Real estate limited partnerships, the sizzling tax-shelter investment strategy of the early 1980s, are leaving millions of Americans feeling burned as the decade closes.
A victim of its own excesses, overbuilding in major real estate markets and flip-flops in federal tax policies, the real estate limited partnership industry is withering, according to numerous speakers at the Real Estate Securities and Syndication Institute conference here this month. Investment levels have plummeted, leaving the formerly high-flying sponsors of the programs struggling to survive.
Many investors, meanwhile, are just beginning to realize that they will not recoup their money, they could face serious tax consequences and they may be forced to take responsibility for failing real estate ventures--office buildings, apartment complexes, hotels and strip shopping centers--all around the country.
“I think we are viewing the end of an era,” Samuel Zell, chairman of the board of Equity Financial & Management Co., a real estate syndication firm, told a glum crowd of limited partnership industry executives.
“It’s all directly related to the fact that the real estate industry has played much too great a role in the economics of the country in the last 20 years,” said Zell, who compared the situation to the aftermath of the Holland tulip craze in the 17th Century and the South Seas bubble in Great Britain in 1720, two schemes of long ago that attracted widespread investments but later went awry.
Real estate limited partnerships, also known as real estate syndication, first soared in popularity in the early 1980s, propelled by inflation-driven increases in property values during the 1970s.
The federal government made investment in real estate even sweeter in 1981 by enacting the Economic Recovery Tax Act, which dispensed additional incentives. High-income people who invested in real estate could quickly write off expenses and losses against income earned from other sources, while a lower capital gains tax rate meant that subsequent profits would be taxed at a lower rate. Many investors found they could deduct up to $4 for every $1 they invested, and some were able to avoid taxation entirely.
Consequently, real estate limited partnerships became an incredibly attractive investment to millions of American investors.
From 1980 to 1985, the amount of money put into real estate limited partnerships increased six-fold, climbing from about $2 billion in 1980 to $12.7 billion in 1985, according to the investment advisory firm of Robert A. Stanger & Co. Cumulatively, the industry raised about $67.9 billion from 1979 to 1988.
But real estate investing became more popular in other circles as well. Newly deregulated savings and loan institutions, allowed to venture into commercial real estate investments for the first time, launched many projects, as did insurance companies and pension funds.
What resulted was a virtual tidal wave of construction nationwide as cash-flush developers rushed to build, build, build.
By their own admission, few investment sponsors and developers showed much self-restraint during those years, with most of them focusing their efforts on raising as much money as possible and building as much as possible without regard for whether there was demand for the structures they were building and financing.
“If you allow (us) to have as much alcohol as we want, we will get drunk,” said Roland D. Freeman, executive vice president for acquisitions of the Hall Financial Group Inc.
The underlying overbuilding problem was exacerbated in 1986 when the federal government abruptly reversed its tax policies, stripping many real estate investors of quick write-offs and the ability to deduct expenses against income earned from other sources.
The loss of the tax benefits combined with overbuilding to drive down real estate prices. Rents had already plummeted as competition for tenants increased, which translated to lower investment returns.
In some cases, property owners were unable to attract any tenants and buildings remained vacant, so-called see-through buildings.
At this point it is unclear how many real estate partnerships are faltering. Thomas Fendrich, managing director for real estate and partnership finance at Standard & Poor’s Ratings Group, said 40% to 60% of the widely sold public real estate partnerships he has reviewed are in trouble, with investors unlikely to recoup their money.
Private partnerships, which are typically made up of smaller groups of more affluent investors, are in even worse shape, according to some industry experts, although less information on their performance is publicly available. In many cases, private partnerships were more dependent on tax breaks than public partnerships.
To make matters worse, the tax implications of their investments are beginning to haunt investors as well, because write-offs for depreciation enjoyed years ago must now be repaid to the federal and state governments.
When the partnership ends, whether through the sale or foreclosure of the building or through liquidation of the partnership, the tax write-offs are “recaptured,” or picked up as a gain. Thus, the limited partners in transactions, including those that failed, are required to repay tax deductions they took earlier.
“Many people failed to realize they would pay back Uncle Sam some day,” said Stephen Lawrence, senior tax manager with Touche Ross in Washington. “It was a deferral of taxes, it was not an avoidance.”
Many investors are so angry by the outcome that they may sue the project sponsors or the financial planners who promoted the investments, Lawrence said.
“Nobody’s actually gone into a courtroom, but I guess that will happen as more people get hit with these tax liabilities,” Lawrence said.
The full scope of the problem has yet to surface because the general partners in the projects-generally the people who proposed and have managed the properties-have been hanging on and paying partnership expenses out of their own pockets, waiting and hoping for real estate markets to improve, according to speakers at the conference.
Now, however, they are running out of money and are unable to raise additional cash from the regular investors, who have now soured on real estate investments.
“The minute the dough stops coming in the door, the syndicator can’t pay the bills,” said investment adviser Robert A. Stanger, who has tracked the industry for more than a decade.
Investors may soon see an epidemic of general partners abandoning their projects and forcing their limited-partner investors to form steering committees to manage the properties as best they can, some analysts said.
“There are a lot of sad general partners,” said Chicago real estate syndicator E. James Keledjian, formerly with VMS Realty Corp. “They want out. They are managing products in which they will never make a dime.”
Such gloominess permeates the syndication industry these days, in marked contrast to years where fund-raising reached new record levels each year.
For example, the group that gathered in Philadelphia this month--100 of them, compared with 175 last year--looked somber, sober and notably lacking in ostentation. Gone, for the most part, were the Rolex watches, the hand-tailored monogrammed shirts, the soft Italian leather shoes and the smooth operators who sold syndication so well.
“We’re moving from a sales and marketing orientation to hands-on management of real estate,” said Joseph L. Ferst of accounting firm Spicer & Oppenheim.
Instead of marketing, participants at the seminar talked about survival.
A panel of experts on distressed real estate, for example, offered cost-cutting strategies that included firing janitorial staff and deferring maintenance.
“The one expendable thing is always the human resource,” said Robert H. Weitzman, founder and partner of Chicago-based Group One Investments.
Weitzman said that owners of distressed properties could also become more efficient in other ways, such as painting only the front of a weather-beaten building, which he said could save 60% of the cost of painting the entire building.
Limited partnership industry executives also engaged in a certain amount of soul-searching as they sought to explain to themselves and others what had happened.
Some blamed it on inexperience in an industry that grew much too quickly, and that permitted young MBAs to make investment decisions that failed to consider whether there was adequate demand for the buildings being constructed.
The “industry became obsessed with mathematical calculations,” Zell said.
Others blamed it on themselves and said the industry is now suffering for the sins of the past.
“Greed and avarice--the twin sisters--are the cause of it,” Keledjian said. They were ruined by too much of a good thing, another said.