Not-for-Profit Real Estate Redevelopment Opportunities
October 01, 2020
In this episode, Candice Meth, National Leader for EisnerAmper's Not-for-Profit Services Practice and Ron Dukes, Manager in EisnerAmper’s Private Business Services Group, interview Patrick O’Sullivan, a Partner at Herrick, Feinstein LLP. During the conversation, they discuss several innovative ways that not-for-profit organizations can leverage their real estate holdings to generate new revenue streams while possibly upgrading their facilities and offsetting the costs to maintain them.
CM: Ron, do you mind setting the backdrop here? What are you seeing across the not-for-profit landscape during these unprecedented times with respect to sustainability issues?
RD: Candice, beyond the people and the relationships, not-for-profits organizations' most valuable assets are often its real estate. But sometimes these assets go underutilized, especially in the global pandemic we're in, and these assets can be very expensive to maintain or improve over the years as budgets get tighter. Patrick, what are some ways that these organizations can monetize their real estate and improve these properties?
PO: Well, Ron. Yes, a not-for-profits' underlying real estate tends to represent the most valuable asset that it owns. And as a result, many of them will come to assess whether there's an opportunity to unlock that unrealized property value. And this is particularly true now, as you indicate, as not-for-profits pivot to address the challenges that have arisen from the COVID-19 pandemic and their need to undertake strategic planning efforts arise to ensure their long-term viability.
When undertaking an assessment, a not-for-profit should begin with both the needs assessment, in terms of its own facilities, and an analysis of what can be built on its property in accordance with allowable zoning. Based on an understanding of the potential redevelopment that it could undertake, a not-for-profit can then determine the potential value redevelopment can unlock. And also it should be noted that the assessment should account for the timing associated with any transaction.
Because, for example, with current real estate values not necessarily reflecting full value and instead reflecting challenging market conditions, development projects take a significant amount of time to plan and execute, and they also may require discretionary public approvals if a rezoning is contemplated, so they can often take time. And I guess with that in mind, one question I would ask you and Candice is oftentimes we'll see that as part of the discretionary approval process and getting approvals from the government, one, the not-for-profit will have to make sure their books and records are in order. How do you guys assist your clients with respect to those items?
CM:Sure. That's a great question. As we know, the requirement for having an audit is generated by state law. And so there are certain thresholds for requiring an audit and also you have to be a solicitor of contributions in the state of New York. That leaves a lot of non-profits that are technically not subject to audit, such as religious organizations. We'll get a phone call asking us to come in and do an audit or perhaps a review, and even maybe do it a couple of years back. And we're very happy to work with clients to get their books and records prepared so that they can go to the New York State Attorney General with their house in order and make sure that the approval process is smooth.
RD: And Patrick, I want to segue into another question. In light of an organization's mission, what are the considerations and steps that would be involved for organizations that are interested in these redevelopment opportunities after they've consulted with Candice's team regarding an audit or review of their financial statements?
PO: Ron, if a not-for-profit determines that a redevelopment can unlock value and then result in an opportunity to upgrade its facilities, the not-for-profit should consider how to best structure that transaction. It'll need to establish a process to identify a development partner, and it'll also need to identify the best structure for the transaction. And although multiple transaction structures exist, I found, and I've worked on a number of ground leases, which offer many attractive features to the not-for-profit. Most importantly, the ground lease allows the not-for-profit to retain its underlying fee interest in the property. And this provides the not-for-profit with protections in the event that a developer were to default during construction.
CM:That's great. Patrick, we speak to real estate clients about tax efficiency of restructuring their real estate holdings. There are some nuances in dealing with nonprofits. If a nonprofit decides they are interested in redeveloping, what are some potential transaction structures they can look to?
PO: Well, as I mentioned, in terms of the ground lease winds up providing an opportunity for the not-for-profit to remain involved in the project and also to protect its underlying real estate interest. And the not-for-profit needs to work on both its involvement in the development and the remedies in the event that there's a developer default and those wind up becoming key parts of negotiations with the development partner.
And with the ground lease structure, the not-for-profit, like I said, retains its fee interest in the property, which represents an important protection in the case of a developer default. And given that the not-for-profit is particularly concerned with construction of its new facility, the ground lease will also typically provide the not-for-profit with review and approval rights in connection with the development of that facility.
Additionally, the not-for-profit will also have to look to the developer or will often look, I should say, for the developer to provide a completion guarantee. And in addition, the parties will also need to agree to a set of provisions that make the ground lease financeable so that a developer can go and get construction financing for the project.
CM:Sure, absolutely. That makes sense. We see a lot of not-for-profits not have the bandwidth to operate real estate assets since they operate fairly leanly. What can organizations expect throughout the redevelopment process and upon its conclusion, and what type of oversight and management would they need to retain?
PO: Well, that is very true. And oftentimes, these not-for-profits obviously are not in the real estate development business, and so they don't necessarily have the resources to devote to undertaking such a project, particularly as you indicate given how leanly they operate. But with that in mind, what not-for-profits and developers who are undertaking a development transaction can do is they can really focus on two pieces of their relationship.
First is for them to negotiate the timing and delivery of the not-for-profit's new facility and the remedies associated with the failure by the developer to complete construction on time. And in addition, secondly, the parties must decide whether in the long-term the ground lease will govern their relationship on construction completion or whether they will modify their relationship.
With this in mind, oftentimes parties will wind up forming a condominium so that the condominium documents really provide the structure long-term for their ongoing relationship. And in each instance, I should note, the parties really will benefit from agreeing upon terms upfront, as opposed to waiting for things to arise down the line. By having an agreed upon understanding, it really can make sure or it really helps ensure the not-for-profit winds up with a new facility on time and with an ability to operate it in a manner that really allows it to further its mission.
