Last week the City Council for the City of Cincinnati, led by P.G. Sittenfeld, passed a law allowing renters the option to pay renters insurance in leu of a security deposit.
 
Sittenfeld claims this is “…removing a barrier to housing.” And mayor John Cranley calls the new law, “…a meaningful act of social justice.”
 
The long term impacts and consequences are yet to be seen, however, from a my perspective, this is going to have negative consequences on the housing stock and cause undue burden on the property owners as they are left holding the bill for units that their tenants decide to leave in a condition less than they found them. 
 
I thought this was a bold move by the City and thought I would bring it to your attention.
 
You can read the full article here: https://www.cincinnati.com/story/news/politics/2020/01/15/cincinnati-renters-wont-need-cash-security-deposit-anymore/4430016002/
 
The law goes into effect in 90 days. 

Swap and Drops are going the way of the Sony Walkman player, except instead of functional obsolescence, “entity sales/transfers”, aka “LLC drop-downs” aka “Swap and Drops” will be legislated into extinction by the Ohio Legislature.
 
Thanks to our friends at Porter Wright Morris & Arthur LLP: Michael G. Reed & Mark A. Snyder for bringing this to my attention to then bring to yours.
 
For the first time, a bill has been introduced in the General Assembly to curtail the transfer and property tax planning techniques known as “entity sales” or “LLC drop-downs.”  Model legislation was previously drafted, but it had not been introduced.  The county auditors’ association has made this type of legislation a top priority for 2020.
 
* * * * *
House Bill 449 was introduced on December 17, 2019 by Representatives Green and Skindell. It would apply the conveyance fee tax to transfers of a controlling interest in a pass-through entity that owns real estate. If enacted, transactions involving real estate where there is a “qualifying transfer” would be required to remit the tax to the county auditor within 30 days.
In addition to conveyance fees being owed, reporting these types of transfers could also result in increased property taxes because school districts will inevitably review these filings and file Board of Revision (BOR) complaints to increase values.
For purposes of this potential legislation, a “qualifying transfer” would mean a transfer involving more than 50% of the ownership interest in a pass-through entity which owns real property. A “qualifying transfer” may occur in one transaction or a series of transactions. Transactions that occur within one year of each other would be considered a series of transactions.  This could be a nightmare to keep track of.  It’s not yet clear “how much” real estate the entity subject to the equity transfer would have to own – potentially, any real estate.
The information required on this statement would include:

1. the total amount paid to the transferor as consideration for the ownership interest,
2. the portion of the total that its attributable to real property located in the county and owned by the entity,
3. the percentage of the ownership interest in the entity being transferred, and
4. for the real property transferred, that entity’s percentage of ownership (e.g., tenancies in common owned by multiple entities or persons).

 
If not paid by the transferor, the conveyance fee plus a penalty could be charged by the county auditor and added to the property tax lien for the property owned by the pass-through entity.
This proposed legislation would also cause many pass-through entity transactions to become discoverable in the public record, including in situations in which avoiding the conveyance fee was not a principal reason to use an equity interest sale.
So what’s at stake here?  Certainly the transfer taxes are of issue, because that is the only true benefit of the entity transfer, however, the larger issue here – the lead that’s buried in the details, is that if the sales price has to be disclosed, regardless of the type of transaction – a drop down or a traditional real estate sale – then immediately the property taxes will be appealed, which will then negatively effect the value of the real property being conveyed. 
 
What does this mean for you, the property owner, investors, managers, principals and developers?  If you’ve recently been toying with the notion of a sale, thinking it might be something of interest, but kind of on the fence about it, now would be the time to ask me for a complimentary opinion of value; because if you wait much longer the value of your property will be negatively effected by this legislation.  The question of, “How do you underwrite property taxes?” will become null and void because the answer is going to be the same: 100% reassessment is how!
 
Again, if you have considered selling your property and would like a complimentary, confidential broker opinion of value, please reach out to me and we’ll be happy to provide one. 

​The Membership Interest Transfer is a method of taking title to properties, commercial, or residential, in a way other than a fee simple real estate transaction; through a securities transaction through the purchase of an LLC which owns the underlying property, but not the fee simple interest in the property.
 
What is an Membership Interest Transfer?
Simply put, an Membership Interest Transfer is a method of acquiring a property, free and clear or with a loan, through which the value of the property is shielded from the general public and is not a matter of public record, like a fee simple transfer is a matter of public record.  It is a specific tax exempt transaction outlined by the Ohio Revised Code.  Instead of the property being directly transferred to the buyer, the seller’s membership interest in the property is transferred into a new LLC formed by the buyer.
 
