You may be hard pressed to find professional real estate investors that do not think a recession is coming in the near future. We’ve aggregated a short list of the top issues and questions real estate investors face as they look to deploy capital in 2019. Our hope is that you are better armed to create risk adjusted returns and protect capital in your portfolio.
In the short term, the Tax Cuts and Jobs Act boosted markets and masked some underlying political problems regarding trade wars, federal budgets, and income inequality. Risk assets are trading at historically high prices and have seen some volatility. That combined with changing social issues like the large political backlash against Amazon’s HQ2 in New York City (Goodman, 2019) have created some skepticism in real estate markets. After the longest bull market in US history, recent volatility in domestic equity markets has prompted the Federal Reserve to freeze its rate hiking plan. Today, the ability of the federal government to act in the same way to lower rates or buy securities is lower than before the crisis. Longer term problems are drawing more emphasis as well. For example, a Bloomberg survey of US CEO’s shows the majority of fortune 500 CEOs anticipate a recession in the next two years. The adage that, “bull markets don’t die of old age” might ring true, but today’s market can be generally characterized by rising uncertainty. Real estate investors have capitalized on year-over-year growth since the recession, but now prospective returns are low, asset prices are high, and funds are engaging in increasingly risky behavior to generate the same level of return.
High Debt Recent Loads:
Private debt issuance has swelled to record levels. Since the financial crisis private debt funds have stepped in to a lending position that large traditional banks used to hold. This shift is notable for many reasons but perhaps most of all because the transparency afforded by large systemically important financial institutions (SIFI) in their lending practices has been replaced by more opaque private vehicles with lower reporting requirements. According to the Mortgage Bankers Association, debt funds originated about $67 billion in mortgages in 2018 versus only $32 billion in 2016 (Fitzgerald, 2019). Investor sentiment has shifted toward a lower appetite for equity positions in real estate and created an environment that, with still very low interest rates, favors debt investments. The historically cheap money has also had an impact on tenants. The size of the domestic bond market is $41 trillion dollars with around $9 trillion in corporate debt (Zacks, 2018). The increase in total debt, decrease in transparency and the decreasing long-term possibility of rolling over these debt obligations at continued low rates may be cause for some concern late in the business cycle.
Over Priced Assets:
Most people with a retirement fund have at least some exposure to the S&P 500 or an S&P 500 index tracking fund. The current P/E ratio of the S&P 500 is 20.76x, which means an investor is essentially buying an extremely liquid, low cost and highly diversified index fund at a cap rate of around 5%.
As an investor, which asset has a more favorable risk/reward profile? According to JLL’s H1 2018 U.S. Investment Outlook , industrial assets in San Francisco, California have a 5.0% cap rate . Both are risk assets that look expensive on a historical basis. The long-term average (since inception) P/E ratio of the S&P 500 is 15.35x, or roughly a 6.5% cap rate.
At the 36th Annual Cornell Real Estate Conference last October, several real estate executives from New York’s largest financial institutions stated that commercial real estate investors have been drifting further out into the risk spectrum to achieve their funds target return objectives, taking on more risk for the same return. As asset prices indicate changes to the broad economy, some investors could see challenges selling into rising cap rates. When cap rates are so low, a few basis points in either direction can have an outsized impact on return metrics versus a the impact of a shift of a few basis points in a high cap rate deal.
Changes to Tax Code:
Political proposals to increase taxes on the wealthy have been picking up steam in the press. One tax question that remains understudied, however, is how a massive increase in taxes for the wealthy would impact LLCs. As pass-through entities that are commonly used to hold real estate assets, the fact that income (or loss) flows directly to the LLC members or partners could become a large tax liability in the real estate world. If the highest earners saw their tax bracket jump from 37% to the 70%+ rate that the U.S. had in the 1960s and 1970s, we could see a rush to convert LLCs into corporations, which are taxed at 21%. The issue of double taxation on employee compensation would still have to be resolved, but at least retained earnings could be distributed in a more tax efficient way at the discretion of corporations. The Tax Cuts and Jobs Act (TCJA) has also created some potential uncertainty in real estate tax treatment. For example, Internal Revenue Service (IRS) code Section 179 deals with depreciation deductions and new changes that have caused many tax planners to struggle when advising their clients on the new code. The TCJA allows for bonus depreciation deductions and some big initial write-offs at the beginning of a real estate holding period. The rules regarding depreciation recapture upon the sale of that depreciated property (after large deductions) can mean being taxed at the ordinary income rate, which is commonly higher than the corporate rate (Bischoff, 2019).
Wrap-Up:
Financial leverage, overpriced assets and changing political policy have the potential to impact investment returns for better or worse. Over a decade after the beginning of the financial crisis in 2008, many investment managers now only have investment track records built during the unprecedented recent economic expansion in their investment pitchbooks. Historically, recessions begin at a time, and by events, that relatively few people seem to predict. Being prepared and carefully considering the future separates great managers from good managers.
Works Cited:
Bischoff, B. (2019, 02 19). What real estate investors need to know about tax law changes — including the potential downsides. Retrieved 02 23, 2019, from https://www.marketwatch.com/story/what-real-estate-investors-need-to-know-about-tax-law-changes-including-the-potential-downsides-2019-02-18
Goodman, J. D. (2019, 02 14). Amazon Pulls Out of Planned New York City Headquarters. Retrieved 02 23, 2019, from https://www.nytimes.com/2019/02/14/nyregion/amazon-hq2-queens.html
Isaksen, G. (2018). Converting Cap Rates to Earnings Multiples. Retrieved 02 23, 2019, from http://ashworthpartners.com/converting-cap-rates-to-earnings-multiples-2/
Jones Lang LaSalle (JLL). (2018, September 01). US Industrial Outlook. Retrieved 02 11, 2019, from https://www.us.jll.com/en/trends-and-insights/research/us-industrial-investment-outlook-h1-2018
Research, Z. I. (2018, 05 14). Bond Market Size Vs. Stock Market Size. Retrieved 23 2019, 02, from https://finance.zacks.com/bond-market-size-vs-stock-market-size-5863.html
