Last month, I talked about how low supply and high demand were driving the single-family housing market across the country. Millennials are in buying mode, but there isn’t enough inventory in the market to supply the demand. On top of that, the distressed housing market is down from a year ago.
According to the National Association of Realtors, distressed sales were less than 1 percent in May 2021. They were at 3 percent in May 2020. The big question is, Why? What’s driving distressed home sales?
Housing Moratoria and Stimulus Packages
On March 18, 2020, the U.S. Housing and Urban Development issued a 60-day foreclosure moratorium for FHA-insured single-family homes. Fannie Mae and Freddie Mac initiated a moratorium on the same day. The next day, the U.S. Department of Agriculture (USDA0 implemented a 60-day moratorium on USDA Single-Family Housing Guaranteed Loan Program loans. These moratoria were extended several times during the COVID-19 pandemic last year and were due to expire on June 30, 2021. Before the end of last month, the USDA extended its moratorium until the end of July 2021.
More than 7 million homeowners took advantage of the moratoria during the pandemic. According to a study conducted by Harvard University, more than 2 million homeowners are still behind on their mortgages.
First, a few quick observations:
- The moratoria have certainly impacted foreclosure rates, propping up homeowners who would have lost their homes were these not in place
- The moratoria and stimulus packages were effective in giving most homeowners facing foreclosure the financial security they needed to get current on their mortgages
- When the foreclosure moratoria do finally come to an end, we can expect to see a sharp rise in foreclosures
Big Banks have already announced when they will begin foreclosures proceedings coming out of the pandemic. Bank of America and JPMorgan Chase both expect to restart foreclosure proceedings when the moratoria are finally lifted. Wells Fargo plans to wait until next year.
During the pandemic, the U.S. spent more than $3 trillion on economic stimulus packages. Forty-three percent of recipients of government stimulus checks put the money toward housing costs. Many of them were renters, but given that the number of households facing foreclosure fell from more than 8 million to just over 2 million means that many were also mortgage holders. It’s evidence that the moratoria and the stimulus packages did what they were intended to do.
Housing Prices Are On The Rise
The pandemic didn’t hurt the real estate market much. It may have dampened a strong market to some degree, but it’s still a strong market. That’s evidenced also by the fact that home prices are on the rise, including distressed home prices. According to CoreLogic data, home prices increased year over year in May 2021, and that includes distressed home prices, by 15.4 percent. The increase month to month from April 2021 to May 2021 was 2.3 percent.
It’s pretty clear that the low supply-high demand environment in single-family housing is driving real estate prices higher. What’s unclear at this time is how an increase in foreclosures once moratoria are lifted will impact prices. It’s likely that the result will be a slow down in price increases.
Investors are poised to take advantage of the market opportunity that will develop when foreclosures do start again. However, the distressed home market is a different market than the new construction market. We’ll likely see a parallel demand curve between those two markets, but prices in the distressed market will be determined by how quickly foreclosures pick up again once the moratoria are lifted. If a large glut of homes hits the market at once, investor competition for those could drive up prices in the short term, but if investors overspend, they’ll see fewer profits on the resale.
There is also a question as to whether homebuyers will switch from the rising market in new home construction to the secondary market. If the low supply situation continues, many homebuyers could switch to buying on the secondary market, and that could impact prices in that market.
While there are a lot of unknowns due to lack of clarity on when the foreclosure moratoria will be lifted, there is plenty of room for optimism regarding the future of real estate, both for the new construction market and for the distressed housing market.
Distressed Homeowners Have a Safety Net
The moratoria and stimulus packages have proven to be a safety net for homeowners affected by business shutdowns and social distancing guidelines during the pandemic. While millions of homeowners fell behind on their mortgages, most of them have caught up. That’s a good sign for the future of the real estate market and the economy as a whole.
During the 2008-09 financial crisis, homeowners had no safety net. Lenders with loose credit standards ended up foreclosing on homes with loan terms that never should have been approved. Today, many homeowners who purchased homes during that time or immediately after are sitting on a cushion of equity in a strong market with rising prices. That means fewer distressed properties, and distressed homeowners, across the board. And the longer the foreclosure moratoria are in place, the more homeowners still behind on their mortgages are likely to catch up.
