REAL 4000 - EXAM 4 – DIETZ - QUESTIONS AND
ANSWERS
DEBT & EQUITY REVIEW - -All Properties are Purchased with Money
Money to Finance Property generally comes in TWO PRIMARY "COLORS":
- EQUITY (Ownership)
- DEBT (Loan to Ownership)
Within Debt and Equity there can be numerous SUBCATEGORIES making a
Capital "Stack" including:
- Sponsor Equity
- Common Equity
- Preferred Equity
- Mezzanine Debt
- Junior Debt
- Senior Debt
- VALUE OF U.S. CRE - -42% Private Equity
34% Private Debt
12% Public Equity
12% Public Debt
- FORMS OF OWNERSHIP FOR POOLED EQUITY - -The choice of Ownership
form for a Property or Portfolio of Properties to be Owned by an Investment
Equity is driven by Trade-offs along multiple dimensions
1. Federal Income Tax Issues
2. The desire to avoid Personal Liability for the Debts and Obligations of the
Entity
3. Management Control Issues (including the potential for Conflicts of
Interest to arise)
4. The ability to access Debt and additional Equity Capital
5. The ability to reduce Return Volatility and share the Risk of the Investment
with other Investors. Including "Special Allocations"
6. The ability of Investors to dispose of their Interests in the Organization
7. The ability to distribute Cash Flows to Investors based on percentages that
differ from the percentage of Equity Capital Contributed
- This last dimension allows the Promoters/Sponsors of the Investment
Opportunity to potentially earn higher Returns than the Passive Investors
who also contribute Equity Capital.
- FORMS OF OWNERSHIP FOR POOLED EQUITY - -Due to the typical size of
Commercial Real Estate Investments, the eventual owners of Investment
Properties almost always Pool their Capital using some form of Ownership,
,allowing them access to a larger amount of Equity to invest and more
efficiently Share the Risk of the Investment with others.
It is important to understand that there are two levels of organizations
commonly at work in Commercial Real Estate Investments. A particular
Property might be Owned through a certain Form of Ownership, while the
Ultimate Owners of that Organization may in turn have a different Structure.
- EX: An Office Building may be Owned by a Limited Liability Company whose
Investors are a Private Equity Fund and a Publicly Traded Real Estate
Investment Trust (REIT).
- GENERAL PARTNERSHIP - -The simplest form of Pooled Ownership is a
GENERAL PARTNERSHIP. One of the biggest advantages of this Form is that
General Partnerships are treated as Conduits for Tax Purposes; Taxable
Income and Losses flow through to the Individual Partners who Pay the Tax.
Thus, Investors who own Commercial Real Estate through a General
Partnership do not face "Double Taxation", where the Entity that owns the
Real Estate pays Tax first, followed by a second Tax Obligation at the
Investors Level.
Other Advantages of General Partnerships are the ease with which one can
be created, and the fact that the Partners also make the Operating
Decisions, such as how much money to borrow or when to dispose an Asset.
Thus, there is no Separation between the Ownership and control of the
Organization, and Conflicts of Interest are lessened, although Partners might
disagree over some decisions, of course.
A Partner's Share of the Cash Flow produced by the Investments is
determined by the Partnership Agreement and may vary from item to item.
In particular, if certain Conditions are met, a Partnership can allocate Cash
Flow and Tax Liabilities generated by the Property or Properties it owns in a
manner different from each Partner's Percentage Ownership Interest in the
Partnership. This ability to Structure Cash Flow rights and Taxable Income
enables the creation of Multiple Classes of Investors.
A major Disadvantage is that all Partners have Unlimited Liability. General
Partners are Liable for ALL Debts of the Partnership, including Contractual
Debts and Debts arising from Legal Actions against the Partnership. General
Partners are also Liable for Wrongful Acts committed by other Partners in the
course of the Partnership's Business. Therefore, the Personal Assets of the
General Partners are subject to the Claims of the Partnership's Creditors.
- LIMITED PARTNERSHIP - -Is created and taxed in the same way as a
General Partnership. However, a LIMITED PARTNERSHIP (LP) introduces an
important trade-off by creating two types of Partners -- "General" and
,"Limited" -- and a Limited Partnership must have at least One Partner of each
type.
The Advantage of this Structure is that is allows the Limited Partners to cap
their Personal Liability to an Amount equal to their Total Equity Investment in
the Partnership. The General Partner still faces Unlimited Liability for the
Debts and other Obligations of the Partnership.
