Tax Law Puts Real Estate Syndication in New Light
John Calvert, a pilot for Pan American Airlines, has been buying and selling apartment complexes and medical buildings in Orange County for two decades.
He considers the county the best place in the world to invest in real estate. And while prices here would generally put large apartment and medical complexes out of the reach of most private investors, Calvert and thousands of others have been able to profit from the county’s building boom by joining real estate syndicates.
But now Calvert, who lives in Villa Park, is shying away from new real estate investments--spooked by the new federal income tax legislation approved last month. “It’s the most confusing time I’ve seen,” he laments.
Calvert is not alone in his confusion. Throughout the nation, longtime real estate investors in the multibillion-dollar syndication industry are trying to figure out whether the new tax law gives them enough incentive to stay in the game.
Their decisions are especially crucial to syndicators in Orange County, which because of its affluence is widely considered one of the nation’s hot spots for real estate syndicators looking to raise private capital. Industry specialists say most of the syndicators are in Chicago, Dallas and New York, San Francisco and the Los Angeles-Orange County metropolitan area.
While there is no record of how many real estate syndicators are based in Orange County, Jeff Matsen, outgoing president of the Tri-County chapter of the Real Estate Securities and Syndication Institute, estimates the number at 200. And dozens of syndicators in other parts of the nation market through brokers in Orange County.
But because of the tax situation, Matsen said, RESSI’s national membership, has dropped 50%. While the situation is a bit better in Southern California, where real estate remains a primary investment choice for many, membership of RESSI’s Tri-County chapter--which includes Orange, San Bernardino and Riverside counties--still has declined about 20% in the past year.
Like investors, the syndicators--specialists in grouping individual investors into limited partnerships to buy apartments, shopping centers, office buildings and other commercial properties--have been severely shaken by the new federal tax law.
Fuhrman Nettles, vice president of Robert A. Stanger & Co., a Shrewbury, N.J.-based partnership research firm, projects that $10.7 billion will be raised nationwide this year by real estate partnerships, down from $12.7 billion in 1985. All the decline, he said, has been in private placement offerings, which he expects to raise $2.5 billion this year, down from $4.7 billion last year. Nettles said he expects syndicators’ private placements to raise only about $1 billion in 1987.
“The shakeout has just begun,” said Sylvan Swartz, president of the Orange County region of the National Assn. of Private Placement Syndicators. He predicts that 25% of existing syndicators in Orange County will get out of the business, starting with real estate accountants and brokers who in the past organized syndications as a sideline.
In the past, many syndicators sold deals primarily to generate losses that wealthy investors could use to lower their tax bills. The syndicates frequently paid excessive prices for properties and mortgaged them to the hilt. Jack Oldham, an accountant with Kenneth Leventhal & Co. in Newport Beach, said that “most of the stuff syndicated was junk” and that the syndicates often “were designed to lose money in a big way.”
The new law in most cases eliminates the practice of using real estate losses to shelter income. In the future, the use of such losses generally must be deferred until the property is sold, when the cumulative losses can be deducted from sale profits or, if there are no profits, from the investor’s gross income for that year.
Capital Gains Impact
The new law--which will be phased in over the next five years--also increases the tax rate on capital gains realized when syndicated properties are sold. The current maximum capital gains tax of 20% jumps to 28% in 1987 and could go as high as 33% in later years.
And, with tax benefits sharply reduced, members of syndications will have to be content with far less dramatic returns on their investments.
Richard N. Kipper, an accountant who reviews new syndication offerings in the Costa Mesa office of Laventhol & Horwath, figures that a five-year syndication with a mortgage for 80% of the purchase price and a 17.1% return on investment before the tax law change will produce only a 12.1% return after the law goes fully into effect.
With those things against so-called tax loss syndications, almost all syndicators who stay in the business will be looking to buy properties that will generate real annual income for the investors and reap optimum profits when they are sold. As a result, syndicators are expected to bargain harder for properties--driving prices down--and to require their investors to make larger cash down payments than in the past.
“Tax-motivated real estate syndications are, by and large, a thing of the past,” said Luke V. McCarthy, president of August Financial Corp. in Long Beach.
But “the sky is not falling,” said McCarthy, who added that he believes that syndicators will survive by becoming more profit-motivated.
