Currently the most important development to residential rental investments has been the ebb and flow of trade tensions, with the U.S. administration unveiling the final list of Chinese goods that will be subject to 25 percent tariffs.
The U.S. is imposing tariffs of around USD 50 billion on imports from China. China has responded firmly, releasing its own list of retaliation tariffs – also worth approximately USD 50 billion. President Trump responded to China’s retaliation by threatening to impose tariffs on a further USD 200 billion of Chinese imports. China in turn threatened to retaliate “forcefully” with “strong countermeasures.” Real estate investors hopes that the U.S. administration’s threats were part of a negotiating strategy that would eventually lead to a deal are now fading, and the risks are rising that the current tit-for-tat game between the US and China might spiral into a full-blown trade war. However, we would not yet exclude that a bilateral agreement can be reached to avoid a downturn for the economy.
Although prospects for growth have moderated a little, employment has been robust. Wage and price pressures should therefore be building according to textbook economics. However, even with unemployment below its natural rate in the U.S., wage dynamics are subdued, while inflation rates are only gradually achieving central banks’ objectives.
What are the prospects that pressures building in both labor and product markets could break out into an inflationary surge, particularly against the backdrop of an energy price rise? In terms of labor market tightness, the U.S. is looking at wage dynamics within different skills and educational levels that indicate no acceleration but rather a moderation of wage growth after an increase in 2016-2017. The relationship between inflation and unemployment is known as the “Phillips curve” and states that a one-percentage point reduction in unemployment should result in a permanent percentage increase in inflation.
Today, the “Phillips Curve” is relatively flat compared with historical values, implying that at present this one percentage point reduction in unemployment leads to less increase in inflation than in the past. This reduced inflation sensitivity to changes in unemployment can be explained by the liberalization of many labor markets over the past decades and most importantly the curtailment of trade unions’ collective wage bargaining activities. With the ongoing deindustrialization in the U.S. economy and the rising importance of the service sector for adding value growth, wage negotiations have increasingly become individualized. Wage bargaining has lost its collective character and wage dynamics are predominately determined by negotiations between firms.
According to Marcus & Millichap, the highly anticipated tax reform recently signed into law by President Trump retained numerous key commercial real estate provisions. The 1031 tax-deferred exchange, the mortgage interest deduction for investment real estate and asset depreciation had few material changes. This consistency in tax law will enable investors to move forward with most of their existing investment strategies. That said, there are many provisions in the new tax law that will have a more nuanced effect on the sector, and these more subtle adjustments could create significant new opportunities for real estate investors.
Over the last year, elevated uncertainty generated by the range of potential government policy changes, including tax laws, caused many investors to move to the sidelines. A more cautious outlook pervaded the industry as investors awaited clarity on taxes, fiscal policy and a change in Federal Reserve leadership. This perspective could begin to ease as the implications of the new tax law firm up and investors better under-stand how the new rules will affect their investments. The new tax plan offers generous tax cuts to corporations and pass-through entities such as Limited Liability Companies (LLCs), and investors may see the new tax rules as an opportunity to reconfigure their portfolios. The new tax structure will apply to 2018 income for tax filings in 2019.
Given heightened uncertainty about the tax laws and the future of trade policy in the U.S. and potential retaliatory measures by China and other trading partners, we are factoring in the risk potential by projecting more “hold phases” in our quarterly publication of MARKET CYCLES.
About the Author: Eugene E. Vollucci is the Director of The Center for Real Estate Studies, a real estate research institute. He is author of four best selling books and many articles on real estate rental income investing and taxation. To purchase a subscription to Market Cycles and to learn more about the Center for Real Estate Studies, please visit us at CALSTATECOMPANIES.COM