Why 2023 Will Be The Year for 1031 Exchange Properties
October 2022 | CPX Insights
by Jason Kono, Managing Partner
If you’ve been waiting years to find a 1031 replacement property before putting your property on the market, 2023 may be the year.
As a broker for 18 years, the number one objection I get from owners wanting to sell their property is that they need to find a replacement property first. While this is a natural response, the seller's market of the past 10 years has made it very challenging to accomplish this.
During the past decade, you often had buyers lining up if you were an Investor selling your property. Buyers became more aggressive to win deals by driving up offer prices, shortening feasibility contingencies, waiving financing contingencies, and even offering non-refundable earnest money at mutual acceptance to make their offer the most attractive.
Investors whose goal of completing a 1031 Exchange by first finding an up-leg property, and then selling their down-leg found it difficult to compete with cash buyers who didn’t need to sell a property to buy one.
While we’ve had a lot of success by positioning sellers with plenty of time and closing extensions to allow maximum time to secure a replacement property, or by assisting in Reverse 1031 Exchanges, there is still a large number of investors who were uncomfortable with taking their foot off first base in order to reach second.
In Q2 and Q3, we witnessed a rapid shift from a seller’s market to a buyer’s market. With the rapid rise of interest rates and the cost of capital increasing from sub-4 % to ±6%, property valuations from the first half of 2022 are no longer valid. We are seeing an increase in inventory that is sitting longer and a level of price reductions we haven’t seen since 2009. For the first time in more than a decade, listing brokers are encouraging buyers and buyers’ brokers to “bring an offer” because their listing has been on sitting on the market for weeks with no interest.
While this is less than ideal when selling a down leg, and investors must sell their properties at a discount, this has created an environment in which sellers have become open to working with exchange buyers who need to make a deal contingent on selling their property while leveraging up into larger assets.
In the example of an exchange seller who might have been able to sell their property at a 4.0% cap rate and now must sell their property at a 5.0% cap, this would mean they are selling a down-leg property for $4M that was worth $5M in 2021. If they owe nothing on the property and can exchange it into a property for $8M that would have sold for $10M in 2021, we believe the net effect of using leverage will likely put them in a superior position in the coming years.
Likely the new property can provide similar annual cash flow, increase yield with principal reduction, and provide new or larger depreciation benefits resulting in increased after-tax net dollars each year. If both properties appreciate at a 5% annual compounded rate over the next seven years, the investor will own an $11.26M value property with $4M in debt and $7.26M in equity vs a $5.63M value property with no debt.
One of the biggest levers to wealth building in real estate has been the ability to use 1031 Exchanges to buy more properties and larger properties while deferring taxes. At CPX, we believe 2023 is going to be the best period in the last 10 years to do this. If you’re interested in exploring this strategy, please reach out for a conversation to discuss if 2023 is the right time for you to make a move.