables will be within the control of the selling company, such as the condition of the properties, others will be more market driven and independent of any actions taken by the seller. One of these more fluid variables is timing. The market for a specific asset type varies over time, and if a company desires to seek a sale of its portfolio during a time period in which the market is trending down, the price that potential buyers will be willing to pay will be lower than if the market was more expansive. In these situations, a company may need to realign its expectations or choose a different strategic alternative.

Tax Positioning

The structure and timing of the transaction is largely driven by the tax position of the portfolio and the tax attributes of the existing investors and the buyer. For example, if one of the investors is a foreign investor who requires investing through mini-REITs, then you may have to exit only through a sale of the REIT shares in that mini-REIT (i.e. an entity sale). This can limit your potential buyers and also the ultimate liquidity value of your portfolio or assets. Furthermore, you may have investors that desire to wait until a subsequent year for tax gains, or may want to accelerate to take advantage of certain tax issues in the current year. Finally, you may want to try and position the sale for a 1031 tax free exchange which can affect timing and the ability to execute on your sale transaction. These tax considerations can affect timing, structure, and ultimately the price you may get for the portfolio. The key is to understand the tax issues on the front end of any investment and also before planning the exit strategy.

Post-Closing Liabilities

The decision to structure the sale as a portfolio sale or an equity interest sale will have important ramifications on the ability to limit trailing liabilities after closing. The reasons for this are that in equity interest deals a purchaser is unable to diligence the “title” to what it is acquiring (equity interests) and will not receive a title policy insuring it as the owner of the equity interests. Therefore, a seller in an equity interest sale will have to be willing to live with more extensive potential post-closing liability in order to account for the higher risk profile that the purchaser is incurring due to the structure of the transaction. The following are several common approaches to limit extensive or open-ended post-closing liability in sale transactions or alternatively to protect post-closing liability issues if you are the buyer.

• Survival Period - Any representations and warranties that survive closing should be limited to a survival period. Some examples of recent transactions include:
  • Portfolio Asset Sale: 6 months to 1 year
  • Equity Interest Sale (tiered structure based on type of representation)
    • Property-related representations: 6 months to 1 year
    • Representations related to the entity being acquired, the financials of the investment vehicle, and items related to the entity’s tax status and filings: approximately 2 years
    • Representations regarding ownership of the equity interests: Sellers should push to set some sort of expiration date, such as 5 years from the closing for these ownership representations, but purchasers may be reluctant to accept such a time period given that in asset sales a purchaser is used to getting title insurance, while in equity deals you have unknown contingent liabilities and other risks that cannot be insured or diligenced
• Cap/Basket – By requiring a cap and a basket (or floor), a company can control its exposure to liability after the deal is done. A basket creates a floor such that the purchaser cannot make claims for any liability unless the amount due exceeds a certain threshold. Once purchaser’s claims reach this threshold then it may make such claims to seller. Any liability of seller after the basket threshold has been met should be subject to a cap. Seller’s liability can be from the first dollar of any claim by Purchaser or from the first dollar after the basket has been exceeded, as negotiated between the seller and purchaser. Equity sales present unique issues given the potential for unknown liabilities and claims that may exist in buying an existing entity. Examples of some recent transactions in equity include:
  • Portfolio Asset Sale: basket of 0.5% of purchase price and cap of 1% of purchase price
  • Equity Interest Sale (tiered structure based on type of representation)
    • Basket (general): 0.5% of purchase price
    • Property-related representations: cap of 1% of purchase price
    • Representations related to the entity being acquired, the financials of the investment vehicle, and items related to the entity’s tax status: cap of 5 – 10% of purchase price
    • Representations regarding ownership of the equity interests: generally not capped or subject to much larger cap than 10% of the purchase price

Third Party Consents

A sale of either a portfolio or the investment vehicle that owns the portfolio may require consents from third parties. For example, an equity interest sale may require lender consent for any loans entered into by the underlying property owners. Additionally, upper-tier equity holders may have consent rights over either type of sale structure. Any requirements for third party consents can increase the amount of time required to consummate the transaction and the costs related therewith. Additionally, third parties may use the threat of denying approval to seek a favorable amendment to the existing arrangement or an additional fee.

Transaction Costs

Transaction costs for a sale transaction may include items such as property-related diligence (updated surveys, title commitments, etc.), transfer taxes, recording fees, and brokerage commissions. The locations of the properties in the portfolio will be critical to determining the transaction costs because each state and local jurisdiction have customs regarding the allocation of costs that parties traditionally follow. One transaction cost that can be quite substantial is transfer taxes. These taxes are generally assessed at a state level, but can also be assessed at a county and city level as well. Additionally, while some transaction costs, such as title policies, may be able to be avoided through structuring the transaction as a sale of equity interests rather than a sale of the portfolio, transfer taxes may still be owed in an equity transfer. The transfer of a direct or indirect interest in a property-owning entity may trigger the payment of a transfer tax in some jurisdictions just as if the property itself had been transferred. Therefore, it is critical to understand the local law and custom of the jurisdiction of each property so that these transaction costs can be factored into any underwriting done by a seller.