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I have been trying to absorb as much information about the state of capital markets for Real Estate as I can. Reports on the “State of the Market” always pop up around the new year and I have been reading as many of them as possible. Below are a few interesting notes I have read.
Clearly, foreign investors are driving the investment in CBD properties. With a future of higher interest rates, investors cannot underwrite cap rate compression and are chasing more development, construction and suburban deals to get their desired returns.
Thanks in particular to REAL Capital Analytics for most of the data used.
Posted by Matt Brown, Director of Acquisitions
1031 exchanges have a huge impact on the real estate market. I was recently looking at a property for Scheer Partners to acquire but lost out to an out of town buyer who had to complete a 1031 exchange. My uncle recently sold his home in Maryland and bought a new one in California with 1031 money. Congress has even been talking about eliminating them in their tax reform package, although it appears they will remain solely for real estate transactions.
1031 exchanges account for approximately 30% of annual real estate transaction volume. Analysts estimate that eliminating the program would result in a short-term drop of 4.6% – 8.0% in property values.
Clearly the 1031 exchange program is bigger and has a greater impact on the real estate market than one might have anticipated so I decided to speak with David Christopher, CPA at our accounting firm, Santos, Postal & Company, P.C. (www.SantosPostal.com) for some more insight on how 1031 exchanges work and how they impact investors such as myself.
Can you quickly explain a 1031 exchange?
A 1031 exchange occurs when you have a sale of business or investment property (in most cases, real estate), in which you would normally have a taxable gain, but because you are reinvesting the proceeds of the sale in a “like-kind” (i.e., similar) property as part of a 1031 exchange, the gain on the sale is deferred.
A common misconception is that this is a tax-free transaction. Depending on future events, it could turn out to be tax-free, but initially, it is simply a deferral of the tax. Also, depending on the exact circumstances of the transaction, there may still be some gain that is taxable in the period of the exchange. For instance, if cash, or “boot,” as it is often called, is received, or if your debt on a property is reduced via the exchange, taxable gain may be recognized.
Why would an investor with 1031 money be able to offer a higher purchase price than an investor without it? Can you give some numerical examples?
Let’s look at two basic examples:
Example 1: Investor A sells a property worth $1,000,000. He has hired a Qualified Intermediary and they have identified a property he plans to exchange it for with a value of $1,000,000, owned by Investor C. In this transaction, ignoring brokerage costs, fees, and any other buying and selling expense, he will not need to come out of pocket at all for the new property. He will have no taxable gain.
Example 2: Investor B recently sold a property for $1,000,000 that had a gain of $200,000. He wishes to use his proceeds to purchase the same property from Investor C as illustrated in Example 1 above. However, because he had a taxable sale and will need to pay taxes on the amount of the gain, he needs to retain some cash to pay the associated taxes (we will assume a 25% combined tax rate, so $50,000). Therefor
Are there any limits to how much money someone can save or who can take advantage of this program?
There is no limit to how much tax you can defer with a section 1031 exchange. If you are exchanging like-kind property with values in the billions that would have taxes of millions, it is fair game. The primary limitation is that you must identify a like-kind property to consummate the exchange within 45 days of your property sale; and, then you also need to close on the new purchase within 180 days of your property’s sale. Also, while the definition of “like-kind” property is vague, cash is not like-kind to a building, providing another limitation. That said, land is considered like-kind to a building, or multiple buildings, so there is some flexibility.
There are other restrictions as well. As stated previously, 1031 exchanges are for investment or business property, not personal property. You cannot exchange your personal residence for another. And if you convert an investment or business property to a residential property and immediately put it to use as your personal residence, the IRS will disallow the transaction and all gains will be taxable.
What would you advise someone to do if they were selling a building and would soon have potential 1031 money to reinvest – what are the financial repercussions?
