Investment Real Estate Transactions 101 For Buyers (Part I)

November 2016

Jeffrey S. Tarr, M.S. (Tax)

Published in the Sussman Shank LLP Winter 2016 Newsletter

Why own real estate as an investment? After all, there are the issues and headaches that come with having tenants; the costs of maintaining, repairing, and replacing capital improvements on the real estate; management costs that sometimes can eat into investment returns; the potential liability exposure (e.g., environmental, personal injury); the potential losses (e.g., theft, vandalism); and so on. Why would you want to take on all of that? 

My answer lies in the fact that a significant amount of American wealth has been created over the past 100 years through investment in and long-term ownership of real estate. Simply put, over time, American real estate generally proves to be a very good long-term investment (with its returns at times outpacing stock market returns), thus making investment in real estate well worth the difficulties of ownership. A well-diversified investment portfolio often includes, in addition to stocks, bonds, and other financial instruments, investments in real estate.  

Okay, so you want to invest in real estate. What is next?

1. The Team

One up-front consideration is who will be on your "team." It is important to identify the members of your team up front, to understand their roles and how they can help you in the transaction, and to be aware of the appropriate time to involve them in the transaction. Depending on the type and nature of real estate being purchased, your team may include several members, some of which are typically involved in most real estate transactions and others who are not.  The team often includes a broker, an attorney, a loan officer, a surveyor, an environmental consultant, an accountant, and a property manager.

The broker is the one professional that is typically involved in most real estate transactions, and is involved at the very front end of the transaction. The broker's primary role is to help the investor find the right property to invest in. Brokers typically specialize in different types of real estate (e.g., single or multi-family residential, commercial,industrial, retail), and therefore the type of real estate investment sought plays a big role in picking the right broker. Once selected, the broker will assist the investor in identifying suitable investment properties on the market for purchase, gathering and assessing due diligence information, writing offers, and handling communications between the buyer and seller.

The attorney is another professional that is typically involved in most real estate investment transactions, and often is involved just before writing an offer to purchase on suitable investment property. The attorney assists the investor in many ways in a real estate transaction, including helping the investor in evaluating due diligence (e.g., title review, zoning review, and lease and other contract review), reviewing the broker-prepared offer to purchase or preparing an offer to purchase, addressing legal and other issues that come up during the transaction (including relating to title, due diligence, and contract assignments), and closing the transaction.

Often, real estate is purchased with some cash invested by the buyer, but with the balance of the purchase price financed by an outside lender. "Leveraging" (i.e., the use of financing to purchase real property) has long been a cornerstone to maximizing returns on investments in real estate.  Sometimes a seller will finance a portion of the purchase price, in which case the parties will determine the terms and conditions of the financing, and the attorneys in the transaction will prepare the loan documentation. However, when outside financing is involved (which often is the case), a loan officer from a lending institution is a necessary part of the team. Often the buyer will commence discussions with the loan officer (regarding, among other things, pre-qualifying for financing and the terms and conditions of the financing) before even entering into a purchase and sale agreement for real estate. Through the loan officer, the investor will determine whether the lender will underwrite the financing, and if so, what will be the terms and conditions of the financing. The loan officer will also help close the financing transaction at the close of the purchase transaction.        

Sometimes the buyer will want to obtain a current survey of the real estate, showing such things as the dimensions and locations of improvements, easements, rights of way, and other non-financial encumbrances affecting the real estate. A buyer may want to obtain a survey of the real estate for many different reasons, including if the buyer intends to develop the property, if the buyer is concerned about potential encroachments of neighboring property improvements, or if the buyer intends to obtain at closing an ALTA extended form of title insurance policy for the real estate. When a buyer elects to get a survey of the real estate, the buyer will need to add a qualified surveyor to the team. The surveyor typically is engaged to conduct the survey after the parties have entered into a purchase and sale agreement and during the buyer's due diligence period.

