Breaking Up is Hard to Do

For some families in commercial real estate, breaking up may be essential to succession

Back Longreads Sep 25, 2018 By Russell Nichols

Before big-time Sacramento developer Mort Friedman passed away in 2012, he handed the keys of the family business to his son, Mark Friedman. The transition was relatively seamless. Mort’s other sons pursued careers outside the industry and in different cities. Mark had been helping his father grow their commercial real estate business since 1991, developing and renovating shopping centers, office buildings and mixed-use projects.

Now that Mark Friedman, president of Fulcrum Property Group, is getting older, he has to think about the next generation. None of his sons has expressed interest in real estate, he says, but he would never select a family member to run the business unless they were fully qualified. Mort didn’t have this issue.

“There wasn’t any question about how it was going to continue, because we were thinking about what the end game would look like at the very beginning,” Friedman says. “Now, it’s not clear what will happen. It’s hard because it really requires contemplating your own death, being realistic about the future. How do you set it up so other people aren’t left holding the bag if I’m not around to run it?”

“The farther you get away from the founder, the more voices there are at the table, the less likely they agree. Then people go their separate ways because they don’t want to see their assets controlled by someone else.” Mark Friedman, president, Fulcrum Property Group

Succession plans can be a nightmare for any family business because there are so many factors to consider: Some family members may have outside interests, children move away, economies shift, industries evolve. But compared to other types of businesses, commercial real estate — which can include construction, development and management —  is unique because family-owned businesses can choose to divide multiple properties among children. Carving up the business to create separate entities may help families avoid conflict. On the other hand, it could cause more friction with issues such as outstanding debt, estate taxes and tough decisions about who gets the highest value assets.

Some families decide branching out, diversifying and expanding into new markets is the only way to keep the business alive. Others set up a holding company to keep the business intact, with all the entities under one legal roof. These strategies might make sense when transitioning leadership from the first generation to the second. But as time passes and more relatives join the mix, that roof can start to show cracks. Then, the best bet may be to break up — even if it’s hard to do.

“These are classic family issues,” Friedman says. “The farther you get away from the founder, the more voices there are at the table, the less likely they agree. Then people go their separate ways because they don’t want to see their assets controlled by someone else — even if it is a cousin.”

FAMILY MATTERS

As a specialist in real estate, tax planning and tax controversy resolution, Belan Wagner sees family-owned real estate businesses split up all the time. In fact, he says, he often recommends it in situations where it looks like family drama could foster instability down the line.

“There are a lot of problems to address, but dividing the business can make the family happier after the death of the parents,” says Wagner, the managing partner of Wagner Kirkman Blaine Klomparens & Youmans in Mather. “That’s an option people need to consider when moving forward with their estate planning, so each child has control of their own destiny.”

Different perspectives can lead to disparate opinions on whether a property should be sold, retained, financed or how it should be financed. This is why understanding family dynamics is critical for success, he says. Parents usually want to keep the business together and treat their children equally. But what if a child has substance-abuse problems or carries a grudge from childhood? What if there is economic disparity among siblings? These issues, Wagner says, rarely work in the context of shared ownership.

“If there’s some kind of problem that is known — marital, drug dependency, acrimony between children — you’ve got to be very careful about putting them all into a family business together,” he says. “It’s rarely a good formula.”

Succession gets especially tricky for family farms, Wagner says, in which the business is often also someone’s home. He has clients in situations where some children want to keep the operation going, but some do not. The ones who do must enter into a lease agreement with other family members who still live on the property. This creates a conflict of interests. The owners want a good lease to pay for maintenance, ditches, land and water rights. The tenants want a good deal so they don’t get priced out. Being family, the negotiations can be more informal than if they were unrelated parties, Wagner says. When some members operate the farm while others are passive, this informality can cause disagreements that result in litigation. He adds that family-owned mobile home businesses face similar struggles.

Conflicts may be resolved with conversation. But these aren’t easy conversations for some to have. One of Wagner’s clients has reservations about their child’s spouse and wanted to ensure, in the event of a divorce, their child’s share would be protected. To accomplish this, the client set up a spendthrift trust for that child, funded with a few properties that the other children had no ownership interest in. This way, the siblings wouldn’t be impacted from a divorce.