While unemployment is higher than it was pre-pandemic, the unemployment rate is down from April 2020. Unemployment remains steady at 5.9 percent. Interestingly, what’s driving most of the unemployment rate in today’s job market is voluntary. The number of people who quit their jobs in June 2021 rose from 164,000 to 942,000. Essentially, people are rethinking their relationship to work.
Don’t underestimate what that has to do with housing. People don’t generally quit their jobs unless they have one already lined up or they have enough money in savings to sustain their spending during a long tenure of unemployment. Remote work is on the rise, which means that homeowners who purchased a home due to its proximity to their office no longer feel the need to remain in the same location. While they aren’t moving far, the general trend seems to be from urban centers toward suburbia.
As jobs return and the economy recovers from the pandemic, the number of distressed homes due to financial stress will continue to decline. On the other hand, once foreclosure moratoria are lifted, we should expect to see a sharp rise in foreclosures and the emergence of a new secondary market in single-family housing.
Bank of America and JPMorgan Chase have both stated that they will resume foreclosures while Wells Fargo is waiting until the end of the year. In April, 1.8 million homes not in forbearance were more than 90 days delinquent, which means that we could see a huge leap in foreclosures in the single-family home market. If so, it will mean the moratorium simply created an artificially low-volume foreclosure market.
In 2020, foreclosures were the lowest they’ve been in 16 years. In fact, they were 90 percent lower year-over-year despite 3.4 million mortgages more than 90 days delinquent. That indicates that the pandemic-related moratorium kept the single-family housing market propped up for most of the year while loan foreclosures ran on fumes.
According to ATTOM Data Solutions, foreclosures rose 16 percent from January to February this year while down 77 percent from a year before. The highest foreclosure rates in February were in Utah, Delaware, and Florida. The foreclosure rate has since come down a bit.
The State of Single-Family Starts
The year kicked off with single-family housing starts down 8.5 percent. The primary driver was the cost of lumber, which increased the cost of new home construction by as much as $24,000, on average. Interest rates on new loans were another factor that contributed to this decline. Add up the additional cost of materials and the higher cost of obtaining a loan and that put some downward pressure on new housing starts.
While starts were down at the beginning of the year, they were higher than the first two months of 2020, by 6.4 percent, which means that housing starts in 2020—the year of the pandemic—increased by 36 percent.
Homebuilders reported holding off on new construction projects in April. Single-family housing starts dropped 13 percent from the month before, the biggest drop since April 2020.
In May, new housing starts remained steady as the market increased overall year-to-date. That’s good news for the real estate market, which has seen a 31 percent increase in housing starts this year. Though housing starts are up, permit issuances are down. The higher cost of new construction permits are having an impact on builders’ plans. If foreclosures skyrocket in July, then that could have a negative impact on new housing starts later in the year. Homebuyers search for the best real estate deals in a market tilted toward higher supply than we’ve seen in later months. That could lower the price of homes in some markets.
Zillow, in its Daily Market Pulse on June 17, also reported higher inventory in May. For-sale inventory rose 3.9 percent from April to May while home values increased 13.2 percent year-over-year. Zillow also reports new home construction was up 3.6 percent from April and 50.3 percent from the previous May. Lumber prices have come down but are still high.
The Federal Reserve announced earlier this month that it will step up its timeline for interest rate increases. Before, the Fed didn’t expect any increases until 2024. Now, the expectation is 2023, and it could come in two different hikes. The announcement caused mortgage rates to bounce.
Overall, builders and real estate professionals across the country are optimistic about new housing starts.
What’s Happening in the Single-Family Rental Market
CoreLogic reports a single-family rent growth of 5.3 percent this year. With housing demand exceeding supply, it’s likely that the rental market will do well. After the moratorium on foreclosures is lifted this month, a glut of homes entering the market could drive down real estate prices allowing some renters the ability to buy some of those homes. However, if loan rates increase, then some of those potential home buyers could be priced out of the market for
buying a home.
Wall Street investors continue to sweep up rental homes. Still, institutional investors make up an exceedingly small portion of the 49-million single-family home rental market. If these investors go on a buying spree when new foreclosures hit the market, that could drive up
Where are the Hot Single-Family Markets Right Now?
The pandemic hasn’t hurt the single-family housing market. There have been some ups and downs, but it’s still strong. In some areas of the country, it’s booming.
In Boston, the median price of a home in May 2021 was 11 percent higher than the previous May. Homes are on the market an average of 22 days, 59 percent lower than the year before.
