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The law of unintended consequences  is hurting the world of 1031 exchanges and ability to do deals that make these deals worthwhile. The 1031 exchange is predicated on selling a property tax free by letting an intermediary hold the proceeds from the sale and apply it to a new property.

The problem that is occurring is that with the tremendous rise in commercial properties emanating from the high prices paid for large skyscrapers that is filtering down to smaller office buildings and parks, there are very few profitable deals out there. Property prices are now way ahead of the rental rates in the commercial markets in many cities (sounds like residential a couple of years ago).

So finding a replacement property for the one you sold that will be profitable is getting more and more difficult, and thus not worthwhile doing the 1031 exchange. Add to that the failure of 2 of the larger intermediaries that cost people a fortune, the 1031 market is slowing down these days.

In the past few months, at least two intermediaries have been accused of misdeeds, shedding a negative light on a largely unknown industry. In one case now in federal court in Los Angeles, investors accused a businessman who ran two qualified-intermediary companies of misappropriating more than $95 million to fund other business and personal activities.
Even before those problems came to light, some small investors say they were using the 1031 strategy less and less. The big reason: Prices for commercial properties have risen so high that investors can’t find attractive replacement properties that would generate adequate returns. That is because the record high prices buyers are paying for skyscrapers in cities such as New York, Chicago and Los Angeles have started to show up in the small office buildings, strip malls and apartment houses popular with small investors.
In many cases, the prices for commercial property have far exceeded rent growth, which means the properties could be unprofitable for the landlord. U.S. apartment prices have risen 52% since 2002 while rents have increased 11%, according to Marcus & Millichap Real Estate Investment Services in Encino, Calif. Office properties have appreciated 47%, with rents growing just 6.5% on average.
So with capitalization rates, or the return on investment during the first year of ownership, compressed to record lows, smaller investors say the abundance of overpriced real estate makes it tough to execute an exchange. via  WSJ.com.

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1. Blackstone Effect on Commercial Real Estate Sales
2. 1031 Land Exchanges Raising Values of Farm Land
3. 1031 Exchanges and Tenant In Common Investing Gaining Ground
4. 401(k)’s Investing in Commercial Real Estate
5. Real Estate Roundtable Sees Credit Issues Hurting Commercial Real Estate