Less Risky Ventures
The new tax law is expected to increase the attractiveness of public syndications, which are registered with federal agencies and usually offer investment in a large and geographically diverse number of properties. Public syndications are considered less risky than private placement syndications, which have fewer investors, often tout only a single property and historically have been sold as tax shelters.
The upheaval in the tax rules is only the latest trauma to shake the industry in recent years. Some syndications have also been burned by real estate investments that mistakenly predicted a continued inflationary spiral or weare linked to geographic areas that now are suffering from the collapse of the oil industry or from severe overbuilding.
The net effect is that the syndication industry is shrinking and consolidating, with some syndicators going out of business or putting some of their syndicates into Chapter 11 bankruptcy reorganizations. Stronger syndicators who have more successfully avoided the pitfalls meanwhile are hoping to expand their business, sometimes by acquiring troubled partnerships and properties at bargain prices.
Experts say smaller syndications will have a higher fatality rate in part because they will not have the financial means to compete for prime properties with pension funds and other large institutional investors
“A lot of people who were doing shoestring deals won’t do them anymore,” said Dan Bolar, an accountant with Deloitte, Haskins & Sells. He also predicts that as the new tax law is phased in “there will be a lot of situations where highly leveraged (with large mortgages), poor deals go back to lenders” in foreclosure actions.
One small private placement real estate syndicator who is considering changing careers is Jerry Sokol of San Juan Capistrano.
Selling Off Properties
He said he isn’t starting any new deals and is busily selling off many of the properties he already has syndicated because he wants to avoid the increase in the capital gains tax next year. He said that while his clients are making hefty profits on the sale of the properties, they don’t seem anxious to reinvest in real estate under the current tax law.
This thinning of the ranks has opened greater opportunities for the syndication firms that remain and that have already forged a track record in income-oriented investments.
Mark Kenny, president of Sierra Pacific, a Newport Beach syndicator-developer that has long sold income-producing investments to a list of clients that includes tax-exempt corporate pension plans, said his firm is looking forward to lessened competition for properties as other syndicators fall by the wayside.
Kenny said he will welcome the waning competition from tax shelter-oriented syndicators, who, he said, typically were willing to pay 10% to 20% more than the market value of a property because their investor clients would write off the resulting losses. With those overbidding buyers out of the market, “it is going to make our life a heck of a lot easier,” Kenny said.
Surviving syndicators also have hopes that the elimination of tax shelter syndicators from the real estate market will slow development, allowing existing apartment and office building gluts to become absorbed, which in turn will push up rents and real estate prices.
As an extra bonus for income-oriented syndicators like Sierra Pacific, Kenny noted that the new tax law enables investors to offset losses from existing tax shelter real estate partnerships with income from other passive investments, including real estate partnerships designed to provide annual cash flow.
Different Strategies
Although real estate syndicators everywhere now are pushing new investment programs aimed at generating higher annual earnings and future gains in property values rather than losses and tax writeoffs, they don’t all agree on the best strategy for accomplishing those goals.
While most syndicators are touting all-cash or low-mortgage deals to keep projects in the black, some are coming up with more maverick financing schemes.
“Our strategy is to increase leverage for yield on investment”--to use borrowed money to buy better properties that will return larger profits without tying up the investors’ own funds, said John A. Bonutto, a general partner in Newport Beach-based BHI-Dover. Bonutto, whose privately owned company specializes in buying shopping centers, said he wants to take advantage of borrowing funds at today’s relatively low interest rates.
He said his firm recently put together a group of about 80 investors to buy the Courtyard, a Mediterranean-style shopping center in Costa Mesa, from Pacific Savings & Loan for about $30 million, all but $6.5 million of which was borrowed.
And at least a few syndicators believe they have found loopholes in the new tax law that will let them continue to offer their customers income shelters.
Wilfred Cooper, for one, was “elated” to discover that the final tax legislation passed this year by Congress left a tax benefit for limited partnerships that invest in low-income housing, which happens to be his specialty. Cooper said he expects the law will create for him a business “bonanza for the next year and beyond.”
Cooper, however, said that his elation follows two years of worry and financial pain while he waited for Congress to decide what kind of tax reform it would ultimately enact. During that time he, like most syndicators, suffered a substantial loss of business because of the uncertain status of his investment products.
