Foreword by Andrew Chilvers
For ambitious companies eager to expand into overseas markets, often the conventional route of organic business development is simply not fast enough. The other option to invest in or buy a business outright is far quicker but often fraught with unforeseen dangers. And even the biggest, most experienced players can get it badly wrong if they go into an M&A with their eyes wide shut.
If you search for good and bad M&As online the Daimler-Benz merger/acquisition with Chrysler back in 1998 is generally at the top of most search engines on how NOT to undertake a big international merger. Despite carrying out all the necessary financial and legal measures to ensure a relatively smooth deal, the merger quickly unravelled because of cultural and organisational differences. Something that neither side had foreseen when both parties had first sat down at the negotiating table.
These days the failed merger of the two car manufacturers is held up as a classic example of the failure of two distinctly different corporate cultures. Daimler-Benz was typically German; reliably conservative, efficient, and safe, while Chrysler was typically American; known to be daring, diverse and creative. Daimler-Benz was hierarchical and authoritarian with a distinct chain of command, while Chrysler was egalitarian and advocated a dynamic team approach. One company put its value in tradition and quality, while the other with innovative designs and competitive pricing.
Michael E. Lefkowitz and Richard Sussman discussed The Art of Deal Making: Using External Expertise Effectively as part of the Real Estate chapter
How important is local market intelligence to effective cross-border real estate transactions, in your view, particularly in the current Covid-19 market? Any examples of how you have helped clients using expert insight into your jurisdiction’s real estate market?
Typically, in a cross-border real estate transaction the foreign investor knows little about the locale in which they propose to invest and looks to counsel to help them to understand the market, local laws, regulations and customs.
New York City has a myriad of complex laws that impact real estate and must be understood and accounted for to minimise risk and maximise return. These include: a complex system of residential rent regulations, the manner in which various classes of real estate assets are assessed and taxed on the local property tax level, and various tax incentive programs that can greatly enhance value in exchange for providing a benefit to the community (e.g. affordable housing, building community facilities and/or providing capital upgrades to municipal facilities). Legal regulations instituted because of Covid-19 have also greatly impacted the market. While these are ‘temporary’, it is impossible to predict how long they will stay in place for. Significant examples that have restricted the rights of owners include a moratorium on evictions (even for non-payment of rent) and prohibiting pursuing guarantors of leasehold obligations. While protecting tenants, they handcuff owners in a manner that can have ripple effects through the economy – consider, for example, the impact of decreased cash flow on the ability of owners to pay mortgages and real estate taxes.
We also do more than simply provide legal advice. NYC (as well as the New York metro area) is a broad and diverse real estate ,arket. We are intimately familiar with the various markets and sub-markets in our jurisdiction and the local laws, regulations and customs. We have done transactions in most of them and provide advice on market trends, competing developments, the lenders acting within the market, etc.
What are some of the key elements involved in achieving an accurate valuation for a real estate portfolio prior to the deal making process?
Some considerations are unique to the client:
- Consider how the proposed investment fits into the client’s portfolio. Does it align with other assets, or does it have unique characteristics? If the former, the client should be able to boost return by taking advantage of economies of scale.
- Where is the source of the equity for the investment? If the equity comes from a recently sold property, can the funds be part of a 1031 ‘like-kind’ exchange? If so, the value to the client may well be higher than to another investor.
Other considerations are more general:
- Is the asset occupied? An unoccupied asset creates the possibility of demolition/construction or gut-renovation, which can create value. If the asset is occupied, what are the occupants’ rights and what is the cost/benefit of a possible buy-out?
- What is the zoning applicable to the asset? For example, if the asset is an older office building and has a handful of tenants, would it make sense to vacate the building and re-adapt to residential or hotel use? This can be a short-term proposition, or a medium/longer-term possibility where the asset is re-sold at a profit.
- Is the asset fully built, or are there excess development rights available? In NYC, these rights are valuable in multiple respects. They can be used in the property by adding a penthouse or adapting space to generate additional cash flow. Alternatively, the rights can be sold to an adjoining property and used within a ‘combined zoning lot’. These development rights are valuable – sales in certain areas have reached upwards of $US600 psf. Many invest without considering this possibility, nor do banks typically account for these rights in property valuations. Knowing these rights exist when negotiating can be used to a savvy purchaser’s advantage.
What Tax-Efficient Vehicles Can Be Used To Hold Real Estate In Your Jurisdiction? Any examples of deals you have structured in this way?
Debt Structure vs. Equity Investing
There is benefit to foreign investors to structure investment in US real estate as debt versus equity because they can avoid becoming a US taxpayer. We recently completed a project for a European client that made its investment as a mezzanine loan. Using this type of structure avoided the investor needing to be a US taxpayer and therefore be subject to withholding and payment of US income and capital gains taxes.
Real Estate Tax Exemption
To combat a housing shortage for lower income families and make market rate development economically feasible in New York, a developer building a certain number of affordable units can obtain an exemption from paying real estate taxes. There’s exemption for the period of construction (not to exceed three years) and – dependent upon certain facts and limitations – 35 (and possibly 40) years on the assessed value of improvements. In exchange, you commit 30% of the apartments in your building to affordability restrictions for lower income individuals for the life of the benefits.
Opportunity Zones are a community development program established to encourage long-term investments in low-income urban and rural communities The program provides a tax incentive for investors to re-invest their unrealized capital gains into Opportunity Funds that are dedicated to investing into Opportunity Zones. State governors can nominate up to 25% of their state’s qualified census tracts for inclusion – these are largely lower income areas in need of investment opportunities.
It’s lucrative for investors who have had substantial capital gains subject to US capital gains taxes from the sale of assets such as stocks, a business or real estate. Investors can defer tax on any prior gains until the real estate asset is sold or exchanged if the gain is reinvested in an Opportunity Fund.
Top Tips – To Optimize a Real Estate Portfolio
- Know the Law
Prior to and during the Covid-19 pandemic many jurisdictions implemented law changes that inhibit a landlord’s ability to increase rents and enforce leases and related guaranties. These measures impact real estate values as they diminish rent collections; thus investors must have knowledge of law changes to invest wisely.
- Anticipate Change
Covid-19 has intensified changes in retail and has caused dramatic effects in the office and hotel sectors. Those who saw the writing on the wall have diversified from retail to other asset classes and are well positioned for growth. One must anticipate continuing changes resulting from the pandemic in the retail, office and hotel sectors.
- Go Green
Tenants are looking for locations that provide green initiatives such as LEED (Leadership in Energy and Environmental Design) certified buildings, solar power and green design. Owners can receive tax incentives and abatements by implementing solar or wind energy elements.