Trends in real estate—inventory, housing starts, financing and market dynamics—affect practitioners and clients in a number of ways. Here are some issues to keep an eye on.
Valuation and Starts
The U.S. Census Bureau (USCB) publishes a monthly update on housing starts (the number of new houses begun during a particular period). These data reveal that housing, particularly in populated areas, will remain robust for the foreseeable future. Rising valuations often increase starts and can be a barometer for supply-demand imbalances as well as some evidence of “hot” markets even among existing homes. Urban markets in general have shown strength across all demographics, as baby boomers have less reluctance than their parents did about moving to dense metropolitan areas for lifestyle and health care reasons.
That being said, urban markets also pose unique problems for planners. Often, they must consider rent control ordinances in valuations attendant to the wealth planning process. For instance, rent control restrictions can depress valuations, which is desirable in an intrafamily transfer. Some urban markets also have co-ops, which require board approval from the cooperative to transfer ownership of an urban apartment to another person. The junior generation or anyone to whom the apartment is to be sold must qualify for approval of the transfer by the board. A planner should anticipate client mobility in these markets, placing greater importance on maintenance of the funds as clients move, refinance or acquire new properties (including rental properties and vacation homes).
Residential markets are likely to remain strong for the rest of the decade. Prior to the second quarter of 2017, public and private sector construction spending was at its highest level since the financial crisis; however, there are signs, as of April 2017, that spending may begin to level off or slow down.
National Real Estate Investor identifies five trends in U.S. commercial real estate markets in 2017: (1) global political and economic uncertainties; (2) low interest and cap-rate environment; (3) foreign investment in the United States; (4) slowing new supply; and (5) volatile energy markets. For planners and attorneys, such trends are good news. We’re likely to see deal volume continue to accelerate, accompanied by the need for more specialized expertise among advisors. Planning in a way that preserves cash flow for senior generations while shifting growth and appreciation to junior generations will remain the theme of most ownership and wealth transition plans of commercial real estate wealth.
Office: On a national level, office investments rank fairly low in future trend evaluations and surveys. For family business owners and their advisors, the office building is generally part of a portfolio that includes the business that’s headquartered in the building itself. Separating ownership of the building from the business is common. The brand of the firm is associated with the building, and the senior generation can guarantee some security in its fixed-income retirement from the long-term lease of the building to the business, soon to be owned and managed by the junior generation.
Retail: While some are discerning ways to integrate their online sales with the retail showroom, there’s little evidence that retailers such as Sears, JCPenney or Kohl’s are making progress that’s increasing sales. On the contrary, it seems likely that retail landlords will have very troubling challenges in the future.
For the advisors, paying attention to force majeure clauses, renegotiating leases (when the client is the operating business, as opposed to the landlord) and developing a strategy for handling competition from online sources are critical. The shopping center and strip mall are depreciating assets in more ways than one. Looking for opportunities to repurpose properties, government and land use permitting to adapt the property to the changing climate will increase—meaning that developing expertise in these areas will benefit the advisors and attorneys of the owner families.
Research and development (R&D)/light industrial and industrial: The newest favorite real estate investment type is industrial. The reasons arise out of strong demand drivers (anticipating increased domestic spending infrastructure and repatriation of corporate profits into domestic industrial sectors), as well as difficulty starting new industrial projects (environmental regulation, “NIMBYism” and construction costs).
From the advisor’s perspective, expect to see growth areas in environmental regulation, permitting and land-use issues. If the family owned the business leasing the property, and it’s essential for the functioning of the business, ensuring the proprietary use is locked up with long-term leases will be critical. If the risk profile of the business is high, then the usual asset protection steps (special purpose entities) should be taken to separate creditors of the business from creditors of the real estate.
If the property isn’t necessary for the family business, anticipate liquidation by way of sale after the death of the owner. This will allow the step-up in basis with a reduction of the capital gains tax when sold by the junior generation. Consider equity stripping by way of third-party loans, with the liquidity used to reinvest in non-correlated investments, perhaps using a traditional family limited partnership, from which partnership interests can then be gifted or sold.
