·The current 1031 exchange rule allows investors to sell a property and defer capital gains taxes by purchasing a “like-kind” property.
·The Biden administration seeks to increase the capital gains tax from 20% to 39.6% for those earning $1 million a year.
·Long term, we may see a significant drop in transaction volume as investors will likely be holding their properties for a much longer time.
A lot has been in the news lately regarding Biden’s tax change proposals and many of these changes target the real estate industry, specifically commercial assets and the investors who purchase and operate larger apartment buildings, retail shopping centers, and industrial buildings. While this is not law, yet, it is likely we will see a significant impact on the commercial real estate industry both in the short and long term. More importantly, it will be interesting to see how this proposal will affect asset pricing and transaction volume over the next few months. The 1031 exchange has been around for many decades and an entire ecosystem of companies has been built on 1031 exchange-related services.
The nature of real estate investing is for investors to continue buying properties with the end goal of either holding and waiting for the properties to appreciate or conducting renovations to flip the property for a quick profit. Before Biden’s proposal, capital gains were passed along to heirs tax-free at death. Per the WSJ, “Mr. Biden seeks to close the death loophole by taxing capital gains on inherited taxes.” Tax loopholes enable investors to save with less cash circulated back to the government. The Biden administration has proposed major tax changes in an attempt to pay for the stimulus packages that have been passed out in the past few months. Unfortunately for the real estate industry, these changes target active and passive investors as well as owners of commercial properties. Broadly speaking, tax laws tend to incentivize behavior which means that significant changes to the way your real estate investments are taxed can lead to property values, pricing, and how commercial real estate is bought and sold.
The first component and most directly targeted at the real estate industry is specifically the proposed elimination of the 1031 exchange for real estate capital gains greater than $500k. The 1031 exchange rule currently allows investors to sell a property and defer capital gains taxes by purchasing a replacement property of equal or greater value, incentivizing investors who created value in their projects to move on to a new deal and repeat the process without having to pay taxes on the value add. Approximately 12% of sales transactions were part of a “like-kind” exchange during 2016-2019 and 52% of properties sold in “like-kind” exchanges were residential properties, according to a 2020 survey from the National Association of Realtors. Also worth noting is that 84% of the properties that were exchanged for like-kind properties were “held by small investors in sole proprietorships (47%) in S-corporations (37%).” When asked about the impact on property values if Section 1031 were repealed, 94% of respondents reported that the repeal would ultimately lead to lower asset values. This would also create an unintended trickle-down effect to make the housing shortage we’re seeing in the United States even more severe.
Residential real estate investors tend to go into acquisition seeking renovation opportunities, whether it be adding more units or simply applying cosmetic changes. If those would-be sellers can’t take advantage of a 1031 exchange, then they would be subject to a hefty capital gains tax upon sale. Thus, restricting the number of new properties entering the market in the future, per the National Multifamily Housing Council. The illustration below further bolsters the argument that developers need incentives to build homes. More importantly, as more homes are set to be built, this would enable the creation of a substantial number of jobs to facilitate the new projects.
The next proposed change that the Biden administration seeks to make is to increase the capital gains tax from 20% to 39.6% for those earning $1 million a year. It is no secret that property values have increased substantially since the onset of the pandemic. A shortage of homes paired with an intense consumer desire to purchase suburban homes creates an expensive market. Thus, if an average investor purchased a property for approximately $700k back in 2001, that property would be worth well over $1 million in today’s market. Even if this investor has a modest salary they have increased their net worth. The investor is now placed in a federal capital gains tax bracket of almost 40% (on what could be a majority portion of their net worth). Moreover, this is on top of the Net Investment Income Tax (NIIT) of 3.8% for married couples earning more than $250k per year.
If the capital gains tax is increased, then the taxation of carried interest may also change from being treated as a capital gain to being subject to ordinary income tax rates. Carried interest is simply the compensation general partners receive on real estate syndications and funds that allow them to receive additional profits on a deal in addition to the equity they invested after exceeding return hurdles set by their capital partners. If for example, capital gains tax rates double for high-income earners, carried interest on mid-sized to larger deals would likely be subject to the 39.6% income tax. Investment firms also rely on promoted interest checks to help fund their operation and to reinvest in their business.
Let’s say that this proposal is passed. What would happen next? First, there would be a sell-off in commercial real estate properties in the short term to squeeze out the benefits of the current 1031 exchange plan. Since more properties will be listed on the market, asset prices will go down and cap rates will increase, potentially causing a buyer’s market. Long term, we may see a significant drop in transaction volume as investors hold their properties for a longer time. There is no guarantee that this proposal will pass. If it is passed, then there will most likely be a middle ground. In the meantime, it’s something real estate investors should monitor and be prepared to fine-tune their strategy before new laws are codified.
Real estate is the largest asset class in the world. Commercial real estate in the US has a market size of $17 trillion while single-family residential homes in the US have a market size of $36 trillion.
Why Invest In Real Estate?
