There’s a common saying that if you fail to plan, you are planning to fail. That’s particularly true in commercial real estate investment. In fact, the savvy investor knows an exit strategy is simply your plan for getting the money you put into an income property, out of the investment.
Before you consider what type of exit strategy is best, you need to ask yourself a few questions first.
Why are you buying this property?
Are you looking to buy a property to add an extra stream of income to your bank account? Or do you plan on passing this property on to your children or grandchildren? Perhaps the NOI on this property, along with several other properties, will support you during retirement?
Do you own numerous properties, but need this one primarily as a 1031 exchange or tax shelter?
There is no right answer, but whatever you decide will help set the tone for choosing the right exit strategy.
How long do you plan to hold on to this property?
This answer will affect the type of loan you choose to finance your investment property. If you plan on holding the property for the short-term, selling it after just a few years, then a loan with a balloon payment at the end of five or so years will suit you just fine. In that case, you want to make sure not to choose a loan with a pre-pay penalty that penalizes you for paying back the loan too soon.
However, if you plan on holding onto the property for as long as 10 or 20 years, then you’ll need a loan – or a series of loans – that don’t penalize you for holding the property.
Once you answer these questions, you need to look at what your primary goals for the property are.
How will selling this property affect my taxable income?
Planning for taxes is essential, lest you get hit with an easily avoidable penalty, or worse, eat up most of your profits by ending up in a higher tax bracket as a result of the sale.
The most common way to handle this is through a 1031 tax exchange, but since there are time limits on when 1031 can be performed, you’ll need to
identify a property before or soon after you sell the property. If you’re unsure, it’s best to consult a tax professional before you purchase the property so you can reduce your tax burden right from the start.
Make sure you choose an excellent tax adviser; if you use a cheap franchise be prepared to get what your money pays for. Commercial real estate involves large sums of money; be ready and willing to pay the money necessary to keep what you earn.
Upgrade and sell
Some investors prefer to find properties that can be upgraded and sold within a few years. Their goal is to get the net operating income as high as possible, then sell. This type of investor is looking for properties that are undermanaged, with delayed maintenance or other easy fixes, in good locations.
Their exit strategy is to increase tenant occupancy, raise rents, and then sell the property for a lower cap rate and make a profit.
Buy and hold
This type of investor is interested in holding a property for at least 20 to 25 years. Although they are interested in raising the NOI as high as possible, they are more interested in getting a steady monthly income over the long term.
They are looking for safer, low-risk properties that offer a stable NOI. They expect to make a profit over the long-term through appreciation and through excellent property management.
These are the main questions you should ask yourself before formulating your exit strategy.
There are, however, several other factors that can affect which exit strategy you choose:
- Market conditions
- Location of the property
- Purchase price
- Property value
- Condition of the property
- Time to close
- Financing options
- Profit potential
At the same time, there are some factors that can ruin even the best-laid plans. These are:
- Unexpected maintenance costs, particularly cap-ex
- Loss of a promised loan
- Tenant vacancies
- Poor property management – this one is very common
- Lack of demand
- Failed escrow
Types of Exit Strategies
This is a short list of possible exit strategies. Don’t feel compelled to stick with these; consult with your broker and an experienced tax advisor for suggestions specific to your investment goals and property type.
1.Hold on to property for the long term.
2.Wholesale the property.
3.Buy and flip the property as soon as possible. If you get an offer close to your ideal price, sell it immediately. The longer you wait, the more things can go wrong.
4.Sell the property after two or three years, then do a 1031 tax exchange with the money.
5.Gift the property to your heirs.
6.Do a sale-leaseback.
7.Do a cash-out refinance loan. The additional money can be used to buy a new property or renovate one you already own.
Remember, an exit strategy can change depending on the circumstances.
You should actually have more than one exit strategy; typically three is the ideal number since you will likely have one type of exit strategy before you purchase the property, another one after you’ve owned it for a while and have a better handle on things, and a third strategy composed right before you plan on selling.
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