Due to their tax-deferral benefits and entry to new market sectors, 1031 exchanges have become a popular investment strategy for modern investors. One promising niche in which to conduct an exchange is retail property, which is eligible since these assets are inherently held for business or investment use.
Before acquiring a retail property to end your exchange, it’s important to first determine whether or not such a type of asset can help you reach your investment goals. Below, Realized 1031 has shared the pros and cons of doing a 1031 exchange into retail property to help you gain a better understanding of what could happen.
What Qualifies as Retail Property in Real Estate Investing
In the context of real estate investing, retail properties are any structures that are used for selling goods or services directly to consumers. Other types of commercial property focus on creating raw materials, conducting logistics processes, and even offering hospitality services. Meanwhile, retail real estate includes shopping malls, standalone stores, and grocery stores or supermarkets.
You can only exchange properties that are held for investment or business use. As such, retail properties are automatically eligible for the like-kind swap.
Advantages of 1031 Exchange Retail Properties
Many investors find retail properties appealing as replacement assets due to the following reasons.
High Potential for Strong and Stable Income Streams
Retail properties, particularly those with long-term leases and creditworthy tenants, can offer consistent and predictable income. National brands or anchor tenants often sign leases ranging from 10 to 25 years, reducing turnover and vacancy risk.
Triple-net Lease Advantages
NNN leases are often the lease agreements used by tenants when renting retail properties. This means that they will be in charge of property taxes, insurance premiums, and maintenance costs — three major net operating expenses. This arrangement ensures hands-off involvement for property owners, resulting in passive income and fewer management headaches.
Diversification
Entering the retail sector allows you to diversify, especially if you’re too concentrated on one market. Since the IRS has a broad definition of “like-kind” properties, you can exchange a multifamily home, warehouse facility, or office building for a strip mall or standalone shop.
Disadvantages of 1031 Exchange Retail Properties
Like any other investment, retail properties do have inherent challenges. Keep the following in mind to better prepare for any possibility.
More Vulnerable to Market Shifts
Retail is a highly dynamic sector, sensitive to issues such as inflation, the emergence of e-commerce, and many other factors. Reduced foot traffic and tenant stability could affect your cash flow, especially if the tenant belongs to a non-essential niche.
Tenant Risk
Losing an anchor tenant could lead to significant disruption in your cash flow. Finding another one will take resources and time as well.
Location Sensitivity
Retail establishments are highly sensitive to their location. If the area loses popularity or experiences demographic shifts, vacancy rates may rise, and property values may fall.
Higher Management Demands
In cases when NNN leases are not the preferred lease agreement, retail properties will have higher management demands. Active supervision is needed for property upkeep, tenant coordination, and marketing if there are multiple units.
Wrapping Up: Opportunities and Challenges When Exchanging Into Retail Properties
Finishing a 1031 exchange by acquiring a retail property can be rewarding, offering a high chance of steady income, diversification, and passive income through NNN leases. However, keep in mind that there are disadvantages, such as vacancy risks, vulnerability to market shifts, and management burdens. Understanding these pros and cons is necessary to determine if retail properties can become valuable assets in your portfolio.
Sources:
https://www.law.cornell.edu/wex/triple_net_lease
https://www.shopify.com/ph/retail/commercial-vs-retail
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
