Archives for February 2023

2023 is poised to be a big year for real estate owners who are looking to take advantage of the 1031 exchange, also known as the “like-kind exchange.” A 1031 exchange is a tax strategy that allows real estate owners to defer paying capital gains taxes on the sale of a property by using the proceeds from that sale to purchase a similar property. In this way, owners can delay paying taxes on their gains until they eventually sell their new property, potentially many years down the road.

Owners can also elect to pass their property down to their heirs which will give them a step up in basis, eliminating the tax expense all together for the next generation.

Here are six reasons that 2023 will see a record number of 1031 Exchanges:

Rent growth plateau

2021 was a record year for rent growth across most US markets. Now with rental rates across many core asset classes like multifamily decelerating, investors in these properties are starting to see their rents plateau while their expenses and cost of capital continue to increase.

Many long-term owners are starting to recognize their upside in the near future is gone, yet their management headaches and expenses remain.

We are seeing more real estate owners show interest in doing a 1031 exchange into more passive assets like STNL properties. At Partners Commercial Real Estate, our pipeline specifically for 1031 exchange clients has increased significantly in recent months. We typically see an average of five to seven 1031 exchanges per year whereas right now we have nine active exchanges for an aggregate $37 million and more requests from owners to meet to discuss this service now than ever before. We attribute this to many investors having seen their property prices increase up to 70% in the past three years, and now rising interest rates and a slowing economy are causing the spigot on the gravy-train to slow.

Manufactured home parks, industrial, self storage and apartments have seen the highest CPPI change in the past decade, providing the strongest arbitrage opportunity for investors considering a 1031 exchange.

Bonus depreciation is expiring

Starting Jan 1, 2023, 100% bonus depreciation initiated by the Tax Cuts and Jobs Act in 2017 expired, and was reduced to 80%. That percentage will continue to decrease by 20% year-over-year until it burns off fully in 2026.

This accelerated depreciation has been a great tool used by exchange buyers to write off the entire purchase of qualified investment property in their first year which has been a great tool to offset major gains that same year—say from the sale of a business.

With this tax-saving tool slowly expiring, more investors are seeing that window close and positioning themselves to take advantage while they still can.

Cash is king

Real estate investors who see the greatest benefit from a 1031 exchange are those generally above the age of 65 who have owned a property 20 years or more. These owners have seen the most property appreciation and have benefitted from years of depreciation. These owners are also the most likely to have zero debt on a property.

Now, with interest rates from many lenders at 7.5% or greater on a traditional loan, debt buyers are out of the game and cash buyers in an exchange have the best money out there.

In January of 2022, the market felt like there were five buyers chasing every one deal. Now it feels like there is one buyer for every five available properties. I’m seeing up to 150 bps of cap rate relaxation on properties we are putting under contract today vs where those same properties would trade a year ago. STNL properties are selling now at prices I haven’t seen in five years. And the competition for these deals is surprisingly low.

The greatest transfer of wealth

Over the next two decades, over $30 trillion in wealth is going to change hands as boomers age out and begin to sell businesses and real estate. Much of this wealth is held in real estate and will be sold because the management is too burdensome for aging landlords or as business-owners retire and sell business-use real estate assets. 1031 exchanges are the perfect vehicle for these owners to save up to 41% in taxes in some cases, all while reinvesting 100% of that equity into stable STNL properties with zero management responsibilities.

Single tenant net lease properties are by far the most popular exchange asset for investors due to their low maintenance, stable monthly income, high-credit tenants and long-term leases. We surveyed 165,000 STNL properties in Costar and found that 66% are owned by private investors—many of whom purchased through a 1031 exchange. This number will increase over the next 20 years.

Swap ‘til you drop

This cheeky expression is one of the most popular reasons that investors do a 1031 exchange. What this means is that owners can do as many 1031 exchanges as they would like in their lifetime, deferring 100% of their taxes each time. Unless they sell and recognize the gain on the sale, they will never have to pay those taxes. When they pass, their heirs can inherit that real estate and receive a step up in bases. So, if they decided to sell as soon as they take ownership, their taxable basis in the property will have reset to fair market value at the time of the devisor’s death.

This is why we call STNL properties ‘last mile properties’, because they are often the last property an owner will purchase with the sole objective being to preserve their equity, provide reliable cash flow and give their heirs a property with no management responsibilities once they pass on. Owners want to leave their kids assets, not jobs. Inheriting a multifamily property is inheriting a job. Inheriting a CVS or a 7 Eleven is inheriting a professionally operated and managed property with the capacity to continue delivering passive income for many years.

Is now the right time to sell?

