2 min read January 2022 — In a conversation with Invest:, Managing Director Michael Houge of NAI Legacy shared the key highlights of the company and the biggest opportunities and challenges they are facing. He also discussed the necessity of knowing the difference between “essential” and “non-essential” real estate and how they appeal to a variety of investors, especially due to the pandemic and related shut-downs.
What were the key successes of the past year, and how are your priorities shifting?
It’s important to differentiate what we do in comparison to other commercial shops. Of course we have a typical brokerage services division that is tied to property management, both of which have experienced growth in the past year. But, our primary focus is on strategic, tax-efficient CRE investments, that we syndicate to a growing list of private clients. We appeal to 1031 tax deferred exchange motivated buyers, as well as people seeking net operating losses through depreciation. At the start of the pandemic in 2020, we began purchasing Qualified Opportunity Zone (QOZs) properties and placed them into a financial structure called a DST (Delaware Statutory Trust). A DST makes it possible for multiple people to contribute varying equity amounts, and receive beneficial shares of ownership in the property. A DST has certain tax advantages, like allowing investors the ability to defer capital gains taxes. We completed a deal in 2020 on a $41 million multi-family property in a QOZ. While being eligible for QOZ status, we were also able to include 1031 motivated DST investors in the deal making it attractive for many types of investors.
We ended 2021 with $100 million in investments in a time when we were unsure that our doors would remain open. We learned a lot about the difference between essential and nonessential real estate which became a moniker for various commercial properties. No matter the state of the economy, it’s critical that there are businesses and retailers that remain open. This realization put us on the path of investing in essential real estate.
What strategies do you use to assist your clients?
We usually start at the end, working backwards with an investor to determine their end goal; should they hold, sell, buy etc. However, we always take into consideration the transaction tax ramifications. We have two different types of investors: those who want to use our broker services or want us to list their properties, and those we consider our “private-client partners.” Private-client partners are those who want help finding properties that fit their investment criteria, mitigating the hassles of acquisition as well as tax ramifications — we package properties into a nice gift box for our clients. When we find the property, we can convert it to a DST structure, finance it, and then offer it to a private-client partner. Oftentimes, we invest alongside these investors. The DST framework is IRS approved for 1031 tax exchanges and provides for significant flexibility for disposition and little or no asset or property management required by the investor.
Another tax strategy is to maximize the depreciation of real property. A commercial property depreciates over a longer period than residential. Using a technique called cost segregation we delineate all of the depreciable aspects of a property which often have varying depreciation schedules. If the depreciable components qualify under the Code, up to 100% of the depreciation is available day one, which can significantly boost the rate of return.
What are the biggest opportunities and challenges you are facing?
The biggest concern in our industry is the government eliminating the 1031 tax exchange and/or increases in capital gains tax. There were recent, high-level conversations and negotiations about doing away with certain incentives in real estate. We have been watching the negotiations closely, and it appears to be a subject that isn’t being raised as much anymore-which is great. It’s excellent news for the CRE industry because it creates and saves jobs, and it should increase the volume of our business. There are also major concerns about inflation, as there have been many initiatives that have increased the propensity for increased inflation. We believe inflation will last longer than predicted, which will have a great impact on real estate. The cost of rental properties won’t be able to keep up with inflation which will decrease the rates of return for properties over time. It’ll vary by industry, but inflation will have a very negative impact on the economy. We definitely want to avoid interest rates hitting numbers as high as they were in the 1970’s.
What locations are hotbeds of activity for real estate?
I believe that it’s more about the type of property than it is the location. The industrial “food group” is the most popular asset class and is currently enjoying outstanding performance. Recently, I attended a program hosted by OPUS who presented to our local SIOR Chapter about the industrial real estate development market and OPUS intimated how fast cap rates in the industry have decreased. Some buyers and property owners are using a strategy of buying industrial properties with shorter term leases, predicting that rents can be increased sooner because of a significant lack of supply. I believe there is still a four to five year run with industrial real estate and it will continue to be an outstanding asset class. Conversely, downtown office space is suffering and beginning to lose tenants to the suburbs.
What is your near-term outlook?
We will continue to focus on CRE investments. I do believe there is a nagging issue with retail investments in the Minneapolis marketplace due to outside capital being less willing to enter the market because of recent social unrest. Since Minneapolis is the “gold standard” in Minnesota real estate investment, this issue is affecting the entire state. It will take some time for outside capital to reenter the retail investment market. This may be a great time to buy if you are a contrarian or understand that this market is comprised of many, many great markets, and properties, and much of it was untouched by the recent problems. We believe investment in industrial real estate will not slow down. Migration of offices in the CBD to the suburbs will increase over the short-term. Banking and lending will experience some disruption, but there is still money to be loaned. The cheapest loans and most available capital will be for deals with good fundamentals and low loan to value (LTV) ratios. I’m amazed at the activity that’s occurring in nearly every market, but think it is as a result of a flood of capital and relatively cheap money chasing a lower property supply – Econ 101. We will continue to find real estate that fits the needs of our clients and will always focus on taking advantage of the opportunities in the tax code. We are all about adding investment value to solid deals.
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