Inside the Property Syndicates
Real estate limited partnerships have made many investors an offer they can’t refuse: cash profits plus tax losses. But not everybody wins.
by Jeffrey G. Madrick
Lured by promises of skyscraping returns, immediate tax savings and bedrock security, individual investors by the thousands have been scrambling to board an investment vehicle once operated almost exclusively for the wealthy and sophisticated few — the real estate limited partnership. Through a partnership, investors with no more than $5,000, and often less, can buy a piece of an apartment house, an office building, a resort hotel, a vineyard, a shopping center. Wall Street’s largest brokers have started selling partnerships hard, often taking a piece of the action for themselves. Their efforts have made the process of buying in almost as easy as the purchase of a share of common stock. As a result, publicly offered real estate partnerships, a rarity as recently as 1969, accounted for some 10% of all new security offerings in the first eight months of this year.
As the illustration to the right makes clear, the flow of returns to the investor in a limited partnership — or a syndication or syndicate, as they are also known — can be almost magical, provided things go more or less according to plan. Real estate projects normally show losses in the early years, especially, but not only, at the stage when cash is streaming out for construction expenses and rents are not yet coming in. Unlike corporations or real estate investment trusts (which are similar to mutual funds but invest in real estate instead of stocks), limited partnerships allow the investor to benefit from these losses by deducting his pro rata share from his taxable income. Moreover, it is quite possible to receive a cash distribution from the partnership in the same year that losses are being written off.
The charms of tax avoidance — particularly when combined with title to a solid piece of American turf — are hard to overestimate. But such attractions, like paperboard walls, are often more surface than substance. For one thing, part, and in some circumstances all, of the tax savings and part of the cash distributions may have to be paid back to the government when the investor sells his partnership interest. An investor generally cannot get out of a syndicate with a positive return for some five years — if he can get out at all. There is no secondary market, like a stock exchange, through which interests in limited partnerships can readily be bought and sold. The seller, or his broker, usually must find his own buyer. As for the solidity of American real estate, New York State’s assistant attorney general in charge of syndications, David Clurman, sums it up well: “Bedrock security? Some people view it that way. But although it can’t disappear like a stock certificate, it can be financed and marketed to death.” In short, real estate is risky.
There are indications that the federal government may be preparing to alter some of the tax preferences on which real estate partnerships depend for their benefits. George McGovern has pledged if elected to reduce or eliminate tax preferences for capital gains, as well as accelerated depreciation schedules and indirect subsidies for low-income housing. Tax reform in a second Nixon administration would presumably be much less sweeping, though some real estate men expect, at the least, an increase in the minimum tax due from wealthy individuals whether they invest in tax shelters or not.
Virtually all the regulatory bodies that oversee security offerings are considering measures to protect the prospective investor in tax shelters. These could change the game a bit by putting restrictions on who may invest in syndicates and on the types of deals that can be made. The agencies considering measures of this type include the SEC, through which all syndicates publicly offered in more than one state must pass, and the various state regulatory bodies, as well as such private groups as the National Association of Securities Dealers and the National Association of Real Estate Boards.
For all the risks and potential abuses, the advantages of the limited-partnership arrangement will continue to attract newcomers to real estate investing. Through partnerships, an investor can restrict himself to what he considers a relatively few choice projects rather than the diversified portfolio that real estate corporations and trusts must seek.
A general partner puts together and manages the project and is ultimately liable should things go bad. The limited partners put up the money but have no say in the management and are liable only for their investments. With the equity capital supplied by the limited partners in hand, the general partner can borrow 75% to 80% of the value of the property he plans to develop. In projects with government-insured mortgages, he can borrow 90%. Thus depreciation, which is fundamental to the tax write-offs, is taken on property worth five or ten times the equity the investors have put up. The tax laws allow the general partner — usually a corporation more interested in fees and profits than in losses — to pass along the tax-deductible losses to those who can best use them, the limited partners. In return, the general partner receives fees and commissions and is entitled to share in cash distributions.