I would hope they have already consulted with their real estate broker, attorney, and certified public accountant. If not, these should be their next phone calls. Hopefully, a seller has already called the required professionals and is using a Qualified Intermediary for the sale, as well as keeping the sales proceeds in escrow. If they sold the property and have already received the proceeds or had a note paid off with the proceeds, it is too late to retroactively turn this into a 1031 exchange. The financial repercussions could be enormous as they would be liable for taxes on the gain of the sale. Assuming they were proactive and listened to their professional advisors, I would advise them to move quickly in identifying a property to acquire as there are tight deadlines, both in identifying the exchange property and for closing on the purchase. If they can identify a property and make a purchase within the allotted time period, they would be able to defer most, if not all, taxes due from their original sale, and the financial repercussions would be negated.
Please note, these decisions need to be looked at from more than purely a tax planning mindset. If you are buying a property through a 1031 exchange only to defer the taxes on a gain, but the new property turns out to be a poor investment, the cash flow implications over time could be worse than had you simply paid taxes on the gain of the original sale. Therefore, it is important for the investor to properly analyze and perform due diligence in their search for a new investment property.
Make sure this process is thought through completely. There are too many rules and guidelines to explain in this limited space. In our experiences, we have seen 1031 exchanges get reversed for errors made and misunderstandings on the part of the client or the Intermediary. If your readers learn nothing else, it is always wise to consult with professionals before attempting to engage in a Section 1031 exchange.
If you have questions about where to start, please feel free to contact me at firstname.lastname@example.org or contact David Christopher at either DChristopher@SantosPostal.com or 240-499-2067. We would be more than happy to discuss the process with you in greater detail.
Posted by Matt Brown, Acquisitions Analyst, with insight and thought leadership provided by David Christopher, CPA
I previously wrote about how many investors are proceeding with caution because assets are starting to command higher and higher purchase prices and that the market may be overpriced. I took this statement as factual because of the many accomplished industry veterans who alluded to this point. However, I wanted some stats to back up this claim.
First, I looked at trading volume in DC. According to a recent Real Capital Analytics report, volume of properties being traded in the Washington, DC Area is up over 5% year over year. This is a sign that investors see value in the market. Additionally, year over year prices for real estate assets are down 5%. The DC Metro area is one of only four global cities that has not seen overall prices increase since 2006 (along with Amsterdam, Tokyo and Chicago) and those other cities all had year over year price increases.
The building we have our offices in, 15245 Shady Grove Road, traded for $24.8 Million in May 2017. That is down from the $32 Million it traded for in August 2011 and the $33 Million it traded for in January 2002. Occupancy levels decreased significantly but so did the cap rate.
Prices are too high now because investors are more conservative.
If prices are too high – then they were WAY too high a few years ago.
What does this mean?
Investing in suburban real estate is not a clear vehicle for growth that it was once considered. Some properties are durable. Buildings in walkable, transit-oriented communities continue to see their valuations increase at the expense of their more remote competitors.
If you are investing in a property you better have a plan. Do you plan to convert it to self-storage (4 Research Place)? Do you plan to capitalize on unused FAR and favorable zoning and build residential on the property (700 Quince Orchard)?
The investors who will have success in this market are the ones with a specific plan that is unique or sees the property in a way that others do not.
What is it?
1031 Exchanges are a way for an individual to continually reinvest profits from one real estate venture into another without paying taxes on that gain.
Example: Say I purchased a property for 100 dollars and 5 years later it is worth $150. If I were a rich man I would have to pay the 20% capital gains tax on $50 gain. However, section 1031 of the IRS tax code allows that gain to be reinvested without being taxed. Now I have $150 that I can use as the 20% down payment on a $750 property. If that property appreciates, I can roll the profits forward again, continually buying more or bigger properties.
This is not a way to avoid taxes altogether because eventually, the IRS will get their money if you decide to cash out and sell all properties without buying a new one. However, if you can make a living off the cash flows the property provides, this is a good vehicle to grow and buy bigger and more properties.
