Exit Strategy Is Key in Real Estate Investing

Think back to the Saturday morning cartoons when Bugs Bunny would get stuck in a tight spot. Whether it was a rabbit hole or quicksand, there was always an “eject” button to catapult him safely out of danger. There’s certainly a valuable lesson to learn here—you should always have a reliable exit strategy.

Having an exit strategy in place for a real estate investment before it’s needed can save you the panic of feeling trapped down a rabbit hole when you want—or need—to get out.

When and How to Plan Your Exit Strategy

Your potential real estate exit strategy is best planned before you buy the property in the first place. It is wise to have a sense of how, when, and at what price you will ultimately be able to sell the property as you negotiate your purchase agreement. This helps you know that the economics make sense from the onset.

The strategy then must be tested and modified as conditions change. For example, many investors have found that the comparatively higher interest rates over the past year have impacted their plans to sell or refinance. Ideally, you will also have a realistic fallback position to guide you if your original plan doesn’t work out.

Some investors buy real estate with the intent to hold it indefinitely so they can pass it on to heirs with a stepped-up tax basis. While this may be a good plan if the property generates net income, what if it becomes a cash drain or requires an additional investment of capital or sweat equity to remain profitable? Or, what if the next generation is unwilling or unable to manage and maintain the property? Or perhaps the neighborhood around the property changes, making the original use less viable or desirable.

For an investment you intend to hold shorter term, changes in interest rates and economic conditions locally or even globally can interfere with sale plans, as many people saw during the COVID-19 pandemic. Additionally, a value-add strategy may be disrupted by labor or material shortages, changes in tenant preferences, or unanticipated structural issues with the property.

That’s why a real estate exit strategy is important, no matter how long you plan to hold on to the asset.

8 Considerations for a Personal Real Estate Exit Strategy

What constitutes a favorable and realistic real estate exit strategy depends upon your goals and risk tolerance. Consider the relevant factors below.

Return Expectations

Are you looking for modest or aggressive cash flow, or is your primary goal to achieve significant appreciation and profit? Consider how much flexibility and cushion you have in your range of successful outcomes.  Running a cap rate sensitivity can help you understand the likely range of sale proceeds based on your projected NOI (net operating income) at the time you hope to sell.

Time Horizon

How long do you intend to hold the property? Is your strategy to hold long-term, to improve and flip quickly, or something in between?  Are you willing to sell your property at a loss in order to exit at a specific time?  Your pre-acquisition underwriting should model the economics of a sale both earlier and later than your goal. This will help you understand the impact of timing on your potential returns.

Need for Liquidity

Is there an upcoming obligation, such as school tuition, that may require you to have a large amount of cash on hand? Do you have other funds readily available to cover unanticipated events? Or may you need to exit the investment earlier than planned to free up liquid assets?  One potential solution may be a line of credit secured by your property.

Changes in Tenancy

Whether your property is an apartment building where frequent turnover is expected or an office, retail or industrial building with longer lease terms, when a tenant exits, the property must be prepared for a new tenant. This means capital improvement expenses and some downtime. You also need to account for the possibility that there may be a lag between tenants. Some good market research before and during your ownership can give you a head start on finding replacement tenants.

Relationships Among Owners

There is a saying that doing business together is a great way to break up a family or friendship. If you own a property with others, have a strategy for moving forward. What if there are disagreements about the property, management or investment goals? Suppose one owner wants to leave, refinance or sell. What if someone dies or becomes incapacitated? A formalized written agreement must be in place at the time of acquisition to address potential exit scenarios.

Financing 

If you purchased the property with a mortgage loan, when does the debt mature? Can you extend the maturity date, and under what terms? Is your loan assignable to a subsequent purchaser of the property? Find out if there are penalties or restrictions for paying off your mortgage early and whether you can bring in financing from other sources. Mortgage interest rates can fluctuate unfavorably.  You may find that lenders are constrained by considerations unrelated to you when you want to refinance.

Market Conditions

Are you open to an early sale if you receive a favorable purchase offer? Can you hold on to the property longer than originally anticipated if market conditions are unfavorable?  Look into your options if your existing use of a property ceases to be the highest and best use for the asset.

Alternative Sale Formats

Depending on the type and size of asset you acquire, your exit strategy could involve a sale in stages rather than a single disposition. You may also be able to sell all or a portion of your ownership interests without transferring the property itself. Options include having a buyer acquire the entity that owns the property and contributing the real estate to a larger fund.

Exit by Selling a Property Outright

The most common real estate exit strategy is a traditional sale. In this case, the property is sold to an unrelated third party through an arms’ length transaction. The primary issues become when the sale should occur and the appropriate pricing.

For single-tenant properties, the lease terms may suggest some logical sale dates, such as the date a new lease or renewal term takes effect or a date after certain lease contingencies.

Traditional Exit Points for an Outright Sale

Depending on the type of property and how many tenants occupy it, some plausible times for an outright sale include “natural” end dates related to the property or the tenants, such as:

• Loan maturity
• After key leases roll
• After significant capital improvements or structural repairs
• A date that coincides with the expiration of relevant operating leases
• A viable purchase offer that allows you to use your capital elsewhere

Value-Add Real Estate

If your property has a value-add component, you can sell once the improvements are complete in order to immediately monetize your upside. Or you may choose to operate the improved property for cash flow for a period of time to enjoy the fruits of your labor.  For larger properties, a value-add strategy may involve improving only a portion of the property and then selling. This leaves some “meat on the bones” for a prospective purchaser who wants to initiate its own value-add program.