An investor’s tax position will make certain types of real estate limited partnerships more attractive to him than others. Some partnerships offer big tax savings and little cash return, particularly suitable for investors in a very high tax bracket. Others offer moderate tax savings with a moderate cash return. A few offer both comparatively low tax savings and low cash return, but with little risk. Some experts expect to see a greater future emphasis on real estate limited partnerships that are less dependent on tax benefits but that promise large profits and capital gains when the property is sold.
The most commonly suggested minimum tax bracket for an investor in tax shelters is 50% — an arbitrary figure, more convenient than logical. Of course, the higher the investor’s tax bracket, the more valuable any tax write-offs are to him. But as the tables at right show, a successful partnership can produce impressive returns for taxpayers in the 35% bracket, and some deals may be advantageous for even less wealthy investors. In any case, inflation has made the top bracket accessible to a lot more people than it used to be. A married couple filing a joint return become subject to a federal income tax rate of 50% when their taxable income —income after deductions and exemptions — reaches $44,000. For a single person, the 50% rate applies to all taxable income over $32,000.
The impact of a particular partnership on any individual investor’s taxes depends on more than a mere determination of brackets. The primary tax question is whether, and for how long, the investor will be able to take advantage of all the deductible losses. Simply put, the investor should be able to count on quite a high income for many years to come. With planning, the investment can sometimes be structured so that by the time the investor pays out taxes on the project, he will be in a lower bracket—retired, for example. It is even possible to defer taxes indefinitely by continually reinvesting capital gains in new tax shelters.
The category in which an investor’s main income falls is also important. The maximum tax on earned income (from wages and salaries) is 50%. Each dollar of deductible loss that a taxpayer in that bracket can use to offset income will reduce his tax bill by 50 cents. The maximum tax on unearned income (dividends and such) is 70%, making possible savings of 70 cents per dollar of deductible loss for investors with high unearned incomes. Other factors, including state and local taxes, create additional variations in the way any given partnership will affect different individuals’ taxes.
Aside from the construction expenses, the key to a syndicate’s deductible losses, and therefore to the tax write-offs passed through to the limited partners, is depreciation. The tax laws allow depreciation to be “accelerated” into the early years of the investment rather than taken on a “straight-line” basis in equal yearly amounts over the life of the project. Accelerated depreciation increases deductible losses in the early years without reducing cash available for distribution to the limited partners. Rehabilitation projects approved by the federal government are allowed the most rapid depreciation: the entire value of the projects can be written off in five years, as opposed to the customary 30 to 40. Accelerated depreciation, however, has a negative aspect too. In the final years of a project, there will be practically no depreciation left to charge off against income, thus increasing any taxable profits.
When an investor sells his interest in a partnership, or if the partnership terminates through bankruptcy or sale of the properties, tax falls due on any gain realized. As in any investment, that gain is the difference between the investor’s original cost and the sale price (usually zero in the case of bankruptcy). In partnerships, all the deductible losses and cash distributions accumulated over the years are deducted from the original price in this computation, thereby adding to the gain. So once he sells his interest, the investor may owe taxes on the ostensibly tax-free benefits he previously received. Since tax savings and cash distributions over the years can total more than the investor’s original stake in the project, he may have to report a taxable gain even if the real estate project goes bankrupt.
Because the increase in value is normally a capital gain, the tax rate is no more than half the ordinary rate — with one important exception, known technically as depreciation recapture. When an investor leaves a project before it is fully depreciated, he may have to pay taxes at ordinary-income rates on all the income he has received over the years that can be attributed to accelerated depreciation. Since the difference between straight-line and accelerated depreciation can easily be as great as the capital gain, the recapture provision can largely nullify the project’s tax benefits to the departing investor, who must then content himself with whatever gain he has been able to reap by postponing the tax payments.
To add to the fiscal complexity, the recapture rule does not apply equally to all types of projects. As a way of encouraging investment in new rental property, the government follows special rules that gradually eliminate all recapture on such property by the 17th year. Thus all gains realized by an investor who leaves from the 17th year on will be taxed at the capital-gains rate, whereas an investor in other types of property may have to hang on for 30 years or more to get comparable treatment. The rules are even more generous for low- income housing projects financed under section 236 of the Housing Act of 1968. There can be no depreciation recapture on these projects after the tenth year.
