Upgrade to commercial property strategy

8 Replies

BPers,

I'm laying out my long-term strategy and need some advice/guidance.  My portfolio currently has a trio of 4-plex properties in the same neighborhood, for which I use a professional manager and oversee things from afar.  One of those are in my name, and the other two in both my wife and I.  Total value for those 3 properties is about $700k.  

We plan on entering active retirement in about 10 years, and would like to reinvest those properties into something bigger.

Here's my plan:

-In a couple years (once the dust has settled from the new purchases and rehab), form a LLC or S-corp (not sure which one), and group those three properties into a single commercial-type loan. Continue to operate the properties as an LLC or S-corp for a period of time (~5 years) to build some type of record and credit for the company.

-When we retire, 1031 exchange that portfolio to a larger property, probably in the $1.5-2M range, still run by the LLC/S-corp, but located wherever we decide to live, so I can self-manage.

My questions:

-Does the above sound feasible? Can I lump my current properties into a LLC/S-corp and get commercial financing for them if I have several years of tax records showing profit?

-Can you 1031 exchange a S-corp held property?  Or do I need to keep them in our names?

-As I understand 1031 exchanges, the names for the exchange need to be the same, so the two properties that have my wife's name on them can't be combined with the one with just my name on it for the new property, right? 

-Does the strategy work well to establish experience for purchasing the larger property with commercial lenders? Would they care if my experience is gained in passive management in a property in my name, or would they prefer to see tax returns for a LLC/S-corp?

Basically, my assumption is I need to build a paper trail (tax-returns, rent roll, etc) of my current portfolio for a couple years to shift things out of my name, and into a company.  My credit score is in the 800 range, but I'd like to start building credit for a company.  

Any advice helps.

Thanks.

@Jack P. that's a well thought-out plan, but completely unnecessary.  It's my opinion that you'll spend a lot of time and brain damage but gain nothing.

The properties are 4-plexes, which qualify for residential financing.  The terms for residential 4-plex loans are quite likely to be superior to what you'll find from commercial lenders.  For example, let's say that you put 15 or 30 year fully-amortizing debt on each 4-plex at a low fixed interest rate.  Under the terms of most competitive residential debt, there would be no prepayment penalty.  In the commercial world, rates tend to be a bit higher, terms are shorter (not amortization necessarily, but balloons) and prepayment penalties are common.  If I were you, I'd leave the title and financing alone.  I'm sure that someone will say that you need to put them in LLCs or a Corp for asset protection, etc, but that's a whole separate (and occasionally heated) debate and, in my opinion, another unnecessary expense and headache given the scope of what you are doing.

I also understand your underlying motivation to build credit for the "company" so that you can get financing later for a larger property. That's another non-issue. If you later form an LLC or corp and acquire a smaller property (call it under $5MM but that's not a hard-and-fast rule) the company debt will most likely be recourse debt where you will be signing a personal guarantee and the lender will be underwriting both the real estate and you personally. Your personal credit will be the credit that the commercial lender is looking at, even if the borrower is your entity. If you are acquiring a larger property, you might find non-recourse debt, in which case the lender will be looking mostly at the real estate and your track record and experience. In larger non-recourse debt placements, lenders typically require you to form a single-purpose LLC to own the real estate and be the borrower, so again all of the calories burned on trying to establish corporate credit is for naught as this newly formed entity will not have benefitted from that previous work.

As for your other questions, in a 1031 the taxpayer buying and selling need to be the same.  You can 1031 S-corp property but the S-corp will be doing the 1031 and will be the buyer of the replacement property.  If you were to ignore my advice and deed the 4-plexes to a S-corp, the one owned by you and the two jointly would all be deeded to the corp, and thus the corp would be the seller and the buyer so the 1031 sticks.  And no, the future lenders don't care if your real estate experience resulted from properties held personally versus in an entity. 

I hope that helps!

@Brian Burke , Thanks! That answered a lot of my questions. 

I'll stop worrying about building corporate credit for now, since it doesn't sound like it makes much of a difference. As for the LLC/corp, I'll explore that a little more in the future. As it stands, I may need the equity from all three properties to reinvest into a larger property in the future. If commercial loans continue to have 5-year terms at high rates, it might make sense to wait to roll all 3 properties into the corp until as late as possible. Either way, I have a while to figure that out.

That's again for your insight and clearing up my misunderstanding of corporate credit.  It sounds like my personal credit is more than sufficient for my goals.  

@Jack P. I’m a lender and just wanted to give you confirmation that everything @Brian Burke advised above is spot on from a lending perspective.

Real estate companies don’t earn credit scores to stand on their own like an auto repair shop or other commercial business might. The loans are either based on the cash flow of the property or the wherewithal of the borrower, and usually a combination of the two.

@Jack P. , Yep, @Brian Burke nailed it for you.  From the 1031 perspective you can go either way.  Any tax paying entity that owns property can do the 1031 exchange.  It can be slightly easier to 1031 when all properties are consolidated in one entity but it's also just as easy to do a series of consolidation exchanges to get the same place.

One thing that resonated with me in your post as your comment that you are 10 years out from retirement.  What you're doing right now is your glide path to that retirement.  And although I'm never a chicken little and don't pretend to predict the market we are 6-8 years into the growth cycle of what is usually an 8-10 year market cycle.  So you'll do well not to try to come screeching into retirement on two wheels in one big massive sell off and purchase.  Make sure that each step of your glide path is stand alone and can withstand a correction.  If you do that then you won't get stuck delaying retirement as so many last time around.

@Dave Foster , thanks.  Yep, this is just one leg of my "retirement" plan.  My other endeavors make up the bulk of it, and it's flexible.  So when the time comes, I'm not completely reliant on the real estate market...it's just icing on the cake.  Point is, I was just seeing if there are any decisions I need to make in the next couple years which I would otherwise regret not making when the time roles around later on down the road.  

Just a quick asset protection question. Every state is different and your personal situation may biunique, but holding rentals in your name may not always be the best idea. LLCs might be something to look into sooner rather than later.

I don't believe it was mentioned (nor is it my business), but your equity in the 3 fourplexes.  The equity now vs the equity in 5,6, or even 10 years from now.  

Would you consider refinancing them (pulling equity out while maintaining advantageous residential financing rates/terms and ownership)?  You would be continuing to hold solid producing investments and have a chunk of cash available to do a larger MF deal.  That assumes you want to continue owning these fourplexes and that they are solid producers.

Best of luck in whatever you decide and thank you for asking all of these questions, some really great responses came as a result.

@Matthew Ries , understand your point about the equity, but I'm not significantly better than the 75% LTV ratio right now, so need to build some equity first, hence the 10-year plan. They're solid producers, and won't be able to find an equivalent property for the equity we have in these ones.

@Kurt Jones , I'm tracking the protection benefits of an LLC, but that comes back to the financing question. Moving the property to an LLC would result in the lender calling in the loan. At this point, we're comfortable with them being in our name, managed by another company, and protected by a healthy umbrella loan.

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