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CREDIT CRUNCH PUTS BRAKES ON 1031 EXCHANGES

By Steve McLinden

As go the capital markets, so goes the 1031 exchange world. Deal volume on these “like kind” exchanges, which allow investors to defer capital-gains taxes on real estate sales through the purchase of additional property of similar or greater value within 180 days, has slowed significantly in recent months.

Transactions fell some 40 percent late last year and early this year at San Diego Exeter 1031 Exchange Services, says Bill Exeter, the company's president and CEO. “Some of the smaller qualified 1031 intermediaries have done almost nothing in the first quarter of this year,” Exeter said. “A lot of people have just tucked in their wings and are holding tight. Some are viewing this as a cleansing of the market with the sellers and buyers getting back to [price] realities.”

The spiraling U.S. credit crunch sent sales of major retail properties down 31 percent in the fourth quarter, to $10.1 billion, according to Real Capital Analytics. Large portfolio transactions were off even more radically during the quarter, with only $4.2 billion logged, versus a combined $32 billion over the first three quarters. “Slower 1031 activity is very much related to the overall story of slower sales activity,” said Dan Fasulo, managing director of Real Capital Analytics. “Obviously, if sales are down, then there is less capital for a 1031 exchange.”

Though 2007 was still a record year for retail property investment, with some $71.6 billion changing hands, much of the action occurred in the first half, when price appreciation was jumping a heady 5 percent, according to the Moody's/REAL Commercial Property Price Indices. Optimism has since given way to recession fears, and financing is no longer as advantageous or as available, says a Real Capital research summary.

Many buyers, seeking security and stability, are struggling to find what they feel are appropriately priced 1031 replacement properties, says Louis Weller, a principal at Deloitte & Touche's national real estate tax services group. “There continues to be some spread between what buyers and sellers believe properties are worth,” said Weller. REITs, on the other hand, continue to engineer carefully orchestrated 1031 exchanges as an ongoing part of their deal making, but their transactions will doubtless be down as a whole this year as property sales slow significantly from last year's frantic acquisition pace, he says.

Tenant-in-common 1031 exchanges, in which exchangers buy into only portions of properties, were fewer last year than the year before, and they may drop yet again this year, Weller says. But a higher percentage of 1031 exchangers seem to be gravitating to these TICs now, because of their affordability, says William Winn, president of Passco Cos. and president-elect of the Tenant in Common Association. TICs represented only $500 million in acquired properties in 1998, Winn says, and by 2006 that had risen to $12 billion. Admittedly, TIC acquisitions did drop to about $9 billion last year, but that is still a relatively robust number for what was a relatively obscure product just 10 years ago, he says.

Pricing fears among retail property investors started to become reality late last year. Sales of open-air shopping centers averaged $156 per square foot in the fourth quarter, down from a peak of $184 per square foot in the second quarter, says Real Capital. Similarly, prices for malls and other retail properties fell to less than $200 per square foot in the fourth quarter, versus a second-quarter average of $232 per square foot. And after a continuous five-year decline, cap rates began rising in last year's second half, in inverse relation to falling values. In recent months they have climbed 40 basis points nationally, according to Real Capital.

In any event, 1031 exchange activity is only about 50 percent of what it was two years ago, says Bernard Haddigan, managing director of Marcus & Millichap. At this year's ICSC Conference on Open-Air Centers, in Hollywood, Fla., in February, “industry leaders were scratching their heads at the rapid slowdown,” said Haddigan, who co-chaired the conference. Multifamily building owners in California, who have traditionally been the most active 1031 traders, are largely on the sidelines, Haddigan says. This, combined with fewer overall commercial sales, has effectively put the brakes on the exchange market. What is more, retailers are slowing their expansions, while leasing terms are routinely getting renegotiated. “This has all put a damper on development and selling,” Haddigan said.

Some investors may be unable to get financing for replacement properties, making the profit from a property sale taxable, Exeter says. “Those players that have a little too much risk in their portfolio are going to have challenging times,” he said. Average equity per 1031 exchange has increased from about $500,000 to roughly $1.3 million, thanks in part to the credit crisis, he says. Many investors holding residential properties are out of the 1031 exchange market. Moreover, the supply of 1031 exchange properties may fall significantly as retail developers delay or pull back on expansion plans, he says.

Winn says some of his firm's 1031 clients have had trouble closing on their properties because of stricter financing. “We are seeing some buyers fall out of escrow,” Winn said. “A year ago 99 percent in the escrow phase were getting closed. That's no longer the case.” Banks have tightened credit and underwriting requirements on both borrowers and the real estate itself, he says. “We have also seen some deterioration in rent growth. But it's important to note that the fundamentals of most retail properties remain good. I have just never seen financing this tight.”

Right now there is more 1031 investment focus on grocery-anchored centers and less emphasis on power centers, Winn says. “And some sellers have started becoming more cooperative and flexible in pricing.”

Exchange activity on the Web site of shopping center owner National Retail Properties, which offers 1031 replacement properties and joint venture development programs, has “clearly dropped off since last summer's peak,” according to Jay Bastian, the firm's senior vice president. There is still considerable interest out there, he says, but the credit crisis is depressing deal flow. Further, he says, perhaps the perception is that the crop of properties available is weak. He notes that one investor that bought some $115 million in deals through National Retail Properties has become extremely cautious.

Some sellers, believing that real estate values may soften further, are simply taking the 15 percent capital-gains hit instead of looking for a replacement property, says Haddigan. “Their thinking is that it is better to take the tax hit now and then step back in when things stabilize.”