Austin, Las Vegas, and Riverside, California also saw huge listing price increases year-over-year while Washington D.C. remained steady. Nationally, active listing prices grew 7.4 percent from May 2020 to May 2021, although that is a sharp decline from the 11 percent experienced a month before. The best regional markets are in the west and the south. In Phoenix, Arizona, some homeowners are seeing extraordinary interest in their houses, proving that the current market is a seller’s market. It’s anecdotal, but one family accepted an
offer of $50,000 above their asking price after receiving 25 offers in two days. Real estate market insiders say Phoenix has never seen demand so high, but, like other parts of the country, there just isn’t enough inventory to fulfill that demand.
The same story is being told in other metro areas around the country. Rutherford County, Tennessee is another hot market. Four of the top 10 zip codes in the Nashville area are in Rutherford County.
Several factors are driving home sales in Rutherford County. First, it has a strong job market. It also has a lower cost of living, and good neighborhoods with a strong education system. These are the kinds of cultural amenities that families look for in a neighborhood and that can drive strong single-family home sales.
Nashville is listed on HomeUnion’s top 10 best single-family markets in the U.S. The other nine are Milwaukee, Wisconsin; Indianapolis, Indiana; Tampa, Florida; Birmingham, Alabama; Jacksonville, Florida; Cincinnati, Ohio; Baltimore, Maryland; Orlando, Florida; and Charlotte, North Carolina. Seven of them are in the south. In most of these markets, a consistent job market is one of the reasons the single-family market is so strong. Of course, this correlates with strong real estate market fundamentals.
At the end of the day, the single-family real estate market is strong and looking good for the foreseeable future. But a lot rides on what happens after the foreclosure moratorium comes to an end.
There’s always been a friction point between real estate professionals and finance professionals, and maybe it’s inevitable. It has to do with the basic difference between the underlying assets driving each of them.
Financial types are, of course, focused on money. And money is fungible. One dollar is exactly like the next, so they have structured one share of a company’s stock to be identical to all the others, and one corporate note to be the same as any in the series.
While understanding that none are to be fallen in love with, real estate purveyors can tell you in detail what makes each property unique, from the shape of the lot to the demographics of the community around it to the condition of the utilities running beneath it.
When one considers that money and property are the twin pillars on which the wealth of nations rests, you can see that members of Team Money are going to have some blind spots when it comes to handling the property. (The inverse is probably true about Team Property, but maybe that’s a topic to be addressed in the future.)
And that’s why a lot of financial advisors may be under the impression that you shouldn’t – or maybe that you can’t – invest in real estate as part of your retirement portfolio. Whether they are uninformed or misinformed or deliberately resistant to the notion, they are wrong.
What Makes Self-directed IRAs Different?
Let’s start at the beginning which, when it comes to U.S. retirement plans, is 1974. (Up until then, there was the defined-benefit pension, which is now racing the Asian elephant to the point of extinction.) When Congress passed the Employee Retirement Income Security Act, it opened the door to, among other vehicles, individual retirement accounts.
In the decades since ERISA, there’s been a lot of legislative tinkering. The biggest came in 1997 with the introduction of Roth IRAs. A traditional IRA taxes your income upon withdrawal and a Roth taxes you upfront.
“Since the banks and brokerage houses which acted as custodians focused solely on selling stocks, bonds and mutual funds, their accounting systems and administrative policies were only geared to those areas. They were neither willing nor able to handle their IRA account holders’ wishes to purchase or invest in real estate, private businesses, commodities, intellectual property, coins, etc.,” according to an unsigned article on the Broad Financial website. So “several trust companies with the administrative flexibility to hold alternative assets entered the IRA arena. As a result, a new level of diversification became possible for IRA investors, one that truly permitted an IRA account holder to ‘self-direct their retirement assets.”
Thus 1997 also brought the self-directed IRA – which can be structured as either a traditional or a Roth account. It brings special privileges, although it also brings an added layer of complication.
The problem with other IRAs – including models designed for small businesses and the self-employed – is that they’re run by fiduciaries who, to be fair, are paid to be risk-averse. They’re the ones who’ll tell you, “You’re not Gordon Gekko. You’re not The Wolf of Wall Street. You’re a 58-year-old orthodontist from Parsippany. Buy Duke Energy and gift the GameStop shares to your kids.”
