Mullets

(Trigger warning: I get into some more historical tax stuff here, but I’ll try to keep this post short so that maybe it won’t be too traumatic.)

I mentioned in an earlier post how, in the old days before private real estate became a recognized asset class that attracted institutional capital, real estate developers like Gerald D. Hines would typically put the arm on their rich friends to stump up the equity they needed for their next deal. They would dangle the tax benefits to be expected from such an investment as a compelling inducement.

The practice of using so-called “tax losses” to entice investors, particularly individual investors, to commit investment capital, often into dodgy or suspect enterprises, became widespread within private real estate in the 1970s and 1980s with the emergence of “tax syndications,” and it is one of the sorriest episodes in the history of PRE finance. The specific techniques that syndicators purposefully employed to milk their investors, and the financial losses that many such investors suffered at the end of the day, contributed to PRE having something less than a stellar reputation for years to come, especially among small investors.

I first heard of tax syndications, or at least their early precursors, in law school. I well remember my tax professor’s derisive term for those poor souls who sought out investment opportunities, not for their intrinsic value or wealth-creating prospects, but for their ability to generate tax losses that were much-coveted because they could be deducted from other compensatory and investment income and thereby reduce the investor’s tax burden. My professor called such investors “mullets,” which I found confusing at first, simply because the only mullet with which I was familiar in the mid-1970s was a ray-finned fish found worldwide in coastal and tropical waters. (Later, that term became associated with a kind of hairstyle as respects the merits of which I will reserve comment.)

In retrospect, I confess that I have a modicum of sympathy for the unsophisticated investor who in those days was looking at forking over as much as 70% of the marginal income to Uncle Sam. (Do people still call the federal government that? Seems like you don’t hear that so much anymore.) The prospect of recovering their investment capital at risk was not from the actual investment itself but from savings on their taxes must have been nearly irresistible, leading them to plunk down money for investments in drilling rigs and railroad cars and such like.

However, for the promoters of these schemes, especially in PRE, I haven’t the slightest sympathy because they were, for the most, part a bunch of greedy unscrupulous con men who had no business being entrusted with people’s money and who left behind them a vast wreckage of capital.

The fees these syndicators charged were nothing short of rapacious—often 25% or more of the amount invested—and they were putatively for everything under the sun. Sales commissions, organizational services, acquisitions, financings, dispositions, arranging property management (not providing property management but arranging for someone else to manage the property), etc. Many such fees were so buried deep that only a legal bloodhound with a nose exquisitely tuned for sniffing out humbuggery could find them. Now, it should be obvious to anyone that money going into a syndicator’s pocket is not money that is being put to work in an investment, which effectively dilutes the amount of capital that the investor has used for the purpose of earning a return.

The syndicators also leveraged their investments to the absolute gills with high-cost debt in an effort to maximize tax loss generation without giving much thought to the risk of default and foreclosure.

And it will come as no surprise to you that the syndicators built in performance incentive structures, the dreaded “promote,” were so outrageous that they would have been laughed out of the room had they proposed them to an institutional investor.

These syndicators succeeded because they built distribution machines that operated in scale. They were all about the ability to push out as much of this toxic stuff as fast as possible to as many “mullets” as they could round up. An old Wall Street banker friend of mine referred to their sales tactics as a “belly-to-belly” sale. Although he was an upright family man and an observant Catholic, he knew that I knew what he meant.

Unfortunately for the syndicators, but even more so for their investors, tax policymakers in Washington, D.C. were not oblivious to all this febrile activity. During Ronald Reagan’s second term (at which time I was practicing law in that fair city), his Secretary of the Treasury, my former law partner James A. Baker III, led the Administration’s charge in pushing through Congress the first major tax reform in over thirty years. The Internal Revenue Code of 1986 supplanted the 1954 Code, and its operating principle was to eliminate so-called tax loopholes in exchange for meaningfully lowering tax rates across the board. It was a resounding success as a tax policy matter, and not coincidentally the changes it made forever doomed the tax syndication business.

In the first place, it reduced the top marginal rate from 50% to 38.5%, thus likewise reducing the dollar value to investors of tax losses. More surgically, however, the law eliminated the deduction for “passive losses,” i.e., the very kind of losses that were created by tax syndications, against a taxpayer’s other income from compensation or investment.

What this meant at the end of the day was that investors now had to have an honest-to-God economic reason apart from tax loss generation before they would be willing to commit their good money to a real estate investment. In response to this level-headed demand, the syndicators had no answer.

The mullets were mullets no more.

With their money spigot twisted firmly into the closed position, the syndicators began circling the drain at various RPMs. They lost investments to their lenders via foreclosure, and their firms went bankrupt wholesale in the late 1980s.

In the meantime, however, between the investments made by them and by others who had access to cheap, poorly underwritten debt capital provided by the financial savants running savings and loan institutions, PRE became so oversupplied with space, particularly office, that it experienced a crushing, years-long recession in the late 1980s and early 1990s.

From ashes of this debacle arose several new, more stable and sustainable approaches to PRE investing and capital formation that continue to this day, and we shall turn to them in future posts.

But you’ll be happy to know that we’re done with tax stuff for now. I promise.

(Until we get to REITs, that is, but you should find them somewhat more interesting, he said, hopefully).

Accordant Investments LLC (“Accordant”) is an SEC registered investment adviser. For more information about our services and disclosures, please visit our website at www.accordantinvestments.com.

This article reflects the personal views and experiences of the author and is provided for informational purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any product or service offered by Accordant Investments or its affiliates. Any such offer or solicitation will be made only through formal offering documents, which describe the terms, risks, and fees associated with an investment. The information contained herein should not be construed as investment advice or a recommendation to buy or sell any security. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results.

No part of this material may be (i) copied, photocopied, or duplicated in any form, by any means, or (ii) redistributed without Accordant’s prior written consent.