Posted by Matt Brown, Acquisitions Analyst
I was fortunate enough to attend an event with DC’s “The Real Estate Group” last week. During the dinner, Dean Adler, founder of Lubert-Adler Partners LLP (http://www.lubertadler.com/managementteam.php), spoke to all attendees about some of his principals for investing. I thought many of them applied well to Scheer Partners and what we are trying to do with our acquisition and development platform.
Partner with Experts – Mr. Lubert said when he began to grow his company, his strategy was to develop close relationships with 2-3 excellent partners in each major US market. He believed that these local partners would always beat out two analysts from global firms who simply parachute into a market to execute a few deals. Deep knowledge of a specific market or product type are invaluable to him.
At Scheer Partners, we are an elite sponsor for any project in Montgomery County and any lab/biotech related project nationwide. Understanding our area of expertise and continuing to bolster that specific knowledge will continue to give us a competitive advantage over our competitors.
Learn from mistakes but MOVE ONE – Mr. Lupert lost a lot of money in the 2008-2009 Market Crash. He was in a daze for months just trying to see where he went wrong. He had recently developed a community of vacation homes that had been wildly successful but when the crash happened that investment went bust. Mr. Adler developed a new game plan based on new market realities. He went to equity partners such as university endowments who still had money to spend and convinced them the time was now to invest with him. These investments are a big part of why he is successful today. He learned from his mistake of investing in “discretionary assets” towards the end of a real estate cycle and immediately moved on.
At Scheer Partners we have successfully executed many projects in the DC Area. But there have been some investments that haven’s been home runs for one reason or another. A few things that we are very conscious of when investing now are realistic market rent growth, supply and demand factors that could impact the related job markets, the appeal of each unit in the project and where in the cycle we are for our specific product type. Learning from past mistakes has made us much stronger developers.
Reputation and Trust is Everything – Everyone involved in an investment must have complete trust in you as the general partner. Your word and ethics are everything. When Mr. Lupert went back to investors after the market crash, he says that the reason they invested with him was because of a long track record of being a faithful steward of their money. He may have been able to get a few deals done here and there without being an honest and ethical partner but his relationships would have suffered and he would not have been able to grow his business
At Scheer Partners we have had a reputation for not only getting results but for treating all of our partners honestly and with the highest ethical standards. We have had a presence in Montgomery County, MD for almost three decades and would not have been able to sustain this track record of success if we hadn’t built long term relationships based on trust.
Thanks again to the DC Real Estate Group for hosting a great event and Mr. Lupert for giving a valuable talk.
Posted by Matt Brown, Acquisitions Analyst
A few months ago, I attended a talk hosted by Bisnow “State of Montgomery County” and a conference hosted by IMN “U.S. Real Estate Opportunity & Private Funds Investing Forum”. It seemed that most investors were concerned about the rising cost of real estate. Many panelists spoke of where we are currently in the real estate cycle (https://www.crowdstreet.com/education/article/four-phases-real-estate-cycle/) and used the old baseball analogy of “what inning are we in?” The consensus is clear, we are in the later innings of the game or the “hyper supply” part of the cycle.
I had my own unique takeaway from these conversations. I think that these cycles are way too broad of a brush to paint with and cannot really be applied to current conditions. It is clear that developers are proceeding with extreme caution in terms of ground-up development. Instead, the flavor of the times is to reposition underutilized assets. Doing this doesn’t increase supply the same way a new building would. According to a quick CoStar search the 5- Year average for office space in Montgomery County (buildings above 10,000 SF) is 69.6 million SF. Currently, that number is only 70.3 Million SF. This 1% increase in supply doesn’t feel like “hyper supply”. Instead, repositioning assets and abandoning properties that served businesses of previous decades and creating more modern workspaces is occurring. This is creating more efficiency, not oversupply.
While my above statements apply to commercial office properties, I do believe that Multi-Family is likely in the “hyper supply” phase of the cycle. This product type has been the darling of the real estate industry for years now. In Silver Spring, MD there are currently 3,300 new residences planned for delivery (https://dc.urbanturf.com/articles/blog/the_over_3300_residences_slated_for_downtown_silver_spring/12858).
