We all know that the COVID pandemic didn’t hit every town with equal force at the same time. So it’s no stretch to conclude that not every town will be impacted in exactly the same way by the economic fallout from the health crisis.
And yet, it’s likely that the communities that are most affected financially aren’t necessarily those that were most devastated by the virus itself. And, while we’re still a long way from recovering from either the disease or the cost of its treatment, there is some predictive analytics that suggests where landlords might have the most trouble collecting rents until both have run their course.
Most at Risk Communities
ATTOM Data Solution released a report ranking U.S. housing markets by their vulnerability to the impact of the COVID pandemic. The paper shows that the Northeast has the largest concentration of at-risk counties, while the West and Midwest have the smallest.
That isn’t surprising. But when you drill into the county-by-county breakdown, it’s not what you’d expect.
Granted, Sharestates is based in and around New York City, so our view might be skewed. Still, the media has appropriately dubbed our town the “epicenter” of the global outbreak, and we venture to say that most people’s enduring image of 2020 to date is some photo of Times Square with nobody in it. But New York County, a.k.a. the Borough of Manhattan isn’t on the list. Bronx County, with the highest proportion of people testing positive in the country and maybe the world? That isn’t either.
Instead, the report reveals that housing markets in 14 of New Jersey’s 21 counties are among the 50 most vulnerable in the country to the economic impact of the novel coronavirus. But the truly bizarre finding is that the second-hardest hit state is Florida, where 10 counties are among the Foreclosed Fifty. In other words, two states account for almost half the potential damage.
And can you think of two states with responses to the pandemic that is more different? In the Garden State, nobody leaves their front yard without personal protection equipment, and, frankly, there’s nowhere to go. In the Sunshine State, hosting spring break seemed at the time to be more important than protecting public health. In the former, decorative masks from Etsy boutiques have become fashion statements. In the latter, a lack of any mask has become a political statement. Granted, New Jersey has been far harder hit, so there is more of a consensus there about the danger just because the danger is more obvious — by an order of magnitude.
ATTOM ranks counties based on an algorithm that factors in the percentage of housing units receiving a foreclosure notice in Q4 2019, the percent of homes underwater in Q4 2019, and the percentage of local wages required to pay for major homeownership expenses. So let’s be clear: This model is predictive. It suggests which communities were most at-risk in the months prior to the pandemic — the ones that were most vulnerable to some disruption or another in early 2020.
Getting Granular On The COVID Impact
“It’s too early to tell how much effect the coronavirus fallout will have on different housing markets around the country. But the impact is likely to be significant from region to region and county to county,” said Todd Teta, ATTOM’s chief product officer. “What we’ve done is spotlight areas that appear to be more or less at risk based on several important factors. From that analysis, it looks like the Northeast is more at risk than other areas. As we head into the spring homebuying season, the next few months will reveal how severe the impact will be.”
The most vulnerable counties in New Jersey include five in the New York City suburban area: Bergen, Essex, Passaic, Middlesex, and Union. Interestingly, Hudson County — which has more confirmed COVID infections than any of them, according to Worldometers — is not on the list. It’s home to posh Hoboken and continuously gentrifying Jersey City, but that can’t be the whole story. Of the bunch, only Passaic has lower per-capita income than Union, and Bergen is one of the wealthiest suburbs in the country. Two of the more down-at-heel New Jersey communities outside the New York metro that made the list are Ocean County, along the Jersey Shore, and Camden County, across the Delaware River from Philadelphia. To its west, Pennsylvania’s Delaware County shares this dubious distinction.
While there are New York counties among the top 50 most at risk of the COVID virus, they’re not in the Five Boroughs. The closest of the four is Rockland County, which is next door to — that is to say a toll bridge away from — Westchester County, the site of New York State’s first hot zone, New Rochelle. Two others, Orange County and Ulster County aren’t too far away, in the Mid-Hudson Valley region. Finally, Rensselaer County is in the Capitol region, near Albany.
Meantime Florida’s COVID cluster is exactly where you’d think — Miami-Dade, Broward, and Palm Beach counties — and yet the economic impact doesn’t seem to be centered along the Gold Coast at all. While Broward does make the list, the risk is concentrated in the northern and central sections of the state, according to ATTOM, particularly Flagler, Lake, Clay, Hernando, and Osceola counties. If you don’t know where they are, you can be forgiven. Hernando is in the Tampa suburbs, and the rest are in the middle of nowhere. Think of Orlando, Jacksonville, and Daytona Beach as an outfield; those counties comprise the swath of shallow left-center where bloop singles land.
Other southern counties that are in ATTOM’s top 50 list are spread across Delaware, North Carolina, South Carolina, Louisiana, and Virginia. The populous suburb of Prince George’s County, Md., is also a risky bet according to the study. Only two ranked counties are in the West: Shasta County, Calif., near Redding, and Navajo County, Ariz., near Phoenix. The five in the Midwest are all in Illinois: McHenry, Kane, Will, and Lake counties, all in the Chicago metro area; and Tazewell County, near Peoria.
And Now Some Good News
But what about those counties at the other end of the spectrum? Is anyone truly immune to the effects of COVID? Apparently yes, sort-of, in an economic armageddon kind of way.
Texas has 10 of the 50 least vulnerable counties in the report. The insulated Texas counties include Dallas, Collin, and Tarrant in metro Dallas-Fort Worth and Ector and Midland in the Midland-Odessa area. Houston’s Harris County is also on the right side of these rankings. And, while that’s welcome news from the point of view of surviving the pandemic financially, they have a cratering oil market to contend with, so maybe they’re not such a safe bet either.
Wisconsin had seven counties on the least-risky list and Colorado with five. Other communities of note include tech industry magnets King County — Seattle — and Santa Clara County, one of the components of Silicon Valley. Again, though, we see some bad news in that good news, as the nearby businesses are exactly those that are never going 100% back to pre-pandemic workplace operations. Many if not most of the employees who were designated to work at home aren’t going back to the office, no matter how many beanbag chairs and foosball tables and Mountain Dew Code Red are on site.
But to leave you with some undiluted good news, a separate ATTOM report shows that much of the foreclosure risk identified in that study remains hypothetical. In reality, there were 156,253 U.S. properties with a foreclosure filing during the first quarter of 2020, and, while that’s up 42 percent from the previous quarter, it’s down 3 percent from the comparable, year-earlier period.
House Resolution 748 of the 116th Congress, Second Session. The Coronavirus Aid, Relief, and Economic Security Act of 2020. The CARES Act. The $2.2 trillion, 808-page bipartisan pork-barrel passing as a national security omnibus. By any name, it’s the law of the land now and, unknown to most, there’s more than a little in there about the tax treatment of commercial real estate because of #StopTheSpread.
Of course, there is plenty in the CARES Act that is appropriate and proportionate to the emergency. Extensions of tax filing deadlines, broadening of unemployment benefits and aid to struggling small businesses are all immediate steps that must be taken. And some of those small businesses are real estate-adjacent. And yet CRE abides. Construction continues because, as has frequently been reported in this space and elsewhere, the housing shortage is a pre-existing national emergency.
Here in New York State, the hardest hit by COVID-19 by an order of magnitude, we are functioning under the “New York on PAUSE” stay-at-home executive order. You’re probably under similar restrictions now, or you almost certainly will be by some point next week. The exceptions here are related to “essential” services, which include first responders, pharmacy staff, grocery store employees and the pizza guy. But that lot down the street where the new condos are going up? It’s still teeming with carpenters, roofers, electricians, and pipefitters. Cement mixers, backhoes, and crawlers still swarm. That’s because this work is deemed by the local development authority to fall into the “essential” category.
