Transferring Real Estate to the Next Generation

Unlike stocks, bonds and cash, real estate assets are tangible property that must be physically managed and operated as businesses. Making decisions regarding buying, selling or holding assets; attracting and retaining tenants; or incurring maintenance and capital expenditures are just some of the myriad issues that owners must address.

As a real estate entrepreneur contemplates the transfer of assets to heirs and/or other parties, they are aware — sometimes painfully — that for those assets to continue to operate efficiently, there needs to be clarity about what individual or groups of individuals will oversee operation and investment decisions in the future.

If clarity about future control cannot be established, the best option can sometimes be to liquidate all or some of the properties, convey the proceeds to loved ones and leave them with a smaller or less complex portfolio of real estate assets.

But how do you determine if assets should be conveyed and, if so, which ones?

To begin to answer this question, Rob Finlay — the CEO and founder of Thirty Capital, a commercial real estate advisory firm — focuses on three key concepts: control, economics and vision. For him, these three concepts form the framework for determining the best way forward for heirs, without burdening them with decisions they are not equipped to make and potentially jeopardizing the very assets meant to sustain them.

It should be noted that this article focuses on the needs of heirs and their interest or ability to manage real estate and leaves the legal and accounting complexities of partnerships, trusts, tax avoidance and other structures to be explored at a later date.

“For me,” Finlay said, “the decision tree begins by establishing exactly what it is you want to transfer.”

Finlay said he thinks about real estate from two perspectives. First, he considers the ownership and operating structure of an asset and then he examines its value. This enables him to determine if there is real enterprise value in the business, or if the value is simply the sum of the real estate. “Have you created value as a real estate organization greater than that of just the asset,” he postured.

“A lot of people look at real estate companies as the sum of their real estate, and I say it's the sum of their real estate plus the infrastructure and their ability to recreate cashflow, to recreate value, to be able to manage and operate real estate.”

Once Finlay has sorted this out, if there are just a few assets to transfer, then it becomes pure estate planning. “I'm going to transfer some assets, they are protected through some sort of trust, and we've got a property manager that's going to manage it,” Finlay said.

This scenario, he said, is much easier to accommodate than the more complicated scenario of transferring wealth from the standpoint of an owner-operator, “because now you have this business that operates real estate.” When there are operating companies or more complex partnerships to convey, Finlay’s three filters help clarify the trio of issues he believes are core to the successful transfer of real property:

• Who has responsibility and control over decisions?
• Is there value in the assets, the operating company or both?
• What is the vision or business plan for each asset and operating company?

He continuously assesses through one, two or all three of these filters as he encounters challenges such as the complexity of operating some asset classes over others, preparing for disinterested heirs or transferring complex partnerships.

Finlay noted that determining control is one of the most important decisions to be made when transferring ownership because that will dictate elements such as when to sell assets; if or when to buy more assets; and how to prepare for capital calls and required distributions.

When establishing who's going to control the assets, Finlay said it’s important to clearly lay out the benefit of that control: Are you benefiting the rest of the family or are you just benefiting yourself?

Typically, the overarching goal of current owners is to ensure the livelihood of their heirs, most often in the form of predictable cashflow. “Any time one family is transferring real estate or generational wealth to another party, it comes down to economics. Some are going to need it more than others,” Finlay said.

“So, do you have a set guideline of distributions, capital calls or things like that,” he noted. Making these determinations is as important as control because managing the cashflow determines how people are going to live. “You're transferring your assets so that people can enjoy and benefit off of them,” he concluded.

Finlay, who said he is going through this personally with his own children, remarked that “one of them is in real estate but the others are not.” So, he understands the importance of establishing guidelines about who's going to control the assets.

Finlay said many factors come to play in making the determination to liquidate or transfer real estate and he provided several scenarios for consideration. They relate to the complexity of operating some assets over others, the interest and ability of heirs to operate CRE, in-place operating structures and conversions to net lease arrangements.

Complexity. If you transfer an office building to your heirs there will be tenant improvement allowances and leasing commissions to pay, maintenance and improvement costs to contend with and capital reserve budgets to manage.

“I've just been going through our capital budgets for the last week or two … and there’s money that has to go into the physical plant of the building in order to preserve value that takes away from distributions. If people need money to survive from that real estate, you have to think about how much money is going to come out of that asset,” Finlay said.

“I don't know if I want to burden my family with office buildings — and I do say burden,” emphasized Finlay. He explained that the last thing you want to do is give someone a building and task them with the complexities of leasing and operating it if they don’t have the skills or interest.

No interest. “If I were to transfer real estate to somebody who has no desire to operate it, then I would need to find somebody who can operate and make decisions on their behalf. I would do things like hire an asset manager, a property manager or both — whatever may be needed to fulfill the mission that I've created for that property,” Finlay observed.

For longer-term decisions about holding, selling or buying assets, Finlay said those decisions should be made by the asset manager. “A good asset management shop is focused on maximizing the return. A really good asset manager is going to be responsible for telling you when to refinance or when to sell,” he said, adding that they will also provide guidance around a host of other issues.

In-place operating structures and conversions. “Having an asset manager, an advisor or even general partners, where there's actually a real estate partner going forward,” may be a good solution, Finlay said. He added that for deals in which the owner in question is a limited partner, one can transfer the limited partnership interest and let a general partner make decisions.

If the scenario is that you’re a multifamily investor that wants to transfer just the wealth you’ve created, that is a different case. Maybe the goal is to sell your multifamily assets and operating businesses and convert them to credit tenant leases or bondable lease structures, Finlay noted.

Numerous conversations need to be had, so there's clarity among potential heirs about the type of work that may need to be done and if they're willing to do it. In real estate families, Finlay said those conversations occur naturally. “I grew up in a real estate family and every trip, every vacation, everything, it was real estate. I was managing properties when I was 16 years old.” He’s also labored on construction sites, worked as an asset manager and completed financial transactions.

“My kids — even though they somewhat grew up in a real estate shop — have decided maybe real estate isn't for them. But they've had enough dining room table conversations to know what's going to happen,” Finlay said. “I do believe it comes down to what they've grown up with. If it's a very active real estate shop and they're buying and selling a lot of stuff then there's probably enterprise value there,” that a family member or somebody is going to have to maintain by running that real estate business.