Over the last year, elevated uncertainty generated by the range of potential government policy changes, including tax laws, caused many investors to move to the sidelines. A more cautious outlook pervaded the real estate industry as investors awaited clarity on taxes, fiscal policy and a change in Federal Reserve leadership. This perspective begins to ease as the implications of the new tax law firm up and investors better understand how the new rules will affect their investments. The new tax plan offers generous tax cuts to corporations and pass-through entities such as Limited Liability Companies, and investors may see the new tax rules as an opportunity to reconfigure their portfolios. The new tax structure will apply to 2018 income for tax filings in 2019.
Locally, the impacts have only started to be realized. Many thought that Q1 of 2018 would be a continuation of a very active Q4 2017. A president with a pro-business reputation and a real estate background had many in the real estate community expecting an explosive start to 2018. However, the complexity of the new tax code caused many investors to take some time for the dust to settle before making any moves. Local investors felt that making a mistake was much worse than missing an opportunity.
But recently, both available inventory of investment properties as well as average time on the market have expanded. Buyers are seeing more options to invest in our local market. As a result, we saw a strong Q1 but not as strong as we forecasted. Year-over-year, we experienced approximately 15 percent more investment real estate sales in Arizona than we did in Q1 of 2017.
Starting in February and March, we’ve seen investors move with more clarity and confidence. The flurry of activity has yielded an accelerated timeline for many buyers and sellers to capitalize on current market conditions. On a local level, our office is forecasting a significant increase in the number of transactions completed year-over-year in April and May.
New Tax Law Retains Key Provisions for Real Estate Investors
The highly anticipated tax reform recently signed into law by President Trump retained numerous key commercial real estate provisions. The 1031 tax-deferred exchange, the mortgage interest deduction for investment real estate and asset depreciation had few material changes. This consistency in tax law will enable investors to move forward with most of their existing investment strategies. That said, there are many provisions in the new tax law that will have a more nuanced effect on the sector, and these more subtle adjustments could create significant new opportunities for real estate investors.
The big news here for Arizona is consistency and clarity. There was a significant fear that the IRS code 1031 Tax Deferred Exchange could be modified or removed entirely. As a result, the CRE industry overall, and specifically in Arizona, would be negatively affected by a slowdown in transactional velocity. With fewer motivating factors for buyers to acquire like-kind properties, demand would wane and prices would fall.
Instead, we’ve seen a significant uptick in activity, especially in 1031 sales. Citing figures from our firm, since the number of 1031X sales in the U.S. is not published: In a typical year, 32 percent of Marcus & Millichap’s sales include a tax deferred exchange buyer. In Q1 2018 69 percent of our transactions included a buyer that was leveraging his ability to defer capital gains with a like-kind exchange, compared to 42 percent in Q1 of 2017.
The recession was incredibly challenging for commercial real estate in Phoenix. Economic stimulus, historically low interest rates and strong net migration has led to strong investor demand in the last 60-plus months. These trends combined with improving operations and investor optimism have yielded rapid appreciation for many assets in our local market. The 1031X provision continues to incentivize buyers and sellers to transact, thus benefiting the local economy and capital flow into the great State of Arizona.
Reduced Taxes on Pass-Through Entities May Boost Capital Flows
Perhaps more important than the modest changes to the core commercial real estate tax rules that investors have been most focused on is the reduction of taxes on passthrough entities. Owners of these types of companies will enjoy a 20-percent deduction on pass-through income, though there are several restrictions that will apply to this deduction. This favorable tax treatment will encourage investors to increasingly focus on after-tax yields when comparing their investment alternatives. On an after-tax basis, commercial real estate could offer a much stronger risk-adjusted return than options such as dividend stocks and bonds. This could entice additional passive capital to flow to the sector through syndicators, partnerships and other passthrough funds. This influx of capital, should it manifest, could place downward pressure on cap rates.
In Phoenix, despite increases in interest rates and spread compression, investors are flocking to commercial real estate investments due to increased cash flows and consistent volatility in alternative investments.
More discretionary income is causing business owners to reassess appropriation of capital. We’re currently engaged in a multitude of conversations with local business owners to expand into additional space, add new or updated equipment and new jobs to grow revenue.
Business interest deduction changes are inspiring companies that occupy the real estate they own to seriously contemplate sale-leaseback scenarios. This strategy allows business owners to maximize return on their investment, convert their illiquid equity into liquid cash, and structure a lease that maintains long-term control of the building as if they still own it. This is a favorable strategy for many because interest is only partially deductible for most business, whereas lease costs tend to be fully deductible. For real estate investors, mortgage interest can be deducted; however, it will affect the depreciation timeline.
Accelerated depreciation on certain assets have many owner-users reevaluating their exit strategy because they can realize these tax benefits immediately in lieu of the typical depreciation schedule.