“Essential construction may continue and includes roads, bridges, transit facilities, utilities, hospitals or health care facilities, affordable housing, and homeless shelters,” according to guidance from Empire State Development.
The kicker, of course, is that pretty much every large-scale multifamily project in downstate New York has some kind of set-aside for affordable housing, so construction really hasn’t slowed much around here.
So the argument could be made that these projects don’t per se need a stimulus to get through the crisis. Nevertheless, they have it. Here are some details.
Down with the sickness
“While the CARES Act provides certain measures that directly impact real estate, the vast majority of its provisions are designed to economically buttress individuals, businesses and hard-hit industries in an effort to enhance their ability to remain solvent and cover operational expenses, including rent and debt service,” according to the blog of law firm Skadden, Arps, Slate, Meagher & Flom. “The provision of monetary relief through the act in the form of emergency cash infusions, financing availability, loan forgiveness/forbearance, tax benefits, and supplemental awards is designed to help owners, landlords, operators, borrowers and tenants survive.”
That said, there are a number of such measures.
The first corrects a supposed drafting error in 2017’s Tax Cuts and Jobs Act. This provision of the CARES Act enables businesses to write off costs associated with building improvements instead of depreciating them. This sounds non-controversial enough, but New York Times readers have been told it’s a $170 billion boondoggle for the well-to-do.
More on that later, but there are other passages that affect CRE. For instance, most borrowers of federally backed mortgages on buildings designed for five or more families can seek up to 90 days of forbearance. These borrowers, though, are forbidden to evict or charge late fees or penalties to tenants during the forbearance period. Also, for 120 days from the date of the act, residential landlords cannot recover rental units or charge fees or penalties resulting from the nonpayment of rent in the event that a landlord’s mortgage is federally insured, guaranteed or otherwise assisted. That means any help from the U.S. Department of Housing and Urban Development, Fannie Mae, Freddie Mac, the rural housing voucher program or the Violence Against Women Act has this string attached.
Beyond that, there is a further earmark of $3.2 billion for a flexible response to the pandemic for tenant-based rental assistance, project-based rental assistance, public housing, and other uses.
The single-family view
Residential real estate also benefits from CARES Act provisions. Foreclosures of most federally backed mortgages on single- to quadruple family homes are prohibited for the 60 days that started March 18. Also, borrowers of federally backed mortgages facing economic difficulties as a result of the coronavirus can seek up to 360 days of forbearance.
Still, there is bound to be some short-term pain in the world of city row houses and picket-fenced suburbs despite the continued strength in CRE. These lower-scale, lower-density projects are considered less essential and, besides, the market for them has pretty much dried up. It’s hard to sell a home if you can’t show it.
And yet, housebuilders and flippers sound downright philosophic about all this.
“I think development will pick up right where it left off,” Philadelphia developer Rahil Raza told WHYY-FM. “I’m not going to say ‘these things happen’ — nothing like this has ever happened — but there are always hiccups in the economy. I think we’ll get back on track.”
He told reporter Jake Blumgart that he expects all this to come out in the wash in about six months.
“I bought these properties for a low amount and so if I have to drop the rent a couple of hundred dollars, I’ll do that,” Raza said. “It’s not gonna break my bank.”
A PR mess?
It’s hard to see how the pandemic might affect real estate markets in general. This is a disruption and, with every family that is diminished by COVID-19, there will be a unique dislocation that can only be modeled in the aggregate but can only be experienced in the particular.
So if you didn’t expect the New York Times to run the headline and kicker: “Bonanza for Rich Real Estate Investors, Tucked Into Stimulus Package: A small change to tax policy could hand $170 billion in tax savings to real estate tycoons,” then you must be unfamiliar with this particular news-gathering organization.
“Senate Republicans inserted an easy-to-overlook provision on page 203 of the 880-page bill that would permit wealthy investors to use losses generated by real estate to minimize their taxes on profits from things like investments in the stock market. The estimated cost of the change over 10 years is $170 billion,” according to Times reporter Jesse Drucker. “[T]he use of [non-cash, depreciation] losses was limited by the 2017 tax-cut package. The losses could be used only to shelter the first $500,000 of a married couple’s nonbusiness income, such as capital gains from investments. Any leftover losses got rolled over to future years.
“The new stimulus bill lifts that restriction for three years — this year, and two retroactive years — a boon for couples with more than $500,000 in annual capital gains or income from sources other than their business.”
Fast Company lumps this in with other “infuriating details and corporate giveaways” in the CARES Act. Writer Marcus Barum lists relaxation of bank reserve requirements, a giveaway to for-profit colleges and an extension of federal funding for the abstinence-only approach to sex education.
He also includes sunscreen becoming an eligible expense for health savings accounts; maybe he never met anyone who ever had skin cancer. But the press has been known to get things wrong occasionally, it might shock you to learn. And provisions in this law that seem like a valentine to the Commercial-Property-Developer-in-Chief could prove to be a magnet for bad publicity.
The constraints on real estate development are related to labor, equipment, and regulation. The current crisis won’t be a big help with any of these, but it also isn’t much of a hindrance. It’s unclear how tax benefits will spur more or faster development, but the money is on the table, so why not pick it up.
In this age of Covid-19 (to address the 10 attogram virus in the room), we’re all being advised to maintain social distance. Until this shakes out, living in high-density cities isn’t as appealing as it was a few weeks ago or — hopefully — as it will again sometime this year. But even before it became a public health issue, many Millennials had already discovered the appeal of moving to a place where they could spread out a bit. While this blog tends to focus on what drives young adults to favor one urban area over another, it’s important to understand why so many have chosen None of the Above, USA.
A reality, not a trend
The appeal of rural life might be underscored by the current, palpable fear of contagion, but is completely independent of it. We’ve seen articles on Millennials moving out to the country since at least 2017, and they almost certainly predate that. And even The PBS NewsHour has reported on this topic.
According to an EY study, young adults are almost as likely to buy a home in the sticks than in the city. The report suggests that, while 31% of Millennials still gravitate toward urban centers when it comes time to buy a home, 26% choose a small town or rural community.
(The report also notes that, between 2016 and 2018, the proportion owning their own homes rose from 26% to 40% while those living with their parents dropped from 30% to 16%. The 43% figure for renters remained constant.)
And the reason is pretty much what you’d expect: money.
“A renter household in an urban area earning the median U.S. household income should expect to pay 36.8 percent of their income on rent each month. In the suburbs, that falls to 31.8 percent; and in rural areas to 23.9 percent,” according to Zillow senior economist Sarah Mikhitarian. “A home buyer looking to purchase the median-valued home in an urban area should expect to pay 26.5 percent of their income on a mortgage payment each month. In the suburbs and rural areas, that falls to 20.2 percent and 13.4 percent, respectively.”
One consistent theme among sources for this post indicates that student loan debt affects the cash flows of Millennials far more than it did those of previous generations.
But what’s the appeal?
According to one report, starting a business is easier in a small town.
“Larger cities have very saturated job markets, especially when it comes to businesses pertaining to the interests of millennials. 30-somethings are finding that in smaller towns, there are more opportunities to open businesses of their own, ”blogger Jonathan West writes in SpareFoot. “Moving to a more rural area affords you the luxury of lax regulation, cheaper real estate, and less job saturation so you can more easily get your business up and running.”
