Shifting Tides: The 1031 Opportunity
I was recently on the U-Haul website searching for a quote to rent a truck. It was for a cross- border move of a three-bedroom household from my hometown in Orange County, CA, to Phoenix, Az.
To be clear, I’m not actually moving. This was just research.
The quote I got from the U-Haul site was $1,499 for the 370-mile journey.
It’s the flipside of that trip, however, that tells the story.
That same truck, covering the same 370 miles distance in reverse – Phoenix to Orange County– costs just $124. It’s less than 10% of the original cost to drive the same route in reverse.
Although you might have heard this type of search method for evaluating migration patterns before, stop and consider the dynamics at play.
The reason for the cost difference is a supply/demand thing. Lots of Southern Californians want a truck so that they can escape the high taxes and the high cost-of-living on the West Coast. They’re creating demand for trucks in Orange County and, thereby, driving the rental price up.
Conversely, demand is low from Arizonans wanting to trade their relatively mild taxes and much-lower cost-of-living for a California lifestyle. Anyone who does want to make that move will find an abundance of U-Haul trucks in Phoenix at a lower cost.
Where there is demand, there is an opportunity
The point here really has nothing to do with the supply and demand of U-Hauls. Instead, it comes down to the analysis of real estate economics and providing an opportunity for today’s real-estate investor to capitalize on a demographic shift.
Through a 1031 exchange, an opportunity exists to transition your real-estate holdings out of places now experiencing a negative net-migration and into properties in states where populations and job-growth are expanding.
And by paring a 1031 exchange with a business trust structured property, you can do so without any more management involved.
You can reduce – possibly even eliminate – exposure to markets such as California, New York, New Jersey, Connecticut, and others. And you can reinvest the proceeds into markets across Florida, Texas, Nevada, Arizona and elsewhere with no management headaches. It actually a simple process and the management free nature of these properties will make you ask why you did not consider this earlier.
As an investor who has personally owned more than 1,000 units/spaces over my career, I realize that owning local can be more advantageous for numerous reasons. Not the least of which is dealing with management issues from afar.
That said, a rising tide of people, jobs, escalating wages and the higher rents those first three factors bring can tip the scale in favor of a strategic 1031 exchange. Especially in those markets with favorable, long-term demographic advantages.
And the business trust structure eliminates long-distance management. In fact, all management is eliminated. I enjoy reading the reports on my management-free properties, especially knowing they are well run institutional quality properties in most cases so I will not have to make calls to any more property service vendors.
The Numbers Driving the Opportunity
Before getting into the details of this opportunity, let’s examine some of the data points that make this a potentially savvy transaction for real-estate investors who understand the power of demographics.
Housing studies from Redfin, Realtor.com, Trulia, and UCLA show that Californians now represent:
43% of new residents in Las Vegas.
30% of new residents in Phoenix.
22% of new residents in Dallas.
* U.S. Census data of American migration patterns show that the 50 cities with the greatest inflow of residents are primarily across the Sunbelt states, and are particularly concentrated in Florida, Arizona, Georgia, The Carolinas, and Texas.
Among America’s fastest growing cities are:
Frisco (Dallas suburb), Austin, Midland, College Station and Round Rock (Austin suburb), Texas
Miami, Orlando, Fort Myers and Lehigh Acres (Fort Myers suburb), Florida
Enterprise, Nevada (Las Vegas suburb)
Mount Pleasant, South Carolina (Charleston suburb)
Murfreesboro, Tennessee (Nashville suburb)
*Among the biggest population losers between July 2017 and July 2018 are New York, Connecticut, and Illinois – all high-tax, high-regulation, high cost-of-living states.
That last point gets to the core of what’s happening, writ large, across the country.
A display at the Building Museum in Washington, D.C., shows that the percentage of Americans that fall into our once-vaunted middle class has radically shrunk in recent years. In 1971, the display shows, 61% of Americans were part of the middle class.
By 2015, the number was down to 50%.
That decline is a function of many factors, including government policies; technological innovation that has destroyed jobs and limited wage growth; high taxation in some of the most populous states that, as a result, has eroded housing affordability; and inflation that, even at relatively tepid levels, has been consuming more of each middle-class worker’s stagnant earnings.
Just like price elasticity that sees consumers switch to chicken when beef prices rise, Americans at some point vote with their feet when taxes and cost-of-living in their chosen state become too much to bear.
