What’s a 1031 Exchange?

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A 1031 exchange, otherwise known as a tax-free exchange, is a process by which an investor is able to defer paying capital gains taxes when selling an investment property by reinvesting the proceeds of the sale into a “like-kind” property or properties of equal or greater value within certain time limits as defined by Section 1031 of the U.S. Internal Revenue Code. This definition contains a number of operative terms that require elaboration.

“…defer paying capital gains…”

Capital gains are calculated by based on the investment’s adjusted basis, which is the original basis plus any capital improvements minus cost recovery deductions. The value of the cost recovery taken is taxed at a different rate and included in the taxable income from the sale.

“…when selling an investment property by reinvesting the proceeds of the sale…”

One of the requirements for a 1031 exchange is for the sale proceeds to be transferred to a “qualified intermediary,” an independent, third party, which then transfers those proceeds to the seller of the replacement property or properties. The seller of the original property can at no point handle the funds.

“…into a ‘like-kind’…”

This refers to the classification of the asset according to the Internal Revenue Code (IRC), in this case Section 1231, property held for use in trade or business. This means that a residential property can be exchanged for an office property and/or vacant land can be exchanged for an industrial property as long as they are held for investment purposes.

“…property or properties of equal or greater value…”

Sellers are allowed to identify 3 like-kind properties regardless of their market value (three-property rule) or an unlimited number of properties as long as their total market value does not exceed 200% of the property being sold (200% rule). Another less commonly known or used option is the 95% rule, which allows the seller to identify more than 3 properties with a total value that is greater than 200% of the property being exchanged IF they acquire at least 95% of the value of the properties identified.

“…within certain time limits…”

The timeline under a 1031 exchange are measured from the sale of the property being exchanged. Sellers have 45 days to identify/nominate (in writing) the prospective replacement property or properties and 180 days to acquire/close on the same (not 45 days plus 180 days).

“…as defined by Section 1031 of the U.S. Internal Revenue Code…”

The IRS strictly enforces the rules and regulations governing 1031 exchanges and due to their complexity it is advised that investors seek the guidance and assistance of licensed professionals when handling such transactions.

Pop Quiz, Hotshot: The Build Out Cost Came in Higher Than Expected. What Do You Do?

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Construction costs have been going up for years.  I remember when I started in the industry in 2008 when $40-$50/SF would cover a full, turnkey office build out. Today, it seems like $70/SF is a minimum estimate. Granted, there’s more glass than ever in “building standard” build outs, but VCT (Vinyl Composition Tile), which looks like real hardwood but is more durable and costs the same as commercial carpet (tiles), is also standard. Exposed ceilings, all the rage, are significantly more expensive than ceiling tiles, which have seen a dramatic increase in quality coupled with (dimmable) LED lights.

We’re still in a relatively tenant-friendly market. Landlords are still having to compete for tenants, but due to oversupply, access to mass transit, etc. rates have not increased as much as construction costs. The DC market average asking rent is $37.53/SF. If you use easy math and divide $70/SF by the average asking rent you get 1 ¾ years before the landlord makes back their initial investment… and that’s not taking into account brokerage commissions, actual net rent, etc.

Whatever the reason, 5-year terms can no longer justify the cost of a full, turnkey build out. We live in a world of 6 and 7-year leases now… but what if your client wants a shorter term? What do you do?

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One option would be to increase the base rental rate by amortizing the improvements (above the cap) over the term of the lease. If the build out costs $90/SF and the landlord’s pro forma has only allotted $70/SF for the negotiated rate and other economic terms of the lease, there would be an outstanding balance of $20/SF. Without taking into account the time value of money or the amortization rate, for a 5-year lease that would equal an additional $4/SF/yr… and that escalates annually. While rental payments are fully deductible, it’s still more cash out of pocket and the landlord may not agree to this deal structure; preferring a longer term.

Another option would be to “give back” any months of rental abatement previously negotiated. The economic value of the free rent could potentially offset the additional build out costs. If we use the previous case in which the tenant prefers a 5-year term and there exists a $20/SF balance, the rent would need to be $40/SF for 6 months of free rent to offset the amount and $48/SF if the tenant is only able to negotiate 5 months of rental abatement. Both of these rents are well above the metro average, which means that in most cases rental abatement forfeiture would not be sufficient; requiring additional economic concessions on the part of the tenant. The benefit of this strategy is that it involves no money out of pocket for the tenant. The downside is that free rent is very helpful to offset up front costs associated with leasing commercial space, i.e. moving, furniture, cabling/wiring, etc.