While Millennials consider themselves entrepreneurial, the EY study suggests they might be kidding themselves and actually aren’t starting businesses at the same rate as their elders did. That said, they do tend to work — either willingly or out of necessity — in the gig economy, and remote work is certainly just as viable in these low-cost towns as inexpensive gateway cities.
None of that is to say there are no Millennial business founders. There are plenty and, if you’re looking for heartwarming anecdotes about young adults finding proprietary success in small-town America, Wells Fargo offers plenty as part of the bank’s participation in the nationwide “Rethinking Rural” initiative.
There’s more to the choice of rural vs. urban life of course.
And it shouldn’t be lost that small towns aren’t all the same, any more than cities are. Each has its own personality, and sometimes a person and a community just click. To paraphrase Andre Maurois: In literature as in real estate, we are astonished at what is chosen by others. (The 20th-century French memoirist actually wrote “In literature as in love …” but the logic holds.)
“Growing art communities such as North Adams, Massachusetts or Marfa, Texas are typically sparsely populated areas, but they are currently experiencing a shift in their demographic – as millennials are looking for a slower-paced lifestyle and a close-knit community, and see it in these environments,” designer Rima Abousleiman wrote for Archinect, noting that “neither North Adams or Marfa was inherently predisposed to cater to the arts prior to their current status as a sort of contemporary art haven.”
Patrick Woodie, president of NC Rural Center, suggests that there might be one more clincher to explain the growth of 30somethings in the Tar Heel State’s least densely populated counties, one that improves education, entrepreneurship and even access to health care.
“If there’s not broadband there that’s robust and available, that’s not going to be one of those communities,” he told WRAL-TV, Raleigh’s NBC affiliate.
Where millennials are landing
Of course, the urban-rural divide is more a matter of degree than a dichotomy. There’s plenty of ground in between, figuratively and literally. They’re not so many young singles anymore as they are young marrieds. And, like young marrieds of earlier generations, they’re gravitating to suburbs. According to the EY survey, 41% of Millennials who owned a home in 2018 lived in bedroom communities.
And yet, there are plenty who are setting down roots in cities, just not the overcrowded, noisy ones.
“Madison, Wisconsin, is a new mecca for millennials, according to a recent study from the National Association of Realtors, which ranked the top millennial housing markets based on both their high share of current young residents and of millennials moving in,” writes CNBC real estate correspondent Diana Olick. “Three out of 4 recent transplants to Madison were millennials and they have mostly stayed in the area, giving the city an overall high millennial population.”
Other secondary markets she notes include:
- Oklahoma City
- Grand Rapids, Mich.
- Omaha, Neb.
- Durham, N.C.
- El Paso, Texas
- Salt Lake City, Utah
It’ll be important going forward to keep tabs on this small-is-beautiful trend because there’s some discussion about how desirable cities will be going forward. Again, these discussions predate the current pandemic.
“A 2016 study by University of Southern California professor Dowell Myers contends millennials will be less likely to cluster in cities in the future,” Casey Fabris of the Roanoke (Va.) Times reports. “Three factors — the size of millennial birth cohorts, job opportunities, and housing availability — ‘harmonized’ before 2010, causing millennials to flock to cities, according to Myers. He expects the trends to shift.”
The good macroeconomic news for real estate investors is that the Federal Reserve appears to be quiet.
That’s in contrast to 2019 when the Fed — after a series of nine target interest rate hikes in three years — reversed course. In dramatic fashion, the central bank dropped the Fed Funds rate a quarter-point per month for three straight months. While this might not be the license to print money that some real estate economists believe — we wrote about this here days before the start of that season of rate cuts — it’s still a positive signal for mortgage applicants and, thus, for the residential markets, single-family or multifamily, new or existing.
But while low-interest rates mean more potential buyers, it’s high capital rates that drive revenue. And it’s the spread between the two that drives what’s ultimately important to real estate investors: earnings.
Defining the cap rate terms
Cap rate, which measures the value of commercial real estate investments, is the ratio of the annual net operating income to the original cost of the property. The formula looks like this:
cap rate = annual net operating income / cost
Annual net operating income is defined here as the portion of the year’s lease income that isn’t going toward operating expenses, mortgage payments, taxes or any other costs. Cost usually refers to the purchase price.
Take for example an office building that generates $1 million in annual net operating income. If the owners sell it for $20 million, then its cap rate is 1/20, or 5%. This is important to investors in that neighborhood because it helps set values for nearby properties. If the building next door generates $2 million, then its owners could reasonably expect the same cap rate and price it at $40 million. Cap rates tend to go up as the local economy improves and down as it declines.
There are other factors, which tend to pop up in the appraisal process, but let’s keep things clean and simple for current purposes.
The target Fed Funds rate, meanwhile, is the rate at which the Federal Reserve Board of Governors and regional Fed presidents want America’s largest banks to charge each other for overnight loans. The Fed Funds rate is thus the lowest rate of interest charged commercially in the domestic market because the lenders and borrowers are the stuff of Goldman Sachs, JPMorgan Chase and the rest of the economic Illuminati.
This rate is determined by a complex algorithm of dynamic … oh, baloney. It’s a matter of opinion. The dozen top policymakers at the Fed get together once a month for a couple of days of committee meetings. These are usually dry affairs because people who rise to the top of the Fed tend to be data-driven macroeconomics nerds who wrote doctoral dissertations in abstruse, statistics-heavy topics that will put you to sleep before you’re done reading the title page. Throw in a couple of career investment bankers whose family contacts have kept them gainfully employed, in civilian clothes and out of jail. Still, these are all political appointees, so there’s bound to be one or two bomb-throwers from either side of the aisle, but their input is largely ignored by the technocratic majority.
The goal is to pick a rate that will keep the economy chugging along at a sustainable rate. Too low a rate can lead to too much investment, which could lead in turn to too much production, too little labor available, too high an hourly wage and eventually to high inflation, which could cause the economy to crash. Too high a rate can lead to too little investment, too little production and eventually to too much unemployment, which could cause the economy to crash.
Again, this is a target rate. (Actually, since 2008 it has been a range of rates 25 basis points wide, with the upper limit being the successor benchmark to the pre-Recession target rate.) The Fed can’t just demand that banks charge each other a certain rate, but it has a number of tools to, shall we say, encourage compliance. Foremost among these is what is called open market operations, in which the Fed buys, sells or holds U.S. Treasury securities, including the bellwether 10-year Treasury note.
What’s important about the 10-year Treasury yield is that it is essentially without risk. It’s like savings bonds for grownups. No matter what happens, the T-note will keep making semiannual interest payments and thus keep its value. It is backed by the full faith and credit of the U.S. government and, if Uncle Sam stops making interest payments, then we’ll all have bigger problems to deal with than the direction of the cap rate spread.
Thought we’d forgotten about that, huh? The cap rate spread is the difference between the aggregate cap rate and the effective yield on the 10-year T-note. It’s a measure of the risk/reward premium for investing in commercial real estate instead of just buying into the safest bet available to mostly upper-middle-class individuals. As that spread widens, investors are more highly rewarded, indicating that there is a higher demand for investment in CRE because it is increasingly riskier of an enterprise. As that spread narrows, it means that there is less perceived risk. If you’re not interested in investing in a project, that’s okay with the developers because they can just call up your grandma and ask her for money.
