The new year began with the most extensive revision of the U.S. tax code since 1986. While questions remain, its potential impact on the commercial real estate industry appears neutral-to-positive.
As a result, 2018 is shaping up to be an “unusually good late-cycle year for the commercial real estate industry,” says Spencer Levy, CBRE Head of Americas Research and Senior Economic Advisor.
Levy spoke with Blueprint, Presented by CBRE to discuss why the tax law and post-hurricane spending in afflicted markets like Houston and Florida are a few of the reasons for renewed optimism in 2018.
Blueprint, Presented by CBRE: The new tax law is foremost on peoples’ minds as 2018 begins. How big of an impact will it have on the commercial real estate industry this year?
Spencer Levy: There are key wins for the industry, both in terms of what the tax law will do and what it won’t do. It did not eliminate the 1031 exchange. It did not eliminate the ability to deduct commercial mortgage interest. It did not eliminate capital gains treatment of carried interest, though it did extend the hold period from one year to three years.
The tax law did make pass-through entities more efficient from a tax perspective. It made REIT dividends more efficient—meaning worth more—from a tax perspective. It changed some of the incentives on “buy versus rent” in the residential market—with respect to multifamily vs. single-family—to favor multifamily, because it raised the standard deduction to $24,000 for married couples, meaning most people won’t itemize mortgage interest anymore. It also topped out the ability to deduct mortgage interest from any mortgage over $750,000. So, at both the low end and high end of the market, multifamily is more attractive.
One sub-category that the tax law largely protected was affordable housing. The one caveat is that one of the ways affordable housing is financed is through selling affordable housing credits (Low Income Housing Tax Credit Program). Those credits are now worth less than they were before the tax plan, in large part because corporate taxes was lowered from 35% to 21%. There is legislation afoot right now to try to correct that. Overall, affordable housing made out well.
The key economic incentives of the new law are a reduction in the cost of capital by lowering corporate taxes and increased liquidity by encouraging repatriation of corporate profits currently held in overseas accounts. It’s very unusual to have that type of fiscal stimulus this late in the economic recovery cycle. Now that we have it, will this extend the cycle and enhance economic growth over the next couple of years? I can’t tell you whether it will, but I can tell you it gives us a better chance.
There are key wins for the industry, both in terms of what the tax law will do and what it won’t do.
Blueprint, Presented by CBRE: One sticking point of the tax law in high-tax states like New York is the change in the state and local tax (SALT) deduction. What impact will this have on the real estate market?
Spencer Levy: Limiting the SALT deduction has caused concern in higher tax states like New York, New Jersey, California, Massachusetts, Maryland and Connecticut. My basic reaction is don’t be too concerned about it. People and companies will remain attracted to those markets because of their high-quality talent, job opportunities, live-work-play environments and strong infrastructure. They were higher-cost markets in which to operate long before tax reform. Cheap real estate isn’t their attractiveness; it is their large pools of talent that attract companies and create job opportunities.
Blueprint, Presented by CBRE: How does the new tax law change job growth forecasts, if at all?
Spencer Levy: Large occupiers need to think about being agile in both individual-market and portfolio terms, including the length of leases, options to expand or contract space and the availability of talent. Occupiers should double down on commercial real estate in those submarkets where they expect to attract, retain and create pools of talent for their business. The current labor shortage in the U.S. is only going to get worse. The very low national unemployment rate is 50% lower in many of the high-skill trades. While being agile protects downside risk/cost overall, don’t put all your eggs in the “save money” basket. Rather, put many of your scarce resources into the “make money” basket of markets with deep talent pools. Agility is key in markets with unusual uncertainty.
Blueprint, Presented by CBRE: Is the CRE market in a late cycle?
Spencer Levy: There are objective signs that it is. The objective signs include the softening of Class A multifamily and office rent in most major metros around the United States; the decline of the net-effective rent in most of those markets, and I would say the decline in returns to CRE over the past year. The decline in returns from a capital markets perspective is because we are unlikely to see more cap rate compression.
The more likely scenario is either a flattening or an increase in cap rates. That means that investors need to shift their focus toward income returns versus capital markets returns because of the lower returns expected over the next several years. What they can also do is get a lower cost of capital by bringing in cheaper, foreign capital partners and by changing their debt capital structures. There are a lot things they can do to adjust to these market conditions. I think the key point here is that the next several years are expected to be a low-return environment overall for commercial real estate and investors’ weighted average cost of capital needs to reflect that.
Investors need to shift their focus toward income returns versus capital markets returns because of the lower returns expected over the next several years.
Blueprint, Presented by CBRE: When should we expect it to change to a high-return environment?
Spencer Levy: Generally, not for several years. In some of the high-growth markets where international capital is still not prevalent—markets like Nashville, Raleigh, Austin, Denver and Salt Lake City—there still is the possibility of some cap rate compression. But even in the multifamily sector, I think it’s mostly been baked in. Overall returns will be harder to come by unless you move out of the risk spectrum and you’re more selective about your market.
Blueprint, Presented by CBRE: You recently said that post-hurricane spending in afflicted markets is among the key reasons why you think 2018 will be a strong year for the CRE industry. Why do you think that?
Spencer Levy: The silver lining of most natural disasters is that you have to rebuild, and rebuilding means you have to spend money on raw materials and labor. Given the scope of the devastation in Houston and Florida, there will be a significant amount of fiscal spending to get those markets back into shape. Secondarily, a lot of cars were destroyed, so that created a lot of demand for automobiles. In short, most natural disasters spur short-term growth. Additionally, prior to Hurricane Harvey, Houston’s multifamily market was a little bit overbuilt and the market was softening as a result. That’s not the case anymore. It’s now a very tight market because many of the residents, whose homes were destroyed, moved into multifamily properties.
Blueprint, Presented by CBRE: Why wouldn’t companies in hurricane-prone markets relocate their base of operations to other, safer markets?
Spencer Levy: Let me put that one to rest. I have heard that argument. A real estate executive recently told me his company was selling everything it owned in Houston and Florida because of these storms. I told him, “Good. Sell them to me.” When we studied Houston and Florida after the hurricanes, as well as Mexico City after its recent earthquake, there was one word that characterized them: resilience. Commercial real estate in each of them weathered those natural disasters remarkably well, in large part because they had upgraded their building code over the past 30 to 40 years because of other natural disasters. So to look at these markets as dangerous places to do business from a commercial real estate perspective is absolutely wrong. They are vibrant and growing markets, and their commercial buildings are much more resilient than we anticipated.