How to Solve New 1031 Cash-Flow Dilemma

By Marc Imrem, Managing Director, Capital Markets, Transwestern

 1031 investors who are dependent on cash flow are facing a new challenge to their investment programs. Because debt fundamentals prevent positive leverage for long-term, high-credit real estate, many investors are currently chasing higher-yield transactions. As they try to follow the standard 1031 strategy of acquiring larger assets with new debt, they have lowered some of their standards to allow what once was considered unacceptable risk. They are buying properties with lower-credit tenants on shorter-lease terms in less desirable locations than they would have previously in an attempt to achieve acceptable returns.  The spreads between cap rates and interest rates are shrinking to the point that 1031 sellers are likely to receive less cash flow if they utilize debt to trade to larger properties. That creates a dilemma for 1031 investors: How can one create wealth if trading up to higher value properties isn’t an option? In the short-term, investors should consider acquiring properties similar in size to the ones they are selling but with better underlying fundamentals. This sort of lateral move is counterintuitive but could help avoid risk and maintain cash flow until utilization of debt becomes advantageous again. Investors may balk at acquiring a property that doesn’t improve their cash flow or value position, but when focusing on the long-run, it can be beneficial to opt for better fundamentals.

The length of a lease is critical in uncertain times. Most net-lease deals lose potential value as lease terms get closer to expiration since there’s a chance the tenant might leave. Properties that currently have a lease near its end face a particularly uncertain future with more than one national retailer announcing nationwide store closures. For instance, while Walgreens is a strong, national-credit tenant, the retailer recently announced the closing of more than 300 stores. For those unlucky locations, there are not many other tenants that would pay the same rent to occupy that space. Therefore, the investor’s rent could decrease by 50 percent if Walgreens decides to leave.

Rental rates in the surrounding submarkets also play a significant role in potential cash flow. If a tenant is paying below-market rent and decides to relocate at the end of its lease, the owner stands to increase cash flow by raising rents. In addition, certain tenants are viewed as less of a risk because they are “recession-proof.” An O’Reilly Auto Parts store, for instance, would theoretically stay busy during an economic downturn as consumers opt to repair their vehicles rather than buying new ones.

Secured, improved fundamentals on a property could also guard against possible changes in tax laws. The idea of ending the long-running 1031 exchange program has been discussed for many years; however, the concept now seems to have some support from both Democrats and Republicans. Acquiring a property with a long-term lease could delay the inevitable tax consequences if the 1031 exchange program is eliminated entirely. Legislators are also discussing the possibility of giving fewer tax benefits to REITs, which could make it difficult to provide acceptable returns. Investors would likely purchase fewer properties until returns moved enough to support their business models. That drop in demand would result in lower property values and higher cap rates in general.

Market forces that are prompting this “lateral trade” investment strategy to preserve cash flow should be temporary. The investment environment will change once an event occurs to normalize the market; that is, something happens to either slow competition among buyers or adjust the needs of buyers. An increase in the spread between cap rates and debt rates will create buying opportunities, and investors will again be able to take advantage of debt to “trade up.” In the meantime, narrow spreads between cap rates and interest rates are expected to prompt a decrease in transaction momentum and have already created an inefficient 1031 market.