You are here
Let’s look at the relationship between the Fed Funds target rate — technically, the range’s upper limit — and the 10-year Treasury note’s constant maturity rate. This is courtesy of the Federal Reserve Economic Data repository, which carries the friendly acronym of FRED:
You’ll see that, historically, there’s a lot of daylight between the Fed Funds rate banks charge each other and the rate investors demand from the Treasury Department. As the economy improved during the ‘Teens, though, U.S. government debt began to look less dicey and Washington could get away with paying less interest. Meanwhile, the Fed ratcheted up its target rate to head off inflation. In 2019, partly in response to tweeting and name-calling from the White House, the Fed reversed course and began bringing down its target. At this rare moment, the 10-year Treasury yield and the Fed Funds rate are more or less the same.
That’s neither a good nor a bad thing in itself. That was their relationship during the dotcom boom of the 1990s and during the best days just before the Great Recession. More typically, though, the Fed Funds Rate is the lower of the two, although the central bankers have been known to goose it for short terms as a shock treatment for inflation; it did this a lot in the 1970s and ‘80s.
But as of late February 2020, the 10-year rate is around 1.6%, having declined by 20 basis points since the start of the year, or a full percentage point over the past 12 months. While this is good information, we need to understand what’s been happening to cap rates in the meantime to determine what’s been happening with the spread.
But notice our use of the plural: “rates,” not “rate”. Cap rates vary not only city by city, but also neighborhood by neighborhood. The best we can present is a national aggregate. Cap rates also vary according to project type, as this chart screen-captured from Nareit indicates:
Hotels generally command the highest risk premium, residences the least, with offices, retail and industrial space forming the layers of meat in the sandwich. They all tend to attract higher returns than the risk-free Treasury yield, as you’d expect. Going forward, we’ll focus on the multifamily market.
According to Marcus & Millichap, “[t]he nationwide average apartment cap rate sits in the low-5 percent range, delivering a 300 to 350 basis-point premium above the 10-year note, among the widest spreads of the past decade.”
The road ahead
But whither shall cap rates go from here?
According to the industry association for real estate investment trusts, low Treasury yields should more than offset declining cap rates.
“[C]ommercial property price growth appears to be well-supported by rising [net operating income],” according to Nareit’s chief economist Calvin Schnure. “And the level of cap rates relative to Treasury yields translates into a good return to investors in commercial real estate.”
“Despite the decrease in cap rates, the spread between asking and closed cap rates for retail and office properties widened by 6 and 2 basis points respectively,” agrees Randy Blankstein of The Boulder Group. “Real estate investors believe we are in the late stages of the real estate cycle with fewer buying opportunities, especially those of high quality.”
It’s important to remember, though, that cap rates measure not just reward, but risk. It’s possible that the reason why they are declining — irrespective of their spread over Treasury yields — is that the mix of properties for sale is skewing toward the high end. The more bougie the property, the less economic risk. And this suggests that investors who want to see a better cap rate spread might be looking in the wrong neighborhoods. Workforce housing, as well as real estate in secondary and tertiary markets, might be presenting more perceived than real downside.
“With the vacancy rate scheduled to stay just above 3 percent this year, the Class C segment will garner attention from many investors,” according to Marcus & Millichap. “The strong job market has invigorated entry-level housing demand, delivering steady cash flows and comparably favorable yields in this asset class. The nationwide average cap rate for Class C properties rests in the mid-5 percent range, roughly 50 basis points above the all-class average.”
“A ship in harbor is safe, but that is not what ships are built for.” — John A. Shedd, 1928
One underreported codicil of 2017’s Tax Cuts and Jobs Act is a 20% pass-through deduction under its section 199A. How a business might qualify for this exemption off a business’s net profit, though, was not clearly defined when the law passed. Clarity came this past September, when the Internal Revenue Service offered its guidance, including a safe harbor provision for rental properties.
The knock on the 2017 tax reform package has been, with some justification, that it benefits corporate businesses greatly but not so much individual taxpayers. What, then is the effect of this particular rule on the closely held firm? And, from Sharestates investors’ perspective, how might it benefit the commercial real estate industry? After all, it’s a general provision, not specific to building and operating rental properties.
Let’s start by defining our terms. It’s not safe to assume that we all have the same understanding of what’s meant by “safe harbor,” so maybe that should be our jumping-off point.
A safe harbor is a provision in law or regulation that specifies actions that are deemed not to violate a given rule, typically one that was vaguely worded. For example, it can help define was does or doesn’t constitute “recklessness,” as in reckless driving or reckless endangerment.
This applies to the Tax Cuts and Jobs Act because its definition of “qualified business income” is comprised in part by the taxpayer’s receipts from a “trade or business”. While the 2017 tax law includes REIT dividends in the definition, it remained silent on the treatment of real estate rental income not connected to these trusts. And, while the term “qualified trade or business” was defined under the statute, it remained unclear if real estate management services were included. The fact that engineering, architecture and investment management services were singled out as specifically not qualified had many real estate investors anxious.
Some case law, though, was on the investors’ side.
“In general, courts have held that in order for a taxpayer’s activity to rise to the level of constituting a trade or business, the taxpayer must satisfy two requirements: (1) regular and continuous conduct of the activity, which depends on the extent of the taxpayer’s activities; and (2) a primary purpose to earn a profit, which depends on the taxpayer’s state of mind and their having a good faith intention to make a profit from the activity,” according to lawyer Lou Vlahos of Long Island-based Farrell Fritz. “In most situations, neither the taxpayer nor the IRS should find it difficult to evaluate the trade or business status of the taxpayer’s activities – the level and quality of the activity will be such that its status will be obvious. Unfortunately, there remain a number of cases in which the various ‘triers of fact’ – first, the taxpayer, then the IRS, and finally the courts – will have to consider the taxpayer’s unique ‘facts and circumstances’ in determining whether the taxpayer’s activities rise to the level of a trade or business.”
Guidance offered in September 2019, though, clarified that the 199A treatment indeed extends a safe harbor provision for some, but not all, interests in rental real estate, enabling them to be treated as a “trade or business”.
It’s mainly a matter of threshold and, if all the requirements are met, an interest in rental real estate can be treated as a single trade or business for purposes of the section 199A deduction. But even if such an interest fails to satisfy all requirements, it might still be extended treatment as a trade or business for 199A purposes if it otherwise meets the definition of a trade or business in the regulation.
A rental real estate enterprise under the IRS definition “may consist of an interest in a single property or interests in multiple properties,” according to the IRS. “The taxpayer or a relevant passthrough entity (RPE) relying on this revenue procedure must hold each interest directly or through an entity disregarded as an entity separate from its owner, such as a limited liability company with a single member.”
Who’s in, who’s out
The following requirements must be met by taxpayers or RPEs to qualify for this safe harbor, according to IRS guidance:
- separate books and records for each enterprise;
- 250 or more hours of rental services are performed in at least three of the past five years, or in every year of its existence for enterprises less than four years old;
- the taxpayer maintains contemporaneous records of hours, dates and descriptions of all services performed, as well as who performed the services; and
- the taxpayer or RPE attaches a statement to the return filed for tax years the safe harbor is relied upon.
If it were that simple, though, it would be off-brand for the IRS. Audit firm CliftonLarsonAllen clarifies that the following activities do not constitute rental services for purposes of 199A qualification:
- financial or investment management services;
- arranging financing;
- procuring property;
- studying or reviewing financial statements or operating reports;
- planning, managing, or constructing long-term capital improvements; or
- time spent traveling to and from real estate.
In other words, you’d have to confine the definition of rental services to the mule work of advertising, negotiating, verifying applications, collecting rent, purchasing, staff supervision and other elements of daily operations.
Further, CLA clarifies that vacation homes, triple net leases and self-rentals are ineligible for the safe harbor.