And that’s fine for most people, but some of us don’t want the dice taken out of our hands. That’s why The Government decided to provide one type of IRA that allows for alternative investments. Immediately after, the Government lost a lawsuit.
James and Josephine Swanson of St. Petersburg, Fla., turned their IRA into a blank-check company – what would now be called a SPAC – and sold their S-corp hardware company and import-export company to that shell, which also bought their old house in Algonquin, Ill. The Internal Revenue Service refused to allow these entities to be taxed under the more favorable ERISA rates, so the Swansons sued the IRS commissioner. They won, so now self-directed IRAs are a thing.
Real Estate Rules
This raises the question: What can you invest in via a self-directed IRA? Rachel Hartman at U.S. News and World Report and Jean Foger at Business Insider breaks it down:
- Promissory notes
- Private equity
- Tax lien certificates
- Gold, silver and other precious metals
- Water rights
- Mineral rights
- LLC membership interest
- Horses and livestock
- Intellectual property
And, of course, the list wouldn’t be complete without real estate, including farms and undeveloped or raw land. These are, in fact, the most popular investments in self-directed IRAs, and private mortgages are also on the approved list.
The non-approved list is much shorter: collectibles, life insurance or real estate you live in.
Even so, there are rules to follow when investing these retirement funds in real estate. Jessica Willens outlines seven of them for the Real Wealth Network:
- Property cannot be owned by you. Your IRA is not allowed to purchase property that is owned by you or a “disqualified person.” According to The Entrust Group, an administrator for self-directed IRAs, disqualified persons include your spouse; your parents, children or grandchildren; your spouse’s parents, children or grandchildren; your employer; anyone offering plan-related services such as custodians, advisors or administrators; and any entity in which you directly or indirectly own at least 50%.
- You cannot have indirect benefits. You cannot have indirect benefits from property that is owned by your self-directed IRA. These might include renting the garage apartment in a house that your IRA owns.
- Property must be uniquely titled. You and your IRA are considered to be two separate entities; as such, investments should be titled in the name of your IRA.
- Property can be purchased with combination funds. You can purchase real estate in your self-directed IRA in combination with other funds.
- Your IRA must pay Unrelated Business Income Tax if financing. Any IRA investments that use financing are required to pay UBIT, because the assumption is that it is engaging in operations that are contrary to the tax-advantaged mission of a retirement account.
- Expenses must be paid from the IRA. These expenses might include building association fees, utility bills, maintenance fees, renovations and property taxes.
- Income generated must return to the IRA. Any and all income that is generated by property owned within a self-directed IRA is required to be paid directly back into it.
Why Bother Investing in Real Estate?
Let’s be clear: A lot can go wrong by holding commercial real estate in your self-directed IRA.
Not every financial institution that serves back-office functions for traditional IRAs will provide the same services for a self-directed one. Also, recordkeeping and tax reporting is more complex. As a result of both of these factors, maintenance fees can be high – and so can the IRS penalties. And when you consider that custodians and trustees have limited duties related to asset selection – that’s what the account holders wanted to do in the first place – the field is ripe for fraud.
Also, you can’t borrow against your self-directed IRA, nor can you lend it to any of those disqualified persons. And you can’t take advantage of many of the alternative investment opportunities presented by the self-directed IRA unless you’re also an accredited investor. One more issue presented by this vehicle is that, like most IRAs, you can only contribute $6,000 per year up to age 50, then only $7,000 per year.
Of course, there are also the usual risks of betting on a piece of real estate, not the least of which is that it can prove to be highly illiquid at a most inopportune time.
So maybe the way to invest in real estate for retirement is to do what your fiduciary has been telling you all along: Just buy REITs. On top of all the other benefits of being securities rather than underlying assets, they’re tax-advantaged.
But wait. So are IRAs. Is there any benefit to keeping tax-advantaged securities in an otherwise tax-advantaged account? Sure, it’s likely to become a bit diluted.
So maybe it makes more sense to use the IRA as a tax shield for what might otherwise be a fully taxable event, such as the purchase of a building or of a partnership in a real estate limited partnership.
The benefits of a self-directed IRA all come down to the two reasons you’d want to engage in alternative investing – diversification and higher potential returns – combined with the one reason why you’d open a qualified retirement account – favorable tax treatment.
Whether to invest via a self-directed IRA or via another account is not a no-brainer decision. If you have the funds to commit to this venture, perhaps the first money spent should be to your accountant.