One Disadvantage of this form of Ownership is that in exchange for Limited
Personal Liability, the Limited Partners give up Day-to-Day Control of the
Partnership and are prohibited from participating in Management or Policy
Making. They must rely on the General Partner(s) to make Decisions on their
behalf. This is an example of a "Principal-Agent" Relationship, where the
Agent (the General Partner) makes decisions that ultimately affect the Cash
Flows of the Principals, the Limited Partners, who typically provide the
majority of Equity Capital.
At times, the Limited Partners may be involved in major decisions, such as
whether to Sell or Refinance the Property. Situations are likely to arise where
the Interests of these Two Parties are in Conflict -- termed "Agency
Problems" -- potentially leading to a Loss in the Value of the Investment, or
"Agency Costs". It is important that Limited Partners understand the Motives
of the General Partner(s) when they decide to cede Management Control in
exchange for more favorable Liability Exposure. The General Partner, who is
sometimes referred to as the "Syndicator" or "Sponsor" of the LP, creates the
"Limited Partnership Agreement" that details the Operation and Management
of the LP.
- LIMITED PARTNERSHIP - -The General Partner(s) is frequently a
knowledgeable Real Estate Broker, Builder, or Investor and is typically the
Party who organized the Partnership to make the Investments. Note that the
General Partner can in turn have its own Organizational Structure, including
one that creates Limited Liability for the Ultimate Owners.
EX: The General Partner may be a Corporation. With regard to Cash
Distributions and Double Taxation, Limited Partnerships are similar to
General Partnerships -- Double Taxation does not exist.
Ownership Interests in an LP can be divided in any reasonable way, as in a
General Partnership.
EX: With 21 Partners, 20 Limited Partners each may have a 4.5% Ownership
Share, for a total of 90%. The General Partner would then have a 10%
Ownership Share. Often, the General Partner receives a larger distribution of
available Cash Flows than her Percentage Equity Investment would warrant.
This disproportionate Share of Cash Flows (sometimes referred to as a
"Special" or "Unique" Allocation) generated by the underlying Property or
, Properties provides the General Partner with at least Partial Compensation
for her efforts in Organizing and Structuring the Limited Partnership.
The Flow-Through feature of a Limited Partnership coupled with limited
liability for the Limited Partners largely explains why the LP form of
Ownership is an attractive option.
- C CORPORATION - -A C CORPORATION constitutes a Legal and Taxable
Entity separate from the Owners who are the Shareholders in the
Corporation. Thus, a C Corporation earns income and incurs Tax Liabilities. C
Corporations pay Income Taxes on taxable Corporate Income and have their
own Tax Rate Structure and Rules. Dividends paid to Shareholders are not
Deductible by the Corporation and are Taxable to the Shareholders.
Thus, One of the Major Disadvantages of using a C Corporation to invest in
Commercial Real Estate is that the Income from the underlying Property or
Properties may be Taxed Twice. C Corporation Income is currently subject to
Federal Tax Rates as high as 21% and, in 2019, Individuals can be Taxed at
Federal Rates exceeding 40%. Thus, the effective Federal Tax Rate on
Income from Properties held by Corporations can exceed 50%.
For Shareholders, a C Corporation provides Limited Liability for the
Obligations of the Corporation. This Limited Liability includes Liability from
Contractual Obligations as well as Obligations arising from Tort Actions
brought against the Corporation. This Limited Risk extends to all Owners of
the Corporation, unlike Limited Partnerships, where only Limited Partners are
afforded such Protection.
Another similarity with Limited Partnerships is the Separation of Ownership
and Control. In a C Corporation, Operating Decisions are made by Managers
who may or may not own much of the Firm and who act as Agents on behalf
of the Principals, the Stockholders. This separation allows for the Managerial
Expertise and helps resolve coordination problems (imagine trying to get all
of a Large Corporation's Shareholders to agree on every Operating Decision)
but comes at the Cost of potential Conflicts of Interest.
C Corporations are not generally a Desirable Structure for entities whose
Primary Purpose is to Acq
- S CORPORATION - -A Subchapter S CORPORATION possesses the same
Limited Liability Benefits for its Shareholders as C Corporations. Although an
S Corporation is a separate LEGAL Entity, it is not a Separate TAXABLE Entity;
that is, S Corporations pay no Income Taxes, and Taxable Income is passed
through to its Stockholders who become Liable for the Tax at their Individual
Tax Rates.
