“Commercial real estate falls into different segments with their own demands and economics. For individuals the most popular assets are apartments, small offices, strip malls and warehouses. So far the real estate crash hasn't been felt in commercial property. And 2007 appears to show only a slight deceleration in commercial rent increases from 2006.

Apartments, where the pace of increases is in line to slacken from 5% to 4%, have benefited from still high home prices and tightening mortgage-lending standards. Offices (up a percentage point to 10%) have seen continued robust demand for space thus far. Shopping centers, which play host to day-to-day necessities--drugstores, hair salons, laundries--are down 0.5%. (The big malls, owned by powerful players like real estate investment trusts, are finding meager advances in same-store sales at their department stores and boutiques.) Warehouses, their growth pace off only half a point to 4%, are still much in demand.

Over the past 12 months commercial real estate has returned an average 13% (property appreciation plus rental income), that bests the 8.4% total return from the S&P 500 and far outstrips the circa 3% return on single-family homes, which are falling in price but provide rental value to homeowners.

Regardless of the megatrends, there are ways that always exist to bring better returns from a property. You can improve building management to stop waste, sign up higher-paying tenants and renovate to attract more of them.

As with the residential market, credit for buying commercial property has tightened. Gone are the days of interest-only mortgages. You'll have to put down 30% of the cost of the building and amortize your loan. A high down payment could be a blessing in disguise; it reduces the risk that you'll run up a loss that can't be deducted on your tax return because of anti-shelter legislation.

Don't be too avid to do a so-called Section 1031 exchange, a swap of one investment property for another that enables you to postpone the capital gain tax on the property you're giving up. This would be a fine idea except for five things:

  1. Middlemen's fees can eat up a chunk of the supposed tax saving. Remember, the tax you owe is only on your profit from the first property, while the fees are going to be a percentage of the whole transaction.
  2. You're not avoiding tax, only deferring it.
  3. The federal rate on most of your appreciation is only 15% now. When you pay tax down the road the rate is probably going to be higher.
  4. The tight deadlines written into the tax rules may induce you to overpay for the new property.
  5. Some 1031 escrow agents lose the money entrusted to them.

All that said, the tax-deferred swap could make sense if you have a single investment property that you want to trade in for a diversified pool and you like the people running the pool.”

(excerpt Forbes May 08)

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