The Future of CRE
Economic Outlook 2021
Experts are bullish on Houston real estate
2020 has been an unforgettable year. Yes, all of us have other adjectives we can use to describe their own experience, but for purposes of this article we will use the word “unforgettable”.
An economy that started the year at record-setting levels, and then saw some of the most violent shifts in unemployment, swings in revenues and personal wealth. 401(k)s tied to the stock market saw record highs, a rapid decline, and then one of the most dramatic recoveries ever witnessed in their lifetime.
And then there was the 2020 election cycle that many would like to simply forget. An election which was filled with some of the most polarizing platforms, debates and campaign strategies which caused interesting political debates at the office, around families and the never-ending news cycles of cable TV.
Well, everyone has cast their vote. All the votes have been counted. Election lawsuits are soon to be over. And just like that, the 2020 Presidential election is finally over. And with it, the unforgettable year of 2020 will be in the history books.
But what does a Biden – Harris Administration mean for the future of real estate development, construction, investing and ownership in the 4th largest city in America? What does a roll out of a COVID-19 vaccine mean for our health, consumer confidence and ability to get life back to normal?
To understand what the Bayou City’s crystal ball may predict, this week the Houston Business Journal hosted a strategy discussion with some of Houston’s most experienced and knowledgeable real estate experts. The cerebral panel covered topics such as capital markets, the economy, construction costs, development trends, effects of COVID, regulatory matters, and much more.
Here is what our panel of experts had to say.
Policy Impacts on the Economy – Sam Herskovits
As we turned the page into 2020, the US economy and its fiscal and monetary policy decisions were all pointing to a robust, strong and record setting economy. However, COVID-19 was a game changer. When comparing the economic meltdown of 2008 with that of 2020, there are some emotional and economic burden similarities, yet the fundamentals are completely different. The 2008 economic crash was more of a financial crisis, yet 2020 can best be construed as a service crisis. The entire society was locked down and masked up.
The government from both sides of the isle worked together to create policies which would help to stimulate the economy, and more importantly, help all Americans through a very tough economic situation. However, as Americans, we are extremely resilient and when we get knocked down, we bounce right back up to fight another day.
The economy remains steady being buoyed by a federal reserve which continues to pump capital into the economy, constraining interest rates to record lows and ensuring that the US does not experience run-away inflation. And the empirical data is showing that even after the stimulus dollars have been exhausted out of our bank accounts, Americans are still spending money, still investing in the equity markets and real estate, and still going about their every day lives.
From a policy perspective, the most important issues affecting our near-term and long-term economy will be centered around substantial fiscal, tax or economic policy shifts of a new Biden administration, as well as the ability of the US Congress to pass another stimulus package. The outcome of the January 5th Senate run-off election in Georgia will be very impactful with either a consolidated government under a Democrat Party rule, or a balanced Congress with a divided House and Senate. In short, the outcome of this run off will create the blueprint for economic policy decisions for many years to come.
Unintended Consequences and Societal Impacts Due to COVID – Dr. Masaki Oishi
As we have all learned this year, life can be unpredictable. In fact, normal life has been flipped on its head and has tested everyone. So, from a macro-economic level, the following are the observations for various sectors in the real estate industry:
One of the effects of the Coronavirus has been the movement out of office space, ostensibly for social distancing purposes. It is uncertain as to if this will be a short-term or more permanent impact on office buildings. As we all know, technology has advanced to enable everyone to be connected, whether they are sitting at their desk in an office or sitting at their kitchen table. As such, many folks are seeing the benefits and efficiency of zero commute time, a more efficient workforce, lower facility cost, etc. So, it seems like office space is getting ready for a shock as existing tenant leases come up for renewal over the next 12 to 24-months.
