In today’s CRE market, there is a consistent shortage of highquality property for sale. The market is therefore strongly aligned in favor of sellers. The primary and secondary regional markets for multifamily housing and triple-net properties, for example, are intensively competitive and significant cap-rate compression is normal in these locations. Further, with the likely continuation of low interest and the resulting attractive arbitrage between CAP rates and the cost of leverage, this type of competition and pressure is not expected to abate in the near-term.

If you are contemplating a 1031 exchange in order to achieve an investment objective, this market - favoring sellers to an unusual extent - must be navigated carefully in order to achieve your investment goals, and keep your capital continuously deployed, that is, defer the tax on the gain from the sale. Hence, a key element of risk reduction is “transaction control” and relates to the timing of the acquisition of the replacement property in an exchange.

Here is the danger: if you start a “forward” or “delayed” 1031 exchange, you’ll likely be able to sell what you are planning to exchange with relative ease. If not, fire your broker and get a new one! But then, having sold your relinquished property, you now become a buyer in a seller’s market. Furthermore, you may very well be a desperate buyer because you have 1031 exchange deadlines to satisfy. The 1031 statutes require you to identify potential replacement properties within 45 days of the close of the relinquished property sale and to acquire one or more of the identified properties within 180 days. If you are unable to identify any properties within 45 days, your exchange has failed and the accommodator is required by statute to return your exchange proceeds immediately. If you identify one or more candidate replacement properties and then are unable to acquire any of them, your exchange will fail and the accommodator is required by statute to keep your exchange proceeds until the 180-day exchange period has expired. Yes, even if you decide not to exchange on the 50th day, for example, if you have identified potential replacement property, the accommodator must keep your money for the full 180 days. 

Of course, if you are able to successfully identify and acquire within the 1031 deadlines, then the forward exchange will work and the desired results will be achieved. However, in the current market, simply finding one or more reasonable potential replacement properties can be a huge challenge. And, it does happen, with scary frequency, that an investor identifies several properties and is unable to acquire any of them, perhaps because they were lost to a competing bidder or to a foot-dragging lender or...whatever. The worst case scenario is that you have sold your relinquished property and have to pay the tax because you cannot find or fail to close on the replacement property. The risk of not being able to complete an exchange once the relinquished property has been sold is much higher in today’s market than at any time in recent memory.

Enter the reverse exchange. This form of 1031 exchange is accomplished by acquiring the replacement property first and selling the relinquished property within 180 days of the purchase. The primary role of the exchange accommodator is to hold title to one of the properties in the exchange, rather than to hold the cash proceeds of the relinquished property sale, as in a forward exchange. 

It is very important to understand that there is also a 45-day identification requirement in a reverse exchange, but it applies to properties that you already own, that is, the potential relinquished property. In essence, the 45-day ID deadline in a reverse is satisfied by deciding which of the assets you will try to sell. And, once you have taken the time to find and acquire a replacement property that satisfies your investment objectives, you now become a seller in a seller’s market! This can be profoundly different because you will be the beneficiary of the seller’s market, rather than one of its “victims” - trying to buy assets for which the competition is intense. You should determine for yourself how much risk to your overall strategy is mitigated by taking the time to acquire what you need or want and then be able to identify and sell candidate relinquished properties from among those in your portfolio. Many, many CRE investors have come to realize that this is a better strategy. 

The second advantage of reverse exchanges concerns return on investment (ROI) potential. The competition for income-producing properties is so intense because these assets represent superior ROI opportunities when compared to other assets. There are many, many investors trying hard to put money to work because of the returns. Those investors that conduct forward exchanges are selling an income-producing asset and letting the cash equity go to an accommodator for up to 180 days, earning nearly nothing during that time. 

By contrast, and this is one aspect of reverse exchanges that is often not well understood, the investor receives the rental income (and obligations, of course) from both relinquished and replacement properties during the exchange period. For example, if your relinquished property generates $5,000/month in rent and you are exchanging into a replacement property that generates $10,000/month, then during the exchange period (up to 180 days), you are receiving rent totaling $15,000/month! The fact is that a dual rent stream almost always offsets both the fees for the reverse exchange and the cost of the money needed to make the acquisition prior to the sale. The arbitrage between CAP rates and the cost of debt is nearly always favorable, otherwise we would not be in a seller’s market! In addition, depreciation deductions can be taken for the property not held by the accommodator during the reverse exchange period. Lastly, there may be significant appreciation in the value of both properties during the reverse exchange period exchange period. 

If it is possible to buy first, there are several other things to keep in mind: 1) cash that you supply to make the acquisition will usually be (partially) replaced immediately after the sale of the relinquished property, which lowers the cost of money advanced to make the purchase, 2) contemporary reverse exchanges are often very well integrated with CRE lending processes, resulting in easier closings and in debt that is long-term and need not be bridge or hard-money financing and 3) committed accommodators are now deploying state-of-the-art reverse exchange processes that subsume complexity for the investor, allowing significant flexibility for pesky problems like environmental analyses and implementing asset security devices that mitigate any conceivable risk of failure. 

The bottom line for many CRE investors is that in a forward exchange, significant income is being “left on the table” with no real compensating benefits while in a reverse exchange, the ROI on the invested capital combined with the other financial benefits can be substantial and attractive. 

Note that if you can’t sell or decide not to sell your relinquished property after starting a reverse, you simply keep both properties, meaning that you have no tax to pay because you haven’t sold anything. This outcome is almost always more attractive than that of a failed forward exchange. In addition, it is possible to extend a standard reverse exchange beyond 180 days should there be a delay in selling the relinquished property. It’s neither simple nor cheap to do so but it is possible and may make sense if the problem is big enough. 

To summarize, the risks of using a forward exchange in today’s market are that 1) your exchange fails because you cannot identify and/or acquire Replacement Property in time, 2) your equity is held by an Accommodator for up to 180 days and generates little or no income for you and 3) if the exchange fails, you have to pay the tax on the gain from the Relinquished Property sale and have no subsequent exchange options for that property. By contrast, using a reverse exchange means that 1) you accomplish your investment objective first and then become a seller in a seller’s market, 2) during a reverse, your capital is at work for you rather than the Accommodator, potentially generating income and other financial benefits during the exchange period that you would otherwise not receive and 3) if the reverse fails, the two options are to keep both properties and have no tax obligation because no Relinquished Property has sold or to extend the reverse beyond 180 days if the financial parameters justify the incremental cost and effort.

All things considered, the reverse exchange may be the informed CRE investors “secret weapon” for achieving advantages, both strategically and economically, in today’s challenging CRE market. 

Stan Freeman is president at Exchange Strategies Corp., Campbell, Calif.