Other clients who want to avoid breaking up the business think making one child a trustee over another is the answer. But putting one child in charge of another child’s money can destroy families, Wagner says.

“Usually for people who’ve spent their entire lives developing wealth, the idea of splitting up the business doesn’t feel really good,” he says. “I’ve had families that are fine having collectively owned assets. But the best scenario for a family with known issues is to carve it up.”

IT’S COMPLICATED

No two families in commercial real estate are alike. Succession plans will vary accordingly. At Fulcrum, which has a project portfolio that exceeds 2.5 million square feet, Friedman is constantly evaluating individual assets and determining whether to hold or sell them, he says. As an illiquid asset, real estate is more challenging to divide, he adds, and less flexible in terms of succession than liquid assets like stocks.

“If I’m going to split it up and Property A has debt, but B and C don’t, how do you deal with that?” Kent Silvester, attorney, Boutin Jones

“If you own real estate, you have to run it,” he says. “If all the kids aren’t interested in staying in the business, you can’t sell a third of a shopping center or apartment building. You need to sell the whole thing and distribute the cash. It’s pretty complicated.”

Even if families get through the hard talks about interpersonal relationships, they still need to ask the difficult business questions: If one child is managing the entire business, does that child get extra compensation? If properties are split up, what happens if one child goes bankrupt? How can value be distributed evenly if properties have different values?

“If I’m going to split it up and Property A has debt, but B and C don’t, how do you deal with that?” says Kent Silvester, an attorney at Boutin Jones in Sacramento.

Silvester, who specializes in tax, business and estate planning, helps clients navigate this shaky ground to help them avoid friction and save on taxes. One of his clients decided to keep their real estate business together, but Silvester helped set up a structure that would minimize adverse tax consequences on any future separation of the properties, allowing for an easier break up should things go south.

“You would typically have less family friction if each is on their own,” Silvester says. “They’re responsible for their own property, don’t have to interact with siblings. But the children may say, ‘Johnny got the great property, and Sally got the dog’ — at the time you did the planning, it looked great, but now Sally has no cash flow.”

DIVIDED INTERESTS

When it comes to commercial real estate, many families are not developers like Friedman. Instead, they are merely investors who let someone else manage their properties, according to Jan Rosati, a CPA and partner for MGO, an accounting, tax and advisory firm in Sacramento.

Families with real estate investments often use a holding company structure, with all the properties owned by a single entity (a partnership or LLC). Family members then own shares in the holding company. This structure is easier to administer and control, Rosati says, but it could also alienate later generations without any stake or interest in a passive operation.

“The first generation sees it as their legacy,” Rosati says. “But by the third and fourth generations, the number of participants has grown [exponentially]. They’ve moved out of the area. At that point, the family may carve it up, and one portion of the family may buy out the other members.”

After his father was killed in an accident while working on his ranch in 2000, Stan Van Vleck bought out seven family members to maintain ownership of his family’s ranch east of Sacramento in Rancho Murieta. Van Vleck Ranch, a sustainable producer of angus and wagyu beef, has been in operation since 1856, and he fought to keep the legacy alive.

Four years ago, surging costs of regulations, labor, land and water in California prompted Van Vleck to sit down with his wife and children to discuss the future of the ranch. They didn’t want to break up the business, but had to do something to compete against producers in South America, Canada and other states with lower costs.

Ultimately, rather than dismantling the family business, they decided to branch out into different markets, dividing in a different way. Van Vleck, a partner at Downey Brand, is now working to diversify beyond the cattle ranch operation and into investment. He’s already launched a commercial real estate investment company and has a broader investment company in the works, which Van Vleck says will open opportunities for future generations to expand into technology, health care, logistics, agriculture or “whatever they believe makes good business sense” moving forward.

“We’re creating a dynamic situation that looks a lot more attractive to the next generation than branded cattle when it is 110 degrees outside,” he says. “I take this dead seriously. We really needed to proactively address this situation, and if we didn’t do it right, we probably don’t make it to the next generation.”

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