When completing a 1031 exchange, investors are required to reinvest their proceeds into “like-kind” investment properties. Fortunately, the IRS allows a very broad range of investment properties to qualify as “like-kind” including residential and commercial properties and less obvious options including raw land, cell phone towers, billboards, water rights, mineral rights, oil and gas, etc. When selling an investment property of one type, investors can freely reinvest in other property types e.g., single family rental into a retail store.
By far, the two most popular 1031 reinvestment options selected by our clients are residential and commercial properties.
Residential properties include single family rentals, apartments, senior living communities, manufactured home parks, and student housing among others.
Commercial properties include retail, office, fast food, service centers, distribution centers, healthcare, and government buildings among others.
Pros and Cons of Commercial Properties
Commercial properties can generally provide investors with long term steady cash flow if occupancy remains stable over the holding period. The relationship between the tenants and the investor is defined in a lease contract that often places much of the responsibility of maintaining the property on the tenant. Among the most popular lease structures is the triple-net lease (NNN) where the tenant is required to pay all property expenses including taxes and insurance and maintain the condition of the building thereby reducing the workload and responsibility of the investor.
Challenges can arise when tenants move out or fail to meet their lease responsibilities. Replacing tenants can be expensive since, to attract new tenants, investments must be made in marketing and upgrading the premises to fit the intended use by the new tenant. Tenant improvements (TIs) can be costly and, of course, there is usually a loss of rental income until the new tenant is found and begins to pay rent.
During periods of good economic growth and low inflation, investments in commercial properties can provide attract overall returns to investors and are generally very popular.
Relative to residential properties, commercial properties can be subject to greater risks during economic downturns and periods of high inflation. During recessions, vacancy is more likely to increase, and more time may be required to find acceptable replacement tenants and resume rent collection.
As highlighted in other recent blogs, the chief concern of many investors in today’s inflationary environment is that allowed rent increases in commercial properties are generally much less than annual reported inflation rates. For example, the average allowed annual rent increases in commercial properties managed by our firm ranges from 1% to 2% - far below today’s annual Consumer Price Index (CPI) increases. If rents cannot keep pace with inflation, the value of a property is likely to be negatively impacted at time of sale thereby raising the risk of a potential loss of equity.
While we expect to see new commercial lease terms that allow rents to be adjusted to meet reported CPI figures (as we saw in the 70’s) which should increase the appeal of commercial properties, our clients are generally reducing their exposure to this asset class.
Why Residential Properties Now?
During the eleven or so recessions that I lived through and managed real estate, well-positioned residential real estate has proven to be the most resilient asset class. I remember my father commenting to me that when he lived through the Great Depression, the family’s first dollar would go to put food on the table and the second dollar would go to the landlord so that the family could have a roof over their head.
Residential properties can not only be good defensive investments, but they can provide investors with better than average returns in areas that are gaining population where housing shortages exist. Owners of rental properties generally have more flexibility to raise rents to meet changing market conditions and can therefore be a more attractive inflation hedge than commercial properties.
COVID has accelerated a mass migration from more expensive cost-of-living to areas that are more affordable spurred in part by a growing shift to remote work and a desire to have more living space. Working remote from one’s employer has become the new normal for a growing number of well-educated workers and many companies are adapting work polices to retain talented employees. As a result, demand for housing in secondary markets has accelerated creating attractive investment options for astute investors who are tracking strategic population shifts.
Unlike our last economic downturn in 2007-2009 which was caused by a bursting housing bubble and global financial crisis, there is a shortage of housing in high growth areas today. Buying a first-time home is also becoming more challenging due to rising mortgage rates that are fueling a growing need to rent versus buy.
In our daily conversations with investors who are selling rental properties, we routinely hear stories of double digit returns and a desire to reinvest sales proceeds in what many know best – residential real estate.
Possible Changes Ahead
We are big believers in the concept of “reversion to the mean” and do not expect that the current hot residential market will remain so indefinitely. In time, high demand will create more supply and we might then be on our way to another correction. Readers are encouraged to read a recent article from Fortune Magazine entitled “Housing Bubble 2.0” for additional perspectives on residential real estate investments.
Next Steps
To learn more about market trends and investment strategies for allocating both cash and 1031 exchange funds, please schedule a meeting with our professionals at First Guardian Group at 866 398-1031 or info@fgg1031.com.
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4 https://www.npr.org/2022/03/29/1089174630/housing-shortage-new-home-construction-supply-chain
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