From a small northwestern observatory…

There is a fair amount of speculation about the future of the U.S. tax code.  I don’t want to get into politics here, but if and as the tax rates change going forward, many serious investors will look backwards and say, “Gosh, I wish I’d done _____ when I had a chance.”

Well selected and well managed real estate has, for generations, been recognized as a hedge against taxes, inflation, recessions, market instability, and all manner of economic fluctuations.  Looking at the economic history of the past 100 years or so, we can only point to one real estate-related bubble, and in reality that was, at the core, a finance problem and not a real estate problem.  Even before, during, and after the most recent recession, well-selected and properly priced real estate performed well.

A few tips and notes, and as usual please bear in mind this is neither tax, legal, accounting, nor investment advice —

• Current income from real estate can be sheltered by depreciation.  Indeed, for most income-producing properties, the current income will be nearly tax free, both for state and Federal taxation.
• Unlike municipal bonds, the income is usually tax sheltered regardless of which state the property is located.  For example, in New York, a muni bond is state-tax exempt only if it is a New York bond.  However, the real estate can be located anywhere and benefit from depreciation sheltering.
• For family-run businesses, real estate can be an excellent way to bifurcate the returns on the business between participating family members and non-participating ones.  The property can be separately held in a trust, with rents paid from the business and enjoyed — with tax sheltering — by all family members.  This also helps insulate the family wealth from any potential business problems that may arise.
• Intergenerational transfers of real estate can be accomplished in a simplified, and often tax-advantaged manner.
• Personal residences are usually sheltered in part from bankruptcy, and in some states (Florida, for example) the entire residence may be used as a bankruptcy shelter.

There is more, of course.  As a reminder, I have a book coming out in January from McGraw Hill — Real Estate Valuation and Strategy.  I’ll expand on these and many other real estate investment topics between now and then.

Someone asked me, “Should I wait to buy a house since interest rates are headed to zero?”.  Huh… well, dude, I got bad news for you – – interest rates whipped past zero a while ago.  Denmark just this week issued some bonds with negative yields.  I’m not saying this is as low as it gets, but it might be helpful to understand a bit more about how interest rate changes affect the consumer.

First, note what I’ll call “wholesale” rates and “retail” rates.  I bought a dozen eggs this week at the grocery.  Locally sourced, cage free, no anti-biotic eggs, from chickens that ate a nice diet of bugs and stuff — the sort of stuff chickens like to eat.  I paid $3.99 (plus tax).  I’m sure we can both agree that the farmer didn’t get all of that $3.99.  Some of it went to the grocer.  Some of it went to the truck driver.  Some of it went to the wholesaler.  The farmer was probably lucky to get $2 (but that’s another story).

Mortgage loans are like that.  Most mortgages get bundled into mortgage backed securities and sold through a somewhat complex pipeline to investors (Fannie Mae, Freddie Mac, certain trusts and pension plans, etc.).  These trusts cannot purposely buy paper at negative yields.  The managers have a fiduciary duty to their clients not to do that.  Hence, there is a floor below which wholesale mortgage rates cannot fall, and that floor is not a negative number.

Now, above that floor, everyone has to get a piece of the action, just like the people in the pipeline who sold me eggs.  Let’s face it, they have bills to pay, and want to take home a paycheck on Friday, just like the grocer and the truck driver.  Finally, there is a fee for servicing the loan, which has to be added to the top before you hear about the retail rate.  W-a-a-a-a-y back when I started in this game, that fee was statutorily set at 55 basis points, or 0.55%.  Thus, if you had paid 10.55% for your mortgage (not a bad rate back then), the point-five-five part went to the people who collected the monthly payments, kept the books, made sure you paid your taxes and insurance, and handled the foreclosure if it came to that.  The remainder — the 10% part — went down the pipeline to all the investors.  The laws were changed a number of years ago, and the servicing rights have become competitive (in other words, the fees have dropped).  However, it’s still a real, positive number.

Probably the more interesting question is what happens to mortgage rates before, during, and after a recession.  Since everyone seems to think one is coming, how should we be prepared?  Here is a chart of mortgage rates (high, low, and average) versus the years in which we had a recession.

We’ve actually had 7 recessions since 1970, but a couple of them ran into one another, so this chart only shows five recessionary periods.  No matter, for our purposes.  Note that in the first two, we were going thru a period known as “stag-flation” where the impacts of the recession were exacerbated by high inflation.  Since the 1980’s, inflation has more-or-less been throttled, so those recessions are more useful as predictors.  From 1989 until 1992, average mortgage rates dropped about 2 percentage points (from 10.32% to 8.39%).  From 2000 to 2002, spanning the shortest of these recessions, rates fell about a half of a percentage point (from 7.44% to 6.97%).  Before-and-after the recent housing melt-down and recession, rates fell from 6.41% in 2006 to 4.69% in 2010 — a difference of slightly over two percentage points.

The average 30-year, fixed-rate mortgage in 2018 was 4.54%.  Today, most lenders are quoting a rate of 3.75% on that same mortgage.  Could rates drop two percentage points (to 1.75%) in an incipit recession?  History suggests that is entirely a factor of the length of the recession.  A brief dip, such as happened in 2001, might have little impact on mortgage rates.  A longer recession would probably have a more dramatic impact.  Notably, of course, there is an absolute floor, and it’s not at zero percent.

I am particularly pleased to announce (brag?) that the Washington State Economic Development Finance Authority (WEDFA) will be honored with the Excellence in Development Finance Award by the Council of Development Finance Agencies at the upcoming National Development Finance Summit.

I’ve had the very real pleasure of serving as a Director of WEDFA for several years now, at the behest of Governor Jay Inslee.  WEDFA is an independent agency within the executive branch of state government, created by the state legislature to act as a financial conduit to businesses through the issuance of nonrecourse revenue bonds.

WEDFA was honored for the Columbia Pulp project, a wheat straw-to-paper pulp facility in Columbia County, Washington. Farms in this area (known as the Palouse region) generate post-harvest wheat straw in quantities too large to effectively till back into the soil. This represents a very real waste issue for the region. A significant portion of that wheat straw will go into an environmentally friendly pulping operation developed and commercialized by Columbia Pulp I. Paper pulp will be sold on the open pulp markets. One major use of the project’s output is expected to be compostable food containers and straws. Although not yet in full commercial operation, the project has brought about 100 new long-term industrial jobs to a county of 2,000 people. Project construction activity also added a powerful two-year economic stimulus to the area.

The Columbia Pulp I project was made possible by a coordinated efforts of institutions and individuals, including wheat farmers, scientists, mill specialists, institutional debt investors, equity investors, local economic development groups, tax credit providers and state and local government. The Washington Economic Development Finance Authority was able to facilitate the project’s debt financing through the issuance of $198,755,000 of Environmental Facilities Revenue Bonds. The bonds were issued in three limited sales to institutional investors, the final piece of which was issued in 2019.

“This year’s recipients are model examples of what is currently taking place in the development finance industry. We are proud and excited to honor this year’s recipients at the 2019 National Summit in Tampa, Florida” said Toby Rittner, President & CEO of the Council of Development Finance Agencies.