ANSWERS
DEBT & EQUITY REVIEW - -All Properties are Purchased with Money
Money to Finance Property generally comes in TWO PRIMARY "COLORS":
- EQUITY (Ownership)
- DEBT (Loan to Ownership)
Within Debt and Equity there can be numerous SUBCATEGORIES making a
Capital "Stack" including:
- Sponsor Equity
- Common Equity
- Preferred Equity
- Mezzanine Debt
- Junior Debt
- Senior Debt
- VALUE OF U.S. CRE - -42% Private Equity
34% Private Debt
12% Public Equity
12% Public Debt
- FORMS OF OWNERSHIP FOR POOLED EQUITY - -The choice of Ownership
form for a Property or Portfolio of Properties to be Owned by an Investment
Equity is driven by Trade-offs along multiple dimensions
1. Federal Income Tax Issues
2. The desire to avoid Personal Liability for the Debts and Obligations of the
Entity
3. Management Control Issues (including the potential for Conflicts of
Interest to arise)
4. The ability to access Debt and additional Equity Capital
5. The ability to reduce Return Volatility and share the Risk of the Investment
with other Investors. Including "Special Allocations"
6. The ability of Investors to dispose of their Interests in the Organization
7. The ability to distribute Cash Flows to Investors based on percentages that
differ from the percentage of Equity Capital Contributed
- This last dimension allows the Promoters/Sponsors of the Investment
Opportunity to potentially earn higher Returns than the Passive Investors
who also contribute Equity Capital.
- FORMS OF OWNERSHIP FOR POOLED EQUITY - -Due to the typical size of
Commercial Real Estate Investments, the eventual owners of Investment
Properties almost always Pool their Capital using some form of Ownership,
,allowing them access to a larger amount of Equity to invest and more
efficiently Share the Risk of the Investment with others.
It is important to understand that there are two levels of organizations
commonly at work in Commercial Real Estate Investments. A particular
Property might be Owned through a certain Form of Ownership, while the
Ultimate Owners of that Organization may in turn have a different Structure.
- EX: An Office Building may be Owned by a Limited Liability Company whose
Investors are a Private Equity Fund and a Publicly Traded Real Estate
Investment Trust (REIT).
- GENERAL PARTNERSHIP - -The simplest form of Pooled Ownership is a
GENERAL PARTNERSHIP. One of the biggest advantages of this Form is that
General Partnerships are treated as Conduits for Tax Purposes; Taxable
Income and Losses flow through to the Individual Partners who Pay the Tax.
Thus, Investors who own Commercial Real Estate through a General
Partnership do not face "Double Taxation", where the Entity that owns the
Real Estate pays Tax first, followed by a second Tax Obligation at the
Investors Level.
Other Advantages of General Partnerships are the ease with which one can
be created, and the fact that the Partners also make the Operating
Decisions, such as how much money to borrow or when to dispose an Asset.
Thus, there is no Separation between the Ownership and control of the
Organization, and Conflicts of Interest are lessened, although Partners might
disagree over some decisions, of course.
A Partner's Share of the Cash Flow produced by the Investments is
determined by the Partnership Agreement and may vary from item to item.
In particular, if certain Conditions are met, a Partnership can allocate Cash
Flow and Tax Liabilities generated by the Property or Properties it owns in a
manner different from each Partner's Percentage Ownership Interest in the
Partnership. This ability to Structure Cash Flow rights and Taxable Income
enables the creation of Multiple Classes of Investors.
A major Disadvantage is that all Partners have Unlimited Liability. General
Partners are Liable for ALL Debts of the Partnership, including Contractual
Debts and Debts arising from Legal Actions against the Partnership. General
Partners are also Liable for Wrongful Acts committed by other Partners in the
course of the Partnership's Business. Therefore, the Personal Assets of the
General Partners are subject to the Claims of the Partnership's Creditors.
- LIMITED PARTNERSHIP - -Is created and taxed in the same way as a
General Partnership. However, a LIMITED PARTNERSHIP (LP) introduces an
important trade-off by creating two types of Partners -- "General" and
,"Limited" -- and a Limited Partnership must have at least One Partner of each
type.
The Advantage of this Structure is that is allows the Limited Partners to cap
their Personal Liability to an Amount equal to their Total Equity Investment in
the Partnership. The General Partner still faces Unlimited Liability for the
Debts and other Obligations of the Partnership.
