Let's say your broker is E. F Hutton, and when E. F. Hutton talks, you listen.
One of Hutton's more provocative sales pitches, you decide, describes a series of real-estate limited partnerships called Corporate Property Associates. The first four in the series closed during the last few years, and are now yielding fully or mostly tax-sheltered returns ranging from 7.45% to 11%. And all hold out the prospect of capital gains a few years down the road, when the properties owned by the partnershps are sold to the next round of investors.
How there is a new partnership available, and hearing that the minimum investment is only $5,000, you're thinking about kicking in a little money. But doubts nag you. Real estate syndication, you know, has gotten a bad press lately. There are rumors that investors are being taken to the cleaners, and that the Internal Revenue Service is tightening up. Is this one of the risky ventures? And how do you tell the difference between the risky and the not so risky?
If investing in syndicated real estate had any drawbacks, you wouldn't know it from looking at the industry's growth over the past few years. Public real estate partnerships alone swelled from $1.3 billion in 1981 to $4.7 billion last year. Private syndications are estimated to total anywhere from 4 to 10 times that much. The largest two syndicators alone -- Balcor/American Express Inc. and JMB Realty Corp. -- each raised more than half a billion dollars in real estate money last year.
The economics of this burgeoning business are simple enough. Selling an income-producing property generates cash for the developer or owner -- even if, as often happens, the owner then turns around and leases the property back. Buying into a property gives investors the tax advantages of depreciation and mortgage-interest deductions, along with an income stream from rents and a chance for profits when the property is sold. Assembling and marketing the deal lets the syndicator take a healthy cut of the whole transaction.
What has made real estate particularly attractive in recent years is the Economic Recovery Tax Act of 198 1, which enables owners to depreciate a property for tax purposes over only 15 years, considerably faster than before. This tax change, coupled with the inflation-beating appreciation of a lot of real estate during the last decade, laid the groundwork for a rapidly expanding industry.
It is not surprising that such fast growth has attracted a host of operators with more enthusiasm than experience -- or, to put the matter differently, with more interest in a quick profit for themselves than in a longer-term profit for their investors. That, in turn, has engendered some critical articles in the business press and a generally circumspect attitude even among industry spokespeople. "Let's say l'm a bit cautious about an industry that has grown as quickly as this one," says Gregory S. Junkin, executive vice-president of Balcor/American Express. "This industry has grown tremendously, and I believe we are going to see some problems -- with deals offered by novices, with investors who are upset, with publicity, and with the tax laws. I caution investors to look closely at the partnership's capital stress and investment philosophy, in addition to the economics of the deal. This is especially important for investors who have not invested in real estate before."
Most of the criticisms of real estate syndication as an investment revolve around three issues. Fees are too high, the critics charge, and some of the costs are frequently hidden from prospective investors. Some partnerships are unduly risky, both as money-makers and as tax shelters. And none of the partnerships are easy to get out of should your circumstances or your investment needs change. Since there is some truth to all these charges, it is worth knowing in advance where the problems may lie.
Fees. When you buy a stock, 98 or 99 cents of every dollar you invest goes for the stock, with the broker getting only the remaining cent or two. Buy a real estate partnership, and very often only 65 cents to 75 cents of your dollar will go to real estate. The rest may be eaten up by partnership fees, management fees, broker's commissions, and half a dozen other expenses. And, when your partnership's property is sold, you as a limited partner typically will share in only 70% to 90% of the gains; the rest goes to the syndicator. Exact fees vary from partnership to partnership, but there is a trade-off between fees and experience. Syndicators with solid track records can get away with charging investors more than newer or less-well-established packagers.
At least the fees are spelled out in a partnership's prospectus. This may not be the case with the other costs an investor incurs. Often, explains Peter Trumbull of the Hartford law firm of Trumbull, Hetzel, Beck & Lauretti, the packager will buy the property and mark it up before reselling it to the partnership. The size of this markup can be critically important, both to an investor's chance for profit and to the IRS, which regards high-markup resales as potentially abusive shelters. But determining the size of a markup is seldom easy. "Even very sophisticated investors -- bank or insurance executives -- do not see enough of [these deals] to know the techniques that are used to mark up prices," Trumbull says. One giveaway, he adds, is a syndicator's refusal to disclose what he or she paid for a piece of property, using "appraised value" as a measure of its worth rather than purchase price.
Risk. Risk in the syndication business takes two forms. One is that the property that is purchased by a partnership won't pan out, or won't appreciate much. One much-cited study, by Charles Wetterer of Real Estate Tax Shelter Review, analyzed 158 sales in different parts of the country and found a compounded annual appreciation of less than 6% a year -- although once tax savings and cash flow were taken into account, the yield rose to 11% to 12%. Since most partnerships have been developed so recently, of course, most of the properties they purchased have not yet been sold. How well they eventually do will depend on regional real estate markets, inflation, and a host of other imponderables.
The second form of risk is that the IRS might disallow some of the deductions, making investors suddenly liable not only for back taxes but for interest and penalties as well. "One of the biggest current risks under the revised tax laws," observes Peter Trumbull, "is that [the sponsor] sells the properties to the partnership at such a markup that the IRS is able to fight it." Another potential problem arises when packagers take out a second mortgage on the property, accruing interest (and thus adding to the investors' tax losses) but not actually paying it. Such a technique, Trumbull says, is a sure sign of a tax-risky deal.