In most real estate transactions, I recommend that my clients retain an environmental consultant as a member of the team to conduct a Phase I environmental assessment of the real estate, and, if necessary (as indicated by the Phase I environmental assessment), to conduct a Phase II environmental assessment of the real estate. Environmental assessments of the real estate help the buyer understand the current and historical uses and environmental condition of the real estate. Environmental remediation work can be and often is a very expensive undertaking (in some more extreme cases, exceeding the value of the real estate itself). Accordingly, buyers should be very cautious about and aware of the environmental condition of the real estate before closing on the purchase. Sometimes an environmental assessment of real estate will show conditions that will warrant the buyer walking away from the transaction instead of closing and assuming responsibility for future remediation work. Like the surveyor, the environmental consultant is typically engaged to conduct the environmental assessment after the parties have entered into a purchase and sale agreement and during the buyer's due diligence period.

Another regular member of the real estate investor's team is the accountant. There are many tax benefits to investing in and owning real estate, including the ability to capitalize or deduct closing costs and expenses, taking depreciation deductions, and utilizing certain types of tax credits. In addition, there are certain tax planning opportunities, including conducting a cost segregation analysis on the real estate (to help accelerate depreciation deductions) and engaging in a 1031 like kind exchange transaction(to sell real estate and avoid paying taxes on the gain by rolling over the taxable gain into the purchase of qualifying replacement real estate). The accountant (and I strongly recommend using only a certified public accountant) is a necessary member of the team if the investor is going to properly report the tax consequences arising from the purchased real estate and take advantage of the various tax planning opportunities. The accountant typically is consulted during the real estate transaction and then brought in on a more significant level immediately after the closing of the real estate transaction.

Another common team member is the property manager. Often, real estate investors do not want to personally handle the day-to-day management responsibilities involved with owning real estate. They therefore often retain professional property managers to handle the day-to-day management functions. Property managers typically are paid monthly based on a fixed percentage of the gross rents collected during each month. Property managers often specialize in managing different types of real estate (e.g., multi-family residential, retail, commercial), and therefore the type of real estate acquired often will play a big role in picking the right property manager. Because the real estate investor will want the property manager to take over management of the real estate immediately after the closing, the real estate investor should identify the property manager and negotiate the terms of a property management agreement with the selected property manager prior to the closing.  The property management agreement is typically entered into by the investor and selected property manager at the closing of the purchase transaction.          

2. Use of "Limited Liability" Entity as Buyer

One crucial legal consideration to investing in real estate is whether to own the real estate directly in the investor's name or to use a legal entity as the vehicle of direct ownership (with the investor being the owner of the legal entity, thus making the investor the "indirect" owner of the real estate through the investor's ownership of the legal entity). This begs the question - what is the benefit to owning investment real estate through a legal entity?

Certain legal entities provide what is referred to as"limited liability" protection. If an individual investor owns a piece of real estate and a liability arises from that real estate, the first line of defense as to that liability typically is insurance. However, insurance does not coverall forms of liability exposure, and sometimes the insurance in place is insufficient to cover the full amount of the liability exposure. If an individual investor owns the real estate directly, not only is the equity in the real estate exposed to satisfying the liability, but so too is all of the individual investor's other assets. However, if the individual investor indirectly owns the real estate through a limited liability entity, only the equity in the real estate is exposed to the liability (i.e., the liability of the individual investor is limited to the equity in the real estate held by the limited liability entity). Therefore, it is always a good idea to create a limited liability entity to acquire and own investment real estate.

Given that it is always a good idea to create a limited liability entity to acquire and own investment real estate, what type of legal entity is best suited for this purpose? Generally speaking, there are four types of legal entities that can be used to own real estate, namely, a corporation,a partnership (either a general partnership or a limited partnership), and a limited liability company. The two forms of partnership should be ruled out at the outset because neither type of partnership provides limited liability protection for all of its partners. While both corporations and limited liability companies provide limited liability protections to their owners,corporations are typically ruled out because they are far less flexible vehicles in terms of real estate-related income tax planning and income tax minimization. Thus, typically limited liability companies are recognized as the most ideal legal entity for owning real estate investments. I therefore recommend to my clients that most real estate investments should be owned indirectly through one or more limited liability companies.       

Once an investor has his or her team assembled, causes a limited liability entity to be formed to be the direct purchaser, and finds the investment property, it is time to negotiate the transaction terms and enter into a purchase and sale agreement.  In Part II of this article, I will discuss the basics of the remainder of the real estate investment transaction, including the purchase and sale agreement, the due diligence process, closing the purchase transaction, and post-closing matters.  Stay tuned for Part II in our upcoming newsletter.

Related Practice Areas

Real Estate and Land Use

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