One Disadvantage of this form of Ownership is that in exchange for Limited
Personal Liability, the Limited Partners give up Day-to-Day Control of the
Partnership and are prohibited from participating in Management or Policy
Making. They must rely on the General Partner(s) to make Decisions on their
behalf. This is an example of a "Principal-Agent" Relationship, where the
Agent (the General Partner) makes decisions that ultimately affect the Cash
Flows of the Principals, the Limited Partners, who typically provide the
majority of Equity Capital.
At times, the Limited Partners may be involved in major decisions, such as
whether to Sell or Refinance the Property. Situations are likely to arise where
the Interests of these Two Parties are in Conflict -- termed "Agency
Problems" -- potentially leading to a Loss in the Value of the Investment, or
"Agency Costs". It is important that Limited Partners understand the Motives
of the General Partner(s) when they decide to cede Management Control in
exchange for more favorable Liability Exposure. The General Partner, who is
sometimes referred to as the "Syndicator" or "Sponsor" of the LP, creates the
"Limited Partnership Agreement" that details the Operation and Management
of the LP.
- LIMITED PARTNERSHIP - -The General Partner(s) is frequently a
knowledgeable Real Estate Broker, Builder, or Investor and is typically the
Party who organized the Partnership to make the Investments. Note that the
General Partner can in turn have its own Organizational Structure, including
one that creates Limited Liability for the Ultimate Owners.
EX: The General Partner may be a Corporation. With regard to Cash
Distributions and Double Taxation, Limited Partnerships are similar to
General Partnerships -- Double Taxation does not exist.
Ownership Interests in an LP can be divided in any reasonable way, as in a
General Partnership.
EX: With 21 Partners, 20 Limited Partners each may have a 4.5% Ownership
Share, for a total of 90%. The General Partner would then have a 10%
Ownership Share. Often, the General Partner receives a larger distribution of
available Cash Flows than her Percentage Equity Investment would warrant.
This disproportionate Share of Cash Flows (sometimes referred to as a
"Special" or "Unique" Allocation) generated by the underlying Property or
, Properties provides the General Partner with at least Partial Compensation
for her efforts in Organizing and Structuring the Limited Partnership.
The Flow-Through feature of a Limited Partnership coupled with limited
liability for the Limited Partners largely explains why the LP form of
Ownership is an attractive option.
- C CORPORATION - -A C CORPORATION constitutes a Legal and Taxable
Entity separate from the Owners who are the Shareholders in the
Corporation. Thus, a C Corporation earns income and incurs Tax Liabilities. C
Corporations pay Income Taxes on taxable Corporate Income and have their
own Tax Rate Structure and Rules. Dividends paid to Shareholders are not
Deductible by the Corporation and are Taxable to the Shareholders.
Thus, One of the Major Disadvantages of using a C Corporation to invest in
Commercial Real Estate is that the Income from the underlying Property or
Properties may be Taxed Twice. C Corporation Income is currently subject to
Federal Tax Rates as high as 21% and, in 2019, Individuals can be Taxed at
Federal Rates exceeding 40%. Thus, the effective Federal Tax Rate on
Income from Properties held by Corporations can exceed 50%.
For Shareholders, a C Corporation provides Limited Liability for the
Obligations of the Corporation. This Limited Liability includes Liability from
Contractual Obligations as well as Obligations arising from Tort Actions
brought against the Corporation. This Limited Risk extends to all Owners of
the Corporation, unlike Limited Partnerships, where only Limited Partners are
afforded such Protection.
Another similarity with Limited Partnerships is the Separation of Ownership
and Control. In a C Corporation, Operating Decisions are made by Managers
who may or may not own much of the Firm and who act as Agents on behalf
of the Principals, the Stockholders. This separation allows for the Managerial
Expertise and helps resolve coordination problems (imagine trying to get all
of a Large Corporation's Shareholders to agree on every Operating Decision)
but comes at the Cost of potential Conflicts of Interest.
C Corporations are not generally a Desirable Structure for entities whose
Primary Purpose is to Acq
- S CORPORATION - -A Subchapter S CORPORATION possesses the same
Limited Liability Benefits for its Shareholders as C Corporations. Although an
S Corporation is a separate LEGAL Entity, it is not a Separate TAXABLE Entity;
that is, S Corporations pay no Income Taxes, and Taxable Income is passed
through to its Stockholders who become Liable for the Tax at their Individual
Tax Rates.
