HISTORICAL PERSPECTIVE ON
DEALERSHIP FACILITIES
As I mentioned in the last article, most dealers have a significant portion of their assets tied up in real estate. Despite its value, the real estate is not liquid. It can't be sold without relocating or terminating the dealership operation, and there are few buyers for these single-use properties. Most dealers hold the properties in separate entities for tax and liability reasons, effectively leasing the properties to themselves. As a result, the rent factor isn't always at a "market rate." A market rate is based on current value of the property and a risk adjusted rate of return. Many dealership rent factors, in contrast, are based on the original property cost, or a cost of capital that is not adjusted for risk to the property owner.
BANKS AND OTHER TRADITIONAL
FINANCE SOURCES
Many dealers finance their properties through banks. Frequently, these loans are 3 to 5-year balloons floating with prime, which increases risk. Loan agreements often contain personal guarantee, cross default and cross guarantee provisions, and may contain other restrictive covenants that reduce banking flexibility and the ability to borrow. Are you required to keep your floor plan with the mortgage financing?
INCREASING LIQUIDITY
Historically, dealers who wanted to pull cash out of the property had two options: sell the property or refinance. Both options have drawbacks. Selling the property disrupts the business; it has to be relocated or sold. Refinancing increases business risk and banks typically lend only 70-80% of value.
HOW MIGHT AN UPREIT/DEALERSHIP
TRANSACTION BE STRUCTURED?
REIT transactions with dealerships will involve a sale/lease back of dealership facilities. The terms of these leases will vary, but expect to see long-term leases (10 years +) with options. Although REITs may not require personal guarantees on the leases, the REIT will want other forms of security. Expect to see rent coverage ratios and cross guarantees (at the dealership level) if several properties are leased.
DETERMINING THE PROPERTY VALUE
The value of commercial real estate is determined, to a large degree, by the cash flow it can generate. Accordingly, discounted cash flow will be one of the primary methods that REITs use to value your property. Other criteria may include the financial strength of the dealer and the franchise, alternate uses of the property and comparable transactions. REITs may or may not base their valuations on third-party appraisals. If the REIT does not order a third-party appraisal, you would be well advised to obtain one yourself.
CAP RATES AND RENT FACTORS
The new rent factor will be based on the sales price of the real estate multiplied by a "Cap Rate" that will vary from property to property. The key here is appreciation and risk. Highly desirable real estate with numerous alternative uses will rise in value, benefiting the REIT. The chance of default on desirable properties is slim, reducing risk to the REIT. These properties will command lower Cap Rates than those in declining markets.
Bear in mind that as a result of the sale of the real estate to a REIT, rent at the dealership level may increase. The value of the property has been reset to a market rate, and the Cap Rate may be higher than the mortgage interest rate was. The REIT has taken on many of the risks of ownership and is providing long-term financing. The rate of return is adjusted accordingly. Future rent increases will probably be tied to changes in the consumer price index (CPI).
SELL FOR CASH, UNITS OR BOTH?
Cash The REIT will give you three options: sell for cash, exchange for units in a real estate operating partnership or take some combination of the two. Selling for cash is a taxable transaction. Your gain will be the difference between the sale price and the tax basis of your real estate. Some of the gain may be taxed at capital gains rates (now 20% for federal income taxes purposes); some may be recapture of depreciation. The tax rate applied to recapture will depend on the depreciation method used when you owned the property. Clearly, the lower capital gains rate makes selling for cash more viable than before.
Units The other option is to contribute your real estate to the REIT in exchange for units in an operating partnership controlled by the REIT. This non-taxable transaction is made possible by the UPREIT structure. The partnership units are generally equivalent to REIT shares and can be exchanged for shares after an agreed upon period of time, usually one to two years. A taxable gain is recognized if the partnership units are sold, exchanged for liquid REIT shares or in the unlikely event that contributed properties are sold by the REIT. The REIT assumes and then refinances your debt. Your basis in the partnership units is, therefore, your basis in the contributed property minus your debt. If you owe more than the tax basis of your property, your basis in the units is negative, triggering a tax from "relief of liabilities." To avoid this situation you may choose to guarantee a portion of the REIT's debt.
Both You may decide that selling for cash and units is in your best interests. If you owe less on the property than your tax basis, you may be tempted to refinance up to your basis (a non-taxable transaction), then contribute the property to a REIT. Be advised that the IRS views this as a "disguised sale" and will tax the transaction accordingly. If you have refinanced in the last 5 years, you will need to disclose this to the IRS and demonstrate that at the time you refinanced there was no intent to sell.
