Managing family assets: The importance of planning ahead

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Friday, August 22, 2014
 

UnknownBY CLIFF HOCKLEY |  OB GUEST CONTRIBUTOR

A wealthy grandmother dies leaving a $3 million commercial building to her heirs without a plan; five family partners share interest in a $5 million apartment building, and one of the partners goes through a divorce while another gets into a terrible car accident. Situations like these can affect any group of investors, but when business intersects with family, a host of  situations can arise. Without a clear vision and careful planning, hard-earned investments can become stressful burdens.

The foundation of a strong financial plan lies in understanding how the assets in question can benefit the stakeholders according to their specific financial goals. For real estate investments, owners typically derive value in four ways:

  • Appreciation: A well-positioned property can increase in value over time. When sold, the difference between the sale price and the original purchase price results in a net gain.
  • Cash Flow: When a landlord leases building, the rent represents a source of income. Understanding the lease is very important to evaluating the potential cash flow. Important factors to consider include the length of the lease term, the amount of any increases, and the financial responsibilities of tenant and landlord.
  • Depreciation: The value of the improvements to a piece of land can be depreciated over time, offsetting the tax burden of income earned from other sources.
  • Debt Reduction: Because they are secured by real property, mortgages tend to carry lower interest rates than other forms of credit. Once equity has accrued, cash from refinancing a property can go towards paying off more expensive forms of debt, such as credit cards or personal lines of credit.

The personal financial situation of each investor determines the extent to which they can derive value, which can make real estate a smart move, even when return rates seem low compared to other types of investments. For instance, consider a choice between a commercial building with a 6.5% cap rate and a well-managed hedge fund earning an average of 10% (assuming similar risk). While the immediate cash flow of the stocks exceeds that of the real estate, factoring in appreciation and depreciation can boost the actual return considerably, depending on the profile of the investor.

A strategic plan is necessary and should address a number of critical questions, including:

  • Who are the owners?
  1. The plan should define who has ownership, and how ownership will change in the event of a divorce, death, bankruptcy, etc.
  • Who makes decisions?
  1. Managing Member: Some families agree on a managing member to make important decisions on behalf of all owners. He/she may be paid a fee for this service, or not, depending on their agreement with the rest of the owners.
  2. Board of Directors: Owners may elect a board to make decisions on behalf of the owners. Terms governing the conduct of the Board should be agreed upon by all owners.
  3. Family Council: A hybrid approach – owners may appoint a managing member who acts on the advice of a non-governing council of family members. This approach vests final authority in one person, but gives all stakeholders a chance to meaningfully contribute to the process.
  4. Asset Manager for Hire: When no owners wish to take responsibility, a family can hire a professional asset manager to do so. Many banks have trust departments that offer this service. This approach can lead to good outcomes when family members are too busy or unqualified to make the required commitment.
  • How are disputes resolved?
  1. If a difference of opinion arises, a protocol should exist for resolving the dispute. All owners should agree to the resolution procedure itself and whatever conclusion results from it. Having a formal dispute resolution process can mitigate acrimonious squabbling as well as legal liability.

These questions can only be answered when the family agrees on the goals of the investment. Each owner should use an understanding of his/her own financial position to frame his/her goals in terms of the potential benefits of a real estate investment. Important factors to consider include:

  • Risk vs. Return
  1. Investors often find a tradeoff between security and return. The family’s comfort-level with risk will determine the types of properties in which it will consider investing. Investors typically see lower cap rates for commercial buildings with well-established tenants, long-term leases and corporate guarantees.
  • Hands-on vs. Hands-off
  1. The degree to which family members wish to involve themselves in investment projects determines the types of projects that the family should consider. It may pay off to hire a management company.
  • Estate Planning
  1. The investment goals should keep in mind the family’s long-term plans for the assets. As John Maynard Keynes observed, “In the long run, we’re all dead”. While a tax lawyer can help ease estate tax burdens, managers should also consider the potential of a property to generate value for future owners.

Just like in any business, a clear set of goals implemented by an effective strategic plan will maximize the long-term earning potential of the group. No matter the goals of the investment, however, families should remember to treat the business as a business. When personal agendas cloud the judgment of those in charge, investments and relationships both suffer. By understanding the benefits of real estate investments, families can agree upon goals that will make their investments work for them.

Cliff Hockley is president of Bluestone & Hockley Real Estate Services

 

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