Record high prices and very low cap rates have many real estate investors wondering if now is the time to take advantage of the market and sell their properties. I have spoken with quite a few people who feel this all-time high won’t last and now is a great time to pull equity out of their properties and have cash available if the market drops and there are buying opportunities. Other investors have pointed to factors like the expanding economy and high inflation and decided that now is the time to shift money into real estate since that is one of the best investments in inflationary times. The best way to make this personal decision is by looking at the fundamentals of the market and choosing based on one’s time frame, goals, and other assets.
Increasing demand from remote workers and underbuilding during the great recession have led to a tight supply of both commercial and residential properties. Combine that with the fact that job growth has created demand for real estate, and you’ll see how the basic principles of supply and demand are pushing prices to the highest we have ever seen. But will they come back down, or will they continue to rise?
The Case to Buy
The rise in consumer prices has hit levels not seen since the 1980s. With everything from food and labor to raw materials and building supplies increasing in cost, the cost of new construction has skyrocketed just like everything else. When it costs more to build a new building, that increases the value of existing buildings, and it is one of the reasons that real estate is a good hedge against inflation. Not only does the value go up as prices rise but investment properties pay dividends in the form of rents, providing a good yield that also rises as prices increase.
Real estate values have only gone down once in our lifetimes and that was due to the collapse of our financial lending market in 2007 - 2008. There are strong financial pressures that lead to increasing prices over time and even those investors who lost value in our worst downturn have come out ahead if they were able to hold onto their real estate for the long term. Even if prices remain flat for the next few years, the income from investment properties often beats the returns of stock and bonds in periods of inflation.
Interest rates are still near historic lows and there is plenty of capital available to investors. Real estate is an investment that can easily be leveraged and when used correctly, this capital will boost returns for investors to improve their yield on the cash portion of their investments.
Real estate investment also has tax advantages. The ability to write off interest and depreciate buildings means the effective tax rate will be lower than the taxes paid on alternative investments. If held for more than one year, the investor pays long-term capital gains rates which is one of the lowest tax rates. If the investor never sells the asset, the value gets stepped up in basis upon the death of the owner, meaning the person(s) inheriting the assets won’t pay capital gains tax.
Reasons to Sell
Contrarily, taxes are also one of the reasons investors may say now is a good time to sell. There is talk of raising the capital gains rate, so today’s sellers may pay a lower tax than sellers who wait. There is also talk about eliminating the 1031 tax deferred exchange that allows sellers to defer their taxes by buying a replacement property. Since taxes can greatly erode the purchasing power of one’s equity the ability to do a 1031 exchange has been a vehicle allowing many investors to sell appreciated assets that they would not have otherwise sold.
Over the past 40 years, we have seen a trend of declining interest rates. This has led to a steady movement towards lower cap rates and higher prices. As interest rates change direction and start climbing, we will see mortgage payments and cap rates rise which puts downwards pressure on prices. This should keep prices from climbing as quickly as they have been recently and could even cause prices to decrease if rental rates do not climb as quickly as inflation.
Government spending and pandemic payments have led to a lot of capital in the market. Easy money means more potential buyers and that is always a good thing for sellers. As access to these funds wanes, we will have fewer buyers in the market. In addition to that we have seen more buildings being built and as supply increases the prices may start to decline.
What to Do
The arguments are compelling on both sides. The answer is going to be dependent upon each individual’s situation. Does the investor own a lot of appreciated real estate? Is retirement right around the corner or years away? What does the rest of the stakeholder's financial picture look like? While selling at the high point is never a bad idea, how many years of income would it take to earn the same amount of income if one does not sell? These answers are very personalized for each investor and require careful financial review. After a thorough evaluation, each investor must do what works best for their individual situation.
