As seen in the Chicago Business Journal

No one could predict the indelible mark left across all industries by COVID-19, including soaring housing costs, inflation rising to the highest levels the U.S. has seen since 1982, and now the collapse of three major financial institutions.

The real estate industry has felt the impacts of an unpredictable market for years, and uncertainty remains the only true constant for many real-estate owners.

Softening rents

After record rises in rents, this finally seems to be stabilizing somewhat with a recent influx of new supply. According to the Joint Center for Housing Studies of Harvard University, rents grew at a record rate in 2022. The rents for professionally managed apartments increased by nearly 12 percent, and rents for single-family homes increased by 12.4 percent.

Many landlords are bearing the burden of additional operational costs. For landlords whose loans were fixed using a derivative known as an interest rate cap, those caps are now beginning to expire, resulting in either a reset of interest rates or increased costs in renewing. The cost of insuring against interest rate increases was extremely low when rates were lower. As rates have risen, the cost to insure this protection has also risen nearly 10 times what it cost just a year ago.

Investor appetite in a higher rate environment and a market in turmoil might make investing in real estate less attractive compared to a year ago. Decreased investor demand will lead to a slowdown in buying, which means sellers will have difficulty turning over their properties.

This cycle raises the cap rate, which is unfavorable for owners looking to sell, and favorable for able buyers with cash on the sidelines. However, this gets exacerbated either when the property’s net operating income (NOI) declines or rents don’t climb quickly. If the NOI remains strong or steady, the cost to borrow is higher which still puts strain on the property.

Commercial vacancies

The way the workforce approaches employment changed drastically over the past few years. Vacancies in commercial office space hovered around 12 percent pre-pandemic and climbed to nearly 15.5 percent in 2022. Though many professionals such as teachers, doctors and city workers still report to a commercial space, vacancies remain at an all-time high. This has made many lessees extremely wary about renewing their leases and will continue to have a significant impact on real estate owners.

Tax implications

Even in the current market environment, owners of real estate may still have a gain on a sale, albeit less of a gain than they would have had if they sold a while ago. A like-kind exchange is still available to defer the gain. However, if there are fewer properties for sale in the market, finding a suitable replacement property may be difficult given the time constraints applicable to like-kind exchanges. A seller has 45 days from the date of the transfer of their property to identify a replacement property and 180 days from the transfer date to close on the identified replacement property.

Bonus depreciation, 199A deductions, state pass-through entity tax and tax-deferred sales continue to be some of the most effective tax planning tools for the purchase, operation and sale of real estate. The Inflation Reduction Act (IRA) also contains several potential tax benefits for real estate businesses by expanding Sections 179D and 45L as well as other energy-efficient tax incentives.

Opportunity or trouble on the horizon?

The collapse of the major financial institutions recently has called the Federal Reserve’s strategy for combating inflation into question. With the demise of these institutions, alternative lenders will be entering the marketplace and likely lending at much higher rates, making it difficult for owners to buy or refinance.

This is an opportunity for real estate professionals to refocus their time on searching for investment opportunities, structuring deals, improving the profitability of current investments and handling new operational complexities through outsourcing. It is more important than ever for owners to have access to real-time financial information to make effective business decisions.

With the ambiguity of what will happen with interest rates, it may be difficult for real estate owners to borrow money for new projects or refinance old debts. Both factors, coupled with low available inventory, will determine how owners will need to proceed to achieve their goals. The answer remains unclear as to whether interest rates will continue to rise, and it is uncertain how this will continue to affect real-estate owners in the coming months.

For more information, please contact Scott Sattler at ssattler@citrincooperman.com.