Who should use the Membership Interest Transfer?
Real estate investors wishing to shield the purchase price of a property from anyone who might be interested in knowing what was paid for the property should use the Membership Interest Transfer.
Investors who like to buy and flip should seriously consider this method of acquiring the property because if they are looking to get into a deal, add some value, (through renovations, management or simply being in the right place at the right time) and then turn around in a short period of time and push it back out to the market will find this beneficial.  Typically when a property is listed, the first thing a buyer does is go to the county auditor’s website to see how much it was purchased for.  This then becomes their basis for evaluation, and makes the quick fix-and-flip a difficult proposition, because everyone and their mother knows how much they paid for it, and for how long they have owned the property; this is none of their business what the property was purchased for, only what it is being offered for.
Another class of investors who should seriously consider the Membership Interest Transfer is those who wish to preserve the current tax valuation of a property upon acquisition.  Typically, when a property is purchased above its current tax valuation, the auditor will shortly after the purchase mark the valuation of the property, for tax purposes, to the value of the transaction.  When the property is purchased for a below tax valuation price there are a few more steps that must be followed to get the county to modify its valuation, like appealing the value and showing that it was a fee simple transaction at a below valuation price; this should remedy the problem fairly quickly because the auditor and the board of revision cannot argue with an arm’s length transaction. However, when a property transacts at an above valuation price – say in the case of a property which was purchased in an extremely distressed state, was turned around through management and physical curing of deferred maintenance and through numerous upgrades – the seller in this case deserves his upside.  The buyer may be willing to pay for this upside; however a barrier to transaction at the seller’s desired purchase price is the tax valuation basis.  Upon the sale, in a fee simple real estate transaction, the auditor and the board of revision will immediately jump the tax valuation of the property from its lower taxation basis, to its new, higher basis, because of the fact that it was an arm’s length transaction.
The problem here is that it may appraise for the higher price, but when it comes time to transact the property, a new buyer is going to look at the purchase price taxable valuation, instead of the current taxation basis, thus eroding the higher potential sale price.
 
When should an Membership Interest Transfer be used?
The best time to use the Membership Interest Transfer are when an investors wishes to keep the price which was paid for a property confidential.  Further, if the purchase price of the property is above the taxable value, and the buyer wishes to shield the purchase price, they may elect to use the Membership Interest Transfer.
 
Where can an Membership Interest Transfer be used?
An Membership Interest Transfer can be used in any real estate transaction where the strike price is higher than the current taxable value.
To my knowledge the method is legal in all 50 states; but I am not an attorney; nor do I claim any formal legal training. I would consult your attorney in the state in which you intend to affect this sort of transaction.
 
Why is an Membership Interest Transfer used?
The Membership Interest Transfer is used to shield the transfer value of a piece, or pieces, of real property (real estate). 
In the case of the above avoidance of an increased tax valuation base, the effect is by no means permanent.  Typically, counties reassess value every three years, when they see a transfer in ownership status (change in the name on title as well as the tax mailing address) that is usually an indication that a change in ownership has taken place; not always, an owner could have split with partners and moved offices, thereby dictating the need for a new entity name and a new mailing address; but more often than not this is not the case.
However, when the tax man does come calling demanding that you pay more for the property than you are currently paying for it because he thinks its worth a certain value, he will not have the fee simple transfer of the property as evidence of the value, rather he will have to dig deeper to prove why he thinks the property is worth a certain amount, using an appraisal or other valuation methods, typically sales comps.  
 
How is an Membership Interest Transfer used?
The Membership Interest Transfer purchase occurs as follows:
1.    A contract addendum is drafted outlining that the purchase between buyer and seller will now be conducted as a membership interest transfer between the respective parties.  The entity being sold is a newly created LLC with a name chosen by the buyer that will be formed in the Secretary of State's Office with the seller’s LLC as the sole member of the entity.  This formation must occur before the closing, and the sooner the better.  
2.  An operating agreement for the newly formed entity will then be signed and executed by the seller’s LLC, by and through its authorized member(s), prior to closing establishing the new entity's governance.  
3.  A deed and affidavit in support of tax exempt transfer will also be executed at the same time as the operating agreement by the seller’s LLC transferring the property into the newly formed entity (which, along with any personal property associated with the property that is currently included with the sale will be the new entity's sole asset).  The deed will be recorded with the recorder's office prior to closing.  The affidavit will tell the auditor the transfer is not taxable as it is a transfer to a entity solely owned by the granting entity.  This is a specific tax exempt transaction outlined by the Ohio Revised Code.  
By recording this deed in advance and transferring the membership interest and not the property itself at closing the seller will save on conveyance tax that the county would have charged if the transfer of the property had been made to a third party.
3.  A membership interest transfer agreement, resolutions, bill of sale, and any and all other documents necessary to transfer the membership interest held by the seller’s LLC in the newly formed LLC over to new LLC will be executed on the day of closing.  Disbursement of funds will follow the normal closing process for a sale of real estate, but the property being sold on the settlement statement will be referred to as the 100% membership interest in the entity.
4.  The buyer’s LLC will become the sole owner of the newly formed entity via the membership interest transfer, and will execute a mortgage and any other required documents to its lender securing the purchase in the newly formed entity's name.
5.  The County will simply have made a transfer for no consideration on its books, and barring any meddling from outside entities, will continue to value the property at its current appraised value for taxation purposes.  The purchase price for the membership interest will not increase the taxable valuation of the property in the auditor's records.  Future tax savings are not possible to calculate, but future savings are possible.
6.  The costs of the membership transfer agreement documentation and filing is $1200-$1500.
7.  No liability will be assumed by the buyer for the seller's current entity’s potential liabilities, nor will the seller’s current LLC retain any liabilities for the newly formed entity.
 