When ‘no’ doesn’t mean ‘no’
Thus, many enterprises still wouldn’t meet the safe harbor requirements, at least not automatically. The threshold is fairly arbitrary, after all. It’s puzzling why triple net leases — in which the tenant is responsible for taxes, maintenance and insurance — are excluded. And what’s magical about contributing 250 hours to the upkeep of the property if the work could be done in 249?
CLA’s Ben Darwin and John Werlhof offer workarounds for enterprises that don’t quite qualify. First, if the hurdle is the self-rental rental rule, there are ways a rental enterprise could be considered a trade or business if the tenant is commonly owned and generates QBI.
“Consider whether the rental rises to the level of a business based on the relevant facts,” they advise. These include the type of rented property (commercial real property versus residential property, number of properties rented, owner’s or the owner’s agents’ day-to-day involvement, types and significance of any ancillary services provided under the lease and terms of the lease.
“In some cases, it may be preferable to avoid business status (e.g., where the rentals generate a loss that would reduce the 20% QBID). You may want to evaluate whether the business classification of your rentals is actually better,” according to the CLA authors. “Consider whether any changes can be made to your lease arrangements and rental operations to obtain more favorable tax treatment.”
Just because you can do a thing doesn’t mean you ought to. And just because your real estate enterprise qualifies for the safe harbor doesn’t mean you should drop anchor in it.
“If you have rental losses, you DO NOT want your enterprise to be considered QBI and included in the 199A Deduction calculation, BUT you (or your spouse) DO want to be considered a real estate professional in order to deduct the losses against your other ordinary income,” according to the blog of tax lawyer and capitalization fiend Mark J. Kohler. “If you have net rental income, you DO want the enterprise to be considered QBI in order to receive the 199A Deduction, but still consider the income passive and not subject to self-employment tax.”
In many if not most cases, though, investors have been handed a 20% rebate on the tax bills for their real estate cash flows. But there’s no end to the flexibility in the tax code, so it’s best to consult a good accountant — or you might need to consult an even better lawyer.[/vc_column_text][/vc_column][/vc_row]
We’ve written a lot lately about fixer-uppers, with articles on both finding real estate owned — or REO — properties and securing private lending for fix-and-flips. But the U.S. Department of Housing and Urban Development may have added a little more encouragement to those who seek to renovate distressed homes. While the recently upgraded program is intended for those who will be residing at the property as their primary residence, house flippers are bound to find ways around the letter of the law.
HUD’s Federal Housing Authority recently raised the ceiling for its rehab loan program by $15,000, so now you can apply for up $50,000 in the FHA’s 203(k) program. But there are restrictions — not to mention a ticking countdown timer.
“Thanks to a new rule, people buying in designated ‘Opportunity Zones’ can borrow up to $50,000 — giving them an extra $15,000 in renovating power,” Peter Miller wrote in a December post in The Mortgage Reports. “But the new rule is first-come, first-served. Only the first 15,000 applicants nationwide will be able to use the higher FHA 203k loan limit. So if you’re interested in a bigger 203(k) loan, check your eligibility and move fast.
(For more about OZs, we recently covered that in this space too.)
Beyond today’s news
It might surprise some to learn that 203(k) loans can be used for acquiring properties as well as fixing them up. The intent of 203(k)s is to eliminate an old Catch-22 of real estate investing: If the property isn’t up-to-code, you can’t get a loan to buy it, but you can’t buy it to bring it up-to-code without a loan.
“The 203(k) lets you buy and fix up a house in one transaction, allowing the lender to approve the loan despite its initial condition,” Tim Lucas writes for The Mortgage Reports.
We’d be remiss not to point out that HUD isn’t the lender. Its FHA serves as a mortgage insurer, taking a substantial amount of non-performance risk out of the loan, thus lowering the rate at which a private lender can offer it to you. FHA, by the way, is entirely self-funded. The good news is that there’s no guilt on your conscience about taking taxpayer money to finance your project. The bad news — and it’s not all that bad — is that FHA charges 1.75% upfront on your mortgage as an insurance premium, then 0.85% annually.
But not all lending institutions originate 203(k) loans and, at those that do, not all officers are equally versed in how they work. You might want to run the names of your available lenders through HUD’s database search page.
As for the principal amount, you need to keep the rehab portion below that $35,000 threshold — or $50,000 in an OZ — but you have to take out at least $5,000. Including the acquisition price of the property itself, the cap varies between $331,760 in low-cost counties and $765,600 in high-cost counties, NerdWallet reports. (OZs tend to be low-cost.) Your loan amount can’t exceed 110% of the project, according to The Balance.
Pluses and minuses
There are, then, plenty of reasons to go the 203(k) route, but it’s not without its potholes.
On the positive side, you need to put down only 3.5% of combined purchase and repair costs, and there doesn’t appear to be any restrictions on how you came up with the money. Also, your FICO score can be as low as 580 and you could still qualify. (At least for the mortgage insurance. Your lender might have other ideas.) Under the right circumstances, you can refinance a bridge loan with 203(k) funds or use them to pay the rent in temporary quarters while the project proceeds. While 203(k) interest rates are usually a percentage point higher than other FHA loans, they’re still below private-sector market rates.
Still, there are strings attached — beyond the loan value increase only applying to OZs. First, this isn’t intended for DIYers; you have to get receipts from contractors. Funds are then held in escrow until they’re distributed directly to those contractors. Not only that, you have to get bids from multiple vendors before you can finalize the deal with FHA, and they have to be licensed, insured full-timers. It’s best if those bids are computed on a cost-plus basis because an appraiser has to sign off on it and it’ll be an obvious red flag if a bid looks like a SWAG.
Also, and this pretty much goes without saying when you’re dealing with Washington, it generally takes longer to close than if you were dealing with a private mortgage insurer, and involves a ton more paperwork. So make sure your lender has experience with 203(k) loans and is willing to walk both you and FHA through the process.
Also, you don’t have complete autonomy over what modifications you can make. FHA is a stickler for taking care of health-and-safety remediation — mold, lead, asbestos, termite damage, broken windows, missing banisters — first. After that, you can see if there’s any money left over to remodel bathrooms, install appliances, paint, lay carpet or improve energy efficiency.
The 203(k) program’s “limited” or “streamlined” loans specifically exclude structural repairs — you’d need to find some other source to fund those — although it permits replacing the roof. Structural repairs are allowed under a “standard” 203(k) loan, but there are restrictions that apply under either version, but these are at least partially subject to interpretation. “Major” landscaping is permitted but “minor” isn’t. Such “luxury” amenities as tennis courts are forbidden but you can fully trick out a kitchen; there’s a whole lot of gray in the middle. But whatever you do, the project has to be completed within six months.
Oh, and you can’t buy furniture. All fixtures have to be permanent.
And that includes you. The 203(k) program is specifically not intended for fix-and-flip. That said, guidance is sort of loose-goosey in this regard. It’s expected that you’ll be moving in yourself. Once you’ve done that, though, you can move out after a year. Also, if you’re buying a multi-family building, there’s nothing stopping you from renting out another unit or two or three. While co-ops are not allowed, 203(k) rules do permit condos under certain circumstances, according to Zillow. Also, as Holly Johnson at LendingTree reports, the property can be mixed-use, as long as at least 51% of the structure is residential.
One more helpful hint: For those who can undertake a project under the auspices of a not-for-profit organization, there’s a carve-out for that.
To learn more about Sharestates please click below
You might not have heard of the real estate owned (REO) market. That’s all right; neither has the secretary of Housing and Urban Development.
