Last month, the Jansen Multifamily Team polled Puget Sound apartment investors about their impressions of the current market. That poll data, coupled with our own observations form the basis for a three-part series on the “Why’s” of today’s Puget Sound apartment market. This week’s post, number two of three, discusses why to sell in today’s market.
Generally speaking, nobody wants to sell in a market like today’s. Values have come down 15-20% off their market peaks, significantly eroding many investors’ equity in their assets, and the prospective buyer pool has shrunk as many investors wait on the sidelines until the market clearly “hits bottom.” For many Puget Sound apartment investors, now may seem like the wrong time to sell. However, the situation is not completely dire, as there are still strong reasons to sell today, including the opportunity to re-leverage, the availability of cheap debt, and a historically low capital gains rate.
Re-Leverage Your Capital
In last month’s JMT poll, 44% of respondents indicated that an opportunity to re-leverage would motivate them to sell in today’s market, and it is a compelling argument. Current market conditions enable investors to sell their apartment buildings today and reposition their net proceeds into superior assets that better fulfill their investment goals.
The fundamental rationale for re-leveraging is the notion that, if your value has gone down, your neighbor’s value has gone down as well. Relative buying power has not changed for the worse. Rather, buying power has gotten better for prospective purchasers. Selling into a declining market gives investors the opportunity to strike a better deal on the replacement property as prices continue to decline. If one were selling into a growing market (i.e. after we have “hit bottom”), relative buying power would decline, as prices would continue to appreciate while seeking a replacement property.
Secure Long-Term Debt While Rates Are Low
The opportunity to re-leverage is made even more attractive by the low interest rates currently available through Fannie Mae and Freddie Mac. Mortgage rates have remained historically low throughout the national economic downturn, as illustrated in chart below (provided by Dupre + Scott Apartment Advisors, Inc.), which tracks mortgage rates over the last 30 years. Investors that start a new holding period today will enjoy the stability provided by long-term debt at the most competitive rates we will see for years. Looming inflation will likely drive interest rates up, which will decrease opportunities for positive financial leverage (explained in last week’s “Why to Buy” post).
Dupre + Scott Apartment Advisors, Inc.
Rising interest rates will take many buyers out of the market; those buyers still in the market will require higher capitalization rates to achieve adequate leverage and returns, thereby decreasing asset values. Apartment owners can avoid this potential scenario by selling into today’s market, where financing is still keeping buyers “in the game.”
Capitalize on Historically Low Capital Gains Rate
Another exceptional way to maximize today’s value is to take advantage of one of the lowest capital gains rates in U.S. history. The current tax rate on capital gains is 15%, per the Bush tax cuts of 2003, which is the lowest capital gains rate since the 1920s, when the rate was 12.5%. The Bush tax cuts will expire at the end of 2010, and President Obama has vowed he will not renew them, thus returning the capital gains rate to 20% next year. As far as where rates could head in the future, it is anyone’s guess (the rate was 28% in the early-to-mid-1990s).
Consider an example where an investor sells a 20-unit apartment building for $2 million. The investor had $1.2 million in debt on the property and their taxable gain after closing costs and depreciation recapture is $500,000 (estimated for simplicity’s sake). At the 15% capital gains rate, their tax obligation is $75,000, while at the 20% rate, their tax obligation is $100,000. By selling today, rather than a year or two into the future, this investor saved $25,000, or possibly more, depending on where the capital gains rate goes in the future.
Selling in today’s market may not be ideal, but whether your motivation to sell is a “have to,” or a “want to,” there are concrete reasons why it makes sense to sell today. If you unsatisfied with your property’s location, you can re-leverage into a stronger submarket. If you do re-leverage, you will be locking in long-term debt at some of the lowest rates we will see for a while. Finally, by selling today and “cashing out,” rather than exchanging, you will take advantage of the final year of capital gains rates at 15%, before they head to 20% and beyond.
There is a downturn in every investment’s holding period, and it makes sense to experience it at the beginning, rather than the end. Regardless of your motivation, now seems as good of a time as any to start.
Check back in next week for the final installment of our three-part series, as we will be discussing why to refinance in today’s market.
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