What a New Administration in DC Means for Investment Sales in NYC
Changes to 1031 exchanges and capital gains taxes could have profound effects
A popular topic on Zoom calls recently has been what the implications will be for the New York City investment sales market of a Biden administration with a House and a Senate controlled by Democrats. The two main impacts that policymakers can have on the commercial real estate market are on the stimulus and tax policy sides.
On the stimulus side, some folks have alluded to the government writing big checks to bail out city and state governments that have been running deficits for years and are now really underwater given what the pandemic has done. If these large checks are written, it could be very stimulative to local economies, and, therefore, real estate fundamentals would be a beneficiary.
However, all the printing of money could create inflationary pressures and, in ordinary circumstances, would exert upward pressure on interest rates. Given the massive size of government debt, the Federal Reserve would probably do everything in its power to keep rates low, and the government will need to continue to sell bonds and would want to pay as little as possible on that debt. Rising interest rates would cost the government more on the existing debt we have, as well as on the future debt we will take on to make these new stimulative initiatives feasible.
Where all that money will come from is another story and impacts the other primary potential issue for CRE: tax policy.
President Biden said many times during the campaign that he would raise, or completely eliminate, the capital gains rate and would modify 1031 exchanges. Both of these things, if enacted, could have profoundly negative impacts on CRE, particularly on the sales side. Our hope is that this was just campaign rhetoric and that he is not serious about these changes.
History has demonstrated that the actions of commercial real estate market participants are highly correlated to tax policy changes. Some economists and some business leaders do not believe that changes in tax policy impact behavior. When it comes to commercial real estate sales, that couldn’t be further from the truth. In New York City, three of the five top years, in terms of investment sales volume over the past 36 years, (I began my career in 1984 and have studied the market since) were catalyzed by changes in tax policy, illustrating the close relationship between tax policy and sales volumes.
To demonstrate this relationship, we will use the Manhattan investment sales market as a microcosm to demonstrate this undeniable correlation. South of 96th Street on the East Side and south of 110th Street on the West Side, there are 27,649 investment properties. Of this stock, we have tracked all sales, and, in an average year, there have been 719 properties sold, or a 2.6 percent turnover ratio. The turnover ratio has been as high as 4.3 percent (1,200 sales), which occurred in 2012, and as low as 1.2 percent (331 sales), which occurred in 2009 and was caused by the global financial crisis. (We will know within the next two weeks or so whether the turnover ratio in 2020 will be lower than the 1.2 percent low — it very well could be.)
We saw a spike in New York City investment sales volume in 1986 because of the Tax Reform Act that year. With increases in capital gains taxes (20 percent up to 28 percent) and changes to deductibility rules scheduled to kick in during 1987, participants rushed to sell in 1986 before the capital gains tax increased, which effectively “stole” activity that would have naturally occurred in 1987 and accelerated that activity into 1986. The cyclical peak in that market occurred in 1988. In 1986, the turnover ratio was 3.4 percent, up from 2.8 percent the year before. Turnover fell back to 2.8 percent in 1987, and then hit its natural cyclical peak of 3.5 percent in 1988.
In 1998, the Clinton administration dropped the capital gains tax rate from 28 percent to 20 percent. For long-time holders of assets with a low-cost basis, this effectively increased the value of their properties by 8 percent overnight and caused a significant spike in sales volume in that year. To illustrate the spike the tax policy change spurred at this time, we see a turnover ratio of 2.8 percent in 1997, 3.9 percent in 1998 (tied for the second-most robust sales year going back to 1984) and down to 2.6 percent in 1999.
The third spike catalyzed by tax policy occurred in 2012. A relatively small 3.8 percent increase in capital gains taxes was covertly imbedded in the Affordable Care Act and was scheduled to become effective in 2013. On top of this increase, the campaign rhetoric during the 2012 elections was peppered with talk of further capital gains tax increases. It has historically been a target for politicians as studies have shown that 70 percent of capital gains go to the top 1 percent of taxpayers.
The actual increase, plus the threatened increase, had investors heading for the exits in droves. At Massey Knakal, we did nearly 50 percent of our 2012 annual revenue in the fourth quarter and closed 26 sales on New Year’s Eve. I remember that Monday night very fondly.
If 1031 exchanges are modified, it would also have a negative impact on sales volume. Modifications would make it more expensive to sell and, as Economics 101 teaches us, when an activity costs more to do, you get less of that activity.
The other impact tax policy will have on commercial real estate revolves around income taxes and migration patterns. One of the most troubling trends we have seen in New York over the past two to three years is the attraction that low-income-tax states is having on traditional New York investors and residents. If income taxes are increased significantly, it could exacerbate the shifts of capital and people toward friendlier tax environments.
Generally, it seems that states with state income taxes below 3 percent to 4 percent have economies that are thriving and populations that are growing. Capital and people are increasingly attracted to these locations.
We remain hopeful that capital gains taxes won’t be increased, as our broader economy needs to be stimulated in the post-pandemic world and, historically, capital gains tax policy has not been a completely partisan issue. The 1998 cut was implemented by President Clinton, a Democrat; and in the early 1960s, John F. Kennedy, also a Democrat, fought Congress, which wanted an increase, to keep the rate at 25 percent, as he feared an increase would slow the economy.
Again, hopefully, these changes will not be enacted. But, if they are, it actually could be good news for transaction volume. Historically, if tax policy changes go against the taxpayer, they kick in during the following year. If policy changes benefit the taxpayer, they have been implemented retroactively to the beginning of the calendar year in which they are passed. Increases could cause a whirlwind of sales activity in the second half of this year. We won’t mention what sales activity would be like in the following couple of years, but you can imagine what that would look like.
We love our city and hope that it can recover quickly and robustly from the pandemic. Tax policy could impact how our commercial real estate market rebounds, but it is far too early to know what will happen. Meanwhile, we must do what we can, and advocate for our wonderful city and the rebound that will inevitably come.
Robert Knakal is the chairman of New York investment sales at JLL (JLL).