The International Council of Shopping Centers (ICSC) has historically cautioned retailers that digital technology will influence the brick-and-mortar sales, but, what the ICSC did not see coming, was the large amount of tenant defaults, bankruptcies and downsizings that were because of the government-mandated closures. What this means is that many 2nd or 3rd tier retailers that once never thought a certain shopping center was in their price range, now can negotiate from a position of strength with these desperate landlords that are looking to fill vacated space.
HOSPITALITY & ENTERTAINMENT
Travel and Entertainment budgets have been curtailed due to cost cutting directives from top executives, fear and ability to eliminate travel due to “zoom” which has now become the “new normal”. Additionally, many directives, recommendations and even mandates from federal, state and local authorities are strongly recommending no travel and entertainment. The Hospitality and Entertainment industries have been dramatically hit as evidenced by 2020 Rev Pars at 48% of what they were in 2019. Even though the operators are doing their best to cut variable costs, their fixed costs remain unchanged. In short, while their revenues have been cut by over 50%, their largest fixed costs remain the same.
INDUSTRIAL, STORAGE & FULLFILLMENT SPACE
Due to increased demand for online purchasing and growing constraints on supply chain, office flex and industrial space demand is growing. As a result of the at-home shopping, ordering and direct delivery, there will be increased demand for assets such as fulfillment centers, cold storage, and dry storage for online ordering.
Current economic forces have had an impact on the incomes, livelihood, and savings of many citizens. Many multifamily assets focus on a middle class America tenant profile, and that sector continues to see strong lease-up, stable rental rates and an ever-increasing occupancy level. Months on end being stuck in the house or apartment, and to go along with the shift away from offices, private designated workspaces in homes will be more important. People will be spending more time at home and as a result, people are looking for larger residential units with private office space and as much yard or common area green space as they can get. Parks, green space, community gathering spaces even if they social distance and other outdoor areas have become a very important commodity.
Construction Innovation and Cost Implications – Honorable Marty McVey
Construction costs for real estate development are generally comprised of labor, materials and general contractor profit. However, COVID-19 and other economic, immigration and trade implications have affected construction costs in many ways. Labor has been constrained because of immigration restrictions, lockdowns and other mandates affecting the free flow of labor. Tariffs, duties, impositions, and restrictions all have an impact on cost, surety and timing of materials that are sourced off-shore. In short, all these factors are outside the control of the general contractor. As a result of these factors, Houston-based Hwami Builders, chose to look to process innovation, efficiencies, and other controllable items to reduce costs for their customers.
For example, one of the large construction cost line items is that of wood stud framing. So, Hwami created a subsidiary which takes the architectural designs into its computer system, and by using sheet roll, 70-gauge steel, they can punch out the individual metal frames, which have been pre-punched for plumbing, electrical and other assembly requirements, the wall frames are assembled off site, and then shipped on a just in time basis to the site. Based on their experience, Hwami Builders is able to use this innovation to reduce the labor by over 20% and the construction materials by roughly 35%. These costs savings can be passed along to the client, but equally, the development timeline can be reduced by two months because of the innovative construction and delivery methods. Due to the ability to get the project completed sooner, the developer sees a reduction in many costs and can start generating revenue sooner as the product can be placed into service quicker.
Federal Tax Consequences – Jan Sparks
Tax consequences of the election results remain unclear. The runoff election on January 5th in Georgia will determine who controls the Senate. If the Republicans maintain control, a balance of power will remain in place, and many of Biden’s proposals would be more difficult to pass as currently drafted. However, if it flips to Democrats, there will be a negative impact on capital gains, Opportunity Zones, 1031 Exchanges, etc. That said, Republicans will probably retain the Senate and uphold current policies, which favor Commercial Real Estate.
