Buying and selling real estate: advising clients.by Mildner, Mark E.
Today, the purchase or sale of real estate places significant burdens and transaction costs on both buyer and seller. It involves property inspection, negotiation of contract terms, price, adjustments, mortgage terms, fee or leasehold purchase, closing date of title, and much more. In addition to all the usual problems and concerns of any business activity, the cost of real estate transactions has increased because of the size and importance of the transactions, involvement of state and local governments seeking increased revenues, environmental regulations dealing with pollution, asbestos encapsulation or removal, and use restrictions such as zoning and height.
FORMS OF OWNERSHIP
Three typical forms of real estate acquisition are:
* Outright ownership of land and/or building (fee ownership and/or leasehold interest);
* Condominium, and
Condominium. A typical description of a condominium is several residences within one building or a multi-unit building on one tract of land where fee simple title (divided interest) to an individually owned unit is combined with joint ownership of common areas of the structure and land (undivided interest). A condominium unit denotes a separate ownership and title and allows for formal filing and recording of a divided interest in real estate. The unit may be separately sold, leased, mortgaged, or handled the same as any individual piece of real estate. Owners of units usually form an association to manage the common areas (undivided interest) in accordance with adopted by-laws. Expenses of management and maintenance are divided among owners, according to their ownership percentage.
Cooperative. In a typical cooperative, the operating, maintenance and control are exercised by a governing board elected by the stockholders. Legal ownership of the entire property is vested in a corporation. Stockholders of the corporation are given the right to occupy specific units. Each stockholder receives a proprietary lease to a specific unit and is obliged to pay a maintenance charge which represents the pro rata share of operating expenses and mortgage costs, which are in turn paid by the corporation. Originally, each unit is assigned shares based on an appraisal. The owner of a cooperative unit is the holder of personal property (capital stock) rather than real estate, which is owned by the cooperative corporation. The owner is not able to place a mortgage on his unit but can borrow on a personal basis using shares as collateral. While the sale of cooperatives has traditionally been considered transfers of personal property, the trend is toward treating these transfers as real estate transactions and subjecting them to applicable real estate transfer and gains taxes.
A CPA plays an important role in advising clients who intend to purchase or sell real estate. Tax implications are only one factor in the complicated maze. A CPA's role includes understanding and analyzing tax implications, reviewing historical financial history and future projections and forecasts, assisting either the buyer or seller in contract negotiation and arranging financing, and providing general business advice as an outsider who does not have a vested interest in the transaction. Many CPAs have years of experience in real estate matters and in helping clients in such matters.
THE PROCESS BEGINS WITH
THE INSPECTION OF
The three main kinds of inspection are structural, legal and environmental. Generally, a potential buyer will inspect or have an expert examine the physical condition of a proposed purchase very carefully. The reasons are obvious because of the substantial funds involved, as well as the length of time and purpose for which the buyer plans to use the real estate. The seller may make certain cosmetic improvements to the property to enhance its value prior to being offered for sale. The buyer will look for evidence of deferred maintenance as well as the type and age of property. The structural review will normally be done by engineering consultants and pest control experts.
Without question, the legal review can be extensive, starting with a title search, which will include encumbrances, mechanic's liens, judgments, property tax, water, sewer rent, easements, survey including parking violation judgments and environmental control board liens, and municipal searches for violations and compliance. This is only a partial list, which grows every year.
Knowledgeable purchasers and sellers now utilize their CPAs, not just for financial study and evaluation, but also for determining purchase price, transaction costs, financing costs, rental revenues and operating expenses. Purchasers want to know what cash flow is actually being generated by the real estate. The CPA may be able to identify opportunities for increased cash flow, or why the cash flow will decrease.
Environmental concerns include presence of asbestos, water, and land pollution caused by legal or illegal dumping, and oil storage. The principals should also pay attention to the surrounding area for potential environmental problems. The general neighborhood, transportation facilities, traffic flow, utilities, school facilities, shopping, houses of worship, as well as the types of garbage removal have to be evaluated. Competition has to be investigated as well as layouts, square footage, average rents, lease maturities, lease incentives and prospects for rent increases.
OTHER FACTORS MUST BE
Other factors presently affecting the real estate market are current economic conditions, the savings and loan problems, and a change in the benefits of syndication. When the growth of the U.S. economy slows, the demand for housing generally declines. The present economic conditions and level of building have resulted in an oversupply of real estate space in a number of markets. The savings and loan debacle is also contributing to this oversupply as many real estate properties are offered for sale through the Resolution Trust Corporation.
Tax legislation has and will continue to be a significant factor affecting the real estate market. Prior to TRA 86, syndicators, the middlemen who package and sell investments, sold investments in real estate to purchasers looking for tax write-offs. Such activity contributed to increased real estate prices, some to the extent that the transaction did not make economic sense except as a potential tax shelter. Now, because of tax reform legislation, tax write-offs have decreased substantially, thus causing purchasers to be more properly motivated by the pure business economics of a transaction.
PUTTING TOGETHER A TEAM
The intelligent buyer or seller realizes that a cohesive advisory team has to be forged, including an attorney, real estate and engineering consultants, and a CPA prior to a contract being negotiated and signed.
Role of Attorney
Attorneys work with a title insurance company, negotiate details of the contract terms, review the form of organization, and participate in due diligence. They clear title objections, negotiate and agree on any contract adjustments, set closing dates, and hold discussions with an insurance broker regarding the proper insurance policies and amounts to minimize risks. If there is a mortgage or other type of financing with the property being used as collateral, the mortgagee's attorneys will also have to be satisfied.