Minerals, oil and gas and mining: While the oil and gas sector continues to remain volatile, many long-term investors see the depression in this sector as a buying opportunity. Oil and gas has never been an investment for those seeking safety. Depending on market pricing, however, there may be intergenerational gifting and sale opportunities to lock in lower pricing for transfer tax purposes.
Income Tax Policy Proposals
Limitations on itemized deductions, state and local tax and interest deductions: Income tax changes are probably coming, whatever their form or wisdom. The idea of “simplification” is again the call. There are two well-known and covered policy platforms—the “Trump plan” proposed by the President and the “Brady-Ryan Blueprint” proposed by House Republicans.
This time, the targets for change include the property tax and state income tax lines on Schedule A (itemized deductions) that detrimentally impact residents of higher tax “blue state” jurisdictions, which are presently underrepresented in the halls of federal political power. That is, the high income and property taxes of these states would no longer be deductible, thereby increasing the taxable income of residents from primarily Democratic states. Further, while one plan seeks to keep the mortgage interest deduction (important for residents who must borrow $600,000 or even $1 million or more to purchase a home), proposals to limit the interest deductions to a fixed amount have been floated.
From the planner’s perspective, undue reliance on these deductions in calculating cash-flow projections of planning strategies is risky. While rates may go down to offset the high taxable income, there are no guarantees in the sausage making that is legislation.
It’s, therefore, important to consider whether your client might be better off converting the vacation home to a rental property, for example, so as to be able to deduct the property taxes and interest expense against the income these properties may generate. So long as the client owner can limit his use of the property to two weeks per year, most tax preparers are comfortable characterizing such properties as investment income properties, with the corresponding tax benefits of Schedule E over Schedule A.
Changes to depreciation and expensing rules: The Trump plan has changed significantly from the Detroit Economic Forum in August 2016 to various later iterations, so where exactly he stands on this issue is unclear. However, consider that some of the iterations suggest changes to the depreciation and expensing rules that might make it easier to expense capital improvements at the “cost” of losing the interest deductions on loans taken to perform those improvements. Stay tuned.
Carried interest changes: One of the two pending proposals will change the so-called “carried interest rule,” by which certain managers of partnerships who are compensated with appreciating interests in the partnership will no longer receive capital treatment of their income (which by some economic measures appears to be compensation but is taxed as capital gain). This rule affects the small property manager taking an interest in the partnership holding the property just as much as the Wall Street hedge fund manager. There are signs this game may be over.
What this means for advisors is that partnership allocations in operating agreements (or partnership agreements) should be changed to comport with the parties’ desired economic relationship. This might mean elimination of the carried interest altogether, perhaps through redemption transactions, or it might mean some sort of income “gross up” to account for the manager’s newfound tax liability associated with his ongoing management of the interests.
Preferential treatment for pass-through entities: Both plans suggest that a lower corporate rate (15 percent or 20 percent, depending on the proposal being reviewed) should be accompanied with a similar rate for pass-through entities, such as S corporations and partnerships. To prevent abuse, it’s likely the changes will be accompanied by guidelines for distinguishing investment returns (taxed at a preferential rate) from compensation (taxed at compensation rates and subject either to the Federal Insurance Contributions Act or self-employment tax, as the case may be). That being said, many professionals are suggesting that clients “unemploy” themselves so as to act as contractors or business entities and receive their income by way of the pass-through entity (K-1), as opposed to a W2 or 1099. Whether this is a viable strategy is unclear, and further, whether the public policy of decentralizing private sector employment is a good thing is debatable.
Planners must be on their toes when confronting the ever-changing landscape of government and industry as it pertains to the real estate market. While asset valuation increases can make the purchasing fool seem a genius, traps remain for the uninformed, sloppy and under-advised client. Advisors are expected to anticipate these, forecast the future and properly advise such clients.
This is an adapted version of the author's original article in the July 2017 issue of Trusts & Estates.