Water Seeking Its Own Level: What If the Tax Code Stays the Same?

A look at the near future for commercial real estate if the tax code does not see the proposed changes put into action – market fundamentals, money, and economic growth.

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Now that the Trump Bump seems to have peaked and oil prices have stabilized in the $50/bbl range, things seem to be settling down in terms of real action in Washington.

The polarized nature of American politics continues to make for some provocative headlines, but continues to produce little in terms of real change.

The recent failed effort to repeal and replace the American Care Act is a good example, as it showed the formidable political divide that exists even within the major political parties. The new tax reform proposal may suffer a similar fate as the debate on the floors of the House and Senate is likely to be just as contentious.

In recent posts we have been looking at the components of proposed changes in tax law that include lower corporate tax rates, personal income tax rates, new rules on expensing and depreciation, the elimination of the estate tax and a controversial border adjustment tax, among other items.

Each proposed change could have a significant effect on who pays and how much they will pay. There would certainly be a new roster of winners and losers no matter which elements of the proposal make it through the legislative sausage machine.

However, we may be watching water seek its own level again, as it inevitably seems to do. Talking about change and making change happen are different things altogether in today’s political environment.

So, if we assume that very little will change relative to the tax code, how will that impact the commercial real estate market? Here are our thoughts on that very important question:

First, market fundamentals remain on a firmly established course.

Sales prices and lease rates are still rising. Owner/user buildings have seen annual double-digit price increases for several years running and lease rates are well past the previous market peak of 2007.

The supply/demand equation remains significantly out of balance, and good quality buildings are as slow to come to the market this year as they were last year. Low levels of construction are contributing to the short supply of space.

Currently, just one building totaling 151,000 square feet is under construction in all of Orange County, and all buildings in the planning stage are set to be larger than 30,000 square feet. The development of smaller buildings, where demand is most intense, is just too expensive, even at today’s record price point. We may never see freestanding buildings under 30,000 square feet come out of the ground again.

Second, money is still cheap.

Even though rates have begun to rise as a result of recent Fed actions, mortgage rates are still historically low. The latest quote for the SBA 504 loan for industrial property stands at 4.83%, up 50 basis points since the same time last year.

That rise is not insignificant, but it has not proven to be a deterrent to owner/user demand, thus far. Further rate hikes are expected during the year, but the current yield on the 10 Year T-Bill, which is the commonly used index for setting commercial mortgage rates, may already reflect the expectation of further Fed action.

The big banks are still more than willing to make SBA-backed loan deals and there’s plenty of money to lend. If anything, banks are tightening up on appraisals and taking a harder look at creditworthiness, but those actions don’t seem to slowing the flow of money yet. At this point, it’s hard to say how far rates will have to rise before buyers become discouraged.

Third, investors in all asset classes have become accustomed to slower economic growth.

The idea of 4% or more of GDP growth, which was the norm in previous economic recovery cycles, is not even part of the conversation anymore.

In fact, US GDP growth was a dismal 1.6% in 2016, after a lackluster 2.4% in 2015, yet businesses continue to hire, wage growth has picked up and the unemployment rate has stabilized at less than 5%.

The aggressive monetary stance taken by the Fed over the last 10 years has brought yields in all asset classes down, including cap rates in industrial real estate. But, there is still a mountain of cash chasing deals, and buyers are lining up to buy good industrial real estate at record low cap rates.

So, what does all this mean for the rest of the year? We think it’s a case of “business as usual”. Demand will still exceed supply, money will remain relatively cheap and the economy will chug along with growth under 2%. We just don’t see anything in the near term that signals a significant change in market conditions. Vacancy is so low that the current price trend is not likely to change course even if demand softened.

Though, we do believe that property owners short term exit strategies will be taking a harder look at moving up their disposition plans, as there are those who believe that the economic recovery is getting a bit long in the tooth.

If our leaders in Washington surprise us with real tax reform, we may all need to hit the reset button and take a hard look at how real change will impact property values and lease rates. As always, we welcome your input. Please give us a call. We are here to help.