We have posed this question to you on several occasions over the nearly 11 years we have been sharing our thoughts with you in this blog. It’s always a good question to keep asking because business conditions, market trends, and life circumstances are constantly changing.
Today, we revisit this important question for those of you who are long-term Orange County industrial property owners with little or no mortgage debt.
The Rise in Industrial Property Values
There are thousands of you out there who bought industrial buildings when prices were just a small fraction of what they are today. If you are one of those who did, congratulations, your property’s value has risen more than anyone in our industry thought possible.
If you bought a 10,000-square-foot building in Anaheim in the early 1990’s for $60 per square foot, you would have dismissed any broker as crazy or dishonest who told you that your building would be worth $400 per square foot in 2026. We certainly would not have told you that, as making such a claim would have been well outside our comfort zone.
Market Reality in 2026
Yet here we are today, and the truth of that statement is a matter of public record. Even buildings purchased as late as 2011 (bottom of the last real estate cycle) are worth nearly 4 times as much today. Oh, sure, some buildings in that size range are worth a little less depending on condition and configuration, but others are worth even more. So, for the sake of this conversation and to make our point, we will stick with $400.
Example of Long-Term Investment Returns
Let’s look at a simple example of a 10,000-square-foot building in Anaheim acquired in 1995 by the owner of a machine shop for $60 per square foot ($600,000) with a 15% down payment ($90,000).
The $510,000 loan he took out was paid off years ago using the rent he charged his own company to use the space. He then sells the building in 2026 for $4,000,000, or $400 per square foot. Let’s assume he took 30 years of depreciation on the structure using a 70/30 building-to-land split and put $200,000 into capital improvements over time.
That leaves him with an adjusted basis of $477,000 and a taxable capital gain of $3,323,000 after 5% in closing costs. After paying California State Income Tax, Federal Capital Gains tax and Federal Depreciation Recapture tax totaling $1,113,000, he keeps $2,687,000 in after tax proceeds. That’s almost 30 times his original down payment—after all taxes are paid!
Would You Have Taken the Deal?
With that in mind, if you were this owner and someone offered to sign a contract on the day you acquired the building in 1995 to buy the property in 2026 at a price that would net you 30 times your original capital investment, would you have accepted that offer?
Your answer is probably yes because you would never have expected to get anything close to that return when you acquired the property. That outcome would have been unfathomable at the time. Yet, this potential scenario is the proven reality in Orange County today.
What Drove the Market Boom
We know, things that sound too good to be true usually are, but these are unusual times. The prolific run-up in industrial property values was fueled by ridiculously low mortgage interest rates, the result of the recklessly loose monetary policy of our central bank that distorted the supply/demand equation.
Then, when the Fed finally raised rates to stop runaway inflation beginning in 2021, mortgage rates more than doubled, and industrial property values topped out in late 2022. Prices have been edging lower overall since then, but we have, until now, avoided a full-blown market correction.
Key Decision: Sell or Hold
This leaves owners of highly appreciated assets with some interesting choices. They could sell and realize their massive gains, pay their taxes, and ride off into the sunset with their saddlebags stuffed with cash, or hang in there and wait for prices to go up again if mortgage rates come back down. For those with a long-term-hold strategy who are planning on passing their assets along to their heirs at a step-up in basis, staying the course makes reasonable sense.
But, for those who own properties that figure into the funding of their retirement, today’s conditions send a clear message to sell and reduce the risk of a loss in equity in the event of a correction. It is important to note that during the last two market corrections, industrial property values fell by 40% or more, depending on submarket and building quality. A 40% correction takes a $400-per-square-foot building down to $240. Not a pleasant prospect.
Why Aren’t More Owners Selling?
So, why aren’t more owners of highly appreciated assets heading for the exits? Two of the most common reasons we hear are
1) the tax consequences of a sale and
2) not knowing what to reinvest the proceeds in.
Tax Concerns and Equity Risk
As to the first reason, it’s easy to understand why no one wants to write seven-figure checks to state and federal tax collectors. That would be a painful experience, no matter how big the gain is. But, watching equity erode during a correction is no fun either.
Even after a 20% market correction, the owner of a highly-appreciated asset will still have a massive tax bill to pay upon disposition on top of suffering the loss in equity, which just adds insult to injury.
Reinvestment Opportunities
As to the second reason, there are many other asset classes to invest in, some of which don’t include the ongoing risk associated with owning real estate. Even four-week US T-bills will yield almost 4% these days, and they are completely liquid and widely regarded as risk-free.
Depending on your unique circumstances and your appetite for risk, there are numerous options available, and some of them just might surprise you in a good way. I
f you’d like to study your own options in detail, just give us a call. We are here to help you and your financial advisors decide what’s best for you.