Government threat

Executive Summary
Industry. Commercial real estate Trend. Government action threatens recovery Key. Commercial real estate values may have peaked

Commercial real estate investors are cheering business expansion, a declining unemployment rate and rising consumer confidence.

So what's to worry about? Plenty, it turns out.

A common theme running through expert presentations at the recent CCIM Real Estate Outlook Conference in Fort Myers was what politicians and bureaucrats at every level of government have in store for the industry. The threat of rising local and federal taxes, interest-rate spikes and burdensome regulations put a damper on an otherwise upbeat economic forecast.

Murmurs of discontent spread through the gathering of more than 300 commercial real estate executives when Lawrence Yun, the chief economist with the National Association of Realtors, said a popular like-kind property swap to defer taxes called a 1031 exchange might be eliminated. “The 1031 exchange is on the chopping block,” he warned.

Yun says a number of deductions will likely be on the chopping block, too, including the popular mortgage-interest deduction. He says the threat comes from both sides of the aisle: Democrats and the president want to raise taxes and Republicans want to eliminate deductions.

Congress and the president aren't the only threats to commercial real estate owners. The Federal Reserve has indicated it may raise interest rates as early as this summer, says Danielle Squires, managing director of interest rate management for Wells Fargo Bank.

Rising interest rates are threats to the values of commercial real estate investors because many of them use leverage. “Staying where we're at today is a bit delusional,” Squires says.

Cap rates rising
Rates of capitalization, commonly known as “cap rates,” are an important measure of commercial property values. It's a simple formula calculated by dividing a property's net operating income by appraised value or sale price and it's expressed as a percentage. The higher the price or appraised value, the lower the cap rate.

Because of the economic recovery, cap rates have sunk to low levels, reflecting rising values. For example, the hot apartment market has seen cap rates in the ultra-low 4% range.

But rising interest rates could threaten property values because many buyers use leverage to buy commercial real estate. Declining cap rates and rising values may be a thing of the past, some warn.

“Don't expect this trend to continue,” says Todd Barfield, regional private banking manager for Wells Fargo Private Bank. “Values will go down and we have to be careful and cautious about that,” says Barfield.

At the National Association of Realtors, Yun also forecasts an increase in interest rates this summer. But Yun was more sanguine about the impact of interest rates on commercial real estate because the Fed will raise rates slowly and from rock-bottom levels. “I don't think it will be harmful to real estate,” he says. “As long as the rents come in, the property prices on commercial real estate don't have to decline in a rising-rate environment.”

Yun says he's more concerned about the availability of credit, especially from community banks that have traditionally been the lenders on commercial real estate. “The local lenders say they are being strangled by new regulations,” he says. “They're being extra conservative. The lending conditions have been very difficult.”

Higher taxes coming
Government tax collectors are on the march, from local governments seeking to boost taxes on new construction to the federal government possibly eliminating popular tax deductions such as the mortgage interest and tax-deferral strategies such as the 1031 exchange.

“The only thing to be concerned about is [government] policy,” says Yun. He's speaking with real estate groups around the country to urge them to discuss the threats with legislators.

For example, many commercial real estate investors who move here to swap their northern commercial properties for like-kind properties in Florida using the 1031 exchange. Yun says the government is considering eliminating such like-kind exchanges, which would be a threat to Florida commercial real estate. There's still time to stop the legislation by lobbying Congress: “We're at an early stage,” says Yun.

The mortgage-interest deduction may also be eliminated, Yun says. Although that's unlikely to happen because it's so popular, he says real estate executives should remain vigilant.

Meanwhile, at the local level, county governments are seeking to raise taxes again, a hot topic during breaks in the conference. For example, Lee County is considering raising taxes on new construction, known as “impact fees.” In addition, the school board is considering raising the sales tax.