Consider the case of David Tepper, a hedge-fund billionaire who called New Jersey home for 20 years. At his income level, Mr. Tepper hasn’t the same financial concerns as do most middle- class Americans. And yet Mr. Tepper is now a Florida resident, and his hedge fund is now based in Miami. He made the move for a simple reason: New Jersey imposes some of the highest taxes in the nation; Florida imposes none.
To be sure, Mr. Tepper is a unique case, and he has (literally) billions of reasons to make the move. But just as all politics are local, so too is personal finance, regardless of income. If an average American family is struggling to survive in Los Angeles or the Bay Area, or in New York, Chicago or the bedroom communities of Connecticut and New Jersey, they often reach the point where they realize their only logical move is to trade their life in high-cost, low- affordability states for more moderate living expenses (and, often, greater job opportunities) in places such as Austin, Nashville, Atlanta, Orlando, Miami and elsewhere across the Southeast and parts of the Rocky Mountain states.
And as real-estate investors, that’s our opportunity: To follow the flock of America’s economic migrants as they ditch high cost-of-living states for those with more-affordable lifestyles. It’s important to know which states have no property tax and those with the highest property taxes in order to take advantage of these shifting tides.
How to Capitalize and Profit on this Demographic Shift
What we’re doing is capitalizing on current values in high-cost locations, where prices have escalated sharply in recent decades, and deploying those profits across destinations where economic migrants are flocking.
In doing so, we’re exiting markets where valuations and rental-growth are likely to moderate, if not decline, and we’re picking up exposure to markets were valuations and rental-growth are much more likely to expand. We’re effectively tapping into long-term population growth, job growth, and wage growth … and in doing so, we’re ultimately tapping into rental income growth, since those first three factors traditionally drive rents higher.
Using the most advantageous tax law for real estate transactions, code section 1031 allows us to continue to buy in markets we expect to perform the best and sell in those we believe ending their upcycle. In some cases, such as Orange County California, we are already experiencing the deleveraging and deflationary side of another long real estate cycle.
By investing in Management-Free Investment Properties (“DST Investment Properties”), we’re able to make life much easier and profitable at the same time. I still like buying investment properties on my own so I generally blend small residential investments with DSTs when I have a significant amount of funds to exchange. I buy my own investment properties in the same markets where I invest in DSTs.
If you are unfamiliar with 1031 exchanges, or just need a refresher course, we’ll help make that easy as well. The 1031 exchange gives us great flexibility in exchanging one property for another, within certain boundaries, without triggering a taxable event. We keep 100% of our capital at work, instead of losing a substantial portion to the IRS and state tax agencies.
One of the great benefits I see in this strategy is that by selling property in high-cost states, we can typically afford higher-quality properties or a larger number of properties in lower-cost states. This helps increase diversification.
Moreover, with the DST structure, we no longer must deal with the “5 Ts” of real estate: tenants, toilets, trash, telephone calls, and time commitments. All day-to-day issues are handled by an experienced real-estate company with the staff and resources to provide higher-quality, timelier, more-efficient management.
In addition, the DST is a “bankruptcy remote entity,” meaning creditors cannot seize properties, thereby protecting us from all the various liability associated with property ownership. I’m not necessarily recommending wholesale dumping of every property an investor owns in high-cost states that are losing population. That might not make sense for any number of reasons.
However, I see great opportunity in exchanging out of the properties I want to hold least. Perhaps these are properties that give me the most headaches, or those with the worst income-to-expense ratios. Or perhaps they’re properties I expect will perform the worst in an upcoming shift in the business cycle.
Indeed, this is the strategy I’ve been using personally: Employing a 1031 exchange to transition out of certain properties and into management-free properties in markets that are better positioned for rental growth and price appreciation. It’s how I’ve been balancing my personal real-estate portfolio.
Every market has its positives and negatives, and there are opportunities even in the worst markets. But as an investor with a long-term focus on the real estate I own, I want to be on the profitable side of the demographic shift that’s reshaping America’s cities and states.
A rising tide of people, job and wage growth, and the high likelihood of commensurate rental growth tips the scales in favor of real-estate markets in places such as Nevada, Texas, Arizona, Florida and elsewhere.
That’s where I see the greatest opportunities, and why I believe a 1031 exchange paired with a DST represents such a unique opportunity in 2019 and beyond.
