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How a Growing US Deficit Impacts Commercial Real Estate Values

The late economist Herbert Stein coined the phrase "if something can't go on forever, it will stop," which is the point Joseph G. Carson, US Economist and Director of Global Research for Alliance Bernstein makes in his recent white paper "What Will Prevent a US Fiscal Train Wreck?"

In the white paper, Carson explains that the US government has accumulated $6 trillion in new debt since the beginning of the Great Recession and has proposed adding $8 trillion over the next ten years, which could lead to economic paralysis for the US. If we assume that the spending will continue over the next ten years, how might this bloated deficit affect commercial real estate values?

First, the government will increase tax revenues by changing the capital gains rate.  This tax change will allow them to capture more tax on the sale of assets, which will ripple through the commercial real estate market as an adjustment to values. Commercial real estate investors will think twice before selling properties because the tax on sale will account for a larger portion of their cost of sale and they will also adjust their expectations on their acquisitions.  This means that when an investor plans his entrance and exit from the commercial real estate asset, he will have priced the increased capital gains rate into his return assumptions, which amounts to his offering less for the property in order to net more than he would have originally anticipated.  Read more here.

Second, the government will increase the marginal tax rate, which will allow them to collect more revenues from payroll taxes, adjusted income, and cash flows on your commercial real estate properties.  As you plan your future cash flows from operating your commercial real estate portfolio, you anticipate your after tax cash flows to account for the mortgage interest, cost recovery, and operating expense deductions.  It is your cash flow after debt service, or cash flows before tax, that the US will examine for additional revenue.  And when your marginal tax rate increases, so will the percentage of your cash flow before taxes paid to the deficit.

Third, the government will increase interest rates.  To stimulate demand for our country's debt, it will be necessary to originate debt that pays a higher return. And when our debt is more expensive, borrowing money to finance commercial real estate will be more costly, which will chill the market and lead to a flattening of values.

In our view, and in agreement with Mr. Carson, the time has arrived for policies that lead to a better budget balance, either through spending cuts or tax increases.  And our number one priority in the US must be to reduce the deficit.

About the Author: Jeremy Cyrier, CCIM is the President of MANSARD, a market research driven commercial real estate brokerage and advisory firm, and member of the CCIM Institute faculty.  You may reach Jeremy at Jeremy@Mansardcre.com.

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