Tax Bill Adds Big Fuel to the Real Estate Boom. Too Much?
There’s no doubt that real estate is a big winner in the new tax bill. But does this tax boon come too late in the boom?
In his first landmark legislative achievement since taking office, today President Trump signed the sweeping tax overhaul passed by the House and Senate—the Tax Cuts and Jobs Act. The $1.5 trillion bill is also the first comprehensive amendment of the U.S. tax code since Ronald Reagan’s effort in 1986, and opens the door to greater returns to real estate investors in addition to preserving and/or improving upon most of the existing tax breaks for real estate investors.
Consensus among industrial analysts formed quickly to forecast that the new tax code will increase investment into real estate assets. Residential, commercial and industrial real estate owners, investors and developers will all feel a stronger tailwind in the days and years to come. Commercial, multifamily and industrial segments will greatly benefit from additional capital that will be attracted by lower tax payments and therefore higher returns. Not only will individuals, corporations, REITS and other real estate players stand to gain, but the entire investment universe will reevaluate real estate’s place in their portfolio. Many have real estate somewhere in their portfolio, but in a chronically low-yield world still starving for return real estate is going to look very attractive.
Breaking Down the New Tax Bill
BL has been tracking tax reform for several months, and shared concern that some provisions of the bill were counterproductive and could cripple essential components of the capital stack and severely hamper development finance. The final bill avoided some of the worst case scenarios as changes were made in the end. Here’s some of the important takeaways for the real estate and redevelopment community from the new tab bill:
State and Local Tax Deduction (SALT) Capped
SALT deductions for up to $10K in property taxes, combined with either income or sales tax, were included in the final legislation. This is better than some feared, but some analysts say a fixed $10K cap puts the important deduction beyond the reach of the millions of middle class families who live in high cost markets and will see their taxes increase because they will no longer be able to deduct their local taxes.
*NB*Commercial property landlords will still be entitled to a full mortgage interest deduction
New Tax Rates
Many commercial property owners will also benefit from a reduction of the corporate tax rate of 21 percent. And pass-through entities such as LLCs and partnerships, ubiquitous in the commercial real estate industry, will benefit because partners in such entities will now be taxed at their individual tax rate less a 20% deduction for business expenses.
Public Municipal Bonds Tax Exemption Saved
Once threatened to be wiped out, but included in final bills in both chambers, thousands of local leaders voiced their concern of the consequences killing the tax exemption on publicly issued municipal bonds would have.
The 1031 Exchange Provision Remains
The bill reduces the depreciation period for multifamily and commercial properties to 25 years, down from 27.5 years for multifamily properties and 39 years for commercial properties.
Private Activity Bonds (PABs) Saved
As BL covered previously, the House version of the bill proposed eliminating the exemption for interest earned on PABs, whereas the Senate bill spared this widely-used tool that finances city infrastructure of every kind.
Tax Credits Saved with Some New Restrictions
As BL also covered, the revitalizing Historic Tax Credit (HTC), championed by President Reagan, as well as New Markets Tax Credit (NMTC) and Low Income Housing Tax Credits (LIHTC) all faced potential elimination in late versions of the House bill. After hearing a consensus as to just how vital these tax credits are, the final bill preserved the HTC and LIHTC, though they are limited somewhat.
Advance Refunding Bonds Lose their Preferential Tax Treatment
The final bill slashes the tax exemption for interest earned on one-time refunding bonds, which will likely raise borrowing costs for cities.
Too much at the wrong time?
Many are also expressing a degree of anxiety that the tax bill does too much for real estate at the wrong point in the cycle. Now 10 years into one of the longest real estate and economic recoveries in recorded history, concerns that this expansion was growing long in the tooth started years ago now. Indeed, some urban markets have been overheating for years, as BL noted in its 2016 outlook. So, for an industry known to boom and boom until a big, sometimes spectacular bust results from over-borrowing and over-building, such a big boost so late in the cycle is a natural cause for concern.