As the economy picks up again and we begin to move into a post-pandemic environment, real estate professionals around the country are asking if we may be in a housing bubble and, if so, when will it burst?
Both Jeff Greene, a billionaire real estate investor, and Jamie Dimon, CEO of JPMorgan Chase, say yes. However, Dimon says he’s not worried about a crash like the one we had in 2008-2009.
Almost everyone else says today’s real estate market is not a bubble. So what is it?
The Factors Driving the Real Estate Market Today
When we analyze the real estate market in 2021, we’ve got to keep in mind that we are following an unusual year of very unusual activity. The COVID-19 pandemic and associated lockdowns, social distancing guidelines, and public health concerns brought the real estate market to a near halt. New construction was hampered, buying and selling were stilted, and lenders tightened their credit standards. It was an unusual year.
What happened in 2008 was a weak labor market drove foreclosures higher while banks and other lenders loosened their credit standards. Last year’s pandemic brought with it mortgage forbearances so that income earners out of work wouldn’t lose their homes. Different environment.
Another way the pandemic has impacted housing is that it caused a massive movement from urban centers to the suburbs. This is interesting because this massive move was spurred by an increase in remote work. People living close to urban centers didn’t need to be near their offices anymore, so they moved out of the city into the suburbs where they could work remotely and more at ease. This drove up demand for housing and increased housing prices since the pandemic slowed down new construction.
This is basic economics. Lower supply and higher demand cause prices to go up. And that’s what we’re seeing in 2021.
Another thing we’re seeing is an increase in homeowner equity. People who bought their homes ten years ago have seen their home’s value increase. Now they have equity, which serves as a cushion in economic downturns. It also means they are in no hurry to sell, but if they do sell, they can put that equity toward a down payment in a more valuable home.
What Causes a Housing Bubble?
Housing bubbles are generally caused by a strong economy giving people more disposable income, which they put into buying new homes. Coupled with low-interest rates and loose credit standards, the market creates opportunities for risky behaviors and new mortgage products. As a result, there is more speculative activity as investors try to invest in the next big thing or predict where the market is headed.
Housing bubbles are also often accompanied by mass moving. A lot of people migrate from one location to another at the same time.
Looking at today’s real estate climate, there are some similarities between the housing bubble of 2008 and 2009 and the 2021 housing market. However, those similarities fall short of causing worry when compared with the differences in the two markets. What are those differences?
In 2008 and 2009, there was a lot of speculation and risky behavior in the financial markets. We don’t see that today. New mortgage products are not rolling off the lending shelves every day with sophisticated sales techniques to push them.
While demand was high, as it was then, it’s coupled with low supply due to the slowdown in construction activity last year. The low supply of housing today was not created by natural market conditions. It’s artificial. As the economy picks up again, developers will begin building again and supply will catch up to demand. It may take two to five years, but it will happen. As it does, prices will stabilize.
Housing prices have gone crazy, but that’s due to the aforementioned conditions of high demand and low supply with stable interest rates. We expect to see this settle down.
One very important way today’s housing market is different is that mortgage companies and lenders have tightened their credit standards. They aren’t loaning money to just anyone. In 2008 and 2009, lenders were creating new credit products and selling them to people who couldn’t afford them. That could easily occur following a year like last year where home equity increased and remote work drove up demand for housing in the suburbs. But it didn’t. Instead, lenders tightened their credit standards, which has served to strengthen the real estate market.
Housing bubbles are caused by a lot of activity in the market due to speculation and risky behavior. We’re not seeing that in 2021. We’re seeing people shifting their priorities and adapting to a new reality, which is leading to a spike in housing demand.
Low Supply Plus High Demand Does Not Equal Housing Bubble
The biggest factor impacting the housing market today is low supply. Builders simply haven’t been able to keep up with demand because, first, it wasn’t expected. Secondly, forced social distancing guidelines and business lockdowns, especially in places like Pennsylvania and New York, meant that new construction came to a halt. We see it picking up again. As the Biden Administration continues to push for vaccines with the hope of vaccinating 70 percent of the population against COVID-19, we should see the economy open up more.
Demand will likely continue to climb, although at a lower rate, as supply struggles to catch Interest rates will likely remain stable. The housing market will remain healthy for the foreseeable future. Older Americans are continuing to downsize as they age and move into senior housing while younger Americans are showing signs of entering the homeownership market.
