Changes Ahead for Quieter 1031 Market

The $25.5 million sale of Crossroads Entertainment Center in Chino Hills, Calif., seemed unremarkable at first glance, at least by dollar value. The new owner, GAS Distomo Inc., bought the property from 26 Del Sur Crossroads L.L.C., a privately held seller represented by Faris Lee Investments. However, 1031-exchange deals are a rarity nowadays, making this deal something of a standout.Whether they involve single-tenant properties or multi-tenant assets like the Crossroads Entertainment Center, 1031-exchange volume is declining even more precipitously than are investment sales in general. By some accounts, 2009 totals have dropped 80 to 85 percent year over year. The 1031 net lease transactions that do unfold will most likely involve properties that changed hands before the mid-decade price run-up, explained Boulder Net Lease Funds L.L.C. president Randy Blankstein.But the cap rates that were characteristic of deals in 2005, 2006 and 2007 now discourage 1031 trades because of their low yields. “When gains turn south, there’s less valuation to protect,” Blankstein explained. In such a climate of poor returns, many investors would rather hold on to their properties than sell them in an effort to avoid taxes. He expects 1031 volume to remain light for the next several years until the owners that are acquiring properties today are ready to sell them, restarting the 1031-exchange cycle. The current decline is also speeding up the contraction of the tenant-in-common industry, which counted on 1031 exchanges for a significant portion of its volume, Blankstein noted.When 1031 velocity does pick up in 2010 or later, it will owe to smaller regional banks and life insurance companies that will fill the void left by the collapse of the conduit debt market, suggested Thompson National Properties L.L.C. director of acquisitions Charles Osbrink. “The market will recover,” he said. “It always has.” However, deals will be less highly leveraged. Another change will likely be the emergence of the Delaware Statutory Trust structure as a 1031 net lease exchange vehicle. DSTs, which permit as many as 499 passive investors, are effective vehicles for long-term, triple-net leases to tenants with strong credit, he said. One of Thompson National’s two current DST offerings involves a net lease asset in a 1031-exchange structure.In the future, Blankstein expects a shift in the net lease property types that investors prefer for 1031 exchanges. As of the fourth quarter of last year, Boulder Funds placed average cap rates for net lease retail properties at 7.5 percent, the lowest of the three major net lease categories. Industrial net lease properties were trading at 7.7 percent and office properties at 8 percent. Investors’ reservations about retail fundamentals, however, should start changing that picture and bring retail cap rates more in line with industrial and office properties. “There is no reason for retail to trade at a premium,” Blankstein insisted.