How long should you hold onto your real estate before selling? While the final decision is up to you personally and your investment strategy, many industry veterans recommend longer holding periods.

That said, what is considered a long-term hold is a subjective metric. Some whalers believe that the holding period should be equated to the length of lease terms in a particular building. For example, let’s assume a landlord bought a building in 2010 with a 15-year lease in place at the time of his purchase. That landlord may elect to sell the building in 10 years (i.e. in 2020) in order to make sure that the future buyer still has some sense of investment safety (i.e. there would still be five years remaining on that particular lease term). Mulfi-family differs with the length of lease typically being 12 months which is considered more desirable in order to command rent increases based on the market.

If you look at the market’s typical 10 year cycle, you might say that in this particular market your holding period would be 3 to 5 years.

Subject to location, finance, and circumstances, seeking investments with longer holding periods has historically been the preference for Appelman Properties’. The tax benefits, operational benefits and inflation hedge of long-term holds generally outweigh anything you get from short-term holds. This article looks at the various factors that go into prudent underwriting for the real estate investor, with a focus on the downtown.

Hedge Against Inflation

A significant portion of the richest men and women in America have made their money through real estate, and they have tended to hold real estate for a long time; sometimes never selling. Wealth is created and built up over time. If you look at long real estate holds compared to the stock market, the long-term real estate hold outstrips stocks in terms of returns, and it also outstrips inflation. It’s all about playing the long game and creating wealth through the “get-rich-slow” scheme.

Other than a few years here and there during recessions, the replacement cost for real estate properties has consistently grown over the last few decades. What this means is that real estate generally tends to grow in value, despite some fluctuations over time, and the cost of replacing a building also generally always grows over time. By adopting a buy-and-hold strategy, the original cost of the building will, over time, always end up being less than the cost of replacing (rebuilding) the building.

Importantly, inflation will also have a compounding effect on rents. As time goes by, rents will inevitably keep pace with replacement costs of buildings. So, if your cost basis is below replacement cost, returns will, over time, grow to be outsized compared to average returns in the market.

This also serves as a hedge against competition. New buyers in the market paying today’s prices for a building have to demand today’s rents to cover their debt and pay a dividend to their shareholders. The long-term player in a market has a competitive advantage over the recent entrant because they can afford to compete on rental rates more aggressively, lowering rents while still servicing debt and paying dividends.

This helps to ensure that the long-term real estate investor has lower vacancies than recent market entrants, and, importantly, has more flexibility to sustain occupancy and rental income during economic downturns.

Solid Rental Contracts Counteract Recessions

Having quality tenants is also a driving factor for successful real estate ownership and management. An owner with a long-term perspective can negotiate better terms with high credit clients for longer leases, because they have greater flexibility in offering competitive lease rates. Having long term leases with high credit tenants serves as a bulwark against recessionary pressures during economic downturns – helping to preserve wealth as well as to build it.

Historically, Appelman has aggressively pursued high credit clients and sought longer leases particularly towards the end of the real estate cycle. A building with a lower vacancy will pay for itself and keep a building profitable even if this means sometimes undercutting local lease rates by 10-20% to keep occupancies high. This tactic for defending a building against the effects of a recession results in a building full of credit tenants with long-term leases. This strategy keeps the building solvent during downturns until things start looking better. Once market rates go back up, rates can be increased again when those long-term leases expire.

Long Holds Avoid Acquisition & Disposition Fees

From an investor’s point of view, long hold times are also better in terms of cost friction caused by transactional fees and associated costs.

Every time a new property is purchased or sold, there are fees tacked on for the people involved; brokers on both sides, escrow, legal fees, title related fees, inspections, transfer taxes, lender fees – they add up. It is not uncommon when buying a real estate building to incur closing costs of this much is $1 million. All these fees are avoided by holding a property for longer instead of buying and flipping.

As a general comment, investors need to be very wary about the cost of transaction fees. Over the last 10 years, billions of dollars of real estate investments have been sold to investors through a broker dealer network. These brokers typically charge 7% upfront to the investor. Often the syndicators that have sold these investments through the broker dealer networks have charged 2-3% acquisition fees upfront, plus extra fees related to lending and management. By the time the investor has placed their capital and seen a building acquired, their equity might only be worth 88 cents to each dollar they invested.