Many of the proposals in Biden’s plan target taxpayers earning more than $400k in annual income. Such areas which have been targeted include the elimination of like-kind exchanges, exemption from passive loss rules, and accelerated depreciation. Nevertheless, the following are some of the more notable areas of the tax code which will be most affected by the Biden-articulated policy positions:
1031 EXCHANGE IMPLICATIONS
Biden’s plan would limit the tax advantages in 1031 exchanges to those making $400,000 or less. This will not only impact taxpayers that make over $400,000, as the ripple effect is that there will be less 1031 Exchange activity which could cause a decrease in demand. This reduced transactional impact in the 1031 Exchange marketplace could affect overall pricing, and this impacts all parties, regardless of their income levels.
Opportunity zones are in 8,700 locations across the U.S. Some of the Biden-proposed reforms are aimed at ensuring the Opportunity Zone areas are truly in need, and that the deferred capital gains dollars are being used to create jobs and affordable housing. Biden’s “Build Back Better” platform calls for reform of opportunity zone funds to ensure they serve black and brown communities, small businesses, and homeowners. Although Opportunity Zones will likely require greater measurability of impact and additional criteria on the zones, Opportunity Zones and most of their benefits appear to remain in place. The likely result is that like-kind exchanges are at risk and capital gains tax increases will be under pressure. Opportunity zones could see more interest to delay and reduce payment of capital gains taxes.
INCOME TAX RATES
The current highest Marginal Tax Rates under the tax code remains at 37%. Biden has indicated that his administration will reverse the Trump and Jobs Act tax cuts for the wealthy, by restoring the 39.6% top marginal tax rate, up from the 37%.
CAPITAL GAINS TAX RATES
Biden’s plan would first raise taxes on capital gains by treating them as ordinary income for those earning more than $1 million, which will increase the tax rate from 20% to a maximum of 43.4%. In practice, this means that proposals to significantly raise capital gains tax rates, with no other changes, will lose federal revenues. Using research data from the Congressional Budget Office on capital gains realizations and these elasticities, it is estimated that raising the top rate to 43.4 percent could lose about $2 billion each year in federal revenues.
However, Biden is not simply proposing to raise the top rate on capital gains. He also proposes eliminating the current regulations related to the step-up basis in capital gains. According to the Joint Committee of Taxation, not taxing gains at death results in a loss of about $40 billion each year in federal revenues. This change could temporarily increase investment sales activity for 2021 in preparation for the change in 2022.
Regulatory Implications on New Development – Honorable Marty McVey
It is a given that law makers will always make more not less regulations. After all, you never hear of a politician running for office to do nothing! Some run to reduce regulations while others run to enhance and increase them. In short, change and regulations are inevitable. The goal is to understand the regulations and seek out those opportunities.
For example, the regulations for development permitting in the city of Houston, is a relatively painless process. Of course, anything can be improved, but when you compare the regulatory process in Houston to New York City, Los Angeles, Seattle, etc., the regulatory process can be cut by a factor of 3. So, instead of taking 18-months in New York City, you can start construction in Houston by month 6.
There is a misconception that the development services department of a city is there to get in the way of development. However, when you look at the big picture, the city needs property tax revenues to fund its general fund obligations. Therefore, the faster a city can get a development started, completed and into service, the faster they can increase revenues.
Capital Markets and the Supply of Capital – Jan Sparks
Capital Markets in Real Estate are tricky due to the uncertainty in the economy, how real estate will be used and investor preference. Transactional volumes are currently significantly off for the same reasons. Capital markets remain uncertain as there is a lack of price discovery for sales and lease rates.
The news of Pfizer, Moderna, AstraZeneca, etc. and their positive coronavirus vaccine results will boost service businesses and the economy. But better economic prospects will also cause interest rates to rise. As a result, the 10-year Treasuries will likely rise above 1% before the end of the year. If vaccines are effective, the 10-year rate will likely rise at least another half percentage point in 2021. However, if Congress fails to pass another stimulus package, then rates will likely tick down temporarily.
Mortgage interest rates have likely hit their low point and will edge slightly upward from now on. During the first week in December, the 30-year fixed rate hit its lowest point since the Freddie Mac rates survey began in 1971 – 2.78%.
