The Client's Story
This couple had been running their eastern Montana cattle ranch for many years, and decided it was time to retire and move closer to their kids and grandkids in Bozeman. Both their CPA and their attorney advised them to perform a Section 1031 exchange into income-producing real estate, in order to avoid paying income taxes on the ranch sale. Their attorney was familiar with Top Hand, and recommended that they call us.
Rolling Up Our Sleeves
When we began, these folks were unfamiliar with commercial real estate and somewhat intimidated by the process. They were conservative by nature, and cared most about protecting their nest egg and the income stream it could provide. They also did not want to manage real estate. Our initial discussions focused on educating them about the different types of commercial real estate available, and identifying which types of properties would be most likely to accomplish their goals.
Their ranch sale price would allow them to purchase two properties, or one larger property. We advised them to buy two properties in two different markets, in order to further reduce risk through diversification.
They were interested in multi-family real estate – i.e., apartment buildings and condo buildings -- as they figured that the cash flow may fluctuate but would never go to zero. They also preferred that it be located in Bozeman, which was a strong market and would be local for them in their new home. We quickly researched the Bozeman market and, through our connections, presented our client with an off-market condominium building that was less than one year old.
The condo building was part of a larger development project consisting of 12 buildings on 10 acres of ground. We were familiar with this development, as another client had purchased two of the buildings previously. The location was exceptional and was within walking distance to day-to-day necessities such as groceries, coffee shops, restaurants and other shopping opportunities. The units were attractive, and each one had a detached single-car garage. The building was already 100% leased, so our client did not have to assume the lease-up risk that often comes with brand new buildings. Turn-key management was already in place.
As we conducted our due diligence on the condo building and moved forward with that transaction, we continued searching for a second property. After thorough analysis of many suitable properties, our client focused on a brand new Wendy’s ground lease in a strong Utah market. As a ground lease, our client would be purchasing only the land. Wendy’s was already constructing a restaurant on the land. Wendy’s would own the building, and would pay monthly rent to lease the land. (Many large restaurant chains choose this approach, which enables them to deploy capital back into the business rather than tying it up in land costs.) The ground lease held Wendy’s responsible for all costs and management duties associated with the property, in what is called a “triple-net” or “NNN” lease. The lease also calls for rent increases of 10% every five years throughout the 15-year primary lease term and each of the three 5-year renewal options. Further, at the end of the lease – or earlier, if Wendy’s ever terminated the lease – ownership of the building would transfer to our client, at no cost. At that point, our client would then be able to lease out both the land and building to a new tenant, which should significantly increase their income and investment return (after making any necessary modifications to the building that the new tenant may require).
The tenant and lease guarantor is a subsidiary of The Wendy’s Company, which has 6,490 restaurants worldwide and reported revenue of $1.9 billion in 2015. The property boasts an exceptional location on a hard, signalized corner offering excellent access and visibility, and is surrounded by dense national retail. In fact, Wendy’s had been operating an existing, successful restaurant just down the block – and they jumped at the opportunity to move to this new, corner location. This speaks volumes about the quality of the location – always a key factor in real estate investing.
As we dug into due diligence on the Wendy’s property, we worked to wrap up due diligence on the Bozeman condo building. For both properties, we examined the lease documents, including the covenants, conditions and restrictions (CCRs) that govern the properties, as well as environmental reports, property inspection reports, market demographics, title commitments and property surveys. We vetted the Wendy’s tenant, examining its ability to fulfill the lease terms. We analyzed the expenses and net operating income of the 12-plex condo building. Finally, we conducted site visits to both properties, touring the buildings and exploring the surrounding areas.
Throughout the process, we helped our client effectively manage their 1031 exchange to ensure all time limits were met, and had suitable backup properties identified in case the subject properties fell through.
Due diligence complete, our client decided to move forward and close on their purchase of both properties, completing their 1031 exchange.
Our client used the Section 1031 exchange to transition from their ranch into two high-quality commercial properties. Together these properties provide them with annual income of roughly $196,000. Over the long term, the income from the condo building will vary according to changes in rental rates, expenses and vacancy rates; the income from the Wendy’s ground lease should rise 10% every 5 years for at least 15 years, and possibly 30 years if Wendy’s exercises each renewal option. Thanks to the professional property management company hired to manage the condo building, our client has no active management responsibilities for either property, which allows them to now pursue an active Bozeman lifestyle and spend plenty of time with the grandkids.
We've provided this information for general educational purposes. It is not intended as specific tax or legal advice. Please consult a professional for specific advice regarding your particular situation.
© 2016 Jack Sauther & Diana Sauther