As a result, section 236 projects are especially lush with tax benefits as well as with other attractions such as insured mortgages and interest subsidies. One recent syndication primarily involved in section 236 projects, American Housing Partners, sponsored by Kaufman & Broad Inc. and sold through E. F. Hutton & Co., promised $6,000 of deductible losses over 20 years for a $1,000 investment — close to the legal maximum. (In no case can the deductions taken by an investor in a limited partnership total more than his share of the value of the property — equity plus mortgage.) But this syndication’s distribution of cash is expected to be small.
Middle-income housing projects, which can obtain government-insured financing under section 221(d)(4) of the Housing Act of 1968, offer a moderate tax benefit with more substantial cash flow than the 236’s. Many government projects, however, especially the low-income ones, are high-risk ventures. Among other things, the low-income projects have been troubled by difficulty in collecting rents and have had a high rate of default on mortgage payments. In most federally insured projects, moreover, rents can be raised only with government approval, which can be hard to get.
The net effect of all the tax rules affecting limited partnerships is that the investor — even if he can find a buyer — cannot get out of a partnership too soon and still come away with a positive return on investment (see the graph on page 48). As Michael Linburn, who is supervising a section 236 project for Shearson, Hammill & Co., says, “Heaven help you if the thing goes belly up halfway down the road, because you’ll have some recapture to pay taxes on.” Agrees Lawrence Winston, director of tax shelters for E. F. Hutton: “Real estate limited partnerships are long-term investments.”
From the tax collector’s point of view, it makes no difference whether the investor pulls out of the partnership voluntarily or the project goes bankrupt; with a bankruptcy, the effect is usually the same as if the investor sold for zero. This is what can make the more default-prone government deals dangerous. Eager investors who think they can guarantee an eventual net profit on their investments from tax deductions alone are fooling themselves. Such deals are feasible, says Warren Wintrub, a partner in the accounting firm of Lybrand, Ross Brothers & Montgomery, but they are scarcely ever syndicated to the public, and they require, at the least, that the project not go bankrupt for quite a while.
So the tale will be told not by the fancy financial landscaping but by the success or failure of the real estate deal itself. Here is where the bulk of the risk lies and where the investor can be most easily misled. “Most people forget that real estate investment is venture capital, nothing less,” says Howard P. Hoffman, a New York property consultant. The real estate business is a perilous arena for the amateur. Complexity is rife and profit margins are often surprisingly slim, resulting sometimes in stunning reversals of fortune; an early wave of public interest in syndications collapsed a decade ago when some prominent general partners could not meet their financial obligations. Thomas Gochberg of Smith Barney Real Estate Corp, characterizes property development as “a nickel and dime business on a grand scale.”
Finding good real estate in today’s market is especially difficult. D. Bruce Trainor, who runs the Tax Shelter Advisory Service, Inc., in Narberth, Pa., says he has $10 million of commitments from investors but cannot find suitable investments. “Vacancy rates are up throughout the country and prices are just too high. Some of these big syndicates are paying outrageous prices,” he says. The surviving dean of real estate syndications, Lawrence Wien, whose most famous project was the Empire State Building, agrees. “There is difficulty in finding suitable properties,” he says. “The competition has made it very difficult for a syndicator today.”
The best advice to the newcomer in assessing any real estate investment is to get professional guidance, and from several sources. The American Society of Real Estate Counselors in Chicago will provide a directory of their members. If a good banker, lawyer or accountant does not have the expertise himself, he should know of someone who does. Trainor’s specialized service may be helpful. Professional guidance, however, will usually be expensive. Trainor’s minimum fee, for instance, is $400 or 4% of the investment.
At the very least, a prospective investor should visit the property (usually an existing or proposed apartment house), get a feel for the economy of the area, find out what other apartments rent for and whether they are comparable to the ones the syndicator is offering. Details on the proposed apartments should be included in the prospectus. Half seriously, one expert advises: “You should never buy into a project more than an hour’s drive from your home.”