This tax cut comes at a time when the overall economy is at full employment and a labor shortage is starting to curtail business’ ability to expand. This is especially true in the real estate segment and related trades, where skilled and “unskilled” workers are in desperately short supply. A rush of investment now could make an already serious situation worse and lead to increased capacity strain and runaway inflation.
Right on Cue
New home sales in November soared by a near record 109K to 733,000, according to the Census this morning, the same day President Trump signed the new tax bill into law. On a monthly percentage basis November turned in the biggest monthly jump since January 1992, although the previous 3 months were revised lower by 77,000 in this morning’s report.
Sales in every geographic region increases, led by growth in the West almost as hot as its wildfires:
- Northeast: 9.5%
- Midwest: 6.9%
- South: 14.9%
- West: 31.1%
Overall, this metric is on pace to complete the year with ~613K new home sales, compared to 561K in 2016. Inventory shrank and the months’ supply stood 4.6 in November down from 5.4 months of supply in October’s report.
Keep an Eye on Lending
Caution has been a theme for a while, especially among real estate lenders and institutional investors. As we wrote in last year’s forecast, the 2008 financial and real estate shock:
For many different reasons, lending has trudged along somewhat like GDP. Slow and steady, but never at risk of running away. This is good news, but the tax bill is not coming on the heels of obviously excessive real estate lending. And if there’s growth, commercial real estate can bear higher interest rates so long as demand remains, rents stay up and too much debt doesn’t pile up in a particular asset class, individual market or in the broader market.
Where exactly is lending? As of the third quarter of 2017, total commercial/multifamily debt outstanding stood at $3.1 trillion, which was only a 1.5% increase from the second quarter, according to the Mortgage Bankers Association. Again, however, the timing is pivoting—the third quarter also marked the first uptick in the total amount of CMBS debt outstanding since the peak of the last crisis.
That could mean there’s room to run to a new all time high or that the air is getting thin.
A lot will depend on the underlying economy. Corporations already hold record cash reserves. Will this tax reform stimulate the private sector by itself? Or still it needs generationally-low public sector investment in infrastructure to catch up before the investment cycle can really find a groove?
- The reduction in the depreciation period is something that’s been tried in the past. Tax reform in 1981 included a similar provision, which many cite has a trigger of a cycle of over-building and an eventual real estate bust.
- The propensity for a construction boom is made even more possible because businesses will be able to immediately expense multiple types of asset purchases, including real estate. This is welcome news to many CFOs in the midst of capital investment plans, such as the e-commerce sector. The race for dominance in the new age of mega-logistics may have just entered a new phase. Industrial and manufacturing segments may expand upon their already record expansions, which may draw additional foreign investment who are also making record expansions into the U.S.
- The bill’s cost could also become a concern if government’s debt load starts to add extra lift to interest rates. If borrowing costs increase, this, in turn, causes the government to issue more Treasury securities to finance the debt. And with interest rates rising for structural reasons already, higher borrowing costs could eventually whip around to hurt the housing market and choke growth in the general economy.
- The new tax bill could also tilt the scales away from homeownership and encourage even more renting. In many cases, especially millennials, the new plan will make it more financially rational to take advantage of the increased standard deduction rather than relying on itemized deductions, such as mortgage interest.
- The new $10,000 SALT will place a higher tax burden on residents of high-tax states, such as New York, Connecticut and California, but don’t expect an exodus. The urban infill trend is too strong and cities still have huge advantages to leverage in the emerging war of amenity and quality of place. Nevertheless, it may give a boost to the suburbs, which BL has written previously are quietly resurgent in many regions.
Bottom line: the risks of overheating are growing, and the tax bill's effects will translate different in each market and each segment. BL remains cautious in our official outlook, noting that the strong structural stories fueling this very long U.S. recovery still have many chapters left to go. A healthy pause seemed possible in 2018, but now, in the wake of the tax bill, less so. This might precipitate a more severe downturn to follow.