Risks of Outright Sale as a Real Estate Exit Strategy

Relying on these traditional exit points can be dangerous because not all things go according to plan, especially when it comes to investments.

Demand Changes with a Changing Market

The market does not always cooperate with your plans. Cap rates, interest rates, tax laws, lending regulations, or the local or national economy may be unfavorable for a sale at the time you originally planned to exit the investment.

As many office and hospitality investors saw post-pandemic, properties in high demand at the time you acquired them may be significantly less desirable if market conditions change. In contrast, the aggressive real estate pricing in 2022 provided huge upside opportunities for investors who were willing to sell early.

Vacancy Woes

In addition, if the property’s tenancy changes significantly, you will likely need to adjust your exit expectations until you find replacement tenants or guarantors. In a multifamily property, changes in occupancy and/or rental rates can impact prospective pricing, especially if those changes position you unfavorably with your nearby competitors.

Partnership Troubles

Additionally, if you own the property with one or more partners, your timing for a sale can change. It may be hastened (or delayed) by a disagreement among the parties, a transfer of a partner’s interests, or a partner’s need for liquidity.

Finance to Get More Capital or More Time

While a loan will not enable you to immediately exit an investment, financing may provide a way to unlock capital invested in a property or buy yourself more time to sell. This can be helpful if you want to:

• Delay the timing of a sale until market conditions improve
• Make improvements to the property to create more value and upside
• Use equity invested in the property for some unrelated purpose

Pros and Cons of Refinancing 

Adding leverage may increase cash flow (assuming your yield is greater than the interest rate). However, it also increases overall risk since the loan will have to be repaid before you can pocket the proceeds from any disposition of the property.

Refinancing an existing loan may allow you to take some of the equity invested and use it for other purposes. It also helps that proceeds from a refinance are not immediately taxable.

Commercial loans can be extended for periods of time. It depends on the lender, the terms of the loan, the credit of the tenant(s), the duration of their leases, and the then-current interest rates.

Financing Options and Considerations

These options assume that you can actually get a loan for the property in question with terms that make economic sense for you and that your existing lender (or a replacement lender) is willing to cooperate with you.

As some investors learned in recent years, credit is more difficult to come by post-pandemic.  There are mezzanine and bridge lenders who can help cover the gap between what your senior lender will provide and your available equity. However, this type of financing typically comes with a steep price tag.  You will have to make an honest assessment about whether your project will leave you sufficient equity if it has to support two layers of debt.

Note that some types of loans may be assignable to a subsequent purchaser of the property, which can be attractive if you can lock in a low interest rate for the long term.  Loans may also have defeasance charges, swap breakup fees, and lockout periods, making an early exit more challenging. You will need to find a buyer who will assume your loan or pay the penalty amount from the sale proceeds.

A borrower cannot receive proceeds from the sale of a property until all mortgage liens are satisfied or the loans are assumed. Therefore, financing should only be used with careful planning, taking investment goals into account.

Repositioning a Real Estate Investment

If the market is not favorable for a sale or refinancing when you want to exit an investment, repositioning or repurposing the property may unlock value.

Converting or Repurposing a Property

For example, if you own an apartment building, consider converting the property to a condominium and selling the units individually instead of trying to sell the entire building at once. You could also make capital improvements to increase the building’s longevity. Depending on the property’s location, size, and zoning, you may lease the roof to generate income from solar energy, cell towers, or recreational use.

Changing the use of a property (or a portion of it) will require additional capital and may require zoning changes as well. However, repurposing a property can potentially better position it for sale.

Some types of changes may or may not be feasible, depending on your plans, the building’s infrastructure, and the local government’s cooperation.  However, you may find that there are government incentives available to convert your property to a different use.

Increasing the Appeal of Your Real Estate

In other instances, interior remodeling, modernizing a façade, or improving landscaping may increase the property’s curb appeal.

Undertaking capital improvements to building structures and systems adds appeal to purchasers who can’t or may not want to do that work themselves in the future, as well as tenants who would potentially lease the entire building on a triple-net basis.

Alternative Exit Strategies

Partial Sale

Depending on the nature of the property, it may also be possible to sell a portion of the physical asset while retaining the rest. This can be done in a variety of ways, such as selling some buildings if the option is available or selling a portion of vacant land. Another option is potentially dividing the property into individual condominium units. There are a number of variables that can affect how much land you can end up selling if you choose to go this route.

Bring in New Equity Investors

If only some of the property’s owners wish to exit, or if a sole owner wants to reduce their ownership percentage without selling outright, you may be able to bring in new equity investors through the sale of ownership interests.

One significant challenge of changing investors is how to value the property interests. You will need to establish how the property will be managed and how the proceeds will be distributed. Note that if you have a mortgage that will be kept in place, the lender must consent.  Alternatively, you may sell outright to a buyer that would permit some or all of the owners to retain an equity interest in the new ownership of the building in exchange for a reduction of the purchase price (a “721 exchange”).

The Right Exit Strategy Is The One That Works For You

Hopefully, your real estate investment won’t trap you in a rabbit hole. With careful and creative advance planning, you can ensure several viable exit strategies to transition profitably out of property ownership.