Maybe it is time to look at suburban office that has been neglected over the years and maybe it is time to sell multifamily assets.
Posted by Matt Brown, Acquisitions Analyst
This is Matt Brown, I oversee Acquisitions and Underwriting for Scheer Partners in Rockville, MD. I am starting this blog to share some of the insights I gather about real estate that I gain from conversations with industry experts, market reports, real estate conferences and our own personal successes and failures. I have the distinct advantage of working next to many of the best leasing and sales brokers in the industry on a regular basis. They provide me with real time information about what type of space tenants they represent are looking for and what landlords have effectively done to beat the competition. Also, I am fortunate to work with many of the best accountants and lawyers who provide me valuable insight into many of the finer points of real estate. Enjoy!
Posted by Matt Brown, Acquisitions Analyst
The area of North Rockville has gone through cycles of being an active and thriving market to the highest sustained vacancy rate in suburban Maryland. Nonetheless, it is still the nexus for a highly skilled workforce, and offers convenient access to exploding developments and prime real estate. Looking at Shady Grove, the area is presently undergoing some exciting expansion. On the East side: Mom’s Organic Market and a new CVS are now in full swing at Shady Grove Road and Choke Cherry Road. 1788 Holdings/Lantian Development is in the planning phase of redevelopment of seven existing office buildings.
Moving over the West side, PS Business Parks is laying out plans for their 75 spec suites – a sweet opportunity for tenants in the market for space. The suites will range from 1,500 – 7,500 of square footage.
And, the National Cancer Institute is poised for their next major expansion!
The open houses for the Bus Rapid Transport (BRT) have begun in Montgomery County last week. Which means that slowly but surely BRT will be coming to our county—and it could not come faster in my opinion. BRT will help connect businesses, provide transportation options, and expand where organizations can recruit to further their growth.
How does Montgomery County remain competitive with markets like Boston? Sure, we are able to compete when it comes to an educated workforce, access to universities and colleges, and actual space for businesses to operate. We have the distinct advantage of direct access to the federal government and agencies. If you line up the pros and cons of both markets—the winning piece would be who can solve the transportation equation the smartest and the fastest.
In the recent weeks, the mayor of Boston released his transportation plan titled Go Boston 2030 which is intended to improve transportation within the city and address a multitude of existing transportation challenges. Read the article here.
So here is the deal—it is time Montgomery County moves quickly and efficiently in solving our transportation challenges. Ease of navigating the county roads, the ability for employees to access their workplace economically and efficiently is one of the biggest recruiting challenges for major corporations. If we do not begin to move forward with the BRT and other transportation options, we will continue to lose out to other major markets—especially frustrating to me and many others because this region is ripe for explosive growth.
Those Seeking Results-Focused Real Estate Solutions Should
Scheer Partners capped off a successful 2016 and will continue to deliver comprehensive real estate solutions to the region in 2017. How will Scheer Partners achieve this? By elevating the firm’s entrepreneurial spirit and capitalizing on the staff’s talents and expertise.
Here is who was promoted:
Brian Bouey promoted to Vice President and Chief Operations Officer. Brian will be directly responsible for Property Management activities and overall operational duties of the firm, including IT, Human Resources, and Administration.
Matt Brady has been promoted to Senior Vice President and Sales Manager. In his expanded role, Matt will be responsible for day to day business development activities for brokerage, construction management and property management services.
Claudia Yates has been promoted to Creative Director & Operations Manager. In her expanded role, Claudia will oversee the firm’s day-to-day operational functions, as well as provide creative direction for client interaction.
New hires include:
Matt Brown joined Scheer Partners as the Acquisitions Analyst. Matt will be supporting the firm’s expansion in development and acquisitions.
Maurice Anderson joined the firm as Property Administrator. Maurice will support property management activities.
Michelle Corrado joined as Assistant Controller. Michelle will support the accounting department.