The recent Silicon Valley Bank and Signature Bank collapses — and the takeover of First Republic Bank — have revived regulatory scrutiny on bank risk to a degree that is reminiscent of the financial crisis 15 years ago.
Suddenly, it seems, everyone is concerned about the trillions of dollars in commercial real estate debt held at banks — and regional and community banks in particular — and whether it can be refinanced at higher interest rates as it matures over the next couple of years. The same holds for hundreds of billions of dollars of commercial mortgage-backed securities.
The conditions are exacerbating a pullback in credit that started last year, which, along with the elevated interest rate environment, has depressed commercial real estate investment sales. In February, property sales dropped 51 percent, from $54.9 billion to $26.9 billion from a year earlier, according to MSCI Real Assets.
Taken together, the wall of maturities, higher interest rates, bank collapses and a slumping economy have largely spooked the investment market, suggests Spencer Lund, chief investment officer with NAI Legacy in Minneapolis, Minn. (which also serves Chicago, Denver and Scottsdale, Ariz.) Still, it’s also the type of environment that breeds opportunity as prices fall, he adds.
“There are a lot of different variables in the market right now, whereas traditionally in uncertain times there has been only one, like rising interest rates,” he states. “Some pricing and modeling will have to change quite a bit from where it stands today, but I think there will be some nice buying opportunities in the next six months.”
Tax Strategy Investor
In addition to providing conventional brokerage, property management, leasing and asset management services, NAI Legacy possesses an investment arm in which firm principals buy assets, often with clients. Since its inception in 2018, the firm has completed around $250 million of acquisitions in the Midwest and Southeast, including net-lease portfolios, warehouse and distribution assets and multifamily properties.
Much of NAI Legacy’s deal activity centers on structuring tax-efficient deals for clients who are selling their real estate. Regardless of the economic environment, some property owners still must dispose of assets for various reasons, including partnership problems or a death in the family.
“We take a holistic approach to their entire investment plan and what their investment goals are,” Lund says. “And then we use tax strategies that are unique to real estate to solve those issues.”
Real estate investors have used the century-old 1031 exchange to build wealth by repeatedly deferring capital gains taxes on property sales, although efforts to repeal or reform the exchange rule continue.
“1031 activity has been down of late after being very high in the previous three years,” Lund observes. “It was a more favorable economic landscape back then, to be sure. But there was also a fear that 1031 exchanges would be eliminated, which contributed to the activity.”
One strategy that Lund sees increasing is the 721 UPREIT contribution, which is commonly referred to as an upgrade contribution. Similar to a 1031 exchange, a 721 contribution allows investors to defer capital gains taxes when relinquishing control of an investment or business property. In this case, however, the owner contributes property to a real estate investment trust in return for a partnership interest in the REIT, Lund says.
“The advantage of 721 exchanges is that they are not a taxable event,” he notes, “and now you own shares of a REIT, which is more liquid than owning a real estate asset.”
Tax Cuts and Jobs Act Alternatives
NAI Legacy also shelters income using bonus depreciation, which was implemented in the Tax Cuts and Jobs Act (TCJA) of 2017. Under the amended rule, investors could take 100 percent of depreciation in the first year of property ownership, up from 50 percent prior to the act’s implementation, through 2022. Beginning this year, the amount steps down by 20 percent a year until it phases out completely in 2027.
“As with many of these types of tax strategies, you can create losses on paper that you can use to offset income from other real estate investments,” Lund says. “The downside is that once you sell, you have to pay a depreciation recapture tax.”
But if investors sell the property as part of a 1031 exchange, he continues, then they can defer paying the recapture tax.
Opportunity zones were also introduced in the TCJA to provide yet another tax-efficient real estate investment strategy in return for injecting needed funds into low-income and high-poverty communities. Through the end of 2020, at least $48 billion had been invested in opportunity zones, according to a March 2023 report issued by the Economic Innovation Group, a public policy organization based in Washington, D.C.
Under the program’s rules, not only do investors in opportunity zone funds get to defer taxes on gains from past investments — and receive a discounted tax rate if they hold the investment for a certain period — but they can also avoid paying taxes on their fund gain if the hold period is 10 years. To qualify for the benefits, fund sponsors must invest in significant property improvements, such as new construction or redevelopment, or businesses.
While NAI Legacy was a first mover in the space around 2019 with an opportunity zone deal in Minnesota, the program is generally not a focus of the firm, Lund says. The typical opportunity zone real estate projects — new development, particularly in the multifamily sector — tend to be outside of NAI Legacy’s usual dealings. Plus, opportunity zone regulatory guidance is largely geared toward incentivizing business investment, he adds.
“If we were looking at two apples-to-apples deals and one had an opportunity zone component and the other didn’t, the opportunity zone deal would be attractive,” he explains. “But more often than not, it’s a good deal versus a bad deal, and our firm focuses on real estate fundamentals over tax strategy, first and foremost.”
The firm prides itself on assessing the current market well. Finding good fits and creative solutions, even amidst ongoing uncertainty, lets NAI Legacy strategize to find better opportunities.
— By Joe Gose. This article was written in conjunction with NAI Global, a content partner of REBusinessOnline. For more articles from and news about NAI Global, click here.