Appelman has elected to go a different route through crowdfunding. The fees being paid to the crowdfunding platform are typically below 2% and Appelman has charged an administrative fee that is typically below one half of 1% (50 basis points).

There will always be some costs associated with buying and selling. It’s unavoidable. The brokers and lenders won’t go unpaid so a prudent investor will watch for sponsors who limit the fees they charge and by keeping an eye on the impact of transactional costs on buying and selling a building in a short period of time.

Deferring Tax Recapture

When a property is sold, all the tax write-offs that have been benefitting the asset can transform into taxable gains for investors. Any losses taken during the holding period will be recaptured and will be treated as income on tax returns. The longer an owner defers the sale of a property, the longer investors can defer the tax recapture. If a building is held indefinitely then tax recapture is also delayed indefinitely.

Another tax benefit of the long-term real estate hold strategy is in borrowing against the equity of a building. Banks lend against income streams, and as these grow over time, the banks will lend more. Also, lenders will provide more loan proceeds because the building’s value also increases. At a certain point in the lifecycle of a long-term hold, banks are willing to lend more than the total cost that the project was to investors. In some cases, the mortgage surplus can be far in excess of the investor’s original capital.

When this happens, investors can enjoy tax-free capital gains because any excess borrowing against the building is considered debt, not capital gain. This capital can be invested in other assets to grow and investor’s overall portfolio and to substantially build wealth.

The tax climate is very favorable for real estate developers, but many of these benefits are lost at the point of sale.

Building Operational Efficiency

The greater a building owner’s relationship is with tenants, the greater the likelihood of them renewing their lease. Every time a lease expires and attended moves out of a building, the building encounters downtime and vacancies. In most cases the landlord will incur significant construction costs associated with the tenant improvements for the next lessee. The landlord will also incur costs to compensate to bring the new replacement tenants.

It is, therefore, highly desirable to retain existing tenants when their lease comes up for renewal. Holding a property long-term can help in building strong relationships between landlord and tenant, which ensures a higher probability of renewal.

With an eye on the long term, an owner can afford to get familiar with tenants and learn as much as they can about them, getting to know them by name, when are their birthdays, building relationships that can help a building owner provide increasingly individualized accommodations for tenants. This can have a long-lasting impact on tenant satisfaction and increase the likelihood of lease renewals.

From a technical standpoint too, owning a building long term allows an investor to get to know the building itself. Spending more time on a building improves overall operational efficiency because the building engineers can get to know the equipment, the building systems, and the nuances of how the building functions. As maintenance issues and upgrade opportunities come up, their intimate knowledge of the building serves to facilitate efficient strategies for handling all contingencies.

Liquidity Events Give You Flexibility

Developers often get into a mindset of buying, fixing, and flipping as quickly as possible. The goal is to flip as many buildings for a profit as possible without sticking around to see if they can retain their value, and this can be a riskier approach than holding for longer periods as we have discussed.

That said, there is certainly merit in looking for quicker exits in some circumstances and a seasoned sponsor will always keep an eye on such opportunities. For example, if investors have already seen the growth they wanted from an acquired building, a liquidity event does allow for migration to the next investment or to exit and get into something else entirely.

At Appelman, we’ve had a policy of accommodating existing partners that have wanted liquidity events by bringing in new financial partners. We refer to this process as a recapitalization. In most cases involving a recapitalization, we offer our existing partners the option to stay in the new recapitalized partnership under the same terms and conditions.

In the case of a recession or a market downturn, liquidating a building quickly can allow ownership to pre-empt losses in an underperforming asset, ending on a high note for an investment and leaving a cash ‘war-chest’ to deploy during recessionary time when prices fall.

Overall, however, the instant gratification and satisfaction derived from a profitable sale after a short-term hold isn’t worth the disappointment of seeing how much others make with the assets in subsequent years. When you see the investment with 20-year hindsight, an early sale almost never leads to the largest profits.

At the end of the day, long holding periods have proven the best for building resilient wealth, with consistent, growing passive income streams, while taking on fewer risks.