What a year 2017 has been. Full of great experiences and challenging experiences. Said another way, a year full of life. My family and I are very blessed.
We will finish off this year with a follow-on format to last month’s article (click here). “So, I have been asked…” Continued.
I have been trying to invest with Altus for months, why won’t you let me invest in Altus projects? There are none. We have only put one property in contract in the last 8 months, and it was only a couple million dollar purchase. We funded that with preferred return investors in a matter of hours. There hasn’t been a lot of market activity in general, and the activity we have seen hasn’t transacted at a price that we felt offered risk-adjusted returns worthy of bringing to our investor partners. We continue to turn over rocks in hopes of finding such opportunities. We are also developing relationships in new markets that meet our economic indicator requirements.
If there is nothing to buy, what does that mean for Altus in 2018? Opportunities tend to come in waves, so we are hopeful that we will find enough investor opportunities to service the demand of our existing investor database. Additionally, we expect to work with several million dollars of 1031 reinvestment. Finding 1031 reinvestment opportunities is often easier than finding general investor opportunities due to nature of the reinvestment, and the specificities around the reinvestment that we can communicate to brokers. The 1031 reinvestments also tend to require lower overall returns due to the nature and timelines of the reinvestment requirements. Please reach out to us if you or anyone you know will be selling property this year, to see if we can facilitate opportunities for the placement of those funds. Tip: Start looking for a reinvestment opportunity or reinvestment partnership well before the sale of your outbound property. Finding a replacement property(s) can take several months, which is longer than the forty five days allowed between property sale and reinvestment identification as allowed by the 1031 tax statute.
Retail sales increased ~4% versus last year. How does this affect your pessimism about the stock market and economic prospects? And wait, there is more. The world Purchasing Manager’s Index didn’t have a single country measure below 50 (the measurement of growth versus contraction) for the first time since 2013. While it seems that corporate earnings may have peaked, it has historically averaged four years from the peak until the economy entered recession (though sometimes it was less than a year). We are now 475 trading days without a five percent pull-back, the second longest low volatility period in history going back to 1928. Should we make it until mid-February without a 5% correction, it will be the longest low volatility period in the stock market since 1928. Those hard economic statistics don’t take in account strong consumer and small business confidence readings, which also tend to paint a rosy picture. With acknowledgement to the strength shown by that consumer data, note that there are many red lights flashing, as well. Government debt is a big problem and the new tax plan doesn’t help, at least not in the short run (see below). Corporate bond spreads are widening and tax receipts are dropping despite the economic growth (prior to the effects of the new tax plan). Government transfer payments and installment debt (credit cards) account for more than every dollar of retail sales (as a rough proxy for “discretionary spending”), not exactly an indicator of strong household finances. Delinquencies are increasing in student loans, credit card debt, and car loans (and are very high in subprime car loans). While corporate profits for US listed companies have been ticking upward (and appear to possibly have peaked?), over 100% of those gains have come outside the US, with corporate domestic profits down in excess of 5% over the past two years. None of this sounds like a strong economy to me. Oh, and the stock markets are dramatically over valued. In fact, if the economy (and correspondingly corporate profits) were to grow at 5% over the next 12 months AND the stock market were to remain flat, domestic stock values measured as a percentage of GDP would still be the second highest in history, behind only the “dot com” bubble. This does not mean I am calling for a January start to a recession or a February stock market crash. I have no idea what the future holds, but if history is any indicator (and it usually is), there will be adjustments, and probably substantial. In a perfect world, that adjustment is corporate profit/economic growth with a muted stock market response. As referenced above, this could cut into the overvaluation, albeit it slowly.