Role of the CPA
The CPA is the financial advisor. His or her investigation is of importance because it directly affects the purchase or sale price. Current and projected cash flows may have to be adjusted by tax implications as well as by the form of organization. For example, in New York City the price can be affected by city and state transfer taxes, state gains tax, and mortgage recording fees. The price will also be altered or modified by financing possibilities (asset versus capital stock sale) and possible depreciation recapture. There is a cliche in the real estate industry "you can set the price as long as I can set the terms."
The CPA's investigation of a real estate transaction can be outlined in the following main areas: revenue, expense, cash flow, depreciation, and tax consequences. The revenue investigation should include a comparison of the rent roll to the lease agreements, a review of escalation clauses, an investigation of surcharges, such as electric, cleaning and fuel, as well as the recovery of real estate taxes and payroll costs. Other revenue, such as parking fees, vending and laundry machine receipts may turn out to be material. Rental concessions and some promised leasehold improvements do not always appear in the lease agreements and thus may require direct communication with tenants to uncover these potential liabilities.
The CPA should prepare a complete and detailed set of workpapers because these will also be used later at title closing for adjustments. Prepayments and accruals can readily be determined from good workpapers.
The expense investigation is important because of its direct effect on cash flow. Because the seller can manipulate some expenses, the CPA may be asked to review all operating expenses to determine whether they were proper and include all obligations incurred. Under-maintenance as well as under-assessment for real estate taxes can have a material effect on projected expenses. Is the area undergoing appraisals for tax equalization? Also, a knowledgeable insurance broker can assist in assessing the risks and determining proper insurance coverage.
It cannot be assumed that depreciation expense and other non-cash expenses should automatically be added to determine net cash flow: these expenditures may reflect capital improvements which will be necessary to maintain the quality of the building. Also, these non-cash expenditures may no longer provide the same tax benefits necessary to rescue uneconomic real estate transactions and make them viable. Thus, the buyer or seller must consider future economic trends both locally and nationally, expectations regarding cash flow, expected residual values and alternative uses and sources of funds.
The CPA can also contribute ideas and suggestions which may maximize value for both the buyer and seller. For example, if the sale of property would result in the seller paying a substantial tax, it may be in the seller's best interest to lease the property or exchange it for another property. Consideration should also be given to the kind of entity that will own the property directly or indirectly through a C or S corporation or a partnership. The entity decision can result in substantial differences in legal liability and tax consequences.
The fair market value of a real estate property will generally be determined based upon the current or expected cash flow and the rate of return (capitalization rate) the buyer is willing to accept. Cash flow (cash operating revenues less cash operating expenses) from the property will determine how much cash is available to pay financing charges and capital improvements. The acceptable rate of return is an important variable as it will determine whether the expected purchase meets the buyer's investment criteria and whether the sale meets the seller's objective of higher returns in alternate investments. Some of the more commonly used techniques are:
* Capitalization Rate. Real estate values are based upon cash flow and desired rate of return (Cash Flow/Rate = Fair Market Value). This is the income approach versus cost approach.
* Highest and Best Use. Real estate values are based upon the assumption of use of property to yield highest cash flow or produce the most valuable use. The value of the real estate will have an important impact on the level of potential available financing. Creative financing can result in improved cash flow and lower interest costs.
The Alternatives are Many
In recent years, real estate financing has undergone an explosion in alternative types of financing, which have been further complicated by differences in commitment fees, origination costs, points, legal fees, and other matters. The challenge to a buyer is to obtain necessary financing at the lowest possible costs. The types of financing available will be determined by 1) the location of the property; 2) type of property (residential or commercial); 3) level of securitization; and 4) financial strength of borrower. The mortgagee will usually request a complete property analysis. As real estate markets are dependent on local economics, so is the availability of financing.
An examle of this difference is the different rates offered on residential mortgages in various parts of the U.S. The type of property will have an impact on the financing available. For example, residential property may be eligible for Housing and Urban Development (HUD) financing, while commercial property may be eligible for municipal financing (industrial revenue or development bonds). Also, many lenders focus on lending for either residential or commercial situations. The level of securitization will have an effect on financing options. Therefore, a loan secured by the property and guaranteed by the borrower should result in a lower rate than a loan that is not secured, guaranteed and/or senior to other debts. Finally, the financial strength of the borrower will determine whether the available terms and credit offered by lenders will be above, at, or below market rates when financing is sought. Examples of the more common financing techniques are illustrated in Table 1.
The CPA Can Help
The CPA can assist both buyers and sellers by suggesting financing strategies. The accountant's business advice and analytical skill can determine methods that would, for example, defer the seller's gain, identify hidden costs for both buyers (points, insurance, etc.) and sellers (continuing financial liability) and identify which method of financing would best meet the objectives of the buyer and cash flow of the property. The CPA can also be a potential source of contact with financing institutions. Because the CPA does not have a vested interest in the transactions, his or her advice will be objective and in the best interests of clients.
Today, real estate strategy requires that one consider economic, accounting, financial and tax elements as a total package before making a profitable sale or viable purchase.
Real estate is not a liquid investment, and many investors find that when they seek to sell, the market is not able to absorb the purchase at the optimum price. Thus, it is important either to purchase the right piece of real estate at the right price, or else have the staying power to wait out a lull in the market.
Philip Wolitzer, CPA, is Professor Emeritus at Long Island University and a Visiting Professor at Marymount Manhattan College. Mr. Wolitzer has a consulting practice in Litigation Support and Quality Control. He is a member of the AICPA, NYSSCPA, AAA, and American Arbitration Association. He has served on many NYSSCPA committees and is a past vice president and secretary. He has authored many articles published in professional journals.
Mark E. Mildner, MBA, CPA, is an Audit Manager in the Emerging Business Services Division of Coopers & Lybrand. He is a member of the AICPA, NYSSCPA, and is a contributing author to the latest edition of Montgomery's Auditing.
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