OPPORTUNITIES PROVIDED BY A REIT
One of the obvious benefits that the REIT industry will bring to car dealers is the option of selling the real estate without selling, terminating or relocating the business. There are basically three reasons to sell to a REIT:
· Pull cash out to invest in other assets you believe will yield a higher return than the real estate, including possibly the REIT stock itself.
· Reduce overall risk by diversifying away from the automotive retail business.
· Provide liquidity and flexibility for estate planning.
SELLING TO A REIT: SOME STRATEGIES
FOR CAR DEALERS
Exit Strategy Selling the real estate to a REIT may be an effective exit strategy. In considering the REIT option, try to separate your interest in the real estate from your interest in the dealership operation. Recognize that they could be worth more separately than together for several reasons:
· Potential purchasers of the dealership operation may not have the wherewithal to also purchase the real estate, requiring you to take back some of the financing. This may apply to your designated successor; a son, a daughter or a long time employee. You may be able to increase your purchase price and decrease your risk by selling the real estate for cash. The property sale to a REIT may also benefit your successor by facilitating the buyout and reducing their financial leverage.
· Publicly traded companies may prefer not to own your real estate. Their investors expect a higher return on equity than real estate can provide, and as C corporations, they don't enjoy the same tax advantages as REITs.
· Automotive retailing may not result in the best use of your land.
Acquisition Strategy Sell your existing properties to a REIT to raise cash and use the funds to purchase other stores. You may be able to use the REIT to finance 100% of the real estate cost of future acquisitions. The equity you pulled out may have a significantly higher yield, if invested in dealership operations, than it did as a real estate investment. The return on dealership equity is 29.1% vs. 10-12% for real estate equity (per NADA). What do your returns look like?
Expansion/Remodeling Strategy You can tailor your deal with a REIT to meet the future needs of your dealership. For instance, it wouldn't make sense to sell your dealership this year and spend $1 million next year to renovate a property someone else owns. Be realistic about the improvements your facilities will need to remain competitive and negotiate an improvement allowance up-front with the REIT. This may be a good way to expand the used car department or update the body shop without taking on more debt.
Diversification Strategy Even if there is no pressing reason to sell, you may want to consider the REIT option as a means of increasing diversification. Historically, the auto industry has been highly cyclical and is now undergoing rapid change. If substantially all of your net worth is tied up in your business, you may want to hedge by pulling cash out and investing in other areas.
Estate Planning Strategy Selling to a REIT simplifies estate planning by splitting the equity in the property into cash or liquid, divisible shares. It eliminates some of the control issues that exist when only one of several heirs are involved in the business. It dovetails nicely with other estate planning tools like gifting and family-limited partnerships. There are drawbacks, however. Estate planners frequently use discounts for minority interest, marketability and control as a means of reducing the value of bequests. These will not apply to cash or publicly traded shares.
WHICH CURRENCY DO YOU TAKE,
CASH OR UNITS?
The big advantage to units is that 100% of the equity in the property will be invested, pretax. This could be especially attractive for sellers facing large capital gains and/or recapture at ordinary income rates. The question is, will 100% of your equity yield a higher return if invested in the REIT than the after-tax portion would if invested in other areas? A lot depends on your specific tax situation and your assessment of the REIT as an investment. Another related issue is diversification. Combining your property with other automotive properties accomplishes some geographic diversification, but is it enough to balance your portfolio?
SENSITIVITY ANALYSIS
One way to analyze your options is through sensitivity analysis. Estimate the after-tax cash flows of holding the property, selling for cash or trading for units over a specific period of time. Be sure to factor into your analysis the change in rent at the dealership level. Assume that at the end of that time period the property or REIT shares will be sold for cash. Discount the cash flows at your required rate of return and evaluate the results. You will need to make numerous assumptions to perform this analysis. How much will the property appreciate if held? How will the REIT shares perform in the capital markets? What would other investment options yield? These are questions you will need to answer for yourself, but if you need help structuring the analysis, call us!
CONCLUSION
In the early '90s, the REIT industry had a profound effect on commercial real estate by creating a market for large office buildings and shopping centers that simply didn't exist before. In a similar way, the REIT industry may increase the marketability, and therefore value, of dealership properties. The demographics of the dealer community, the strength of the capital markets and the new capital gains rates all conspire to make this an excellent time to sell. In the past, dealers had to be in the real estate business; this is no longer the case. What you get when you sell to a REIT is improved access to capital markets, diversification and liquidity. What you give up is a measure of control and potential appreciation of the specific properties contributed. How does this fit your strategic plan?