Common Questions:
Would the new buyer take on the original basis of the previous owner?  For instance, if a property is sold for $12,000,000 to a new buyer, but the seller took title to it at a valuation of $2,000,000; would the new buyer, the one who bought it for $12,000,000; would his basis be for $2,000,000?
No, the new buyer’s basis, as far as the IRS and State are concerned, when it comes to capital gains, own the asset for $12,000,000.  If they acquired the property via a 1031 exchange then their basis would be based on the chain of transactions in the 1031 exchange, not the previous owner’s taxable basis, for capital gains purposes. 
The main reason to use an Membership Interest Transfer is to shield the transfer value from entities who want to tax a property on an ongoing basis based on the sales price; OR to shield the price at which an asset is owned from potential buyers when at a future date the property is put up for sale. 

​Today I would like to examine the Dayton Market, and how the rental rates have shifted over the past 24 months and how its market activity compares to the composite data set.  It should be noted that I am using Yardi Matrix to procure the data, I prefer it to other data providers, and I find the platform easy to use and intuitive compared with others.
Now, as we examine the data in Dayton VS the composite set the first thing that sticks out to me is that the distinguish between Discretionary rentals and Upper Mid-Range rentals is nearly identical, with the rates for the Discretionary actually dropping below the Upper Mid-Range in Q3 2018.  The spread between them in Q1 2018 is only $34 in Q1 2018 whereas in the composite set the spread is $253 in the same time period.  What’s more astonishing to me is that in Q4 2019 the Upper Mid-Range is higher than the Discretionary rents by $32; whereas in the composite data set the discretionary rents are $287 apart.  Nonetheless the rents in each category rose across the time period, discretionary was the laggard of the category at only a 2.1% increase over the period, and Upper Mid-Range showed the strongest with 7.9% over the same period.
The increases over time across each category in Dayton as compared to the data set is interesting also.  In the composite data set we saw an average increase in rents over the period of 7%, with most of the data points falling pretty close to the mean, +/- 0.5% with the Upper Mid-Range showing the weakest increase, and the outlier in the limited data set of only a 5.1% increase.  However, in Dayton, we see the opposite, with Upper Mid-Range showing the strongest increases in percentages and in actual dollars. What I draw from this data is that the market not as healthy as the whole of the composite data set, and the discretionary renters have their pick of the units they would like to lease.  To me that Upper Mid-Range category is the healthiest and I believe still likely has room to grow.

​Next we take a look at how the actual dollars changed from quarter to quarter.  2018 was not a kind year for the Discretionary category in Dayton as in the Q2 2018 it saw a decrease of $30 from the previous quarter and then again it fell, this time by $44 in Q3 2018.  The class did make up most of its losses in Q4 2018 with an increase of $60, however it was not enough to makeup for the losses sustained earlier in the year. Q2 2018 was difficult too for Upper Mid Range, our star over the period, and Workforce Lower, however for the remaining quarters none saw dramatic gains or losses. It should be noted though that Q1 2019 was the healthiest for Upper Mid-Range, Lower Mid-Range and Workforce Lower, with increases in rates of $26, $16 and $9 respectively.
Comparatively Q1 2019 was not healthy for the Upper Mid-Range as it was for Workforce-Upper and Workforce Lower in Cincinnati; for that period Upper Mid-Range saw a loss in rental rates of $5 but Workforce Upper and Workforce Lower each saw health increases of $10 and $15 respectively.
When we look at the same period for the composite data set, Q1 2019, we see that only Discretionary and workforce lower saw substantial increases of $21 and $9 respectively.  To me this shows that Dayton is a lagging market as compared to the other two being discussed. 

