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With numerous office condominium projects now under development in downtown Washington, law firms may want to think hard about owning their own space rather than leasing it. Given the increases in rent downtown, as well as the skyrocketing value of D.C. real estate, owning an office condominium may look more and more appealing to some law firms. Still, owning property can create thorny issues for a partnership to resolve, including how to allocate tax benefits, appreciation in value, and equity among new and retiring partners. Office condominiums are not a new phenomenon, of course, but until recently the downtown Washington office market had very few of them. Certainly the suburban markets feature many office condominiums, including townhouse-style projects that house many small law firms. Now, however, the downtown market has several Class A office condo projects under way, including projects at Gallery Place, McPherson Square, and 16th and L streets. Several more are rumored to be under development in the West End. These projects may provide homes for many law firms over the next few years. Several unique factors may affect the financing of office condominium projects. Much real estate is financed based solely on the value of the commercial property. That serves as the collateral for the loan, as opposed to relying on the financial strength of the firm or company that will own the real estate. Office condominium projects present a challenge for lenders underwriting such real estate loans. First, appraisers report that the absence of comparable product tends to suppress appraised values. Because office condominiums are still scarce downtown, their appraised value may be less than expected. Also, condominium owners share in the decision making for the building as a whole, and this loss of individual control may negatively affect the value of the property. Anecdotally, we have found that these factors may reduce the combined value of all condominium units in a building by as much as 30 percent when compared with the value of the same building before it was subjected to a condominium regime. The effect of this discount may be offset somewhat by the preferable rates lenders charge for owner-occupied properties. Still, it is likely that an owner of an office condominium will need to invest somewhat more equity as a percentage of the total project cost than would be the case if it invested in a stand-alone property with otherwise similar characteristics. As of this month, the District’s Enterprise Zone Bond program has lapsed, but if it is reauthorized by Congress, low interest financing of up to $15 million for office condo units may once again become available in large parts of the District, predominately east of 16th Street. Law firms and other professionals who do most of their work in offices located in this zone are often eligible Enterprise Zone businesses. THE CHALLENGES OF OWNERSHIP The ownership of real estate by law firms, whether in condominium form or otherwise, itself presents several challenges. One ever-present factor in law firms is the constant change in ownership associated with the admission of new partners, the retirement of partners by reason of age or relocation, and the often annual reallocation of profits and losses based on productivity and other factors. If a firm owns real estate in the District and these changes aggregate in excess of 50 percent in any 12-month period, transfer tax would be due — the District requires a form of deed to be recorded in such a case, and imposes a 1.5 percent tax. At present, no parallel rule applies in the suburban jurisdictions. Frankly, however, if a firm is that volatile, it’s probably a bad candidate for a real estate loan and may have other reasons to avoid owning real estate. Even more stable firms, however, must give careful consideration to several other factors that may complicate firm management when real estate is owned. First, the tax benefits of real estate ownership tend to be the greatest in the early years of ownership, when depreciation and mortgage interest deductions offer greater tax shelter. As a mortgage ages, the portion of the payments allocated to the principal increases and eventually exceeds depreciation, creating what is known as phantom income. In a stable interest environment, this problem can be mitigated by periodically refinancing, but eventually one may want to actually pay off the mortgage. This tax anomaly therefore benefits “founders,” who realize the greatest tax savings, at the expense of those who join a firm later. Conversely, at least in Washington, real estate seems to appreciate more often than not, so that if the appreciated real estate value of an office condominium project is ultimately realized by a sale, the founders may not enjoy the benefits, while their once-junior partners may reap a windfall. Most law firms have sought to correct for a related business succession problem by requiring new partners to, in effect, buy a portion of the accumulated equity of the firm upon admission. When a firm owns real estate that has appreciated significantly, however, this cost to buy in may become punitive and thus may ultimately stifle normal succession planning. A similar problem arises when the offices of a firm are owned by one set of partners and rent is paid by another, most typically the more junior partners. While it can be argued that the rent represents a form of retirement annuity for the founders, it may be a fragile retirement plan if the junior partners elect to relocate the firm in later years to other space. And in any event, this sort of arrangement may create intrafirm economic tensions that are otherwise avoidable. Despite these concerns, office condominium ownership by law firms may present substantial benefits. Certainly the avoided cost of periodic firm relocation at the end of lease terms can be a significant plus. Similarly, the advantage of a largely fixed cost of occupancy over as much as a 30-year term provides for greater budgeting certainty than does frequent lease renewal. In addition, in this market, where rents seem to rise far more often than they fall, the avoided rent expense itself may be a substantial benefit for a firm that owns rather than leases. In fact, the savings and stability in overhead achieved through ownership may be significant enough to offset those considerations that would otherwise reduce the appeal of ownership for a law firm. Unlike renters, the owners of real estate accumulate equity. For a law firm with an office condominium, that means the pot of gold at the end of the ownership rainbow will belong to the firm — not its landlord. Richard Newman is a partner in the law firm of Arent Fox PLLC, and co-chairs its local real estate practice group.

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