If you have, though, then you know that this is the rock-bottom path to homeownership or residential real estate investment. These are properties on which the occupant could no longer pay the note. Then a short sale could not be arranged. Then nobody was willing to buy it at a foreclosure auction. So the lender that got stuck with it has withdrawn its liens and boiled down the terms and conditions of sale to two short words: “as is”. Essentially, even the banks have walked away from these distressed properties.
And yet, just like any piece of real estate, there is such a thing as a price at which both a buyer and a seller can shake hands. Today, that price might be heading lower as the number of handshakes starts to rise.
Where we are, and Where we Were
Let’s roll the tape back a decade. The current economic expansion has been going on long enough that real estate investors with a decade’s experience entirely missed the Great Recession.
As the crisis dawned in 2009, Georgia Institute of Technology’s Dan Immergluck — then a visiting scholar at the Federal Reserve Bank of Atlanta — took a snapshot of the situation. As long as REOs could be chalked up to urban blight, then the “destabilizing impacts on neighborhoods and communities” wasn’t a problem. But when this class of real estate started to pop up on Forsythia Lane or Warbler Crescent, suddenly there it was a calamity.
“In general, in traditionally weak-market metros — many of which had substantial REO levels before the advent of the national mortgage crisis — REO tend to be relatively concentrated in central cities. Conversely, in regions where REO accumulated more recently and in those with high central-city housing prices, REO tend to be somewhat more suburbanized,” Immergluck found. “In particular, in the formerly ‘hot-market’ regions where home values have declined rapidly, a large majority of ZIP codes with ‘severe’ REO levels are suburban.”
Through 2009 and 2010, it wasn’t unusual to have 80,000 properties per month entering the REO market. That’s on top of about 250,000 per month that were auctioned off or fell into default. According to the HSH real estate portal, REOs comprised almost half of all transactions during that time.
Today, the volume for each of those situations is roughly one-seventh what it was when the economy was at its worst.
ATTOM Data Solutions reports that, while foreclosures are still trending downward, that is not the case for repossessions, as REOs are otherwise known.
“There were 49,898 U.S. properties with foreclosure filings in November 2019, down 10 percent from October 2019 and down 6 percent from a year ago,” according to ATTOM, which then points out that REOs are heading the other direction. “Lenders repossessed 13,996 U.S. properties in November 2019 (REOs), up 4 percent from the previous month and up 22 percent from a year ago.”
While that doesn’t mean another recession — or even another nationwide real estate bust — is coming, that’s still a troubling statistic.
Hunting Houses, Finding Funding
Ten years ago, the internet was alight with stories — some real, some apocryphal — of homebuyers targeting such distressed communities as Cape Coral, Fla., or Detroit’s “greyfield” neighborhoods, putting the whole transaction on their credit cards. And why not? There was so much inventory, banks were willing to accept pretty much any offer that covered closing costs.
Supply is more constrained now, so the price per unit has gone up. Generally speaking, people aren’t buying REOs strictly on price anymore. An REO now goes for pretty much the same price as any other fixer-upper in the neighborhood.
There may be a few bucks to be saved, but that’s around the margins now. Essentially, the main distinction between an REO and a starter home is that the seller is a bank rather than a family that got too big for it. They can all be found via the same websites, listing services, and neighborhood real estate agents.
That said, there’s no shortage of professional flippers looking to acquire cheap properties to rehab, and they can often pay cash. People looking to buy their starter homes — as well as those looking to enter the REO market for the first time to make a profit — probably don’t. Retail banks and other mortgage lenders generally don’t stick their noses up at REOs, so conventional mortgages are one way to go. But it’s more typical, according to FitSmallBusiness, to keep up with the nimbleness of the cash-on-the-barrel investor, to get the funds through a hard-money loan then refinance later.
From House to Home – REO Style
Ultimately, the whole purpose of the REO market is to get units off the bank’s balance sheet. For anyone who doesn’t work at the bank, though, the most obvious sign of a successful REO transaction is that the creepy house with the plywood windows and the Jumanji lawn is now the abode of human souls still attached to their bodies.
But what’s the fastest way to get that done? Here’s where the data conflicts with the received wisdom.
“Conventional wisdom in the mortgage servicing industry has traditionally defaulted to …: a neighborhood is better stabilized when a distressed property reverts back to the foreclosing lender [which] is more likely to get the property back into the hands of an owner-occupant, and owner-occupants have a more vested interest in neighborhood quality and stability than do real estate investors,” according to Auction.com economist Daren Blomquist. “But a thorough analysis of data … shows that properties sold to real estate investors at foreclosure auction more quickly convert to owner-occupancy than those that revert to lenders at the auction.”
Even so, Blomquist’s June 2019 article noted his surprise that more than 40% of the REO properties sold through his portal’s “Day 1” program were soon-to-be owner-occupants rather than investors. Of course, that also means that the majority were sold to investors, suggesting that there is more than enough demand to make REO management and resale a profitable endeavor.
Geographically, Hawaii is unique among U.S. states. The only state composed entirely of islands, it sits in the middle of the Pacific Ocean. Just below the Tropic of Cancer, Honolulu is on a latitude with Mexico City and Havana, nudging aside Key West. Fla., for bragging rights to being the United States’ southernmost city. A motorboat ride east of the International Date Line, Hawaii is two hours behind Pacific Time, a distinction it shares only with some barely populated rocks in Alaska’s western Aleutian Islands.
Who Lives in Hawaii?
Hawaii is the only plurality-Asian state in the Union — majority-Asian, depending on how you count people of mixed ancestry. Filipinos and Japanese are the largest ethnic groups, followed by pre-contact Polynesians. There are slightly more women than men living in the state, and roughly half the adult population is married. The median Hawaiian is 36.2 years old and the median resident of Honolulu is 39.7, in line with a national median of 38.1.
More Interesting Demographics about Hawaii
The entire economy is predicated on tourism. More than 14% of all employed Hawaiians are directly engaged in the sector, and most of the rest are in public-sector careers related to education, health care or government service. Within greater Honolulu — essentially the island of Oahu — there are also a lot of retail sales jobs and positions on maritime crews. It should be noted that the unemployment rate in Hawaii is persistently lower than that in the U.S. overall.
Considering that almost one out of three Hawaiians 25 years of age or older is a college graduate, one can surmise that there are lots of people willing to settle into underemployment if it means living the tropical lifestyle. The weather is nothing if not predictable. While Hawaii sees a lot of precipitation, it’s warm rain. City-data.com ranks Honolulu first among major U.S. cities for the smallest temperature differences during a year.
Politically, Hawaii usually has a big, blue “D” next to it, but that’s not an absolute. Certainly, native son Barack Obama did exceedingly well in the Aloha State but, in 2004, George W. Bush came very close to adding it to the Republican column as he won his second term. Religiously, Hawaiians tend to be more secular than mainlanders. While there is a significant Catholic presence and a smaller Protestant one, roughly two-thirds of the population adhere to no religion. Most non-Christians who follow a religion are Shinto Buddhists.
Oahu is just one of eight major islands in the archipelago, arranged politically into five counties. (There is effectively no city- or town-level government.) One of those counties is a former leper colony that was closed off in 1969 and fewer than a hundred people are still alive there. Of the rest, more than two-thirds of the population lives in the City and County of Honolulu, otherwise known as the island of Oahu. So that’s where we’ll zero in.
Beyond the Tiki Bars
Most of what you think of as Polynesian art and culture is pure baloney. “Tiki culture” was invented by Californians to reflect some idealized version of South Pacific hedonism. Even the Mai Tai — the rum-curaçao-umbrella concoction emblematic Honolulu’s touristy Waikiki Beach — was invented in Oakland.