We should see a gradual shift in homeownership over time with younger Americans buying from older Americans. New construction will cater to the needs of younger Americans and remote workers with greater emphasis on suburbs and rural communities. When supply matches demand in the housing market, we’ll have reached a point of equilibrium that should keep the real estate market stable for a few more years.
·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.
The District of Columbia has always been in-demand, with a strong jobs market centered around government and its adjacent accouterments, but 2020 has put it over the top. Long & Foster reports inventory of active listings is down more than ~30% in the DC and surrounding metro area (Long & Foster). While government jobs will always ensure demand in the area, the rise of work-from-home culture may deflate some of the pent-up demand from the pandemic. While growth may slow slightly, particularly in the upcoming months (predicted to be the worst of the pandemic thus far), once a return to “normalcy” is restored, DC is expected to see continued positive progress for the coming year.
Closing out the year, Oklahoma is one of the only metros in the country that has not reached the recovery stage in the top 50 markets (Realtor.com). Oklahoma is also the 4th least-expensive market in the nation (Norman Transcript). These two factors are red flags, the latter of which should not be interpreted as an investment opportunity. The continued weakness of the economy throughout the state should ward off investment, especially as the economy is projected to suffer further short-term weakening whilst COVID enters its worst phase yet.
While Louisiana also benefitted from the COVID market price increase, the numbers reflect the state’s continued economic quagmire. Whereas some states posted double-digit sales price increases throughout 2020, prices in Louisiana have increased only ~1.7% to date, ranking 48 of 51 entries, including 50 states and the District of Columbia (LittleBigHomes.com). Much of the country posted significant gains as a consequence of the COVID-induced housing boom, so such a small margin of growth is concerning. Additionally, Louisiana is among the states with the most underwater mortgages (CoreLogic). With federal assistance via the CARES Act expiring in December 2020 and a likely retraction of prices nationally, Louisiana is projected to be in another poor position come the new year, with the number of mortgages underwater increasing as the economic effects of the worst of the COVID impact take hold.
Alabama could become yet another victim of the post-COVID boom. October clocked in with home prices soaring ~14% from the previous year; inventory declined by almost ~28% (Huntsville Business Journal). However, the high demand is leading to two major problems: 1) affordability and 2) foreclosures. Alabama was among the three states posting the highest foreclosure rates in the nation (1 in every 6,600 housing units) (World Property Journal). Alabama also posted some of the largest numbers of REOs filed in October. While still well below the national average, and foreclosures are thus far ~80% lower nationally than 2019, such figures are worth taking notice of. Foreclosures are occurring in COVID hotspots where unemployment rates are higher, something Alabama has seen; additionally, foreclosures could be down nationally due to government measures. Given the evidence, and with governmental assistance drawing to a close, these numbers are sure to increase, placing the state in a precarious position to kick-off 2021.
Floridians are looking to potentially suffer the worst in the new year. Florida has been notoriously lackadaisical regarding protections for workers and providing relief for tents and renters. Via CNN, more than 1M Floridians have “slight or no confidence” that they will be able to pay rent for January 2021, as the CDC moratorium on evictions is set to expire on December 31 (CNN). In Broward County alone, evictions are expected to rise to ~15K- triple the number of that time period for the previous year. In Miami-Dade County, the Miami-Dade Homeless Trust reported ~6,400 eviction notices filed from March 13 to November 30; that figure is set to impact around ~18K people (Miami Dade Homeless Trust). The problem will be multifaceted from an investor standpoint: 1) rental income has dried up for the better part of the last nine months; that is surely impacting ROI and ability to pay bills, mortgages, etc., leading to the question: how many landlords are already in arrears, and could this impact foreclosure rates? 2) with so many people affected by pandemic unemployment and turned out to the street, is there enough of an influx of population to Florida to afford these homes, further compounding problems and leading to a foreclosure crisis? and finally, 3) in the event that homes are sold quickly to get out from underwater mortgages, will homes be undervalued in a low-tax, warm-weather state, causing an overheating of an already competitive market? It bears watching heading into the first few months of 2021 before making any calculated investor moves.