Due to its sheer size, every major institutional fund has some allocation to real estate. For any sophisticated investor (or $1 billion+ fund), diversification and benefits from risk parity become crucial to portfolio management. Zillow also expects more pronounced growth in 2021 as sustained demand pushes asset prices higher combined with a lower cost of capital. The 2020 US housing market gains were also the largest in the last 15 years.
How To Gain Real Estate Exposure In Your Portfolio?
There are multiple methods of investing in real estate. We can broadly categorize them as being through public markets or private markets, and equity or debt.
When individuals buy real estate for themselves or engage in fix & flip projects, they engage in private equity. At the institutional level, these projects would be building major apartment complexes, malls, or hotels.
Respectively, individuals engaging in private equity need financing. For residential projects, that is usually from a bank. The bank provides a loan with terms based on the creditworthiness of the borrower and uses the property as collateral for the loan.
Public equity in real estate exists predominantly through REITs. In 1960, REITs were created as a way for individuals to own shares in commercial real estate portfolios–which was previously only possible for wealthy individuals. One way of understanding this is to think of REITs as public companies on the stock exchange from which you can buy ownership at $10 per share- the difference being REITs only invest in real estate. There are over a dozen types of REITs, including retail, residential, healthcare, and office REITs. They could behave as classic asset managers or they could be master-planned communities. Moreover, due to the strong dividend income REITs provide, they are an important investment both for retirement savers and for retirees who require a continuing income stream to meet their living expenses.
When a loan is financed by a bank, that loan stays on its balance sheet–which in turn reduces its ability to originate more loans. In order to originate more loans (and collect fees), banks sell off these loans in the form of mortgage-backed securities (MBS).
For residential loans, a commercial bank would acquire a large pool of loans, group them all together, and securitize them–making them into an investable product for the open marketplace. MBS are often made into other structured products such as CLOs, CDOs, and SIVs. Therefore, although they are technically “public debt” (since anyone can invest), your everyday individual is not able to invest as each slice of MBS requires a minimum investment of $10m. Investors of MBS are generally pension funds, insurance companies, and banks.
Real Estate Opportunities Vs. Costs
When the average person invests in real estate, he/she typically turns to fix & flip or other private equity projects. This category provides a broad degree of agency and allows for investors to choose any location or project and structure it however they would like. For commercial real estate, institutions generally choose between core, value-add, or opportunistic projects.
Equity investments have a higher potential return on investments than debt investments. In a debt investment, the maximum return on investment is the interest rate whereas the value of physical real estate property can increase without end. For example, if someone finds an appealing fix & flip project, he/she could make a 40% ROI in one year whereas the bank financing this project will only earn the 12% interest rate that was placed on this loan. However, debt instruments can be considered “safer” as if the borrower defaults, the debt holder obtains the property. The right debt instrument would mean an expected return equal to the interest rate as well as a default upside.
REITs (and some MBS) benefit from being liquid.
Where Does Sharestates Fall?
Banks primarily act as the financiers of private debt for residential projects. While this is true for term loans (refinance, purchases), fix & flip deals fall within the privy of hard money loans, which are not funded by banks. Sharestates engages in funding both term and bridge hard money loans and offers these loans to accredited retail investors, allowing them access to a market that would ordinarily have a huge wealth requirement as a barrier to entry.
Retail investors in Sharestates also have agency and can pick and select the loans they believe are most promising. Done correctly, investors have a base case scenario where the expected return is the interest rate. In the worst-case scenario, the risk is mitigated if a borrower defaults and the property is worth more than the expected payments on the loan. Sharestates’ underwriting standards are, thus, critical to both our borrowers’ and investors’ mutual success.
• The shortage of homes paired with intense consumer demand for suburban single-family homes leads to single-family asset prices increasing tremendously.
• SFR rent growth provides better ROI than peer asset classes.
COVID’s impact on the Market
Covid impacted the housing market at a disproportionate level—ultimately creating big winners and big losers. Of course, the housing market is a very general term and we must define the segment of interest. The single family market turned out to be triumphant due to the numerous number of people fleeing major cities in hopes of finding suburban homes. As mentioned in 2021 Multifamily Market Outlook: First Quarter written by yours truly, “vacancy rates in the suburban multifamily market have declined…areas like Long Island and the suburbs of New Jersey seemed to be the biggest winners here… government aid certainly helped people expand their supply of cash along with a decrease in consumer spending (at least in the beginning portion of the pandemic)…consumers are able to spend more and for a longer duration.” What does this mean? To put it simply, because the onset of Covid forced everyone to stop production, home development halted immediately. Ultimately, creating a shortage of homes. The shortage of homes paired with intense consumer demand for suburban single-family homes lead to single-family asset prices increasing tremendously. According to CoreLogic, “home prices continued to increase in February, reaching the highest annual gain since April 2006.”
Is a Housing Bubble on the Horizon?
It is natural to think that we are approaching a housing bubble similar to that of 2006-2008. Asset prices in the single and multi-family home sectors have been climbing since the onset of the pandemic. However, Ben Carlson, CFA from A Wealth of Common Sense argues that in this case, history will not repeat itself. Carlson states that more loan originations are being made for higher credit borrowers which was the exact opposite of the subprime boom. Notice the sharp trend upward of higher creditworthy borrowers compared to ’07 levels.