The simplest and most obvious solution is for the tenant to pay for the balance in cash. Of course, the “easy way” is rarely the best and this option is the least desirable for a number of reasons. The time value of money states that money today is worth more than money tomorrow. By coming out of pocket today the tenant is expending capital that could be put to more productive and profitable uses. Also, while a tenant enjoys beneficial occupancy of the real estate they do not own it, and at the end of the lease term the space reverts back to the landlord; meaning the tenant is paying to improve someone else’s property. Office build outs are generally “turnkey-ed” by the landlord; meaning they manage the entire process from architectural drawings to permits to the actual construction and are responsible for all the costs (and risk). Tenants do not want to have to run their business AND manage a construction project, but if the landlord places a cap on the allowance and the estimates exceed that cap they suddenly have an interest in the management of the build out. This is because the landlord knows that they will have to spend the $70/SF (in this case), but anything above that will be at the tenant’s expense. Therefore, they don’t necessarily care if the project costs $90/SF or $100/SF… it’s not their money at that point. In cases such as this the tenant will want to hire their own construction manager to oversee the landlord’s work to ensure it’s done to budget, on time, etc.

The best alternative for the tenant is to agree to the longer lease term with a termination option after 5 years. This option allows the tenant to retain all the rental rate and abatement concessions and only pay the unamortized transaction costs (brokerage commissions and build out cost) and a termination penalty IF they decide to terminate. Termination penalties are generally quantified in terms of months of rent. Timeframes for notice and the point after which the tenant can terminate the lease are also points of negotiation. The greater the notice period the more time the landlord has to market and relet the space thereby providing justification for a lower termination penalty. A good rule of thumb is to analyze the average absorption rate for the submarket, asset class, and property type and negotiate a combination of notice period and termination penalty based on that time. For example, if the average rate for similar spaces in the submarket in which the property is located is 2,000 SF per month and the tenant is vacating 18,000 SF the tenant might propose a notice period of 6 months with a 3-month termination penalty.

12,000 SF (2,000 SF x 6 months) + 6,000 SF (2,000 SF x 3 months) = 18,000 SF

In this scenario the tenant gets to have their cake and eat it too. They are able to negotiate a market rental rate, keep their rental abatement (potentially negotiate additional months based on the longer lease term), get a full turnkey build out (no capital outlay), and control the space all while shifting the risk to the landlord. Understandably termination options are not favored by landlords, but if the tenant is financially strong and the terms are reasonable the landlord should be willing to agree to one in order to get the deal done.

Northern Virginia’s Town & City Submarkets Q3 2019

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Northern Virginia’s Town & City submarkets include Fairfax City, Falls Church, Vienna, McLean, Oakton, and Great Falls (in order to rentable building area). Of the combined 13,509,588 total square feet only 1,592,828 SF is comprised of 4 & 5 Star properties (11.8%). The fact that these submarkets’ average asking rents are below the metro average ($37.53/SF) is the result of the predominance of 3-Star and 1 & 2-Star properties and not necessarily due to supply and demand fundamentals as evidenced by the fact that all but Oakton have vacancy rates below the metro average (12.95%). Tenants that choose to locate their business in these submarkets do so for different reasons than traditional office users; making these submarkets unique when negotiating lease terms. Oftentimes, it’s “take it or leave it.”

Fairfax City

  • RBA: 5,047,260 SF
  • Vacancy Rate: 10.8%
  • 12 Month Net Absorption: 46,300 SF
  • Average Asking Rent: $24.78
  • 12 Month Rent Growth: (0.6%)

The number of office condos in Fairfax City and non-institutional landlords/owners impact market fundamentals in a way that is more reflective of said owners’ individual, financial “market” than outside market conditions.

City of Falls Church

  • RBA: 2,829,773 SF
  • Vacancy Rate: 12.6%
  • 12 Month Net Absorption: (32,600 SF)
  • Average Asking Rent: $25.49
  • 12 Month Rent Growth: 1.1%

Town of Vienna

  • RBA: 2,007,856 SF
  • Vacancy Rate: 7.5%
  • 12 Month Net Absorption: (9,500 SF)
  • Average Asking Rent: $28.56
  • 12 Month Rent Growth: 1.5%

Vienna apparently has 662,589 SF of 4 & 5-Star properties, but you’d be hard-pressed to identify them.

McLean

  • RBA: 1,701,139 SF
  • Vacancy Rate: 10.6%
  • 12 Month Net Absorption: (45,500 SF)
  • Average Asking Rent: $31.38
  • 12 Month Rent Growth: (0.4%)

Despite having ZERO 4 & 5-Star properties, McLean has the highest average asking rent of these submarkets at $31.38/SF. Proximity to DC matters.

Oakton

  • RBA: 1,649,594 SF
  • Vacancy Rate: 16.4%
  • 12 Month Net Absorption: (5,400 SF)
  • Average Asking Rent: $27.26
  • 12 Month Rent Growth: 2.0%

Poor Oakton. At 16.4% this is the only submarket in this category that has a vacancy rate higher than the metro average.

Great Falls

  • RBA: 273,966 SF
  • Vacancy Rate: 7.2%
  • 12 Month Net Absorption: (5,000 SF)
  • Average Asking Rent: $25.97
  • 12 Month Rent Growth: 2.2%