The Federal Reserve has recommitted keeping short-term interest rates near zero, which likely means through 2024. The Fed is also continuing to purchase $80 billion of Treasuries and $40 billion of mortgage-backed securities every month. In short, the Fed is all in to do whatever it takes to support the economy. Its statement said that it will be willing to tolerate inflation levels above 2% for a time. That means that the Fed will not raise short-term rates even if inflation begins to pick up.
Stimulus Policies for Homeownership – Sam Herskovits
From a macro level, the largest single investment for most US citizens, will be their home. Consequently, many administrations have supported tax incentives for first-time home buyers to get Americans in the practice of building up equity in their homes. The Biden platform is no different.
However, given the current fundamentals in the marketplace, what a Biden Administration does or does not do will not be the deciding factor. The fundamentals involved in single family acquisitions are at their all time best. Interest Rates are at record lows, inflation is at a stable rate and demand continues to rise for single family homes.
As previously stated, this current situation is more of a service crisis, as opposed to a financial crisis. It appears that once the vaccine for COVID-19 is delivered, we should have a robust and rapid recovery. This belief has been evidenced by accelerating single family closings, and this level of transactions is expected to continue in 2021 regardless of tax incentive for first time homebuyers.
Predicted Threats and Opportunities – Dr. Masaki Oishi
With respect to office and retail, and the impending vacancies, rental rate compression, tenant defaults, etc., all these factors contribute to a short-term reduction in NOI and ultimate value. As such, values in these asset classes will be negatively impacted. Now is not the time to rush out and acquire these assets, yet keep your powder dry to be opportunistic over the next 2 to 3-years. Relative to industrial, storage and fulfillment centers, the current environment will likely be an attractive investment as an alternative investment class.
But, massive demographic shifts are underway, which are creating an avalanche of new renters for multifamily as follows:
- The effects of COVID-19 have eroded purchasing power, creating less buyers at each price point
- Millennials are still not moving into home ownership due to student debt and lifestyle flexibility
- New renter households increased by roughly 10-million households over the past 10-years
- Demand for 500,000 new rental household units will continue through 2025, but annual supply in the last 3-years was only 300,000
- Single population generally a renter grew by 15 million more units above married couples over the past 10-years
- Baby boomers are looking to downsize to urban apartments
- Immigrants have lower home ownership rate and US immigration continues to rise
- Tight construction labor market is constraining multifamily construction
Should we Lean in or Retreat? The Consensus of the Panel
No matter how divided a society may be, a balance of power in government generally indicates that future policy will remain consistent with current policies, despite overtures of change. Furthermore, population counts continue to grow, yet last time we checked, no one has made more land! So well-placed real estate, like gold, is a finite supply and always a great long-term investment.
We are at a point that a savvy investor could capitalize on all markets, especially when focusing on foreclosures with solid, quality property fundamentals. Yet, to summarize real estate is always a good play despite the stock market, president, or parliament. We will feel pain in the short term due to the pandemic, that will translate through to CRE, but long-term fundamentals for core locations are solid. As an investor, this is the time to pounce. As a property owner, this is the time to hold. As a property owner on the edge this is the time to refinance and benefit from a historically low cost of capital.
Guest Contributor: David Gordon Wallace is an American businessman, politician, former officer and director for the Texas One Economic Development Corporation and author from the state of Texas. You can learn more and follow him on social media: LinkedIn
MarketSpace Capital, LLC is a Houston, Texas-based private equity real estate development firm focused on ground up developments and value-add investments throughout the United States.
Disclaimer: *For sold properties, actual sales price is reported. For active investments, the Estimated Current Value is based on the Managing Member’s estimate of current value. Recent acquisitions are generally valued at the acquisition price. Values may be internally prepared. This web-page/website is for informational purposes only and is qualified in its entirety by reference to the Confidential Private Placement Memorandum (as modified or supplemented from time to time, the “Memorandum”) of any offering of MarketSpace Capital.