He said he laid off most of his staff, closed his Irvine office and began operating out of his house on Balboa Island. Impatient with the slow course of the tax legislation, Cooper raised $2 million in a public offering that he sold to investors by promising full refunds if the tax bill turned out to be unfavorable for syndication.
It did. “We guessed and we guessed wrong,” said Cooper, who was obliged to return all the money he raised from the offering, plus interest, to the investors. He also absorbed the $250,000 cost of the offering.
In another attempt to find and take advantage of a remaining loophole in the new tax law, some syndicators are shying away from limited partnerships in favor of an alternative kind of group investment known as “tenants in common.”
In tenants-in-common programs, investors claim direct ownership in a piece of property, rather than through a general partner.
Harvey Pavlick, president of American Equity Council, a Newport Beach syndication consulting firm, said that the new tax bill allows members of a tenants-in-common program to deduct up to $25,000 in depreciation and other property losses from their personal incomes as long as their annual adjusted gross incomes are under $100,000.
As weaker syndicators who don’t adjust to the new tax rules fall by the wayside, others are seizing the opportunity not only to increase their own business but to aggressively expand through acquisitions.
“We have let it be known in the investment community that we are able to negotiate to buy other syndicators,” said Dudley Muth, president of the syndication arm of Cambio Investments Inc. in Fullerton.
Cambio recently acquired Oak Capital Corp., an Encino syndicator that Muth said was unable to stay in business. Muth said he also has been involved in negotiations to buy three other real estate syndication companies that were up for sale.
Art Birtcher, general partner in Birtcher, a major Laguna Niguel-based real estate development and investment firm, said that his company recently took over the general partner role in an investment in a large San Diego office complex at the request of the limited partners in a troubled syndication. He said Birtcher has received “dozens” of similar requests that it is deciding whether to oblige.
In a much larger transfer of syndication management, Santa Ana-based Butterfield Savings & Loan, which was declared insolvent and taken over by federal regulators last year, recently sold about 40 of its real estate syndications to Property Management Services Inc., a Vancouver, Wash., real estate firm.
Butterfield, in addition to being the syndicator, also loaned money to its syndicates to finance their real estate deals--many of which are in trouble. Before selling the syndicates to PMS, Butterfield took advantage of lower interest rates to refinance the loans and made a number of other loan concessions on the properties to prevent them from going to foreclosure.
But not all existing real estate syndication deals can be reorganized to make financial sense in the current economy and under the new tax laws.
Some syndicators blame their problems on geography. One Orange County syndicator who has lost one Houston apartment building to foreclosure and has another in a bankruptcy proceeding recalled that when he bought those properties in 1982, Houston “was the fastest-growing metropolitan area in the country and was projected to remain that way through 1990.” But by 1984, dropping oil prices had sent Houston property values into a tailspin.
Irvine-based McCombs Securities Co., which has more than a third of its syndicated properties in oil states, has stopped making new deals and has hired a national property management firm to handle its buildings.
The traumatic experience of some syndicators in “oil belt” states has whetted their appetite for properties in Southern California, including Orange County, where syndication activity in recent years has been slowed by high real estate prices.
“A lot of people in Orange County really got burned in Texas,” said RESSI’s Matsen. He said he has heard numerous local syndicators vow that from now on they will be investing closer to home.
Several investment counselors said they are still highly recommending real estate to their clients. Ron King, senior vice president and national marketing director of Tustin-based Titan Capital Corp. said that “real estate is still the No. 1 investment,” even though his customers are showing an increasing interest in municipal bonds, mutual funds and insurance.
Once investors have sorted out the new rules, many are expected to resume their love affair with real estate, especially in Orange County--where many fortunes have been made because of skyrocketing property values.
There are stories like that of Wilma Burley of Long Beach who, with her husband, bought a house in Laguna Beach in 1957. Every three years from then on they bought additional real estate, frequently in syndications. As a result of rising property values, Burley, who was trained as a home economist, said that she and her husband, an engineer, became millionaires by the time they turned 40.
Burley said that although the tax changes will greatly reduce the couple’s real estate profits, she isn’t giving up what’s been mostly a very good thing. With real estate, she said, “We have had very, very few failures. And I can’t say that for the stock market.”
