The fiscal cliff: How will it impact the real estate market and investors?

These days you can’t turn on your TV or radio without hearing something about Armageddon the impending fiscal cliff. And in hearing these pundits and newscasters and their lame, over stretched metaphors you would swear that the cliff must’ve been what the Mayans were talking about – they just missed it by a week and a half. But recently, some of our clients have called and asked me about the potential impact of the fiscal cliff on the real estate market as a whole and real estate investing in particular. Because of their concern, I think it would be beneficial to do take an objective look at the scenarios that could unfold and their real estate implications.

Scenario #1: No deal to avoid fiscal cliff

Under this scenario, if Congress does not reach an agreement to avoid the fiscal cliff, taxes increase on everyone (tax cuts expire) and deep spending cuts are applied across the board. The real estate market as a whole would suffer deep negative consequences on several fronts. First, a study by a leading commercial real estate services provider cited in a recent article on TheStreet shows that spending cuts from sequestration in 2013 would hit hard government contractors and their demand for commercial office space. The same study predicts that if these cuts were allowed to happen, office space the size of the entire Dallas office market would become vacant. Such an increase in the  supply of vacant office space would put downward pressure on prices as buildings compete to lease out their vacant space. On the other side, higher taxes across the board in 2013 mean everyone’s tax bill will be higher and their take home pay will decline. Everyone that’s ever done a family budget on the kitchen table will tell you that you budget based on your net income – not your gross. So with less money to spend on housing, potential buyers will opt for lower priced properties or worse yet, hold off on a purchase they were planning on making. So even the residential market would not come out unscathed from this scenario. Last but not least, an overwhelming majority of economists agree that the combination of cuts and tax increases would push the economy back into recession. And a receding economy is never good news for real estate markets.

But as gloomy as all that sounds, there’s no need to worry. In my opinion, this scenario has worse odds of becoming reality than snow in Cancun. That’s because in order to have a real negotiation, leverage has to exist. When it comes to the fiscal cliff Republicans have exactly zero leverage. If they do nothing, taxes go up. If they agree to a deal, taxes go up. The reality of it is that taxes are going up and everything else that’s going on is just political theater. In the next week or so, you will see how “very reluctantly and unwillingly” the parties will agree to an increase in tax rates on incomes over $250k per year.

Scenario #2: Fiscal cliff deal is reached along the lines of the Democratic proposal

Under the Democratic proposal put forth by the Secretary of Treasury, the deal would involve raising just over $1T in revenue over the next 10 years by raising tax rates on incomes over $250k. The plan also involves some spending “cuts” – mostly mathematical maneuvers of inflation adjustments and reductions in planned increases. The plan would leave the current tax deductions and most importantly the mortgage interest deduction largely untouched.

The effects of such measures on the economy as a whole can certainly be debated but it is not the purpose of this article to create and address a political debate. As far as the real estate market is concerned, this proposal  largely preserves the status quo. The luxury real estate market will be impacted somewhat as the income tax bills of higher income earners rise. But as much as sending the IRS a bigger check hurts like hell, higher earners can economically absorb such a hit better than a lower income earner with much less disposable income. That’s not an endorsement of higher taxes – god knows I’ve never met a tax bill I deemed too low 🙂 – but rather a statement of fact. However, when it comes to investing, this will produce two counter currents.  On one hand, higher income earners are usually active investors and now they will have less capital to invest because they had to send it to Uncle Sam. On the other, higher tax rates will push higher income earners to seek more tax sheltered investments like real estate.

Scenario #3: Fiscal cliff deal is reached along the lines of the GOP proposal

The GOP proposed solution involves $800B in new revenues that would be obtained by not raising tax rates but by closing loopholes and eliminating deductions. The plan does not outline which loopholes and deductions would be eliminated but judging by the size of the revenues it seeks to raise, you can’t make the numbers work without eliminating the mortgage interest deduction – a darling of the National Association of Realtors and a pretty popular deduction overall. I was listening to the Diane Rheem program on NPR a few days ago and one of her guests that day was Lawrence Yun, chief economist of the National Association of Realtors. In his opposition to the elimination of the mortgage interest deduction he offered the following analogy and I’m paraphrasing:

One way to look at the mortgage interest deduction is as a dividend on your asset (your home). If the dividend on an asset is cut or eliminated, the value of that asset declines. So if the mortgage interest deduction is eliminated, property values across the board would decline by an estimated 15%.

That sounds like a solid, well thought out analogy. It’s too bad that it’s wrong. Your home isn’t an asset in the same way that a stock is one and the mortgage interest deduction isn’t the same as a dividend. Sure, there’s an investment component to owning a home. Most people buy properties in desirable neighborhoods because they want that property to be worth more in 10, 20, or 30 years than what they are paying for it. And if you itemize on your tax return, the mortgage interest deduction can result in substantial tax savings that certainly affect your decision to purchase that home vs the alternative of renting. But a property is a home first and foremost and the most important thing it does is to provide shelter. You couldn’t go live in your stock or bond, could you? So when you look at it that way, a home is worth what buyers have been recently paying for similar shelter in that location. The value of that asset to its owner isn’t exclusively determined by the income or yield it produces in the way of tax deductions. Because if that were true, when the mortgage interest deduction was created in 1986, property values should have immediately increased by the same amount Mr Yun is projecting them to drop now.

Now that we’ve addressed the issue of a drop in values across the board, there are still an unanswered questions: If a prospective homeowner cannot deduct the interest on their mortgage, does that change their decision to purchase? In other words, would the elimination of this deduction affect real estate demand? Could this elimination perhaps tip the scales towards renting? The short answer is: Not really. First and foremost, buying a house satisfies a need and the elimination of the deduction does not eliminate that need. People still have to have a place to live. But what about the alternative of renting? The truth is that rents have been increasing across the country for the past two years at the same time that interest rates on mortgages have plummeted to record lows. If you have the means and the ability, buying beats renting by a long shot right now, regardless of the deduction. Last the mortgage interest deduction can only be claimed if you itemize your deductions. According to the IRS, two out of three taxpayers claim the standard deduction instead and as such don’t deduct their mortgage interest. Of the remaining 30%, a large portion makes less than the $250k a year income threshold where the deduction would be eliminated. So the short of it is – only a very small portion of taxpayers would actually feel the effects of such an elimination.

But a real estate investor has a different perspective on this issue. To the long term investor, the asset’s worth is determined by the after tax yield it produces for her. Currently, the mortgage interest paid in a particular year is deducted from the income the investment property produced in that same year as an expense – not a deduction. So investors would not feel the effects there. But the portion of investors that make over $250k per year will see their after tax returns go down as their ordinary income tax rate rises.

I don’t have any means to predict the future as my crystal ball’s been in the shop for a few years. But something tells me that the deal that will be reached will not involve the elimination of deductions but rather an increase in income tax rates. We will find out in two weeks time if my hunch was right.

Jim via Compfight