Information contributed by David Levin of NAI Ruhl Commercial Company.
Multi-family is coming off another record high year, both in terms of growth and sales volume. Per unit sale prices, once again, rocketed up in the fourth quarter after holding fairly steady most of the year.
Multi-family continues to outperform other property segments and has the lowest vacancy rate of all the major property types at 5.2%. It still accounts for the second-largest share of institutional investors’ real estate holdings, behind only the office sector.
Although the national vacancy rate for multi-family property is projected to increase to 5.6% in 2017 and to 5.7% in 2018, that still is below the 15-year average vacancy rate of 6.1%, according to CoStar Group.
Meanwhile rental rate growth is expected to moderate over the next two years to 2.3% in 2017 and 2.2% in 2018, but will remain above the 15-year average growth rate of 1.9%.
Demographics tend to contribute considerably to the growing popularity of renting. According to a study published by the Joint Center for Housing Studies of Harvard University, the increase of 9 million rental households the U.S. has experienced since 2005 is the largest increase in any 10 year period on record.
One key demographic segment that has contributed to the change in multi-family are the Millennials. As a whole, Millennials are delaying marriage and children, and are buying homes later in life. This has a major effect on the renter pool nationwide. Also, many Millennials are carrying a higher load of student loan debt, which makes financing a first-time home purchase difficult.
Local Multi-Family Market
There has been very little multi-family investment sale activity in the Quad Cities during the past three years. There currently is limited inventory available for sale and investment opportunity. Those that own quality complexes are electing to retain ownership. Occupancy of most quality and well located complexes is well into the 95% range and most downtown market-rate loft units have a wait list.
There also has been very limited development of new market rate complexes. Most likely, this is due to the cost of new construction outweighing the rent tolerance of tenants, as well as difficulty in obtaining commercial loans.
Capitalization rates remain historically low in the multi-family sector. Based on the latest NAR report on Realtors CRE markets, capitalization rates averaged 7% across all property types, a 50 basis point decline on a yearly basis. Apartments posted the lowest cap rate, at 6.5%, with Class “A” apartment transactions recording average cap rates of 6.2%.
Commercial investment property sales volume in 2016 fell about 11% over 2015. In 2016, investors pulled back from larger investments due to the election and an uncertain economy. Perhaps the biggest challenge in 2016, especially so in our regional market, is a lack of product to purchase that meets the investment criteria of buyers.
However, 2016 still was a strong year for investment sales volume, according to Rene Circ, director of research at CoStar Strategy Group. Last year also marked a change in investor preferences from primary to secondary markets, as secondary markets now offer higher returns.
Local Market Investments
2016 was a quiet year for investment transactions in the Quad Cities. With several retail strip centers changing hands in 2015, it left very few retail investment opportunities. Notable transactions include the sale of JMF in Bettendorf, Goodwill Industries in Moline, and NAPA Auto Parts in Moline.
The number one challenge for investments in the Quad Cities is the lack of available inventory. A stronger leasing market for retail nationally and the knowledge that there are solid investors pursuing leased product, has encouraged developers to continue creating projects to fill the pipeline.
As a new Administration and Congress are up and running in Washington, D.C., we cannot predict what changes might happen with the Real Estate sector of the economy, however we do have some insights from the National Association of Realtors for 2017.
Until recently, the mortgage interest deduction was protected by lawmakers on both sides of the aisle. Backed by the powerful National Association of Realtors and supported broadly by middle-class homeowners, previous efforts to dismantle the mortgage deduction have gone nowhere.
When investors or businesses structure their asset sale and replacement purchases as 1031 Tax-Deferred Exchanges, they are able to defer paying capital gains and recapture taxes. The 1031 Exchange is a powerful tool that encourages people and entities to re-invest their profits into newer, more productive property, stimulating business and economic growth. However, it is very possible that 1031 Exchanges could be repealed or limited if they are included in upcoming tax reform bills.
The House Republican Blueprint for Tax Reform, titled “A Better Way” is expected to be the model for tax reform in 2017. The proposal pairs 100% immediate expensing with unlimited loss carry forward for all tangible & depreciable personal property assets and real estate improvements, except land. The proposal would also eliminate the business interest expense deduction. While the proposal does not repeal Section 1031, neither does it expressly preserve the provision.
The last comprehensive revision of the U.S. tax code was in 1986, when President Ronald Reagan signed the bipartisan Tax Reform Act of 1986. Since then, income tax rates have increased and the code has become more complex, leading many political leaders to call for a rewrite and updating of the current tax code. Goals for tax reform are varied, but include simplification, increasing the global competitiveness of American businesses, promoting job growth, and increasing the fairness of the tax system.
The changes to carried interest structures would significantly increase the tax liability for investors, an increase of somewhere between 13% and 19.6%. The problem is, in real estate there are different types of partnerships, different types of carried interest, and different amount of risks for investors. The issue isn’t black and white and the reform to carried interest shouldn’t be either. If the reform is included, real estate partnerships and joint ventures may take a big hit adding disruption of many local property markets, harm to both tenants and owners, and potential job losses.
That impact not only hits the real estate industry hard, but the entire economy. Over a 10-year span, we’re talking up to an estimated $131 billion decline in U.S. GDP, according to a 2015 analysis by Ernst & Young. The same study estimates that investments would drop by $7 billion, and labor income would fall by $1.4 billion in the long-run.
This tax reform, as it is now and with the repeal of Section 1031, brings up some serious questions. Is this going to create a ripple effect on other industries? Will this result in contraction of our economy? What are the negative impacts on small businesses and start-ups? Ultimately, will these negative impacts on the economy be offset by lower tax rates? Only time will tell.