Business real estate: buy, sell or keep?
The commercial real estate market was battered, shattered and left for dead by COVID in 2020, but came back to life in 2021 with record sales of $809 billion.
I was a broker to a seller or buyer of investment property sales totaling $55 million last year, and the phone calls haven’t stopped. When I consult with my investor clients, the most frequent question I receive is: “Should I buy, sell or hold?” My answer is: “It depends.”
Private commercial real estate has always provided a strong hedge against inflation. Landlords of properties with short-term leases such as apartments, self-contained warehouses, and manufactured home communities can quickly raise rents to match inflation, as measured by the Consumer Price Index. This is a significant advantage since the CPI exceeded 8% in March and April, the highest rate since 1981.
While inflation is the friend of many homeowners, recession is not. On a recent trip to Los Angeles, I stopped by the office of an 84-year-old manufactured home community owner I know who has an extensive national portfolio. I learned that the owner – one of the savviest investors I know – plans to sell his entire portfolio for an estimated $400 million.
Over lunch, I sensed he thought the commercial real estate market may have reached a cyclical high and the threat of a recession was growing. A recession has followed every surge in inflation for the past 75 years, and the current trend of defying gravity shows no signs of abating. Wholesale price inflation – what manufacturers pay for raw materials – is now 11%, and those costs will be passed on to the consumer, driving up the CPI even further.
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Moreover, given that sudden spikes in energy costs preceded six of the last seven recessions, another recession seems inevitable. My friend is selling at the cyclical peak of market values when he can fully control the allocation of the proceeds – tax free – to create a more diversified and less demanding real estate portfolio. My advice (not that he needed it) was, “You made a wise decision.”
The decision was, for him, the right one because what is bad for the economy is most often bad for commercial real estate. Investment real estate performance and GDP rise and fall together. A weak economy means lower business and consumer spending, which limits landlords’ ability to raise rents. Investors with a Dollar General or Walgreens, with fixed rents for 10-15 years, will lose money every year. The same will be true for landlords of big-box shopping centers and medical office buildings with long-term leases not indexed to the CPI.
The Fed’s more aggressive monetary policy will create higher long-term interest rates, causing a recession and tighter commercial lending requirements. Higher rates and capital requirements on loans lead to lower yields, causing investors to withdraw and property values to decline. For most clients with such assets who are alarmed by a disintegrating economy and considering a sale, my advice is to hold on.
The cycle of decline and recovery often spans a decade or more. Owners under 50 can afford to wait for the next bull cycle if the market sees a significant correction. My advice to young investors considering new investments is to buy while interest rates are even lower than they may ever be in our lifetimes. Commercial real estate has been on the rise for decades and for 25 years has outperformed the S&P 500 Index, with average annualized returns of 10.3% and 9.6%, respectively. And, unlike stocks, bonds, and cryptocurrencies, real estate has never had zero value.
But what about baby boomers? If you’re a doctor over 60 and want to cash in on the equity in your doctor’s office building to facilitate a more comfortable retirement, now might be a good time to sell and rent. Owners with intensively managed assets like single-family rentals, manufactured home communities, and small apartment buildings may want to relax, travel, and enjoy the results of decades of hard work. They can use IRS Code Section 1031 to trade in an “absolute net” retail business without management, benefiting from historically low interest rates, avoiding capital gains and pocketing money tax-free .
Being sensitive to economic cycles when buying, selling or snagging is key to succeeding in commercial real estate.
Chris Zarpas is a Commercial Real Estate Broker with SL Nusbaum Realty Co. For more information visit chriszarpas.com.