Predictions are a bit mixed for Maryland heading into 2021. Areas like Baltimore are seeing historic demand, fueled by record-low interest rates and pandemic fears. In Baltimore City and the surrounding Metro, prices are at 10-year highs, and the median number of days on the market is the “lowest in recorded history” of the area (The Baltimore Sun). The demand applies to both detached and attached housing and is spilling into townhomes as inventory continues to dwindle. While some, such as Bright MLS, forecast this trend to continue as pandemic fears also continue, others are not as optimistic. CoreLogic predicts that the average sales price will decrease by around ~1% by April 2021, the first time in nine years (CoreLogic). The theory rests upon continued elevated unemployment, which might be exacerbated by a tragic COVID winter. However, with just a slight dip, a new federal administration seeking to shore up coronavirus regulations, and still-tight inventory, Maryland will potentially have a rebound into the summer months and for the coming years, making it still a strong area of investment for 2021 and beyond.
Delaware will remain a strong point for investment into the new year, aided by its optimal location, sandwiched close to Philly, NYC, NJ, and DC (just ask President-Elect Joe Biden). With lower costs than its East Coast counterparts, Delaware is decidedly more affordable for relatively the same access. Over the course of the last decade, income is up approximately ~40% and rent growth over the same period is up ~74% (Morris Tribune). Delaware also has a strong rate of foreclosures, one in every 9,310 housing units (Mortgage Professional America). These two factors together would provide a strong opportunity for a long-term investor looking to potentially pick up properties at auction and stabilize them. Delaware’s location will ensure a demand, regardless of the overall market forces that may occur in 2021.
Razorback Country is poised to see some pains following the pandemic. CoreLogic predicts a contraction of home price growth to ~.6% by July 2021; by contrast, that number was ~4.3% by the end of June 2020 (CoreLogic). With such negligible gains, some markets are expected to see losses next year. Arkansas ranks among the top 5 states with underwater mortgages at 5%. Given that many mortgages are currently in forbearance, and that the projected national economic hardship will exacerbate the situation when federal mortgage safeguards expire at the beginning of the year, this number is likely to increase. Efforts to invest in the state may be hampered by the lack of viable buyers and the possibility that renters will be unable to make market rents.
Atlanta has been a red-hot market for years, and COVID’s impact likely will not have any bearing on that in 2021. Unlike some of the inflated demand pent-up from the pandemic, Atlanta’s population increased ~17% from 2010-2019, whereas the population of the US grew only by ~6% during the same time period (US Census Bureau). With the median home value of around ~$289K (Zillow), Atlanta remains an affordable option for investors, either in the fix and flip and investment rental space. The broader metro area also is experiencing the same demand, meaning that the strength of potential investment also extends into the exurbs, and will likely be sustained into 2021.
Nashville is leading the way for Tennessee to close out 2020 strong and setting a strong tone for the state for 2021. Zillow reports ~26% decline in inventory from the previous year, with sale prices up ~7% and rental prices up ~2% (Zillow). Zillow similarly predicts an increase in these figures into 2021. If opportunities for foreclosure fix and flips present themselves, either for sale or to rent, investors should jump at the opportunity. With vaccines on the horizon, the hospitality industry is poised for a resurgence- combined with lower taxes and relative affordability, the city is set for continued growth into 2021.
Auction.com shares some troubling signs about the state of the Kentucky housing market for primary homeowners, but an opportunity for investors. Kentucky had an above-average rate of foreclosure (56%) in September 2020, and that number remains high (Auction.com). Prices in Louisville are continuing to remain high, making things hard for affordability. As such, there could be a major opportunity for investors looking to purchase at auction and flip for a profit. Additionally, affordability might be an issue for some would-be buyers, so the rental market might so be a strong opportunity.
Like its northern twin, South Carolina is looking at a booming market. Unemployment is lower than relative to the rest of the country, with unemployment rising only 3% at the height of the pandemic, compared to low double-digits nationally (Greenville Business Magazine). Columbia, Charleston, and Greenville, for example, make up a tier of so-called “smaller cities” that are seeing traction based on affordability, relative safety from the COVID pandemic, and amenities of larger cities without the sky-high prices (Zillow). The average home price is just over ~$204K in the Palmetto State, making it a prime opportunity for investment, as prices are predicted to rise over 7% in the next year.