There’s nothing magical about Honolulu. It’s just another city, with the same benefits and challenges as other cities. But, like all cities, it also has its own unique cultural flairs and neighborhood personalities.
(The weather is really, really nice, though. There’s no getting past that.)
There are 18 neighborhoods in Honolulu,” according to Norada Real Estate Investments, which focuses on the single-family market. “Some of the best … are Waikiki, Ala Moana-Kakaako and Hawaii Kai. Waialae-Kahala has a median listing price of $1.9M, making it the most expensive neighborhood. Makiki- Lower Punchbowl-Tantalu is the most affordable neighborhood, with a median listing price of $408,000.”
Renters vs Homeowners
The single-family option is gaining ground at the expense of the multifamily market, and the stark economics of the buy-versus-rent decision appears to be driving it. Writing for Norada, Marco Santarelli reports that Honolulu is the single least affordable market in the U.S. for apartment rentals or condo purchases. This dynamic will get worse before it gets better, as a 1%-to-2% annual population increase is expected to lead to a shortfall of 26,000 units in the next decade. When you consider that there’s a baked-in need for rental units from the strong U.S. military presence and the off-campus housing needs of the University of Hawaii, the demand keeps piling up.
“Roughly sixty percent of Hawaii residents are cost-burdened renters, people who spend more than a third of their income on rent,” Santarelli continues. “Compounding the matter is that they’re competing with several large pools of renters who are almost immune to local economics, driving up rental rates.”
Such efforts as The Michaels Organization’s $41 million, 320-unit affordable housing project currently under construction in Ewa Beach will barely make a dent. Altogether, fewer than 1,500 new low-rent units come online in a typical year.
Still, low property taxes and a generally developer-friendly City Hall spur continued growth in the real estate market overall.
It should be noted that one unique feature of the Honolulu market is that multifamily real estate is almost an afterthought. While $608.8 million was invested in apartment construction in 2018, according to CBRE, that pales in comparison to the $1.6 billion funneled into retail and $2.4 billion into hotels.
Trouble in Paradise
So Honolulu is a much more nuanced place than the Elvis movies would have you believe. Contrary to trends on the mainland, crime is rising and air quality is falling.
There are geopolitical issues to consider as well. Honolulu Harbor is, as we’re reminded every December 7, a strategically important location. We now fight wars across the Pacific with tariffs on computer parts and soybeans rather than with aircraft carriers and heavy bombers. Tensions in the region are nonetheless tense. The fallout for multifamily real estate is that some investors — not to mention potential residents — are waiting for tempers to cool before committing their money.
“Overall across Hawaii, home sales grew 12.3% while prices fell slightly by 2.5%,” Gord Collins reports for property management software vendor ManageCasa. “Homebuyers may be waiting for the trade deal to happen before committing to buying in Hawaii. Yet, even with the tariff slowdown period, prices haven’t dropped much.”
Maybe that’s because of the one, immutable truth about Hawaii: Land itself is at a premium. There will never be enough paradise to go around.
Honolulu at a Glance
Population: 953,000 (2010, Oahu total)
Unemployment rate (2019): 2.9%, compared with a national average of 3.7%
Average household income (2017): $138,492, compared with a national average of $48,150
Cost-of-living index: 172.3 (2019), compared with a national average of 100
Let’s start by saying the headline above is in no way facetious. Almost certainly, Reader, your boss has a 068xx ZIP code from Greenwich, CT.
Greenwich (pronounced “GRENN-itch”), Conn., is a town of 62,000 people and 16 yacht clubs. It is the wealthiest town in Connecticut and vies with New York City’s other exurbs and Silicon Valley redoubts for top honors nationwide. The closest thing to “industry” along this stretch of Long Island Sound in the Nutmeg State’s southwest corner is Blue Sky Studios, which does computer animation for Disney, although there might well be more florists per capita in Greenwich than anywhere else in America.
The majority of people residing in Greenwich are in finance, the professions or education, according to City-Data.com, and about a quarter of them eschew the excellent public schools and send their children to private academies. “Top executive” is one of the most frequently cited occupations, as is “other management”. So if your boss doesn’t live there, it’s very likely your boss’s boss does. And, considering that Greenwich’s environs are also dense with financial managers and other finance specialists, it’s even more likely that the portfolio managers of the institutional investment firms that own enough of your company to be listed on its annual proxy statement know what the Manhattan skyline looks like from Round Hill.
So if you didn’t get a year-end bonus, it was because the Greenwich stole Christmas. (Shame on you if you didn’t see that coming.)
Who Lives There?
There’s no sugar-coating it: Greenwich is glaringly white, like 80%. There are more than three times as many people of Asian origin than there are African-Americans. Japan, incidentally, is the largest source of immigrants to the town. The United Kingdom is second. There is a significant Latino population due to one neighborhood in the southwest corner that abuts the largely Spanish-speaking town of Port Chester, N.Y.
That said, Greenwich is not as WASPy as its reputation. It is far more Italian and Irish than you might expect. Most non-Catholic residents declare no religion — far more than identify as either mainline or evangelical Protestant. While there is some Jewish presence there, that community is far more concentrated in Stamford to the northeast and Westchester County, N.Y, to the southwest.
The majority of Greenwich’s population is comprised of college graduates. It is also older than most; the average age of 42.8 years is significantly higher than Connecticut’s 39.2 and the U.S.’s 37.8. Most residents — 52% — are female. We’re not sure what accounts for that, but the divorce lawyers’ dictum, “give him the pension, give her the house” might have something to do with it.
Politically, Democrats have the edge in Greenwich, as they do throughout Connecticut. That said, many of these voters are persuadable given the choice of an old-school Republican candidate. Mitt Romney and George W. Bush both did very well in Greenwich’s precincts. Donald Trump, not so much.
What do you Mean by ‘Greenwich’?
We recently wrote about what an imprecise term “Los Angeles” is. While Greenwich isn’t anywhere near the scale of the “72 suburbs in search of a city,” it does have its internal peculiarities.
There are seven Census-designated places comprising the Fairfield County town: waterfront Byram, artsy Cos Cob, historic Glenville, moneyed Old Greenwich, primly suburban Pemberwick and fame-soaked Riverside, as well as Downtown Greenwich. Between them there are five ZIP codes and four MetroNorth commuter train stations. When you stick Greenwich under a microscope, you’ll find the CPDs subdivided into no fewer than 30 neighborhoods. That Greenwich neighborhoods have an average population of barely 2,000 tells you all you need to know about population density.
Depending on where you look through these 48 square miles, home prices range from exorbitant to surreal. The median value of a housing unit is upward of $1.1 million these days, or roughly four times the Connecticut average. And that’s if you’ve bought-and-held. If you’re looking to move to Greenwich today, you’re talking table stakes of $1.6 million.
The gap between existing and asking rents are similarly stark. Roughly one-third of Greenwich units are leased and, while the median gross rent is $1,322, the asking rent for vacant units is $2,440.
While the vast majority of Greenwich homes — roughly 17,000 — are single-family, there is some room for multifamily dwellings. About 3,500 residences are located in structures containing five or more units, the majority of which are in structures containing more than 20.
And while residential real estate can be an exceedingly seasonal business around the country, it’s not as cut-and-dried in Greenwich. If you don’t sell by the end of August, you don’t necessarily have to wait until April to find a buyer.
