Historically speaking, independent real estate investors who held for the long-term walked a relatively straightforward (although bumpy and slow at times) path toward achieving asset appreciation and long-term wealth. This path would often look something like this: An investor would purchase a piece of property that would potentially generate enough cash flow to cover the expenses, including principal and interest on the mortgage, insurance, property taxes and maintenance costs. Over time, the property would (hopefully) increase in value, income (rents) would rise, and certain tax advantages, like the ability to deduct operating and depreciation expenses, could be utilized to improve cash flow.
However, the steady march of new government regulations, the impact of COVID-19, and some basic real estate economics have helped some real estate investors recognize that the real estate investments they own have become less profitable and could even worsen to the point where investors could actually lose money each year.
The Growing Impact of Rent Control Before and After COVID-19
While this may sound like hyperbole to some, our firm is actively working with numerous apartment owners across the country, and we hear firsthand some of the challenges and pressures property owners are facing. Even national media are picking up on this trend. For example, a recent Wall Street Journal article cites that apartment owners and investors are leaving California and the Northeast for places like Florida, Texas and the other Southern states where warm weather, business-friendly governments and laws, lower taxes and fewer regulations seem like a breath of fresh air.
Reuters recently lamented that beset by COVID-19 and its fallout, many smaller local landlords are offloading their properties and selling to national institutional investors, and CNBC recently reported that at least 60% of single-family rental homeowners are owed back rent and are being forced to sell their rental properties to recoup losses. Finally, CBS announced that as a last-ditch effort to claw back tens of billions of dollars in unpaid rent, a national group of landlords is suing the federal government for back rent.
However, even before COVID-19 rolled across the nation’s multifamily rental real estate investment market, landlords were seeing new rent-control legislation start to encroach on their investment real estate portfolios, and squeeze owners’ profits. When COVID-19 arrived in the United States, cities across the country started expanding rent-control laws and eviction moratoriums at an alarming rate, directly exposing landlords to financial peril. Legally speaking, the term “rent control” can be defined as any statutory rule that regulates the timing or frequency of increasing tenants’ rent, the services landlords must provide tenants, and the limited ability of landlords to evict tenants.
Today, multiple cities, states and jurisdictions are under some form of strict rent-control regulation, including Washington, D.C., Maryland, New Jersey and New York. Most recently, Oregon and California have enacted statewide rent-control laws that have greatly reduced landlords’ ability to raise rates. Cities like Santa Ana and St. Paul have both passed bills limiting rent increases to 3% a year. Seattle even passed a bill requiring landlords to pay the moving costs for tenants who can’t afford to stay in their homes, and Los Angeles passed a law that protects tenants from eviction for unpaid rent.
Perhaps no other region in the nation is more challenging for landlords than California’s Bay Area. For example, Berkely has had one of the strictest rent-control environments in the country, capping not only rents, but also garbage and parking fees; Hayward caps rent increases at just 5%, and rent increases following voluntary move-outs cannot be more than 5%; Oakland’s Rent Adjustment Program (RAP) limits rental increases to 30% in a five-year tenancy.
Even more worrisome for landlords, cities like Portland and Oakland have recently created new restrictions limiting the ability of landlords to screen potential tenants, including:
- Prohibiting the use of criminal background checks.
- Limiting the use of financial background checks.
- Requiring landlords to accept previously evicted tenants.
- Limiting security deposits to 1.5 x month’s rent.
Adding to these growing restrictive rental laws, landlords today must also face the reality of complicated and costly eviction laws and the soaring costs associated with repairs and maintenance.
Finally, many owners are recognizing that perhaps their rental property may not make as much financial sense as it once did. Why? Well, for several years now, property values in certain situations have risen faster than an owner’s ability to raise rents. The result is that the cash-on-cash return, or “equity yield,” gets compressed the higher property values rise. In some cases, this cash-on-cash return can be squeezed from a double-digit return to a low single-digit return. Add to this the uncertain factors, like inflation and unemployment, higher taxes, and a softening rental market, combined with city- and government-imposed rent-control and eviction moratoriums, and more landlords are coming to the conclusion that now might be potentially a good time to sell their investment real estate.
Enter the Delaware Statutory Trust and Passive Real Estate Investing
So why don’t rental owners simply take their equity positions and cash out? The simple answer because of the tax liabilities — including federal capital gains (15%-20%), state capital gains (0%-13.3% depending on the state), depreciation recapture tax (25%) and possibly the Medicare surtax (3.8%) — will now be due upon sale. These associated taxes could potentially take up to 40% of the asset’s sale price out of the seller’s proceeds.
In addition, while it is true that a 1031 exchange would allow them to defer their taxes, it is also true that they would most likely be limited to exchanging into another multifamily building or a single-tenant NNN building. What’s the problem with these assets? Nothing, except investing in another multifamily building doesn’t offer the owner much diversification, and because the proverbial “Three T’s” of tenants, toilets and trash will still be involved, there will always be headaches and management expenses involved. A single-tenant net-lease property relies heavily on the quality of that sole tenant, and if that tenant fails, the investor’s income is likely to be reduced or eliminated (during COVID-19 there were a number of NNN tenants who went bankrupt or sought rental relief from their landlords). Also, triple net lease properties can be hard to locate, and conducting proper due diligence can be difficult to accomplish within the time frame of 1031 exchange.
That’s why many landlords are utilizing Delaware Statutory Trust (DST) 1031 exchanges to exit the active management role of owning rental real estate. Delaware Statutory Trusts are a form of fractional ownership that can be used to make passive investments in real estate and achieve monthly income potential via ACH direct deposit and diversification across multiple assets. Also, because DSTs are eligible for 1031 exchanges, investors can sell their investment property and reinvest the proceeds into one or more DST investments while deferring capital gains and other taxes.
Another reason DST investments are popular among real estate investors is because many types of diverse real estate assets can be owned in a DST, including industrial, multifamily, self-storage, medical and retail properties. Also, it is not uncommon to find properties within a DST investment that include institutional-quality assets like those owned by large investment firms, such as a 450-unit Class A multifamily apartment community or a 100,000-square-foot industrial distribution facility leased to a Fortune 500 logistics and shipping company.
In addition, Delaware Statutory Trust 1031 exchanges offer real estate investors the following specific potential benefits as well:
- The ability to close their 1031 exchange within typically three to five days.
- The opportunity to eliminate the hassles of tenants, toilets, and trash (i.e.. the Three T’s).
- The potential to receive regular monthly distributions via ACH direct deposits/
- The ability to access institutional-grade real estate assets.
- The potential advantages associated with greater portfolio diversification by geography, tenants, and asset class.*
The Bottom Line
Investment properties have gone through significant changes over recent years, and in many cases, owners have been faced with challenges they have never seen before, including the COVID-19 pandemic, and ensuing eviction moratoriums. For qualified property owners who are motivated to sell soon and are facing capital gains, reinvesting the proceeds in qualifying properties, including DSTs, will allow them to not only defer capital gains taxes but also become part of a diversification* strategy with the potential for appreciation and monthly income.
*Diversification does not guarantee returns and does not protect against loss.