You have talked about the fire’s impact on you and your business, but is it really having that much of a financial impact on individuals and individual businesses? Hard to say. Most homeowners have insurance. If you take a black and white stance, those that didn’t have insurance should have. There are likely many that are underinsured, but those that I have spoken with that thought they were underinsured felt differently once they reviewed all the available provisions for reimbursement in their insurance policy. That isn’t to say there aren’t those that were underinsured. There are, and they will have a rough time of it. However, the true travesty is the renters. In the best case scenario, renters had Renters Insurance so they should have coverage, but those I have spoken with so far only have six months of coverage. Meanwhile, rents have drastically increased, if you can find a place to live at all. There will be very few additional units on the ground in six months and we still have residents living in hotels and in family members’ living rooms. One carpenter that used to do work for us contacted me from Virginia. He was a renter who lost his house and couldn’t find any place to live, so went to stay with his sister (in Virginia) while he continued to look. Almost two months later, he still hasn’t found a place to live. What are renters going to do? A smaller, but possibly even more impacted class are the renters in homes that didn’t burn down but are owned by people that lost their homes in the fire. They are asking their renters to move out so they have a place to live themselves, but the renters that have to move out aren’t entitled to any insurance or federal assistance since they weren’t directly impacted. If residents like the carpenter in Virginia don’t come back, our local economy loses. And be sure, there are many wondering why they should live here versus moving somewhere else where they can afford housing.
Now that the tax bill is passed, what are your thoughts? It is important first to consider two bullet points at a higher, summary level before jumping into the details.
- It is my belief that the US tax code needs a serious overhaul. The tax code is far too complex and has far too many loopholes, creating obvious winners and losers. Serious economic resources are wasted in both compliance and enforcement. And at the end of the day, we are still spending far in excess of what we collect.
- Which brings me to broader point number two: I am something of a fiscal hawk. I believe people, business, entities, governments, etc. should spend within their means. I am not opposed to debt, since debt can be used to increase returns, but I am opposed to non-productive debt or growing debt load faster than the income of the entity, which is certainly the case with our current government deficit. The Congressional Budget Office (CBO) calculates this tax plan will increase yearly deficits and therefore increase the national debt. The outcome of their analysis is likely correct, HOWEVER, the CBO does not do dynamic scoring, which means they don’t calculate any possible benefits to economic growth of the tax bill, the so-called “trickledown” effect. There are two types of trickledown effect:
- The first, also called the “wealth effect”, hypothesizes that if asset prices rise people will feel “richer” and will spend more and that spending will then stimulate economic growth. This is what the Federal Reserve has tried to do since the Great Recession, which, since this recovery is the slowest on record, would mean it had very little efficacy in this round of usage. Those in the higher economic classes are the ones that own assets. As is often pointed out, the wealthiest 10% of the US population own “76“% of the wealth, therefore increases in asset prices are benefiting the rich more than the rest of society and exacerbating the rich/poor gap. Additionally, since the top 10% of wealth owners probably are either not overly compulsive (how do you think they gained the wealth?) or didn’t change their spending habits with lower asset prices, there is no real impact on spending. Even if that 10% did increase spending, it is only 10% of the population. Lastly, an increase in asset prices doesn’t increase cash in pocket, it doesn’t increase direct business investment (in fact, it can do the opposite), and it doesn’t create taxable income except upon sale, which happens to be at the lowest tax rate within the current tax system.
- The second kind of trickledown is based on the theory that if business owners are taxed less on their income, they will invest more back into their businesses (and the economy). That investment leads to more jobs, more economic growth, etc. There are so many different forces that impact economic growth that it is usually difficult to point to any one policy as being a success or failure, however, evidence, at least circumstantial, would point to the 1980s Reagan trickledown effort creating economic growth and increased tax receipts, though the true benefit of those increases wasn’t experienced until a decade or so later. Those in favor of this tax bill claim that the tax plan will be budget neutral (or better) because the tax break impact on tax revenue (as calculated by the CBO) will be more than offset by a broader tax base through economic growth spurred by those same tax cuts. As much as I hate paying taxes, and as much as I believe that the trickledown work done by Reagan did work, I am still skeptical that this plan will not increase the yearly deficit, let alone the debt. We won’t truly know for many years, even decades, to come.
- And about tax plan specifics, you ask?