“The real estate market continues to see sales as the winter season approaches,” according to an early December article by Ken Edwards at the Connecticut Post. “[S]howings will taper off while the buyer pool gets ready for the holidays. The serious buyers will be out, however. Last week our local Greenwich MLS reported 11 real estate closings totaling over $21 million. The mix of sales included eight single-family homes, two condos and one multi-family home in Pemberwick.”
Greenwich Time reports that, in response to strong demand and in contrast to the town’s resistance to change, new apartments and condos are in the pipeline.
Even so, even an enclave as prosperous as Greenwich isn’t completely immune from the softening of the real estate market throughout the New York City gravity well.
Berkshire Hathaway Home Services’ Mark Pruner recently explained to an audience, that a local house that sold for about $9 million ten years ago would sell for $7 million now.
“That’s still someone spending $7 million on a house in Greenwich,” the Greenwich Free Press quoted Pruner as saying. “Too often we focus on the hole and not the doughnut.”
Greenwich at a Glance
- Population: 62,000 (2013), little changed since 1970
- Unemployment rate (2019): 2.9%, compared with a national average of 3.7%
- Average household income (2017): $138,492, compared with a national average of $48,150
- Cost-of-living index: 172.3 (2019), compared with a national average of 100
It’s not news that multifamily construction is bottlenecked. We’ve already documented in this space how construction delays are one of the issues exacerbating the current housing shortage. Builders would have to crank out 30,000 more units per year, we reported, just to keep up with demand. But the problem is likely to get worse before it gets better.
For this article, we took a look at some U.S. Census Bureau data about housing starts. Peeling away the small-scale projects that contribute to the headline numbers, we focused strictly on projects that are expected to add 20 or more apartments each to the landscape. Then, going with the rule of thumb that these projects typically take two years to complete, we compared how many units ought to have been completed in a given year with how many were delivered. It’s not pretty.
The first odd thing about this graph is how steady and in-tandem starts and completions were in the early years of the Millennium — right up until the real estate market fell off a cliff. As the U.S. emerged from the Great Recession, completions exceeded starts, presumably because so many projects were put on hiatus as demand and capital dried up. But 20-plus-unit starts soon made up for lost time, and the number of big-project apartments completed in 2015 matched those promised in 2013 almost exactly, in the neighborhood of 250,000. Still, that was 50,000 more than in any year in recent history, and it soon became clear that the industry was reaching capacity. Last time that many units came online at once, The Godfather was still in theaters. This past year we reached the point where developers are getting shy about breaking ground on new projects until the current ones are farther along the pipe.
Things were bound to fray. The multifamily homebuilding industry has hit its ceiling, absent some massive public policy initiatives such as the Housing Act of 1949. (This paeon to government overreach and unintended consequences might have destroyed more homes than it built, but that’s another story.)
According to RentCafe, multifamily unit completion volumes are expected to be 8.2% lower in 2019 than they were in 2018, which were 8.2% lower than the year before. That supply trend is, of course, moving in the opposite direction of the demand trend.
“High construction costs and a narrow pool of skilled labor are just a few of the factors hindering the development of new apartment units,” blogs Florentina Sarac.
Must investors adjust their thinking to assume that a typical project is going to experience another six months or so of burn rate before the ribbon gets cut and that the cash stream won’t start flowing back until that half year is up? Do they have to face a new reality that the rate of return on a multifamily project will henceforth be lower than it has historically been?
Contributing Factors to Construction Delays
The short answer is “yes”. There’s more than one reason for the bottleneck, and all those must be solved before the industry is anywhere close to supply-demand balance.
Sarac cites Yardi Matrix as the source of those completion figures, and quotes a Yardi executive as suggesting that the decline “is part of a larger trend of developers gearing up for the next cycle.” There’s not much to support that, though. Construction contractors might put cash away for the next cycle, but they don’t turn down work. Plenty of time to rest during the next recession.
Considering how long this building boom has been going on, though, maybe the crews deserve a little break.
In a separate report, Yardi also posits that a major contributor to the slowdown is a spate of state-level rent control laws.
“After a period of below-par growth in housing stock, the U.S. needs more units built, but rent control moves the needle in the opposite direction,” according to an October 2019 paper.
It’s only three states, but two of them are New York and California — plus Oregon if it matters to you — and there are similar bills under consideration in other statehouses.
Even so, it’s rather simplistic to say that these laws are causing the slowdown all by themselves. There are, after all, reasons why they were proposed, passed and signed. Many people in these — and other — locations are rent-burdened. That is, they spend more than 30% of their monthly pay on rent. (That’s up from 25% a generation ago if memory serves.) That 30% figure is just a rule of thumb of how much you ought to pay, at maximum, for four walls and a roof. It’s pretty meaningless because rent could be well above 30% of pay for the poorest renters yet well below 10% for the wealthiest. It’s those people toward the bottom of the socioeconomic scale that rent control laws seek to protect.
So rent control doesn’t cause developers to stop building — it just causes them to stop building Class B, C and D projects. Just as there are limits to what poorer people can spend, though, there are limits to how many rich people are available to move in before the local Class A submarket is overbuilt. We talked a little about that here.
What’s Really Going on
The construction delays do come back to labor economics, but not necessarily a labor shortage.
“We aren’t facing labor shortages, but rather cost increases that are needed to ensure there aren’t any shortages,” Summit Contracting Group President Marc Padgett told National Real Estate Investor. “We have not seen an issue with the quantity of labor, but rather the cost of having it.”
A recent Forbes article reveals that, while average wages are currently rising 2.9% per year, those for residential construction workers are rising 5.0%.
The NREI article goes on to note that the typical delay on a two-year project is five months.
“Every week of construction delays results in a week of lost income, and another week during which the developer must pay the rising cost of the project’s often floating-rate construction loan,” Bendix Anderson reports.
Also, let’s remember that the two-year project plan is just an anecdotal historical average. As projects get bigger — and yes, they are — they’ll take longer to complete. A five-month construction delay on a three-year project might be more forgivable.
Reframing the Questions About Construction Delays
There will always be a preference for living in posh environs, and there will always be a preference for building big, new, shiny towers for those with the wherewithal.
So there’s no real crisis here. If your money is in limbo for a few months longer than you naively expected to have it tied up, that’s a good problem to have. After all, the same effects that are causing those construction delays on your financial return are also driving an insufficiency of supply to the market, which tends to hike up rents once the units are delivered.
The issue is at the bottom end of the scale. Everyone agrees that there’s a shortage of housing stock for lower-income renters, but industry and government seem to be talking past each other to solve this problem.
Rent control is at best an inelegant answer because, as it keeps the housing cost down for the tenant, it disincentives developers from building more units for those priced out of the market. As the Class B, C and D stock is aging past its knockdown date, it’s time for anyone serious about solving this problem to realize both price and quantity must be taken into consideration.
Are there ways to build units for less? Of course, there are. Modular construction and smaller floor space per unit come to mind. But this means governments must pass — along with or in place of rent control provisions — new building codes that would permit these. And if that doesn’t get the cost down far enough, governments are positioned to provide tax incentives and access to municipal services to serve as an in-kind partner in projects that further their objectives. A study commissioned by the National Association of Home Builders and the National Multifamily Housing Council calculates that almost one-third of the cost of an apartment building is driven by regulation, so there’s a lot of slack right there.
But even having government as a fully engaged government partner might not be enough.
We recently came across a University of Maryland study that renters could be classified as a natural resource (“prey,” the authors call them). And, just as any natural resource can be depleted, so can the renters. Is an economic model in which an entire class of people pays more than 30% of their income in rent sustainable? Or, at some point, will investors concede that a 3.75% cap rate is just about as good as a 3.76% cap rate?