Realtor.com has projected Charlotte as the third-best housing market in the country for the coming year (Realtor.com). Prices are projected to soar ~10% into 2021, as new construction continues to keep pace with demand. Additionally, Charlotte is establishing itself as a hub for technology companies, ensuring that high-paying jobs will remain in the area. One interesting point of note, as well: millennials are expected to be the key demographic for driving growth and sales prices. One key factor: Charlotte’s affordability. All things being equal, Charlotte’s market will be thriving well into 2021.
Virginia’s housing market remains red-hot to close the year and to start the next. While COVID has fueled home sale trends, the demand in Virginia pre-dates the pandemic by several years (Richmond Association of Realtors), meaning that much of the demand is not artificial (WRIC). However, it has been impacted by the pandemic, which could pose some longer-term problems by overheating the market. For instance, renters are facing significant hardship as incomes are lost due to proactive and prolonged shutdowns in the state. As such, landlords are pressed with lower profit margins and to make ends meet (RAoR). Further complicating demand has been a delay in production and rising costs as goods struggle to get into the country. Homebuilding has gone from a two week to 15-week lead time on windows alone, drastically slowing the process; costs are up nearly $20K on a new build (HHHunt Homes, Virginia), as inventory is scarce and production capacity is reduced with social distancing guides in place.
SOUTH & WEST: MIDYEAR, 2020
With lockdowns ravaging California to close the year, the housing market continued on a tear. The median sales price crossed the $712K threshold for the first time in history, despite a whopping 16.4% unemployment in April 2020, and resting at about 10% to close out the year (New York Times). Despite this, Los Angeles, San Jose, San Diego, Sacramento, and San Francisco represented the markets with the biggest mortgage originations nation-wide (ATTOM Data Solutions). Fueled by a lack of inventory and stringent lockdown rules, and aided by record-low rates, homes are moving quickly. Equity is building at a rate not seen in the state since 2005, and homes are outpacing equity rates nationally (Bloomberg). Given that a broad swath of the state is seeing high demand, from Riverside, Sacramento, and San Diego, to LA, San Francisco, and San Jose, the opportunity is rife. Any chance to take advantage of a flip or acquisition of a long-term rental should produce a solid windfall for investors- a trend that will likely continue into 2021.
Interestingly, while the market has been hot across the country, things are beginning to stagnate a bit in New Mexico. Demand has been steady, without some of the larger spikes based out of major cities into the suburbs. The median sales price for a home in the state is under $200K (Farmington Times), but New Mexico is close to the top with foreclosure rates nationwide (PR Newswire). Despite the affordability, it would remain to be seen whether there is an opportunity for sales in the flip market; perhaps diving into the rental pool in the major cities, such as Santa Fe or Albuquerque, would be a smarter move.
While Arizona is on fire, some cities are suffering a massive shortage of homes at the time of incredible demand; Phoenix alone has only about 1-4 months of inventory, down ~21% from September 2019 (Redfin)– well below the markers for a balanced market. Furthermore, the COVID-driven home buying effect is exacerbated by a ~16% population growth from 2010-2019, a figure which is higher than the national average and comparable metros, and that was before the pandemic (US Census Bureau). With such limited options, home prices are predicted to increase, led by Phoenix, which is projected to have its home prices increase ~6% (Home Buying Institute). As such, 2021 should continue to be prosperous for sellers in the Grand Canyon State.
Colorado might see the first initial pains of the post-COVID real estate boom in 2021. Denver sets the economic and real estate tone for the state, for good and bad, trending this way in the most recent recessions. While recent years have been a boom for the city, the loss of wages caused by the pandemic may be a harbinger of economic decline for a state that relies heavily on tourism, which has been largely impacted by coronavirus (Colorado Hard Money). With less money, there is less real estate demand, either for primary or secondary homes, resulting in what is predicted to be a ~9% drop in prices by May 2021 (CoreLogic). This would place the Denver-Metro area among the most-overvalued areas nationally. While inventory is limited and may be a mitigating factor in the predictions, investors should hold off on making moves in Colorado any time in the near future.
Montana is seeing a boom in the luxury and secondary home market that is projected to continue into 2021. The FHFA reports that Montana has seen one of the largest price increases in the country at ~10%, fueled by open spaces and relatively limited coronavirus impact (FHFA). Housing prices were on an accelerated trend prior to the COVID crisis, even though income is not rising with respect to living and real estate costs (The Missoulian). The rise of work-from-home culture, however, has meant that big-city employees are getting more bang for their buck in Montana; opportunities may be available for a flip property in 2021.