​Finally, let’s look at the %’s and how they fared through the period. Not surprisingly the graphs for both the $ changes and the % changes look nearly identical.
In examining the data, with the exception of the Discretionary period, the rental rate increases as measured by percentages (%) is relatively flat quarter to quarter with 2.2% being the most significant quarter over quarter increases, excluding the wild swings of Discretionary, and what was done by Upper Mid-Range.
My takeaway from this analysis is that Dayton is a market in which caution and patience is going to win the day. If I am investing in Dayton, I would look at the workforce or Mid-Range categories, and I would think that even these are relative compared to the other cities in the composite, but also the whole market as well. 

​Curiosity, it got the best of me.  After yesterday’s blog post I got to wondering which cities had the greatest change in rental rates and more specifically which saw the greatest decrease in rental rates.  So, I decided to start closest to home here in Cincinnati.  I began by pulling the same three reports which I had pulled for the three combined cities and look at the data presented there to see what we could find.
The first data set we’re going to contemplate is the actual data that shows what rental rates did across the trailing 23-month timeframe.  As with the composite data of all three cities, Cincinnati mirrored the discretionary increase across the time period, however it was much stronger in the Upper Mid-Range and Lower Mid-Range, Workforce-Upper and Workforce-Lower than the composite data.
What this tells me is that Cincinnati had much greater demand for rental housing and as such property owners were able to command higher percentage increases for their units than the data set as a whole. Its interesting to note that the rents in Cincinnati are higher than the composite data set, I attribute this to Dayton being included in the data set as Dayton has historically lower rental rates.

​Next, we move, as we did in the previous post, to look at how rental trends in the actual dollar amounts increased or decreased.  Here too we can see that Cincinnati is strong overall, with actual dollar increases well above the composite data set.  It should be noted though that In Q1 2019 the Upper Mid-Range saw a decrease of $5 and in Q2 2019 the Discretionary saw a decrease in rent increases of $4; whereas in the composite data set the Upper Mid-Range saw an increase of $4 and the Discretionary saw an increase of $17. 

​Finally, we come to the percentage changes across the five property asset classes in Cincinnati as measured against the composite data set of Cincinnati, Dayton and Columbus for the trailing 23 months from January 2020. The strength of Cincinnati persists here in the percentage increases as it had in the dollar increases, and overall though there are a few points of negative changes in rental rates, the overall trend here remains positive.  The data points mentioned above that I highlighted are that in Q1 2019 the Upper Mid-Range decreased only 0.3% or $5 and in Q2 2019 the Discretionary class decreased only 0.2% or $4.  It appears that the overall effect of these two slight negative points had minimal effect on the composite percentages overall. 

​My takeaway from this analysis has been that Cincinnati appears to be a strong rental market overall with only tow instances of slight negative rent increase amounts in percentages and dollars, but in subsequent periods the market was able to overcome that slight decline and rebound substantially.  This shows me that Cincinnati overall is a healthy market and should be strongly considered for current and future investment by the market. 

​By pulling a series of simple reports from our data service providers we can see how the rates have shifted over the trailing 8 quarters (2 calendar years).
Our first chart and corresponding graph shows the rental rates across asset classes.  The largest rental rate increases occurred in the discretionary asset class amounting to $99 over the time period. This increase in the discretionary market class amounted to a 6.5% increase over the period. However, the largest percentage increase occurred in the Workforce – Lower asset class amounting to a 7.5% or $49 over the time period. 

​Our next chart and corresponding graph show the actual increases, quarter to quarter, across the three markets.  What is interesting to see is that the increases are strong through 2018 and into Q2 of 2019; however, we see a drop in the dollars increasing starting in Q3 2019 and then negative rent increases in Q4 2019.  I believe this is due in part to the oversupply we’re seeing in Columbus in particular. Its no secret that the market has seen tremendous growth over the current market cycle with lots of new units having been added, and as such renters have a choice, and properties are having to compete for those tenants.
The bright spot in this data is that the Workforce - Upper and Low Mid-Range properties have been pretty consistent throughout the timeframe, however too were not immune to the rate increase drops. 

​The final analysis of the rental rates and trends over the previous 23 months focuses on the percentage changes across the time period across the asset classes. Here we can see how rent levels behaved quarterly throughout the time period.  The trend outlined above, of a strong 2018 into Q2 of 2019 persists here with the Low-Mid Range housing seeing the strongest percentage rent level increases of 1.8% quarter over quarter in Q2 2018 and Q2 2019.  Evaluating the data though it appears that the Workforce-Upper was the most consistent performer of rent increases, finishing with a 0.8% rent increase in Q4 2019 while all the others were nearly flat if not negative. 

​What the data shows is that rents are still rising, though over the past two quarters at a much slower rate than previously.  What we can take from this is that the rental market may be cooling for renters.  However, the demand from investors has not ebbed to this pointe, perhaps though, it could.  If you and your partners are interested in a confidential valuation of any of your assets please reach out to me at Stash@Capstone-Companies.com or on my cell at 513.417.5588.
 
Sincerely,
 
Stash