Hot 1031 market shows signs of cooling
|The market for investment real estate is no longer the feeding frenzy it once was, but it remains strong, particularly for higher-quality properties.|
Franchisees have been benefiting from the voracious appetite for investment real estate. Overwhelming demand from private investors—particularly those pursuing the tax perks of 1031 tax deferred exchanges—has sent sale prices soaring.
Although demand remains robust, there are some signs that the white hot 1031 market has cooled in recent months. For some owners, that pullback in demand is translating to lower sales prices, less flexibility and a longer lead time to sell. During first quarter, the mean selling price for retail properties reached $1.45 million, a slight decline of $3,600 compared to fourth quarter, according to a report by the Boulder Group in Northbrook, Ill.
The demand for 1031 investments has shifted from a feeding frenzy to a more healthy, strong demand for property where investors are taking a more prudent approach to purchases. “Before we were in a very frenzied market, and now it is a more stable, healthy market where real estate fundamentals are coming back into play,” says Keith A. Sturm, CEO of Upland Real Estate Group Inc. in Minneapolis.
In recent years, rapidly rising property values in both the commercial and residential sectors, motivated investors to sell their properties and realize substantial gains from appreciation. In order to avoid hefty taxes on those gains, investors have been entering into IRS sanctioned 1031 exchanges, which allow sellers to defer capital gains when proceeds from a sale are rolled into another real estate investment within a certain period of time.
The two main reasons behind a drop in 1031 buyer demand are greater caution from lenders and less dramatic property appreciation. Apartment markets, particularly those in California and Florida, experienced significantly less value appreciation in 2006, which resulted in fewer sales and less demand for 1031 exchanges.
Flight to quality
Although 1031-driven sales remain strong, the most noticeable impact in the past year is a growing divide among higher quality, good credit transactions and lesser quality deals. “Better properties continue to see top dollar and huge demand, while lower quality assets are seeing a pullback in pricing,” says Bernie Haddigan, managing director of the national retail group for Encino, Calif.-based Marcus & Millichap.
“The higher the credit, the newer the property, the better they sell,” agrees Richard Walter, president of Faris Lee Investments in Irvine, Calif. For example, Faris Lee Investments has sold about 20 Starbucks-anchored strip centers in the Western U.S. in the past 18 months, all of which sold for cap rates between 5.75 percent and 6.25 percent. The average cap rate on retail properties priced between $2 million and $3 million is 7 percent, according to the Boulder Group.
Essentially, cap rates are a measure of the investor’s return that are calculated from key factors such as the purchase price and projected net operating income. So while a rising cap rate environment is good news for investors, it means that pricing for sellers is on the decline.
Sales of franchisee-occupied properties have experienced a 75 to 100 basis point drop in price in the past year, according to Marcus & Millichap. For example, a franchisee-leased property that sold for cap rates of 7.25 percent to 7.75 percent a year ago are now selling for 8.25 percent to 8.75 percent, whereas high-credit deals such as CVS or Walgreens have experienced no change in price. “Historically, this is premium pricing. It may not be as hot as it was 24 months ago, but it is still a very strong market,” Haddigan says.
Upland contends that the pricing shift for franchisee-owned stores has been more modest. For example, Upland sold a franchise-owned Wendy’s location in Houston last September for a list price of $2.3 million or a cap rate of 6.75 percent to a very motivated 1031 investor. In comparison, Upland is currently marketing another franchise-owned Wendy’s in El Paso at a list price that puts the cap at 7.0 percent a 25 basis point increase. Both properties are similar in that they are owned with multi-unit franchisees with similar credit, 20-year triple net leases and comparable locations in Texas.
Incentive to sell
It is important to note that even though there has been a pullback in activity among 1031 buyers, pricing remains at near record levels. In fact, the dip in sale prices, coupled with fears of interest rate increases, may end up convincing more franchisees that now is an opportune time to sell.
“It’s a great time for people to take money off the table. It’s a great time for franchisees to do sale-leasebacks, and to take advantage of the current market,” Walter says.
In addition, there are a number of ways that franchisees can make their properties more attractive to investors. The biggest opportunity to maximize values is by changing lease terms. Some options for securing a favorable sale price include increasing the lease term from 15 to 20 years, increasing annual rent increases to 3 to 4 percent versus 10 percent every five years, ensuring the lease clauses are the best possible triple net lease—including the correct casualty and condemnation clause, and having no cancellation provisions, Vannelli notes. Under a triple net lease, the tenant pays for everything regarding the property including rent, taxes, insurance, maintenance and utilities.
Despite the slight dip in pricing, many in the industry remain bullish on both the supply and demand for 1031 investment properties. “In my opinion, this is the best time in history to sell your property,” Walter says.