There are complaints that this plan is structured to help the “rich”. As previously discussed in Altus Insights, since high income earners pay the vast majority of income taxes (the top 20% of income earners pay 85% of taxes), any tax plan designed with the hope of spurring economic growth will have a benefit to high income earners. It is simply math. This plan does reduce tax rates for high income earners but it also reduces tax rates across the board. People earning between $10,000 and $77,000 will benefit from an absolute 3% reduction of their tax rate (a 20% reduction on a percentage basis). The highest income bracket, those earning over $500,000 ($600,000 for a couple filing jointly) receive a smaller 2.6% absolute reduction (a 6.6% reduction on percentage basis). Note that the highest income bracket did increase from $427,000 to $500,000, so people making between those two limits will benefit from a 4.6% absolute reduction. In the middle brackets, those making between $93,000 and $157,000 ($156,000/$315,000 filing jointly) will benefit from a 4% absolute reduction, while many making between $157,000 and $426,000 will either see their tax rate increase or stay the same. Joint filers benefit from the joint filing limits increasing to double that of the single filers limits, all the way up until the highest tax bracket, when the joint filers only benefit from an extra $100,000 over individual filers.
- There are additional benefits for those in the lower tax brackets. A very small portion of those filers include itemized deductions in their filing. The standard deduction is doubling under the new plan, definitely a large benefit for those in the lower tax brackets. Also, the per child deduction increases from $1000/child to $2000/child, with the deduction being phased out for higher income earners.
- And there is also additional tax impact to higher earners, several in fact, especially higher earners in high tax, high real estate-value states:
- State, sales tax, and property tax deductions are limited to an aggregate $10,000 per year. It is highly unlikely this impacts filers earning below $100,000. It will definitely impact many readers of the Insight, myself included.
- Mortgage interest deduction was already limited to the first $1 Million of mortgage. That limit is reduced to $750,000 BUT existing loans are grandfathered in. If you listen to the Realtor’s Association, this is going to implode the real estate markets, a complaint so outlandish it reduces their credibility moving forward. Fortune Magazine (who has been very critical of the tax plan) estimated that even in the high income, real estate-expensive, Washington DC metro, only 5% of home owners would be impacted by the change. The average mortgage balance in the US is $137,000, with new mortgages averaging $244,000 in size, far below $750,000. This change is obviously not going to impact most Americans, and since someone has to being doing pretty well financially to have a $750,000 mortgage, I don’t think I am going out on a limb to say this tax code change is impacting high income earners more than those in the lower tax brackets
- Tax deferred exchanges (1031 exchanges) are eliminated for everything other than investment real estate not held for sale. This obscure part of the tax code was definitely used by very few tax payers outside the higher tax brackets.
- University athletic seating is no longer deductible. I assume this is a relatively small loophole being closed, but is aimed at high income earners.
- There are benefits to high income earners as well, though more geared to business owners and investors in small/private investments. I don’t understand the mechanics of how it works yet, but owners of non-professional services pass-through entities receive a substantial tax benefit on any income produced by those entities. With the caveat that my opinion may be influenced by my own benefit of this changed code, I believe this sort of tax cut should lead to reinvestment in small businesses, which have historically been the driver of economic growth. Equity investors in Altus Equity-sponsored entities are likely to see a benefit.
- The wealthy benefit with a doubling of the estate exemption to $11.2 M. If you are heavily invested in real estate, tired of dealing with the property, and trying to figure out how to get assets to your children, contact Altus. We have some experience and structures that can help.
- Previously tax brackets were adjusted according to the Urban Consumer Price Index. This has been changed to the Chained CPI-U. Seemingly a minor change, the chained CPI index generally sees lower cost of living adjustments. This should lead to an increase in effective tax rates in the future, as incomes rise.
As has been stated by people far smarter than I, it isn’t how much you make, it is how much you keep. We will continue to study the new tax plan to make sure we are making the best investing decisions possible.
Wishes for a safe and prosperous 2018.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at email@example.com.