Partnerships Cope With Changes

There are 12 of them and they can make 12 individual servings. Or three or four omelets. Or one huge omelet. Or two, three or four servings, scrambled.

But, it’s still a dozen eggs.

In the same way, William H. Elliott, chairman and chief executive officer of Angeles Corp., says a real estate limited partnership remains a real estate limited partnership regardless of how the whole--or bits and pieces of it--may be packaged and marketed as something else.

Elliott’s comments in an interview come as this “togetherness” approach to real estate investment swirls in the backwash of uncertainties arising from last year’s income tax overhaul and what that restructuring may or may not have done to such partnerships.

Although it’s a 300-year-old concept, it has only been in the last 20 years in America that the real estate limited partnership has taken off in a big way.

Classic Advantages

For the investor, here were all of the classic advantages of owning income-producing real estate--cash flow, depreciation and the tax deductibility of management, taxes, mortgage interest and other expenses. And, at liquidation of the property--characteristically, 5, 7 or 10 years later--the lion’s share of any appreciation in the value of the property is prorated among the limited partners.

All of it without the hassle of management, and available in investment increments as low as $5,000. Annual returns, based on cash flow, tax considerations and eventual appreciation, have been in the 20% to 30% range.

Twin “flies” have surfaced in this “ointment,” however--one as a result of last year’s overhaul of the tax code and the other as result of natural economic developments.

Tax reformers aimed their biggest guns at heavily leveraged limited partnerships--those acquiring property with a minimal cash outlay and a heavy debt service--that were established to throw off losses that could be written off against the limited partners’ ordinary income.

Tax Code Changed

Enter brand-new rules covering “passive investors.” Under the new tax code, all rental activity is considered passive regardless of how inappropriate the adjective is in terms of the owner’s management of the property. And passive losses--formerly used to offset both rental and ordinary income--can now be used to offset passive income only, not “active income” such as wages, dividends and other ordinary income.

And, on top of this zinger, another complication: An interest rate structure which, safe or not, has given all-cash limited partnerships a yield in the 5% to 10% range with a bias to the low side of that spread.

To this less-than-glitzy investment appeal, add (or subtract) another depressant: A capital gain, when the property is liquidated, that promises to be considerably less than the reasonable expectations if the property were highly leveraged.

From a marketing standpoint, then, how do you turn such a sow’s ear into a silk purse?

In the opinion of Angeles Corp.’s Elliott, the marketing challenge is being met with the sort of trendiness normally associated with such in-fashion/out-of-fashion consumer items as cars and women’s dresses.

‘Creative Packaging

“Investors today are being hit by a flood of creative packaging “--new wrappings and new names for standard investment products--” Elliott says, “and the inherent danger is that investors may buy on the basis of unrealistic expectations and be disappointed even when the investment performance is normal.”

And so, today, the limited partnership field has become a jungle of hybrids that tip-toe around the subject of passive loss as though it were a social disease--real estate deals that de-emphasize leverage, that put “all-cash” partnerships in the cat-bird seat and that try desperately to beef-up the cash flow.

For old-hand Elliott, and old-line Angeles, it’s a new form of fence-straddling that is worrisome.

Beginning in 1953 as a small, privately owned portfolio management company (it went public on the American Stock Exchange in 1968), Angeles and its subsidiaries currently manage assets in excess of $3.5 billion for major corporations and institutions and for about 165,000 individual investors.

Leveraged Partnerships

“The pre-tax-reform feeling that the change in the law might be the death knell of the leveraged limited partnership,” Elliott said, “has, to some degree, come about, but for the wrong reasons, based on misperceptions and misinformation. One of the major perceptions at the moment is that creating passive income--for writing off passive losses--is the greatest thing you can do.

“In reality, you don’t really lose your passive losses at all, you carry them forward. So, you’re talking about the time value of money, not the losses, themselves. Any passive losses that you don’t use get carried forward just as if you have charitable contributions which you also carry forward.”

There’s a phase-in period, of course--65% against regular income this year, 40% next year and then 20% the following year, and then all excess losses get carried forward until the property is liquidated. “Obviously, there’s some advantage to using them sooner than later, but our position is that one shouldn’t make significant changes in his normal investment strategy in order to use some losses earlier than he might otherwise,” Elliott said.

Deferred Debt Service

But in the scramble to avoid leverage and hop on the passive income bandwagon, some curious limited partnership hybrids have emerged:

--The “zero coupon” approach to real estate patterned on zero coupon bonds. “You simply start out,” Elliott explains, “with, for instance, a $2-million mortgage on which no principal or interest is paid.

“Thus, at the end of the first year, you owe $2.1 million and the next year, you owe $2.22 million. And so the investor is buying something today with a high cash flow because of the zero coupon, and the debt service is being deferred 15 or 20 years out.

“Now, when the property is ultimately sold, if the investor is used to a conventional limited partnership, he’s expecting some sort of return from the sale. Does he understand that there’s a good likelihood that he’ll get nothing back because of that deferment? And, if the property hasn’t done particularly well, is he prepared for that sort of day of reckoning?”

--”Class A and Class B” units in real estate limited partnerships. Under this hybrid, Elliott says, the holders of Class A units receive the lion’s share of the cash flow and the holders of Class B units receive the lion’s share of the appreciation in the value of the real estate when it is liquidated.

Requires Understanding

Again, Elliott emphasizes, “there’s nothing wrong with this, any more than there’s anything wrong with the zero coupon approach--as long as the investor really understands what he’s doing. Does the equity guy understand that he’s given up most of his yield and that, if the appreciation on the property hasn’t been all that great, that he may end up with very little to show for his money?

“And, does the holder of the income units, even though he’s gotten a higher yield, realize that he may get little, or nothing, on his money even if the property has done well?”

--The real estate limited partnership where the real estate involved is almost an after-thought. “In recent years,” Elliott said, “we have seen the financial structure of limited partnerships applied to investments that are businesses--such as fast-food companies and health care providers--rather than real estate concerns. We sincerely hope that when the success or failure of these types of businesses is finally determined, the specific business itself, and not real estate, will be praised or blamed.”

Despite the current, sometimes convoluted efforts to “repackage” the real estate limited partnership as something else, it’s an investment, Elliott adds, “that’s as alive and well as it ever was, and while the all-cash approach that’s so popular today is perfectly proper for some investors--a retiree investing strictly for income and with no need for a large tax shelter, for instance--I feel that a well-leverage property, about 25% cash, is still the best real estate investment today in terms of risk, reward and everything else.”

10-year Liquidation

One partnership Angeles is now putting together, for instance, is a traditional, 75% leveraged deal that aims at a 10-year liquidation and is geared to an after-tax rate return of 13.4% over that life span.

“That’s fairly typical,” Elliott explains. “In the fifth year, a leveraged property will catch up with the unleveraged property in terms of cash distributions.”

So, why scramble or omeletize a perfectly good dozen eggs just to disguise that it is a dozen eggs?