Real Estate In 2019: Trump, Tax Reform, And Interest Rates

|
Includes: BBRE, DRN, DRV, FREL, FRI, FTY, HOML, IARAX, ICF, ITB, IYR, JRS, KBWY, LRET, NAIL, NRO, PKB, PPTY, PSR, REK, RFI, RIF, RNP, RORE, RQI, RWR, SCHH, SRS, URE, USRT, VNQ, WREI, XHB, XLRE
by: John Engle
Summary

Uncertainty looks set to dominate the real estate market in 2019; government policies and actions appear set to have an outsized impact.

Fed rate hikes will continue, tightening money supply and putting pressure on rate-sensitive assets such as REITs.

Qualified Opportunity Zones, which provide tax incentives for investment in economically disadvantaged areas, have sparked a gold rush in certain areas.

While REITs will suffer, record amounts of private equity dry powder will continue to hunt for deals; the sheer amount of private capital could help prevent a severe correction even in the event of broader economic troubles.

Opportunities in both public and private real estate can still be found, but 2019 will almost certainly prove challenging.

The real estate market in 2019 faces immense uncertainty. The asset class is one of the most important to ordinary savers and investors, whether it is in the form of private homes, REIT holdings, or private investments.

When property market faces turbulence, it tends to cause ripple effects throughout the economy. Of course, the current state of the real estate market is far different from how it was in 2008, when a housing bubble contributed to the instigation and exacerbation of the financial crisis and subsequent Great Recession. This time around, there do not seem to be the same systemic risk factors as were present before the last crash. But that is not to say all is well.

2019 is poised to be a year of great volatility and anxiety across capital markets and in the underlying economies of developed and developing world countries alike. In the case of real estate, government actions and policies look set to have particularly outsized influence in the year ahead. Impacts from the Trump administration’s aggressive trade policies, the 2017 tax reform law, and Federal Reserve interest rate tightening will all impact the sector considerably.

Property investors must tread carefully in 2019, as the shifting sands of government policy look set to create potential pitfalls. But they also offer a few opportunities that could prove tremendously lucrative for the well-placed investor.

Let’s discuss.

Fed Rate Tightening Dries Up Capital

The money supply is tightening. That is to be expected in light of the Federal Reserve’s efforts to raise interest rates throughout 2018. The implications for real estate of further interest rate hikes may be profound, as David Scherer of Origin Investments has pointed out:

“The Fed’s bond buying after the recession increased the money supply in the market and buoyed the economy, driving investors to commercial real estate and other higher-yield assets. Now, by selling government bonds, central bankers are taking cash out of circulation and making bank credit less available. The Federal Reserve still holds nearly $3.8 trillion in Treasury and mortgage backed securities - a portfolio built up during the financial crisis of a decade ago. Now the government is unwinding its portfolio, which was well over $4 trillion until this past September, by selling bonds at attractive rates. With treasury bonds looking better, money will be less available for other investments, including real estate.”

Fed Chair Jerome Powell cut a particularly hawkish figure throughout the year, even defying President Donald Trump in December to raise interest rates one last time. While the resultant market furor has sent Powell down a more dovish path, there is little doubt that monetary tightening is still on the menu for 2019. That means money may flow out of real estate - in aggregate, at least.

As federal policy shapes the contours of the 2019 real estate market as a whole, it is important to recognize that it will likely do so unevenly. Publicly traded real estate, especially REITs, appears likely to face further punishment in light of rising interest rates, as well as a range of other macroeconomic factors flashing warning signs of economic slowdown.

Tax Reform Sparks QOZ Gold Rush

Back in December 2017, we discussed the likely impacts of the Tax Cuts and Jobs Act on the commercial real estate market. At the time, we foresaw a rush of private capital into real estate in 2018:

“The new tax law is set to help fuel the bonanza that has already engulfed private real estate investment. But as more and more capital floods in, investors must be ever wary of the dangers of an over-exuberant market.”

As things played out in 2018, we were proven largely correct. But 2019 will bring a new dynamic to the market: Qualified Opportunity Zones, or QOZs.

The QOZ designation is a product of the GOP tax reform bill. It provides a powerful tax incentive for private, long-term investment in economically distressed communities. Underserved or otherwise troubled areas have difficulty attracting significant investment capital, especially development funds, thanks to perceived risks inherent to such areas. Once designated as a QOZ, a distressed community may find itself awash in investment capital via Opportunity Funds, thanks to three key tax benefits:

  1. Temporary deferral of inclusion in taxable income for capital gains reinvested in an Opportunity Fund.
  2. Step-up in basis for capital gains reinvested in an Opportunity Fund.
  3. Permanent exclusion from taxable income of capital gains if sold after 10 years.

Those are huge benefits, but thanks to a quirk of the tax law requiring QOZ developers and Opportunity Funds to begin work by July in order to remain eligible, it has sparked a gold rush mindset that may ignore idiosyncratic risks and opportunities. This is an issue playing out all over the country.

Consider Chicago, for example, where 133 QOZ designations have been awarded, principally in the impoverished South and West Sides of the city. Most of these plots have been made far more attractive than they were before, but many of the underlying economic problems remain. However, there are key QOZ sites that look like veritable jackpots. The Illinois Medical District (“IMD”), located on the West Side, is home to four renowned hospitals and two highly regarded medical schools, and has about half its extent zoned as a QOZ. As the IMD pursues its own vision of becoming a major life sciences innovation cluster, the investment opportunities in its QOZ look almost too good to pass up.

REIT Weakness, Private Capital Strength

As various banks and big asset managers issue their guidance for 2019, most are wary of REITs. Wells Fargo, for example, is far from optimistic about the sector, according to its 2019 forecast, in which it recommends “Lower allocations to the most rate-sensitive assets, including REITs and most bonds.”

As we discussed last November, REITs as a whole look increasingly treacherous, but that does not mean there are no good options:

“It is hard to know exactly what will happen in 2019, but the evidence currently suggests that economic headwinds will intensify further, weeding out weaker REITs that have grown fat on leverage and near-zero interest rates.”

Yet, while there may be buying opportunities in particularly resilient and financially strong REITs, they have lost some of their allure. Private real estate investment, however, may well be able to take up the slack. Indeed, allocations to real estate private equity have once again hit all-time highs, with $180 billion flowing to the sector, according to Preqin’s latest data.

With large amounts of dry powder, these funds may well be able to seize opportunities in the event of a correction in the frothy real estate market. The sheer quantity of capital ready to be deployed may even help keep a floor under real estate prices, should a nasty reversal in commercial or residential property occur.

Outlook 2019: Uncertain Waters

As 2019 gets going, there is little way of knowing exactly how things will play out. Forecasting is a fraught activity at the best of times. In times of heightened market volatility and political uncertainty, it is exponentially more challenging.

Still, we can predict a few things with decent accuracy. We know that the QOZ gold rush will propel significant investment, and we can be pretty sure that REITs will have a hard time in an environment of rising rates. The behavior of private capital is less knowable, but we have made as good a prediction as any based on available data.

There will be opportunities for savvy real estate investors in 2019, both in REITs and private property investments. But those opportunities may be harder to find, and the market will likely be less forgiving than it has been in recent years.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.