By Paul Getty, president & CEO, First Guardian Group
The calendar year is rapidly drawing to a close, and society is moving closer to pre-pandemic normalcy. As 2022 approaches, we expect a combination of more-of-the-same trendlines punctuated with a few new developments that will reshape the residential and commercial real estate landscapes in 2022.
Due to a combination of scarcity, demand and historically low interest rates, betting on the strength of residential real estate, both single- and multifamily alike, seems like a low-risk proposition in 2022.
According to the National Association of Realtors, the country is currently experiencing a housing shortage of some 6.8 million units. The Brookings Institute reports that millennials now make up more than half of the U.S. population, and a growing percentage are hoping to start families and buy homes. Thanks to the Federal Reserve’s accommodative policies, the golden era of low-cost financing will continue into 2022.
Many landlords and commercial real estate owners hit pause on rent increases amid the pandemic. But 18 months into the public health crisis, we’re seeing rent hikes across the country for investors to catch up and return to normalized rates of return.
The constrained supply of single-family homes and the popularity of remote-work flexibility should combine to cause rental rates to increase, especially in lower-cost-of-living areas that are disproportionately attracting new renters relative to expensive urban areas.
As investors increasingly see further evidence that the rise of inflation is not transitory, more are looking to redeploy funds in inflation-resilient asset classes like apartments and self-storage. Unlike in office and retail, owners of these multifamily and self-storage buildings can quickly raise rents in the short term to keep pace with rising operating costs.
Many commercial asset classes, including office and retail, generally have fixed-term leases that contain limitations on the amount of annual rent increases that can be put on tenants. Asset classes like apartments do best at keeping rental income at a sustainable market level amid inflationary periods.
Restaurants, entertainment venues and hotels were hit hard by COVID-19 but are starting to see a return to normalcy. The cash flows of these businesses and properties may not completely recover in 2022, but astute investors can find prime investment opportunities amid market lows within these sectors.
COVID-19 accelerated the rise of remote work, causing employers to embrace hybrid work models, which offer more freedom to split time between work and home. A recent report from Accenture found that up to 83 percent of workers prefer hybrid work, and 63 percent of high-growth companies have already adopted a “productivity anywhere” workforce model.
Hybrid work routines are expected to grow in 2022, further changing the office landscape. Companies like Google are already embracing smaller hubs for face-to-face interactions in lieu of massive office campuses. Owners and developers of large office buildings are scrambling to adapt to the new post-COVID workplaces. Renovations are sure to rise in 2022 to meet these shifts in tenant demand and preferences.
Other Trends to Follow
While not all the current proposed high-ticket government spending programs are likely to pass, many will, starting with the recently passed $1.2 trillion infrastructure bill. Approval of this legislation will place more pressure for the Federal Reserve to create more liquidity to cover related costs.
With inflation expected to continue into 2022 and beyond, interest and mortgage rates will likely rise. Mortgages will be tougher to obtain, requiring higher credit scores and pristine borrower payment histories. It’s even possible that variable-rate mortgages will resurge. The U.S. government does, at least, seem to be aware of this, as evidenced by Fannie Mae and Freddie Mac’s recent announcement to back single-family home loans of up to $1 million. This move, a first of its kind for the government-sponsored enterprises, should help more buyers compete on assets that are rapidly appreciating in price.
As for where investors want to be, California’s population dropped by over 182,000 residents in 2020, the first known loss in its history. Many factors caused this, including cost of living, urban decay, rent control and eviction moratoriums.
California real estate investors are accelerating the movement of their investment equity to landlord-friendly areas that attract new employers. California’s issues are shared with other high-tax and over-regulated states like New York, where residents are leaving for seemingly greener pastures. Real estate investors know the benefits of deploying capital in growing areas, and many of them will be moving equity into areas of growth in 2022.
Construction costs spiked in 2021 due to high lumber prices, labor shortages and supply chain issues. Cost increases will likely persist in 2022 with additional upward pressure caused by higher energy prices. High energy prices raise costs of transportation and petroleum-derived building materials. To that end, fixed-cost contracts are a must for any upcoming construction.
The 1031 exchange provision within the U.S. tax code is a powerful wealth-building tool that has been with us since 1921. It allows real estate investors to potentially defer up to 100 percent of the capital gains on the sales of their investment properties and reinvest all their net sales proceeds into new “like-kind” investment properties.
Investors have been anxious this year as politicians propose various ways to pay for new governmental programs, fearing that the 1031 exchange will be eliminated or at the very least, revised. It’s not yet happened, and so far, there hasn’t been mention of proposed 1031 changes in the “Pay-For” sections of the recent spending proposals.
The recent efforts of various real estate lobbies have, seemingly, successfully convinced politicians that preservation of the 1031 tax deferral is in the best interests of the U.S. economy. Preservation of this important portion of the tax code will help fuel needed reinvestments in commercial assets in 2022. Demand for qualifying 1031 replacement properties such as Delaware Statutory Trust (DST) options should also continue to rise in the new year.
First Guardian Group is a full-service investment and management firm based in San Jose, California.