Commercial real estate prices seem to be inflating and rates of return appear to be at all time lows. Could this suggest that real estate is in a “bubble”?
There are two factors circling around that could spell a meltdown in real estate values in the not too far distant future. The first is what might be called the Trump Effect which should lead to an overhaul of the tax laws while the second is the probability that interest rates will rise..
THE TRUMP EFFECT: The brouhaha over Trump’s tax returns and the apparent agreement between Trump and Clinton that the tax laws need overhaul are one reason that tax code changes may be in the offing under a new administration. But another reason is the fact that Donald Trump has probably not paid any significant federal income taxes for several years at least. He has gamed the system and bragged about it with statements like “I love depreciation” coupled by remarks of surrogates that the ability to avoid paying taxes shows how “smart” he is. Every real estate professional knows that the tax laws are very favorable to real estate but, until now, the general public did not realize how really favorable they were. Until the campaign induced focus on the Trump tax returns the general public may have thought the tax laws were unfair but now they are convinced of it. This sets the stage for probable, strong public support for a major overhaul of the tax laws to remove that favorability and create a more balanced system. This not to say that Donald Trump did anything that was remotely illegal because he absolutely did not do anything that was against any law. He used the convoluted tax codes to his advantage. That’s all.
Most people without real estate experience don’t realize how the tax codes help investment real estate owner and developers. There are many ways but, most importantly the depreciation allowance and the tax deferred exchange provisions are major “tax shelters”. Looking at depreciation first, real estate owners can deduct, from taxable income annually, over the “useful life” of the building only (land is theoretically not depreciable) an amount that will “recapture” 100% over that “useful life”. Useful life for commercial buildings is generally codified as 39 years but there are methods for accelerating that recapture. Theoretically, this depreciation schedule simulates the gradual loss in value as a building deteriorates. However, the notion that buildings depreciate in value by 100% over 39 years due to deterioration is just not supported by the facts. The theory completely ignores that, over a 39 year period the odds are that a building will increase in value. Just in case that happens there is a recapture provision in the tax code that claws back any charged depreciation in excess of that actually incurred at the time of sale.
Now the tax deferred exchange comes into play. A property owner can “postpone” any taxable gain by just exchanging the property for another one of like kind with a greater value. Theoretically, the tax on the gain is deferred until the new property is sold and may be further postponed by another exchange. When the owner dies and leaves the property to heirs the property gets a “stepped up” basis and this avoids any capital gains tax on the asset.
The foregoing is an over simplification as the tax code is full of twists and turns. For example, property repairs are deductible in the year incurred but if the extent of repair is considered as a renovation for tax purposes, the cost may be required to be “capitalized” (added to the cost basis and depreciated over time).
Most people only experience real estate ownership through their homes. Homes may not be depreciated which is one major difference from investment property. Accordingly, depreciation write-offs have not been a popular focus. For the individual homeowner, the only tax benefit is the ability to deduct local real estate taxes (ad valorem taxes) and the ability to deduct mortgage interest (with some limitations).
There are transaction structures that greatly improve the ability to shelter income from taxes. And, it can’t be overlooked that investor/developers only invest a small percentage of the cost of an asset as they borrow the lions share from lenders. Thus, they depreciate the borrowed funds as well. That may be OK because they must repay the loan and pay the lender interest (also deductible) over the life of the loan.
To make tings more complicated there are “loss carry forward” provisions in the tax code that permit any loss (like Trumps almost $1 billion) to be carried forward for multiple years, to the extent they are not already charged. There is no basis for assuming that the loss carry forward provisions will remained unchanged in the next round of income tax legislation.
Years ago, syndicators tied up properties and sold them to investors who became limited partners in the property. Many of these transactions were so cleverly structured that no tax was incurred by the partnership with an excess “write off” available to the limited partners to apply to other otherwise taxable income for years to come. Many of these Master Limited Partnerships failed and the investors lost everything plus getting added tax problems. They were sold as “tax shelters” and were not always great investments.
INTEREST RATES: It is not a matter of whether interest rates begin an upward climb. It is only a matter of WHEN. When they do move upwards the spendable income from a property will diminish unless there is a corresponding rise in rents to offset interest cost. However, rents in many urban areas are already at unaffordable and unsustainable levels particularly when one considers the potential cost of doing business add-on of an increase in the minimum wage.
CONCLUSION: Donald Trump may think he knows more about our tax laws than anyone else and, thus is best equipped to fix them. But, that is an unsubstantiated boast. Real estate could be very vulnerable to a Trump Effect when the tax laws are redone as the overhaul will be designed to close all of the glaring loopholes which can only be a big problem for the very rich. Any material rise in interest rates should be expected to depress real estate values as such will increase the rates of return (capitalization rates) expected by investors unless there is a corresponding increase in rents to offset the effect of higher rates. In many parts of the country, rents appear to be reaching unsustainable levels, particularly in multi-family residential, in view of economic change. Retail rents may come under pressure as retail stores face continuing heavy competition from alternative retailers selling on the internet without the need for a retail store (think Amazon) or big box retailers located outside the CBD (think Costco and Wal Mart). Escalating office rents in central business districts coupled with technological advances via computers may result in causing less need and demand for offices as tele-commuting (working from home via computer) increases. Accordingly, increasing rents is not necessarily something that can be depended on. The bottom line is that there are reasons to worry about the current levels of value and price of investment real estate in the long term future.