What's Next for the Real Estate Market?
July 17, 2017
EisnerAmper Tax Partner and the Partner-in-Charge of the firm’s Real Estate Services Group, Kenneth Weissenberg, takes a look forward at a wide-range of issues that could impact the real estate market such as capital markets, foreign investors in U.S. real estate, and tax reform. Ken also drills down on 1031 like-kind exchange deferrals, REITs, carried interest, and depreciation.
DP: So, Ken, let’s start with the new presidential administration. It certainly brings a slew of challenges as well as opportunities to the real estate sector. Let’s talk regulations.
KW: Well, in terms of regulations, there is a freeze on regulations right now so environmental protections are basically on hold. It’s good for industrial properties. For residential and in general commercial properties, which is mostly what I deal with, it really doesn’t have much of an impact at all. The uncertainty that the administration brings to the market place is impacting real estate. People are not making decisions – not knowing what’s to come. One of the proposals in the tax code is to write off the cost of new assets – completely. So, if you buy a building for ten million dollars, you get a ten million dollar write off. I certainly would wait to buy a building if I knew I can get a ten million dollar write off than buying something today and depreciating it over 39 years.
DP:Sure, sure that seems to be a common theme in what we’re hearing is just uncertainty. That’s the biggest question mark at this point. We are hearing some interesting chatter concerning the capital markets. Maybe you can tell our listeners about that.
KW: Well, we’re at a crossroads in financings. A lot of the commercial mortgage backed securities that were issued before the last crash in 2007 are coming due because those were ten year financings. So this is the end of the wave of the refinancings of the ten year CMBS loans. And they have restricted lending to a large degree with the Dodd Frank and with Bozell 3 so that you’re seeing a reluctance of lenders to come into the market place for the same kind of leverage that existed pre 2007. There’s a gap in the financing strata which is being filled by private firms at a higher interest rate. The good news is that the interest rates on the first mortgages which run about sixty percent of the loan to value today are fairly historically low. So you’re looking at a three and a half / four percent interest rate on those loans. The mezzanine levels coming in are getting a higher rate of interest – somewhere between ten and fifteen percent – depending on the level of leverage. Lended – it’s probably your average rate from the early 2000’s.
DP: Anything going on with real estate investment trusts?
KW: Everything is going on with real estate investment trusts. The private real estate investment trust market was somewhat disrupted by American Realty Capital’s scandals. But that seems to be coming back fairly strong. There is a strong demand for capital in the marketplace. REITs are a great vehicle for raising capital in the public market place with a unlimited life for the investment. In the public REIT there is a free market for trading the stock. The interest rates impact REITs dramatically. People view REITs as a long term income producing vehicle. They are looking at it for the dividend potential. When interest rates rise the dividend looks less attractive. REIT stocks get hit disproportionately compared to other stocks in the market place.
DP:So, if you had to look into your crystal ball at some of the factors that would determine a buyers’ market or a seller’s market – you know interest rates, price of real estate, capital flow – what do you see?
KW: Retail is turning into tremendous online experience and the retail establishments are becoming more showrooms than actual places of buying the goods. The industry has to adapt to that by making the malls and other shopping areas an entertainment – experiential environment – as opposed to a go in, buy and leave. You’re looking at vacant stores in every retail area in the country. The big boxes in the suburbs, the malls, the strip malls, the retail corridors in the major cities, they’re all experiencing downturns and that is something that I think is going to be creating tremendous opportunities going forward. But it’s a result of a lot of different long term trends that are impacting that industry. Other sectors of the market are also being affected by this technology millennial wave. As we’re shifting to an internet based economy – and you’re looking for delivery points – warehouses are becoming much more valuable. Industrial properties are becoming more valuable as we are bringing manufacturing back on shore. The commercial office building going through a technology change – impacted by the way we live and work today. Residential units are getting smaller in the cities.
DP:Sounds like a lot of change and a lot of very overt changes and a lot of very subtle changes out there.
KW: Yeah and it’s an evolution of the market place.
KW: And it’s interesting to watch and really interesting to hear about.
DP:Okay. Now for everybody’s favorite topic – tax reform. Where are we headed here vis-à-vis real estate.
KW: Well, we were promised tax reform by the speaker of the house by the end of the year. There is a lot of common ground that is missing when they’re talking about tax reform. Certain darlings of the tax code that have been in place for over a hundred years – like 1031 exchanges – are under attack.
DP:And the carried interest exemption for investment managers?
KW: There’s been a consensus amongst all of the pundits and all of the politicians for at least fifteen years that carried interest should be taxed at ordinary income rates but they haven’t done it. Why haven’t they done it? Because who’s paying their election campaign costs? The same people who would be hurt by that change.