As far as cap rates are concerned, apartments in the major cities used to be in the low single digits but rose drastically as people fled, causing demand and prices to fall respectively. We may see somewhat of a normalization of cap rates in major cities but they won’t be at levels we were used to. It is not surprising that investors are staying away from NYC loans, especially ground up in the near term. NYC apartment cap rates for the longest time suggested a safer return on investment. However, we ultimately saw a reversal in the sense that suburban asset cap rates declined while city cap rates increased. This is why single family homes continue to outperform. According to Altus Group, “another advantage [of SFR] is that tenants tend to renew their releases which results in lower turnover costs… SFR’s have a 70% retention rate.” Even during the ’08 crisis, when home prices decreased, “SFR rent growth diminished but never went negative… owners can capitalize on this by refinancing or selling and realizing the gain.”
As John Burns, Chief Executive Officer of John Burns Real Estate Consulting stated in a presentation titled The Single Family Rental Boom is on the Horizon hosted by Berkadia on April 14th, “home renters prefer a single family lifestyle to an apartment lifestyle.” Simply put, consumer preferences dictate market trends. Thus, when more consumers demand more bedrooms, more privacy and more yard space, single family demand and subsequently price will rise accordingly. Also, interesting to note, is that more single family home communities are being developed. Areas such as Florida have been seeing a lot more ground up community style projects that are built for people to purchase. These gated communities tend to be for adults averaging above the age of 55 and offer plenty of amenities such as shopping centers, schools, banks, dog parks, pools, golf courses, etc. The graph below shows rent growth by city. Notice how Jacksonville is going strong, with Tampa on par.
Sharestates and Single Family Investing
The Sharestates Trading Desk has already been receiving plenty of promising ground up deals in communities similar to those in Jacksonville and Tampa. We can expect more to come as consumers look for more affordable options that offer local and community-based amenities. As Sharestates’ very own Alison Hoffman stated in a prior post titled South Florida Real Estate Performance, “South Florida’s real estate resurgence has all the signs of a boom that’s here to stay for a while as the country’s other major metropolises like Manhattan and San Francisco struggle with long-term re-pricing.” In addition, “there’s an influx of European and South American buyers… competing with local buyers who are moving from urban high rises to the suburbs.” Many single family properties are also in the process of renovation which will result in higher property values, further bolstering confidence in the single family housing market.
To view Sharestates’ open real estate investments create an account here.
• The Multifamily sector managed to weather the storm better than most sectors.
• Vacancy rates for affordable multifamily housing will likely be low.
• With more people renting multifamily properties in suburbs, the higher cost of city living becomes in question.
How the Pandemic Impacted Major Urban Markets
Major cities, whether it be New York or Los Angeles, faced a similar dilemma during the onset of the Covid-19 pandemic—over saturation in a confined area. What was once an energetic and animated city, New York City fell silent as more and more people started to exit into the suburbs in hopes of getting more living space. At one point, NYC perhaps even lost its luster at the height of the pandemic. It is undeniable that the virus has transformed almost every facet of our lives, ranging from spending habits all the way to living situations.
Comparatively speaking, the Multifamily sector performed better than most asset classes. The Commercial space was terribly affected almost immediately as businesses were forced to shut down and offices to vacate. According to a report published by Deloitte, “new [CRE] investments slowed down due to increased uncertainty and valuation concerns.” Sentiment treaded lower and lower with no bottom in sight. However, the CRE market is also making a comeback, though at a slower pace than the multifamily sector.
What Does the Future Look Like For Multifamily?
Multifamily investment sharply rebounded between Q4 of 2020 and Q1 of 2021. CBRE predicts growth of 33% paired with “favorable mortgage rates” that will provide further incentive for increased investment. The bar graph below shows helps to illustrate this trend:
With more people fleeing the major cities and finding homes in the suburbs, vacancy rates in the suburban multifamily market have declined. Areas like Long Island and the suburbs of New Jersey seemed to be the biggest winners here. Government aid certainly helped people expand their supply of cash along with a decrease in consumer spending (at least in the beginning portion of the pandemic). Consumers are able to spend more and for a longer duration.
According to an outlook commentary published by Fannie Mae, “The national multifamily vacancy rate is expected to peak in 2021, at around 6.5 percent… and then begin to trend downward starting in 2022.”
Consumers and investors have become much more comfortable with the Multifamily segment. Suburban multifamily properties continue to generate rental income consistently with little borrower delinquencies. The multifamily market is past the “bottoming out” stage as more consumers develop confidence in the nation’s recovery.
Rents in NYC will rise eventually but the fact of the matter is that the suburbs seem way too attractive not to rent or purchase. NYC will certainly come back but the overall recovery of the city may still be in question. The de Blasio administration (per The Real Deal) plans to bring back 80,000 employees which include caseworkers, computer specialists, and clerical staff into the office which is a good sign for the city’s recovery and overall public sentiment.
To view Sharestates’ open real estate investments create an account here.