Tax-Induced Behavior Changes Will Be Meaningful
In addition to the direct effect the new tax law will have on commercial real estate investments, indirect effects could be equally important. The increased standard deduction and limits on local property and income tax deductions could significantly alter housing demand and behavior. At the same time, the elimination of the personal mandate of the Patient Protection and Affordable Care Act could impact long-term demand for healthcare real estate. The new rules could also spark increased consumption spending and more business investment into infrastructure.
Changes to Carried Interest could slow the pace of construction because developers who use the Carried Interest provision will need to hold the assets for three years instead of one to treat their profits as capital gains.
Investor sentiment indexes have increased dramatically since tax reform was passed. Here in Phoenix, the explosion of multifamily developments evidences that optimism surrounding multifamily operations has increased, the optimism due to expectations of longer-term tenant retention. As a result, some Phoenix investors have become more bullish with assumptions and pro forma scenarios forecasting more favorable returns and higher prices.
Changes to carried interest have some Phoenix investors altering their strategies to extend their ownership timelines. We expect there to be slightly fewer transactions over the next 36 months as developers and syndicators who utilize carried interest will have to decide whether to hold for three years or see their gains taxed as ordinary income.
Tax Law: Changes Impact Behavior and Real Estate Investment
Apartment demand is likely to rise. The previous tax rules created an economic incentive to purchase a home through itemized deductions. If the mortgage interest and property taxes exceeded the old standard deduction of $12,700 for married couples ($6,350 for individuals) then taxpayers received a reduction to their taxable income that effectively offset a portion of the housing payment. The threshold home price to receive this benefit naturally depended on interest rates and local property tax rates but was in the $200,000 range for married couples. Under the new tax law, the standard deduction has been raised to $24,000 for married couples ($12,000 for individuals), and as a result the threshold home price to benefit from itemized deductions has increased to the $400,000 range for married couples. Because the threshold has increased well above the median home price in most metros, there will likely be a modest reduction of first-time homebuyers, lifting apartment demand.
Long-term prospects of healthcare real estate will soften. The elimination of the personal mandate, a provision of the Affordable Care Act that required people to have health insurance, will reduce the total number of insured by 13 million people over the next 10 years. As a result, about 5 percent fewer people will have health insurance compared with the number that would have been insured if the personal mandate were retained. This will modestly reduce the future demand for healthcare, implying a slight downshift in demand for healthcare real estate compared with projections with the personal mandate. Nonetheless, the aging population will still increase demand for healthcare services over the next 10 years, just not as much as would have occurred with the personal mandate in place.
Market liquidity could rise; net-leased properties are positioned favorably. The newly introduced 20 percent deduction on income from pass-through entities could invigorate investment in real estate. On an after-tax basis, the yields offered by the sector will be even more compelling than under the previous tax structures. New capital could enter commercial real estate through syndicators and investment funds that are structured to capitalize on the pass-through advantages, but some new investors will enter the market with direct acquisitions. The additional capital will undoubtedly flow across a variety of property types including apartments, self-storage facilities, and retail, office and industrial buildings, but a segment that could attract a disproportionate share of the investment is single-tenant net-lease properties. These assets, often occupied by high-credit tenants on long leases, afford passive investors compelling yields that could be structured to benefit from the new pass-through tax rules. In addition, because these types of properties generally require minimal management and are available in a wide range of price points, they are well positioned for passive investors.
Expanded expensing rules benefit niche real estate. Changes to the Section 179 depreciation rules will favor several niche real estate investments. Under the revisions, business owners will be able to fully expense up to $1 million of depreciable tangible personal property used to furnish lodgings. This change will allow investors with investments such as hospitality, student housing and seniors housing to deduct the full cost of furniture placed in service at their properties rather than depreciating them over multiple years. The rules also extend to roofs, heating, ventilation and security systems in non-residential property. This provision is largely targeted toward small businesses, so the deduction phases out as business investment purchases exceed $2.5 million.
In general, the new tax laws should boost economic growth a bit; we anticipate growth in the 3-percent range. This should bolster wage growth and consumption, but the very low unemployment rates will restrain the pace of hiring.
On the residential side of real estate, a housing market slowdown could offset growth. The restructuring of the tax rules will likely weigh on the owner-occupied housing market, particularly in states with elevated home prices and property taxes. The new tax law affects home sales in several ways: The increased standard deduction will modestly restrain first-time homebuyers, while limitations on the deduction of state and local property taxes will weigh on upper echelon housing, particularly in California and states in the Northeast. The introduction of a lower limit on mortgage interest deductibility, now $750,000 instead of $1 million, will also weigh on higher-priced home sales. Since the recession, the housing market has contributed about 3 percent to economic growth, about half of the sector’s contribution levels of the early 2000s. Under the new tax law, housing’s contribution will likely weaken.
John Chang is First Vice President of Research Services with Marcus & Millichap Real Estate Investment Services, provided the broad-view analysis of the tax act and the economy. Ryan Sarbinoff, vice president and regional manager in Marcus & Millichap’s Phoenix office, provided the facts on real estate and real estate investor activity in Metropolitan Phoenix.
This article goes with Cross-Border Real Estate Investing.