A WARREN, GORHAM & LAMONT PUBLICATION Vol. 17, No. 1 / Spring 1987

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Srencrn SyNorcerrou Ser.rs Dare

SvNorcarroN Toprcs/David A, Smith

Rrer. Esreru Exrcurrvr CovrprNserrou/l erry Kovach

o FoorNorES Fnolur e Lewyrn's Jounxer,: EasrrvrrNr Rrcnrs /Gary Smolker

o Rrer Esrers Mesrrn Lrvrrrrr PenrxrnsHrps: Wnv hvvrsrons Lmr Tnntt/Stan Ross

MensnarlrNc Prnsoxer, SevrNcs ron Rrer, Esrerr INvpsrurNr/Bertraru Lewis

Menxrr TrnarNc ron ConpoRATE eNo INsrrTUTroNAr- Orrrcrrts/Robert l. Rodino

Tur Ruar, Esreru Lrgurorrv Cnrsrs/Stephen P, larchow. AoveNTAGES or PenrrcrpATrNc Monreecns/Peter C. Kelley

A Worr rn SHrrp's ClornrNe/lonathan M. Rozek

Wrrr rnr Crrrrs Losr Tnrrn Becr Orrrcrs? /Mitchell L. Moss and Andrew Dunau

Rrer, Esrerr RrrunNs eNu Menxrr RrspoNSES ro r986 Tex Rrronnr/Williarn B. Brueggeman and Thomas G. Tkibodeau

Tnr IupacT oF THE 1986 Tex Rrronu Acr oN Rrel Esrart/lames R. Follain,Patric H. Hendershott, and David C. Ling

PrxsroN FuNo lNvrsrnrrur MeNecEns' UNrr Var,ugs Dgsrnvr CoNrronNcr/Rebel Cole, David Gwilkey, and Mike Miles

How Bnoxrns CeN Rrnucr VuTNERABTLTTy ro Lewsufis/Charles P. Edmonds andRudolph Lindbeck

Monrcecu INsunrns Snouro Br rnr Rrsr Terrns/Robin Paul Malloy

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The Real Estate lnstitute of New York University

The one thing more dangerous to an investor than a clear threatis the illusion of safety.

A Wolf in Sheep's ClothingJonathan M. Rozek

Co*o*u.s AGArN HAs attempted to reform thetax code. The stated goals of the reform are taxsrmplification, the creation of a ,,level playing field"that favors no one investment over inothJr, andlower taxes for the poor. A conspicuous justifi-cation was the elimination of abusive tax shelters.

- Therefore, Congress took away many of the de-ductions that were the mainstay of deep-shelterprograms. Lawmakers and investors alike maynow believe that only 'oeconomic', investments havbsurvived. But appearances are only skin-deep, and

only the appearance of abusive programs hzuchanged.

THE PROMOIER AS ADAPIER

An abusive investment promoter does not carewhether his program is a deep shelter or an ,,eco-

nomic" program. He wants only to maintain his

Jonathan M. Rozek is Assistant Vice president of an invest-ment division of New England Life, and lectures on real estatetopics. Copyright @ 1986 by lonathan M. Rozek.

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Furthermore, the risk in most deals is the abilityof the project to produce long-term profits, notinitial cash flow. Leases in place and a current highdemand for commercial and residential space arereliable indicators of profitability during the firstsix to thirty-six months of ownership. Lease-up andoperating deficit guarantees that do not extend be-yond this initial period are more selling tools thanrisks to developers and promoters.

,A Distribution of lease buyout procee,ds. It isnot uncommon for promoters to be the last ones toenter a real estate market and to buy at the top.This is not coincidental. The best-sounding storycan be told when the promoter has the greatestamount of statistics about the strength of a market.This accumulation of data is greatest immediatelybefore the decline of that market.

The promoter may have acquired the propertyjust before lease rates start to soften. When a com-mercial tenant later becomes aware that there areleases available at much lower rates in other build-ings, he may be willing to negotiate a lump-sumpayment to the owner to get him out of his high-rate, long-term lease. General partners sometimesdistribute this one-time payment to investors as asupposed indication of property management acu-men. Although the distribution may bolster other-wise anemic cash distributions and please investors,it represents a dangerous policy. If the market is

tl The ofrer of an unusually high preferred re-turn. Everything else being equal, the more a gen-eral partner subordinates his profits to a statedminimum return to investors upon sale of the property, the better. This appears to give the generalpartner a greater incentive to perform. Unfor-tunately, everything else is not equal The generalpartners who offer the highest return to investorsbefore taking their profits are often sponsors of themost abusive programs. The larger the fees theytake at the outset, the less they need the profit thatthey subordinate to investors down the road.Ironically, promoters who are aware of the lowprofit potential of a property would be more in-clined to offer a high preferred return. They arehuppy to lure investors with what they know will bea large percentage of a small number. A high pre-ferred return is not the same as a high probabilityof return.

J Early refinancing. fn recent months there hasbeen an explosion in the number of public and pri-vate limited partnerships that assume mortgage re-financing in four to six years. This cannot be at-tributed to the recent drop in interest rates. Becauserates are currently lower than they have been forseveral years, it is reasonable to assume that theywill be higher in four to six years and refinancingwill be difficult.

The popularity of refinancing is due to its effecton cash distributions to investors and fee distribu-tions to promoters. Many investors do not draw thedistinction between return o'f capital and return oncapital. Before the original investment is returned,a high yield is no yield at all; it is a return of capital.

As mentioned earlier, promoters now have goodreasons to buy properties with less debt than lenderswould be willing to loan. Consequently, the projectmay borrow more money in later years even if its netoperating income does not rise or interest rates donot drop. In four to six years, the promoter simplyborrows the rest of what he could have borrowed atthe outset, and makes a large cash distribution toinvestors, minus fees. If this new level of debt hadbeen placed on the property from the beginning, in-vestors would not have considered the money theynever had to invest as a distribution. Now their re-turn of capital is heralded as an achievement.

Refinancing rs a useful and legitimate techniquewhen used for the right reasons. A conservativegeneral partner may wish to have lower debt serviceand a lower breakeven occupancy during the initialyears of ownership. If the property stabilizes athigher net operating income or if interest rates fall,

softening and other propertiescompetitive rates or amenities,

afethe

offering moreproperty man-

ager would be well-advised to use the proceeds toimprove the vacated space, the property in general,or advertising efforts. Such proceeds should bedistributed only after the vacated space is leasedagain on acceptable terms.

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