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December 29, 2016

Real Estate Investors head into 2017 with Caution


2016 has turned out to be an interestingly mixed year for real estate investors in sharp contrast to the forecasts of solid gains. At the start of this year, many real estate analysts submitted that the U.S. real estate market would book massive gains. The bullish forecasts were grounded in line with the performance of the real estate markets in the previous two years. Real estate prices climbed up 4% in 2015 in response to a slowdown in supply for real estate properties. Real estate investors had previously booked 6.4% increase in home prices in 2014.

This article explores some of the market trends that influenced the performance of the real estate markets in 2016. The article also attempts to draw insights on some of the emerging trends that could affect the U.S. real estate markets in 2017.

Here's how U.S. real estate markets fared in 2016

The U.S. real estate market turned out to be a mixed bag for investors because the performance of real estate assets varied across different sectors of the market. Of course, the real estate industry showed a predominant trend towards increase in home prices; nonetheless, some markets recorded increases in home prices at a much slower pace than others. Hence, one can safely submit that the gains in home price had an uneven spread in 2016.

Real estate analysts at Lazard Global Real Estate Securities provided some valuable insights into how the U.S. real estate market performed in 2016. In the report published last month, the analysts observed that real estate investors booked mixed gains this year. U.S. real estate market returns at the end of November showed that investors in Apartments had a 4.5% loss, Regional Retail lost 5.2%, and self-storage properties had a loss of 15.2%. In contrast, Office properties returned 9%, Industrial properties were up 25% and Hotel properties gained 14.4%. See chart below for more.

However, the broad REITs market seemed to underperform U.S. equities in 2016. For instance, All REITs booked 4.9% gains, Equity REITs booked 4.0% gains, REIT Preferred booked 3.3% gains but the S&P 500 booked a bigger 9.8% gain.

What will 2017 bring for real estate investors? 

  • Tax reforms and plans to ax the 1031 and business interest deductions could make real estate less profitable in 2017

President-elect Donald Trump has plans to reform the tax code, although he isn't able to sign any tax reform bills until after he takes the oath of office in January 2017. Congress is already working on some tax reforms and one of the bills that could have an adverse effect on the U.S. real estate market is the plan to kill the 1031 exchange and business interest deductions.

The business interest deduction and the 1031 exchange have been important parts of the tax code since 1913 and 1921 respectively. Both aspects of the tax code protect taxpayers from paying taxes on income and gains that are never received or earned. However, the House Ways and Means Committee is currently drafting major tax reform legislation that they intend to pass through the budget reconciliation process.

The problem however is that the budget reconciliation process requires that major tax reductions be offset by the elimination of other tax provisions, or the introduction of major tax increases, to make sure that any new bill maintains an equilibrium in the tax code. In essence, the House Ways and Means Committee is trying to kill a tax provision that protects million of people in the middle class, and the largest percentage of real estate owners, in order to reduce the taxes that the wealthiest 0.01% of the population pays.

  • Reasons why killing the 1031 could hurt real estate investors

The plan to eliminate business interest deductions will hurt the real estate market by causing real estate investors to pay taxes on the interest payments they make on their real estate assets, reducing their after-tax income. Furthermore, the elimination of tax-deferred exchanges, such as the 1031, would economically prohibit the sale of millions of properties nationwide, driving real estate values back down into recession levels, or lower. When asked for a comment, SaveThe1031.org remarked that "the loss of both of these provisions together would be an economic catastrophe that will crash the commercial and residential real estate markets as well as the economy, and lead to the loss of hundreds of thousands of jobs, and ultimately, a deep recession."

The elimination of the 1031 exchange would cause millions of homeowners to lose significant equity in their properties. Hence, old investors might be forced to hold their real estate while new investors might want to hold out for properties that can be purchased at lower prices, since financing may become more expensive and values may drop, and that can be held for income over the long-term, since exchanges may become taxable. Heading into 2017, stakeholders in the U.S. real estate market must understand that the axing of the business interest deduction and 1031 exchange could crash the U.S. real estate market because it would force a massive increase in taxes on millions of people who pay investment mortgage interest.

  • An increase in interest rates could cause mortgage rates to jump

It is no longer news that the U.S. Federal Reserve has raised interest rates by 0.25% – this marks the second rate hike in a decade. The fed also has plans to raise interest rates three more times in 2017 as a testament to the fact that the economic has improved modestly. The increase in interest rates could make investing more profitable for investors with exposure to equities and bonds.

However, the increase in interest rates might make the real estate industry less appealing because an increase in interest rates could cause mortgage rates to rise. Mortgage rates have already jumped half-a-percentage point in the last two months in anticipation of a rate hike. Now, the Fed has gone ahead to increase interest rates; hence, you can reasonably expect mortgage rates to go higher in 2017.

  • Home prices might grow modestly because of better access to credit 

On the positive side, real estate investors can expect modest gains in home prices as easier access to credit draws in more people into the housing market. The low interest rates environments did not encourage lenders to give out loans to many qualified borrowers. The fact that many lenders were averse to giving out loans also affected many small builders who were unable to get construction loans. Now that interest rates have increased, lenders have more incentive to give out loans to qualifying borrowers.

More so, Anne McCulloch, Fannie Mae’s senior vice president for credit and housing access observes that Fannie Mae has created products that make housing affordable and available to more buyers. In her words, “We’ve refreshed our renovation products because we’ve found many consumers are buying fixer-uppers, while current homeowners need cost-effective financing to improve the energy efficiency or the accessibility of their homes.”

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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