Some owners feel that they missed the boat, and are coming to terms with the fact that their assets are worth 20% less than they were a year ago in some cases. They want to take advantage of an exchange but feel they are leaving money on the table.

This graph provided by Green Street shows the CPPI index of property values across the economy from 1998 to 2022. It’s important for investors to understand that if they are doing a 1031 exchange from one property to another, both their downleg property and the future upleg property are similarly affected by macroeconomic conditions. If you could have sold your property in January of 2022 for $5 million and now your property is only worth $4 million, you actually aren’t losing anything because your exchange property has likely “decreased” in value by that same margin, yet the cash flow remains the same. The same would be true if you sold your current property at a 10% premium and exchanged it into a property that had also increased by 10% due to the market conditions.

Source: “Six Reasons 2023 Is the Year of the 1031 Exchange“

Experts are at odds over when a recession might occur. On the whole, they’re expecting one. But timing is the question. Well, one of many, to be accurate.

‘The National Association for Business Economics (NABE) recently released the February 2023 edition of its regular Outlook survey, in this case of  48 professional economic forecasters.

“Results of the February 2023 NABE Outlook survey continue to reflect significant divergence regarding the outlook for the U.S. economy,” an organization release quoted NABE founder and President Julia Coronado, who is also president and founder of MacroPolicy Perspectives LLC, as saying. “Estimates of inflation-adjusted gross domestic product or real GDP, inflation, labor market indicators, and interest rates are all widely diffused, likely reflecting a variety of opinions on the fate of the economy—ranging from recession to soft landing to robust growth.”

For example, 58% of the respondents expect a recession this year, but only a quarter expect it by March, as AP reported. That’s half the number who expected a first quarter setback when polled in December. A third now are expecting a recession in the second quarter of the year, while 20% say the third quarter.

“Panelists’ views are split regarding how high the Federal Reserve may raise interest rates, how long rates might stay at the peak, when cuts would begin, and what would signal the central bank’s actions on each of these fronts,” the release also quoted Dana M. Peterson, NABE Outlook Survey chair and chief economist of The Conference Board. “Respondents are also highly concerned but divided in their opinions regarding the consequences of other matters that might affect the U.S. economy, including the impact of China’s reopening on global inflation and the looming debt ceiling.”

One of the challenges facing prognostication is the ongoing volatility of economic conditions. For example, the Federal Reserve Bank of Cleveland in its most recent analysis of yield curves, shows the shifts conditions seem to predict. In December, the probability of a recession within one year was 53.8%. By January it had grown to 63.3%. Now, in February, it is down to 62.7%. Next month, who knows?

The New York Fed, also reading yield curve inversion tea leaves, last fall said that the probability of a recession by September 2023 was just under 23.07%. Now, the bet is a 57.13% chance of a recession by January 2024.

If uncertainty suggests anything, it might be that the Federal Reserve will consider higher rates longer.

Source: “Experts Keep Guessing at When the US Will See a Recession“

For years multifamily developers and owners have flocked to the Sunbelt cities to invest, drawn by the region’s fast-growing markets, great fundamentals and light regulatory touch. All that development, however, has taken a toll and this year, apartment rent growth in the Sunbelt markets is expected to be lower than that of Gateway cities, according to CoStar’s estimates.

Rent growth for gateway markets will be fairly low, coming in at 1.4% for the end of the year, Joe Biasi, strategic consultant at CoStar Advisory Services, tells GlobeSt.com. But Sunbelt rent growth will be even lower at 0.04% growth, he says.

This downward slope in rent growth began in Q4, in fact, and investors responded immediately.  For the first time since 2015, Sunbelt multifamily transaction volume was lower at the end of the year in 2022 than at the start. “Investors are looking at these markets like Phoenix and Raleigh and see that their rent growth expectations have gotten turned on their head,” Biasi says. “There is no rent growth and the exits don’t look good either.”

This trend will continue into 2024, Biasi says, but beyond that the situation will turn again. “For the next two years the Sunbelt will struggle but in the long term a lot of things that made the Sunbelt interesting to apartment investors will not go away. Just because investors are taking a pause now doesn’t mean that is permanent.”

To understand the region’s seesaw trajectory, it is important to grasp just how fast and furious development has been in the Sunbelt. “It is a little unbelievable just how high construction levels have been,” Biasi says. The share of multifamily construction in the Sunbelt as a percentage of total inventory is 7% right now, compared to 4.4% in Gateway cities. In 2019, product under construction in the Sunbelt as a percentage of total inventory was 4.9%, compared to Gateway cities’ 4%, he notes.

The pandemic was one reason for the acceleration as more people migrated to states like Florida and Arizona, but there were other longer-brewing reasons as well that explain the rush to the Sunbelt, according to Biasi.