CM:Absolutely. That makes sense. And again, being prepared is half the battle, right? Ron, we would be remiss if we, as accountants, didn't bring up the fact that there could certainly be some unrelated business income tax. And we know that sometimes a rental agreement for a nonprofit can lead to this unrelated business income tax or what we call UBIT. Are there ways to structure a lease to avoid that?
RD: Absolutely, Candice. While there's many exceptions to every rule, the general structures that will help keep a rental activity from being taxable would include including structural elements like it being passive rental activity. In other words, the not-for-profit organization doesn't offer personal services, like lifeguards, parking attendants, people who park your car for you, et cetera. Also, you could rent out the space that is not debt financed. And lastly, you could, as an option, have no profit motive in the business.
And especially concerning for not-for-profits, we actually want to make sure that our clients are not being subject to unrelated business income tax, because it's a surprise for a lot of our clients at the end of the day when they find out that they may have to file the Form 990, who are usually not required to, or also have to pay a tax on earnings that they had not set aside previously to go towards a tax authority.
CM:Sure. And Ron, I think you raise a really good point, which is certainly nobody wants to get surprised with a 21% tax, but at the same time in these current times where we're looking for different, creative revenue streams, we may see some nonprofits that decide, "You know what? I recognize that I might pay tax, but it's still worth it for me to bring dollars in the door and remain sustainable." And I think what's important is working with the clients to identify what the revenue stream is, the tax ramifications, any offsetting expenses and make sure that they file the form timely.
And what we want to just be careful about is we don't think that UBIT is a bad word per se, just as long as everybody recognizes that in some instances these types of rental agreements can lead to tax and maybe that's still worth it to make sure that you're healthy and sustainable and getting revenue in the door. And before a nonprofit is contemplating this type of business venture, what are some upfront considerations that they should be looking at in terms of budgeting and cash flow projections, and how do they get ready for this type of very significant investment? Ron, what do you see here?
RD: Right, Candice. I think a lot of organizations should definitely focus their efforts on their budgeting process, ensuring sound financial close process. And from that, ensuring that their financial statements, balance sheets, income statements, statement of positions, cash flows, are all showing a healthy cash flows for the organization. I think one of the most important things for an organization to consider in looking towards these deals, that they have the necessary cash flow to be able to sustain this type of endeavor in their finances as an organization.
And it's important that, as EisnerAmper, we have a service organization here in the private business services group that walks our non-for-profit organizations through the process of budgeting through the process of analyzing the balance sheet, their statement of financial positions, their income statements and their cash flows to see what opportunities they have for an opportunity of redeveloping their properties.
And Patrick, on that note, what services does your firm actually provide not-for-profit organizations who are interested in redeveloping their properties as well?
PO: First, I would just echo what you've said in terms of making sure that the organization has gotten their budget in place because oftentimes, this is something new for them. And I do think that working with a trusted advisor who can assist them in making sure that they're going to be able to both undertake this significant effort, as well as continue on with their operations and furthering their mission on a daily basis.
I do think that's important. And from our perspective, we'll often work with the not-for-profit. The not-for-profit, an advisor will work with them as well, just to make sure that from the early stages of the process, a process is put in place so that the not-for-profit is devoting sufficient resources to making the transaction or the redevelopment happen while at the same time, making sure that it's not acting as a drain on the organization and on the organization's ability to further its mission.
CM: I think that's so important because to Ron's point, when you undertake projects like these it's the unknown, right, that can really make the price tag go up. And making sure that you have a solid foundation, a solid plan, making sure that you've looked at cash flow projections to ensure that you've got the right cushion or that you've lined up the financing, to Patrick's point, to ensure that the project can continue without a hiccup is very important. And it's just one of the many considerations as you go into this type of structure and the upside is fantastic.
RD: Excellent. Excellent. Thank you, Candice. And I think after all we've heard from Patrick and Candice about not-for-profit entities who are looking to redevelopment, I think we should end today's conversation with a final question about what some of the next steps would be for not-for-profit organizations. And Patrick, what resources are available for organizations in their decision making and what services are your firm able to provide throughout the process?
PO: Well, thanks. I think that we're all seeing that given the uncertainty in the market, that a number of not-for-profits are beginning to undertake strategic planning efforts in terms of their future operations. And I would just say that as part of any strategic planning effort that a not-for-profit may undertake, it should assess whether long-term opportunities exist to monetize its real estate, both in terms of potentially improving its own facilities, as well as solidifying its financial condition.
And while market conditions may not today provide immediate opportunities to realize value, planning and executing and development transaction can take time. And a not-for-profit should really have a long-term mindset when it's undertaking these strategic planning efforts. And in terms of what we do, we advise not-for-profit clients throughout the life cycle of a transaction from the early stages, in terms of these strategic planning efforts, all the way through construction completion.
And we, at Herrick, we can advise on how those real estate assets can be developed, in terms of from a zoning perspective, as well as how a partnership with the developer can be structured. And we can advise on everything from financing options that parties may have to how to address construction and condominium issues at the back end of a transaction. What we really try and do is become a trusted and strategic advisor to our not-for-profit clients at an early stage of this transaction.
CM:Patrick, thank you so much for these fresh insights to help not-for-profits re-imagine the use of their space. And Ron, thank you so much for joining us today as well. Thank you all for listening to Breaking Ground, real estate insights from EisnerAmper, and please be sure to join us for our next podcast and visit EisnerAmper.com/RE for more real estate news.