Syndicators often provide tempting cash-flow projections similar to the ones shown in our tables. But the projections are only as good as the assumptions they rest on. The critical factors are the assumed vacancy rates and operating expenses, and they are usually underestimated. A check of similar, nearby apartments will serve as an important clue to the likelihood of low vacancy rates. As for operating expenses, a survey of 65 California syndications by Kenneth Leventhal & Co., a Los Angeles-based accounting firm, found that projections of these expenses averaged 31.6% of rentals for new buildings and 36.7% for old. Trainor says that actual operating expenses average closer to 45%. A year-old study by the Institute of Real Estate Management found an average of about 45%, but with a wide range of individual variation.
Another item often understated is the amount that will have to be reserved for repairs and replacement of facilities such as refrigerators and ovens. Finally, while a high mortgage may provide handsome tax benefits, it leaves little room after interest and amortization payments for unexpected run-ups in operating expenses, or anything else.
The track record of the developer and manager of the properties, often outlined in the prospectus, is important. If they have done well before, they probably know what they are doing. If they have not, there is a good chance they don’t. Some managing partners will not tell the investor what they intend to do with his money. Such “blind pools,” which do not specify the properties to be bought, are strongly discouraged by regulators in New York and Texas, and for good reason. No analysis, expert or superficial, can be done on them. The investor is giving a blank check to the general partner.
The compensation investors pay for the various services provided by the general partner and others is always complicated and frequently excessive. First, there are “front-end,” one-time fees. These include sales commissions to the broker from whom the investor buys his share and real estate commissions or acquisition fees to the general partner or whoever purchases the property. Then there are annual management fees, usually including some participation in any cash distribution or capital gain. Still other fees may be charged for refinancing, sale of properties and to cover special expenses.
Management compensation in many syndications has been high enough to make the general partners happy even before the first spadeful of earth is turned. Leventhal’s study found that front-end fees average 17% of investors’ equity, and many of the big, broker-backed projects charge up to 25% and 30%. The National Association of Securities Dealers has recently suggested that front-end fees, including the first year’s management fee, should be limited to 12.5% of the investors’ equity.
On top of the explicit fees, which are usually mentioned in the prospectus, there can be additional benefits to the general partner through self-dealing. For example, a prospectus issued by CNA-Larwin Realty Fund, a subsidiary of CNA Financial Corp., states that while investors will be spared one fee—the brokerage commission on the partnership interest they buy—“the Fund will purchase all or most of its apartment projects from a parent” of the general partner. Any profit that the parent company collects on these sales will be an extra bonus for the corporate family. The prospectus also discloses that the parent’s offspring — the general partner — will take a 5% commission on any properties it purchases.
The best compensation arrangements are those that tie the general partner’s rewards principally to the success of the project. Arrangements of this type provide just about the only control an investor can have over his general partner. Stephen E. Roulac, a San Francisco consultant and author of a book on syndications, strongly advocates performance fees and commissions based on a percentage of investors’ equity rather than of gross invested assets. Commissions based on assets, he says, ‘ ‘merely induce management to pay more for the properties they buy.” The NASD agrees and is proposing flatly to prohibit general partners from accepting real estate commissions on purchases made on behalf of the partnership.
Roulac believes the general partner should participate liberally in the profits of a project after the limited partners have received a specified minimum return. In this way, Roulac says, the goals of the general partner and the limited partners become “congruent.” One syndication using this sort of fee structure is known as SB Partners, managed by Smith Barney Real Estate Corp. The total front-end fee is a modest 4% to 5%, and annual management charges are based on the investors’ equity only, not on gross assets. But once the limited partners are receiving a cash return averaging 8% annually on their investments, the general partner becomes entitled to 25% of the remaining cash.
Given this country’s pressing need for housing, there is good reason for optimism about the future of the better publicly offered real estate syndications. But this method of investing in land and buildings is still young, and time and competition have not yet weeded the bad from the good. Joining a partnership is simply not analogous to buying a share of stock. Unusually thorough analysis is necessary, and the investor must shop around among as many brokers and syndicators as he can, looking for the gold beneath the glitter, the solid real estate deal beneath the financial wizardry.