One simply is that the South is cheaper for both companies and people. Despite the overall surge in rent growth of the last two years, the Sunbelt remains less expensive in terms of rent to income. There have also been a lot of corporate expansions into the Sunbelt, providing better job opportunities. “The Sunbelt has some of the fastest growing educated populations in the country,” Biasi says. “The makeup of those metros have changed significantly.”

The Sunbelt has less rules around zoning too, which means there are not a lot of constrictions around construction. “A lot of growth combined with not many rules is how we got here,” Biasi says.

The Sunbelt was set to continue this track but then inflation became embedded in the economy, putting a damper on people’s ability to pay their rent. The problem? Sunbelt developers bet that strong growth and continued spending would keep fundamentals strong. As it turned out, they were wrong.

But as Biasi predicts, fundamentals and investors will return. “This is a short-term blip due to a huge pipeline.” Also, institutional investors have gotten a taste of the Sunbelt since the pandemic. Before COVID-19, institutional investors had been married to Gateway cities.

The only longer-term concern about the Sunbelt is its low tax structure, which understandably is a huge draw. But as developers expand they will need services to support their projects, which could be difficult under the current tax regime, Biasi says.

Source: “This is Why Multifamily Developers Have Soured on the Sunbelt“

After the Federal Reserve developed its 2023 stress test scenarios — the baseline and severely adverse sets of assumptions used in testing the resilience of large banks — Trepp projected potential commercial real estate property prices and portfolio losses under each.

This is scenario planning, so the most challenging assumptions aren’t a prediction of a likely outcome. But even the baseline wasn’t all that encouraging. Given the current economic climate, that shouldn’t be surprising.

Under the baseline scenario, the economy undergoes a slowdown and then a gradual recovery. Unemployment begins to increase, reaching 4.9% in the first half of 2024, and then recedes to 4.6% by 2026 Q1. CPI starts at 3.2% in the first quarter of this year (which already seems low), slowly declining until it reaches 2.2% at the beginning of 2026. The 10-year Treasury starts at 3.9% and finally lands at 3.2%; the 3-month peaks at 4.8% by the middle of this year and then declines. Real GDP growth is -0.5% now (measured numbers aren’t yet available), gets worse in the second quarter, then begins to improve, reaches 2.3% at the start of 2024, and by 2026 is down to 2.0%. That includes a moderate recession.

“Equity prices remain at their Q4 2022 level throughout the scenario,” Trepp writes. “Nominal house prices increase gradually by about 2% per year throughout the scenario, and commercial real estate prices increase by about 3% per year.”

In the severely adverse scenario, unemployment hits 5.6% by the end of Q1 2022 (which seems high, given numbers from January), quickly rises to 10% in the third quarter of 2024, and slows to 7.5% by Q1 of 2026. CPI is at 2.3% in 2023 Q1 (again, it seems low), drops to 1.3% at the end of this year, and by the beginning of 2026 is back to 1.6%. The 10-year Treasury starts at 1.1%, dips to 0.8% by midyear 2023, and in 2026 is up to 1.5%; the 3-month goes from 1.7% and by the third quarter of 2023 reaches 0.1%, where it stays. Real GDP growth closes 2023’s Q1 at -12.5% and then starts improving. By 2026, it’s up to positive 4.7%. In this scenario, there’s a severe global recession.

“Asset prices drop sharply in the severely adverse scenario,” writes Trepp. “House prices and commercial real estate prices also experience large declines. In this scenario, CRE prices are projected to reach a level in the fourth quarter of 2023 that is nearly 40% below the level at the end of 2022.”

Trepp then examined 10,420 bank balance sheet loans ($89 billion outstanding value) and created a representative sample bank portfolio. “Term defaults present the main source of risk for the CRE market within this timeframe, but longer-term exposure to maturity defaults also presents a risk, especially within the severely adverse scenario, if prices stay depressed and interest rates stay high,” said the firm.

After the 13 quarters of the scenarios, overall, CRE values would fall by 0.7% under the baseline and 5.8% under the severely adverse. This varies by type. Lodging is hit hardest, losing 2.6% for baseline and 17.3% under severely adverse. Office, retail, and industrial all drop 0.5% in the first scenario and 5.1% in the second. Multifamily, though, has the smallest loss of 0.4% in baseline but is down 6.3% in severely adverse.

Under a second adverse scenario in which Trepp took a more conservative look at office and lodging, the overall portfolio drop is 6.7%. Lodging would actually do better then, at 16.5%, but office would be down 9.4%.

Source: “CRE Prices Could Fall 40% This Year in an Adverse Fed Planning Scenario“