What is Disposition in Commercial Real Estate?
The basic premise of a commercial real estate investment is that a property is purchased for a certain price, the space within it is leased to businesses to generate a stream of rental income, and the property is sold after some number of years holding it. From a return standpoint, the rental income tends to generate a small, but steady return while the largest gains tend to come from the profit made upon “disposition.”
The purpose of this article is to define what a disposition is, to identify potential disposition strategies, and to briefly discuss what happens after a disposition.
What is a “Disposition?”
The term “disposition” is just commercial real estate (CRE) jargon for “selling” an investment property. The terms “buy” and “sell” can be used interchangeably for “acquisition” and “disposition.”
What is the Disposition Process?
To understand the disposition process, it is helpful to discuss it within the context of the full commercial real estate investment lifecycle.
The first step in the investment lifecycle is to find the property. In most cases, this involves selecting a market and reviewing dozens of investment opportunities in it to find one that meets an investor’s criteria. For most investors, it makes sense to find 3-5 properties in this initial screen and to carry them into the second step of the investment lifecycle, underwriting the property.
In the second step, financial due diligence is performed on each of the properties identified in step 1. This financial analysis includes a review of all historical financial statements, creating a projection of future income and expenses, and the calculation of key investment return metrics. If the cash flow and returns meet an investor’s return objectives, an offer is made on the property.
If the offer is accepted, the commercial real estate acquisition is completed and the property moves into the management phase of the investment lifecycle. During this phase, key responsibilities include collecting rents, paying expenses, and generally ensuring that the property is in good condition for tenants and visitors. While the first two steps happen relatively quickly, the property management phase can last for years. For many investors, the plan is to hold a property for 5-10 years before moving into the last step, the disposition phase.
Prior to acquiring a property, a financial model assumes that the property must be sold for a certain price to achieve the desired returns. When market conditions reach a point where this price can be achieved, the disposition process begins. It starts with reviewing the prices for the recent sales of comparable properties, retaining the real estate services of a brokerage for representation in the transaction, listing the property for sale, vetting potential buyers, and finally “disposing” of the property. In most cases the disposition is an outright sale, but not always. There are several strategies that could be pursued.
Potential Disposition Strategies
There are three potential strategies that could be used to dispose of a property: a traditional sale, a sale with seller financing, and a 1031 Exchange. The decision-making process for which one to use is based on the real estate needs, occupancy, market conditions at the time of sale, and the property type. Details on each strategy are below.
Traditional Sale
A traditional sale or “real estate disposition” is the most common option. In it, a property is listed for a fee simple sale. The property value/asking price is agreed upon between the property owner and the brokerage acting as their representative in the transaction.
In a traditional sale, the buyer is a third party who acquires the commercial real estate property for their own investment purposes and they obtain financing from their own lender. When the transaction is closed, funds are first used to pay off any outstanding loans and anything left over is distributed to investors.
Sell Property With Seller Financing
For whatever reason, a potential buyer may be interested in the property, but unable to obtain financing from a third party lender. In such a circumstance, it may make sense for the seller to finance the purchase. The key difference between this scenario and a traditional sale is that, instead of the lender placing a mortgage on the property, the seller places the mortgage and the buyer makes payments directly to the seller.
For the seller, the major downside of financing the sale is that they may not receive a large cash payment at the time of closing. Instead, they will receive it in monthly payments over a long period of time, which can make it difficult to return investor funds. On the flip side, the seller earns interest on the “loan” and could actually end up earning a larger return over time, assuming the buyer doesn’t default on the loan.
1031 Exchange
Selling a property for a profit is a double edged sword. Making a profit is always a good thing, but it can also come with a sizable tax bill. In order to defer taxes on a profitable sale, owners may choose to use the sale proceeds to execute a 1031 Exchange.
This type of transaction is very common in the real estate industry and it allows the property owner to defer their tax bill as long as the sale proceeds are “exchanged” into a property that is considered to be “like kind” to the property sold. There are a number of rules and regulations that must be followed to ensure the transaction is completed correctly, but the result is an indefinite tax deferral, which can be incredibly beneficial for the property owner.
Regardless of the strategy used, deciding when to sell the property can be a tricky decision.
Why/When to Dispose of a Property
The decision of when to sell a property and for how much is one of the most consequential decisions that can be made in a commercial real estate transaction. There is no “right” answer. Instead, investors must rely on their years of experience and their knowledge of the market. With this in mind, there are generally two reasons to sell a property:
- A Great Offer: From time to time, an investor may get an offer for their property that is just too good to ignore. Typically, it comes well before the end of the planned holding period, but at a price that allows for the delivery of an excellent return to their shareholders.
- Time is Up: When the investment reaches the end of its planned holding period, investors expect their money back. In order to return it, the property must be sold. However, if market conditions are not favorable for a profitable sale, it is common for the holding period to be extended until they improve.
Selling a property for the best price is just as important as purchasing it for the right price and it can be the difference between a profitable transaction and an unprofitable transaction.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