DP:What about active/passive loss depreciation.
KW: That is something I hadn’t really heard of them changing necessarily but this goes back way before some of our listener’s memories but when they passed the Tax Reform Act of 1986 they added the passive loss rules. Those passive loss rules basically took away a favorite deduction for doctors, lawyers, dentists, stockbrokers which was that you could write off the cost of real estate against your other income. You get depreciation deductions; you get a really nice write off. In fact, Reagan in 1981 made depreciation on commercial property fifteen years. Huge write offs – huge tax shelter business spraying out of it – the problem was that it didn’t become economic because people would buy the buildings not for the value of the property but for the value of their tax write offs. We had something else going on around that time – it’s called the savings and loan crisis. How could there be a savings and loan crisis? Well if a bank, a savings and loan bank, lends a million dollars against a piece of property that is intrinsically only worth five hundred thousand dollars and you take away the inflationary things that made it worth a million at the time they made the loan – your loan is now only five hundred thousand dollars even though they leant a million in cash.
DP:Now, there appears to be a big appetite for infrastructure spending – by some accounts more than a trillion dollars – what could this mean for commercial real estate?
KW: For the economy as a whole our infrastructure is in dire need of repair. And I’m not talking about a wall to nowhere. I’m talking about roads, bridges, rails, airports, ports. Our infrastructure is crumbling and it was basically built during the depression era. We need to re-invent our infrastructure to meet the modern needs of today’s economy. By putting money back into the infrastructure, we’re going to become more competitive. More competitive means more jobs – a better economy overall – a better economy overall means that commercial real estate is in higher demand. How will they do this trillion dollar investment? Probably through privatization. So that you’ll have a public/private partnership in the buildings of roads, highways, airports. Will that cost taxpayers money in the long run? Probably not. Probably because those jobs will actually get done. They’ll get done efficiently – hopefully within budget. If it was a pure government project – a trillion dollar government project – cost to taxpayers would probably be two trillion to three trillion after mismanagement. Putting it in private hands for development would probably keep it at around a trillion dollars or we could limit it to a trillion dollars. If there is overruns, the private company would pay for it. Going forward, the private company would be able to charge fees for use of those facilities.
DP:Now, Ken, turning your attention overseas for a minute. What might potential policy from Washington mean for those foreign investors of real estate here in the U.S.?
KW: I think the current dialog from Washington, or monologue from Washington, Twitter storm – whatever you want to call it – is scaring foreign investors that their own countries have nationalized. Assets of foreigners over the past, they’re probably afraid similar type things could happen here. Are we still seeing a large influx of currency and buying properties and making other investments from overseas? Yes. Why? Because the U.S. still is the most stable political environment in the world.
DP:Now, when you’re out there in the trenches, Ken, what are the concerns that you’re hearing from your real estate clients.
KW: Well, it’s not a universal thing across the board.
KW: There’s different pockets of opportunity and distress. Today we are seeing a little bit of distress in the hotel markets. They were over built for a little bit. I think that will be absorbed over time. There is still an underserved market for hotels in major areas like New York and San Francisco and Washington. Retail obviously is hurting. Luxury housing isn’t really hurting. Affordable housing is in huge demand. The economics for affordable housing haven’t been made to work lately. So, we’re seeing a new government program in New York City – the Affordable New York Plan – which provides for tax exemptions for building affordable housing as part of new developments. Will that stimulate affordable housing enough for New York? We’re probably shy about a hundred thousand apartments a year. So we’ll see if that works but that’s an area where there are opportunities. Commercial office, there is a lot of new product going on the market right now. The buildings in New York, on average, are seventy five years old or older. So, the new properties going up – Hudson Yards, the Trade Center area – are new and modern and much more efficient for use today. Will we see a re-building of other sections of New York? Probably over the next, you know, ten to twenty years, you’ll see the mid-town corridor, which has tremendous value, starting to see face lifts and renovations. There’s a couple of projects going on like that today.
DP:Now I know every client is different but given the times that we live in, is there any broad based advice that you’re giving to your clients? Do’s and don’ts?
KW: Yeah. Don’t over buy, don’t overpay and sell when the selling is good but don’t pay tax – do a 1031 exchange while they’re there.
DP:Sounds like advice to live by. Well, Ken thanks for your expertise and this great insight. And thank you for listening to the EisnerAmper podcast series. Visit EisnerAmper.com for more information on this and a host of other topics. And join us for our next EisnerAmper podcast when we get down to business.