Commercial real estate safe from downturns? If not what?

Question

What can you park your money in (other than cash) that protects it from down turns such as the 2007 bubble? I don't believe we are in one now, but when they time comes, I want to put my money into assets that are sheltered from it. I thought commercial was a good way to go since they are valued off their NOI rather than supply and demand like houses are. But I've talked to a few people that said that commercial still goes down in value in those situations. Is that accurate?

If so, then where to invest your money to cash flow but not lose a ton of equity? I thought about buying houses paid in cash and just soaking up the cash flow for years, but with the 1031 rules, I have to have a mortgage the same size as what I sold. So that put a stop to that idea.

Surely there is something that one can invest in that doesn't cycle like residential real estate does.

Dave Foster · Answer

@Jack B. Yes you are fine purchasing one or three replacement properties and you can allocate the cash proceeds anyway you want in those purchases.

But it is not true that you must carry equal or greater debt   I get what the author you quote is saying but it needs to be rephrased to be specifically accurate - Here's what it should say - ..."To effect a completely tax-deferred exchange, you will need to spend all of your $500,000 in equity on real estate and you will need to purchase at least $1,000,000 in replacement real estate."

Cash from any source can replace debt to reach the investment target.  However, if you reduce debt and do not replace with outside cash then yes you incur a taxable event.  In most instances its a moot point because the investor doesn't have any other cash sources.  But it is a common tool used by investors to mitigate risk from a potential market downturn by combining cash in a 1031 with outside cash to purchase and consolidate properties free and clear.

Jack B. · Answer

I'm just trying to figure out how to avoid losing a lot of net worth during the next down turn. My options are to either cash out and pay huge capital gains taxes and transaction costs close to 500K or to 1031 into assets that will decline in the next down turn.

One thing I had considered doing was buying free and clear properties and pooling the cash flow during the downturn to buy more properties, though of course the free and clear properties I'd own before the downturn would lose some value too.

Surely there has to be a better way.

Aristotle Kumpis · Answer

Jack, there is no investment that is fail proof. You have to have staying power and ride out the bad storms when they come around. But buy and hold residential real estate is one of the best ways to park your capital. Everyone needs a place to live. And if you invest in a market where there is population and job growth, your property will do good. (You also have to have a good property manager as well.)

Just look at some of the investors that have held on to property for 20-30 years. They are glad they bought back then because they are probably doing well right now. Its not all about appreciation and equity, unless you like to play that game.

David Faulkner · Answer

It is true that commercial is valued off of NOI but not true IMO that it is immune to business/economic/real estate cycles (though it may be on a slightly different cycle than residential). For example, to back out commercial property value from NOI, you use a CAP rate ... the CAP rate is set by the local market and is subject to change/cycle. In a recession, CAP rates will tend to expand, decreasing the value of the same NOI in the same market, and in a boom like we are seeing now CAP rates will tend to compress raising commercial property values. So, there is no port that is safe for each and every type of storm. In fact, I'd argue that in many markets commercial (at least multi-family commercial) is more overvalued than residential.

You are correct that free and clear reduces your volatility (both to the up side and to the down side). Diversification of different asset classes and markets can also help, but then you run into the problem of investing outside of your area of expertise, which can have its own risks. I would say that just like residential, not all commercial property is created equally. Higher quality properties, in higher quality markets/neighborhoods will tend to have lower CAP rates but also lower volatility of cash flow and may hold up a bit better during a downturn. Finally, if you buy a good deal and do value add forced appreciation, you can minimize your risk by having a lower cost basis and multiple exit strategies (hold for cash flow or sell for profit). These are the different "levers" I can think of for managing your risk ... to repeat in a different way, it is an investment and there is no way to completely avoid risk, but risks can be assessed and managed, and it is the overall portfolio risk, which is different than the risk from an individual property, that really matters at the end of the day IMO.

Jack B. · Answer

Are you sure that's accurate? Every 1031 site I've read up on says you must replace the debt with equal or greater debt. Or are you saying that as long as the debt is cumulatively equal to the debt I replaced, regardless of whether I buy one or three houses, I'm fine?

http://www.aptmags.com/blog/1505/1031-exchange-debt-replacement-requirements.html

Dave Foster · Answer

@Jack B., Why not consider a hybrid approach?  First there's no statutory requirement to carry equivalent debt or any debt on your replacement properties.  What is required is that in order to defer all tax you must purchase at least as much as your net sale and that you use all of the proceeds in the next purchase or purchases.  Most folks don't have access to outside cash from anywhere so they end up taking out similar debt or reducing the size of their purchase and paying tax only on the amount they don't reinvest without jeopardizing their exchange.

You also do not have to place your cash in any sort of proportional way in the exchange.

What this means is that you could pursue two different approaches might help put you where you want to be.

1.  Do a partial exchange - Buy less property and pay tax only on the difference keeping the rest of the 1031 intact.  This reduces debt and mitigates risk.

2. Take your cash and purchase a mix of free and clear properties and some that are leveraged in whatever configuration you want.  By shifting your cash position you'll have crash proofed a few free and clears so that the risk from the leverage on the others is minimal.

Commercial real estate safe from downturns? If not what?

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