The most dangerous sport in the world could well be BASE jumping, wherein thrill seekers leap from tall buildings or the steepest cliffs. They wear odd overalls with makeshift wings to help direct their flight away from the cliff. At the last moment, based on their visual estimates of how close they are to the ground, they must open a tiny parachute to save their lives. Sometimes the chute doesn’t open, sometimes volatile winds cause them to lose control and they crash against the mountainside, and sometimes they mistake how close they are to the ground.

Everyone who practices the sport for any length of time has friends or knows of fellow BASE jumpers killed by the sport. Why would anyone seek out such danger on purpose, knowing the odds are stacked so surely against them? I ask myself that same question when I watch our political leaders engage in a fiscal form of BASE jumping. As I write this article, the country is preparing for the year-end fiscal cliff, as negotiations to avoid it remain stalemated. But even if we survive that jump, our thrill-seeking leaders have us headed toward a series of cliffs.

The current jump is dangerous. The inflammatory rhetoric suggests both sides are willing to concede only enough for both of them to

declare themselves the winners. Politics are trumping sane policy. The election results mean that the free money programs of Ben Bernanke will continue. High-yield bond and loan issuance is back at pre-crash levels. Issuance of collateralized loan obligations, the poster child of the 2008 crash, is greater in 2012 ($45 billion) than in the past four years combined. The current historically low interest rates mean pension funds are significantly underfunded, savers dependent on income are on life support, and the real winners are speculators.

The Federal Reserve is trying to drive investors away from bonds toward riskier assets, while retail investors are racing away from equities toward bonds. Stock mutual funds are seeing an outflow of assets that is causing havoc, while bond funds are ballooning in scale and earning ever-decreasing returns. Large-scale commercial real

Economic BASE Jumping by Ted Cronin, CEO, CIO

wintEr 2013

INsIde thIs Issue:

cio report As our political leaders prepare

to hurtle off the edge of the fiscal

cliff, the question becomes, what

kind of landing can we all expect?

will this oasis of return continue? Commercial real estate has

proven to be one of the strongest

investments of the past few years,

and our team is optimistic about the

possibilities it continues to present.

impact of taxes in 2013 and Beyond Taxes of all kinds are headed up, in

some cases dramatically. We look at

the larger implications and consider

ways to address the increases.

inside mcm Introducing our new employees

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estate is again appearing frothy as AvalonBay and Sam Zell chase Archstone, the ex-Lehman debacle. It’s eerily reminiscent of 2007.

With terrible effect, 2007 demonstrated once again that it is always impossible to accurately price the true value of any asset, other than at the moment of sale. Are bonds in a bubble? Are stocks overpriced? Are premier commercial real estate properties starting to get stretched? The only thing I know for certain is that the Fed policy cannot continue indefinitely. Bernanke has his wings out, steering away from the cliff, but when will he pull the chute?

Simpson-Bowles tried to avoid jumping entirely and their recommendations remain some of the best solutions to solving our debt and deficit problem. Everybody would suffer modest sacrifices, but the country would begin to address its excess spending and adopt rational tax policy based on a simpler tax code with fewer deductions and uniform progressive rates. As Senator Simpson explained, there is no conceivable way to grow ourselves out of our debt, tax our way out of our debt, or reduce spending sufficiently to avoid the pending debt burden.

Increasing taxes by raising marginal rates on the wealthy might add $87 billion per year in revenues, but that is insignificant

compared to trillion-dollar deficits. America’s growth rates are marginally at 2%, with an ever-increasing number of workers giving up on trying to find work. At the same time, global demand is slowing and unlikely to pull America’s economy back to 3.5% GDP. Going off the cliff means we fall at the rate of $1.2 trillion in deficits per year with the Fed’s chute flapping above.

Should we survive this jump, there are others on the horizon, such as the debt-ceiling cliff and the interest rate cliff. Our government is currently borrowing money at very low rates thanks to the generosity of the Federal Reserve. Short-term

Treasuries are paying less than 0.18% and 20-year Treasuries are paying less than 2.4%. Holding cash is the safest way to ensure a loss. Three-year returns from holding dollars, after inflation, result in a projected 6.3% cumulative loss on assets.

When the global financial markets finally force interest rates up toward their normal risk premium rate, our federal interest payments will soar. Like a homeowner trapped with an adjustable rate mortgage that suddenly requires unsustainable payments, America will face interest payments that drain the government’s ability to meet its most fundamental obligations. For every 1% increase

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in interest rates, interest payments on the debt increase by $163 billion.There is also the entitlement cliff, which is even taller. As we step out toward the edge, we can look down at more than $70 trillion worth of obligations to Social Security, Medicare, Medicaid, and a multitude of pensions promised to an aging demographic. Unlike the thrill-seeking BASE jumper with the chance to step back, this is a leap we have promised to take. Like the thrill seeker, we have many friends—Greece, Argentina, Ireland—that have been seriously injured trying this jump.

The next decade promises to offer more excitement than any sane country would want. Clearly, the best course would be to step back from the edge of the cliff. But as investors, we don’t have control over whether our politicians decide to jump or whether the chute opens in time. As an experienced politician once explained to me, Congress can do anything it wants whenever it wants, and it is better to adapt rather than complain.

Our best strategy is to avoid immediate dangers when we can identify them—such as cash and long-dated Treasuries—and seek opportunities as they appear—such as long-term equity holdings in quality companies. The average annual return on the U.S. stock market since 1928 has been a little over 7%, and we are justified in expecting a similar return going forward if we can step back from

the edges of the cliff. Given the immediate dangers, we should hedge our bets with multiple allocations to diverse, but perhaps not so obvious, areas.

What we do have confidence in is that free market enterprise has proven successful since our founders achieved independence over two centuries ago. We can identify faults and have experienced setbacks, but as a nation we continue to want to do better and be better tomorrow than we did and are today. It’s been four years since we suffered a terrible recession of excesses. The rebound has been excruciatingly and needlessly slow, but by many measures we can identify a viable recovery. We just need our politicians to keep us away from the edge of the cliff.

wElfArE ASSiStAncE

For every 1.65 employed persons in the private sector, 1 person receives welfare assistance.

For every 1.25 employed persons in the private sector, 1 person receives welfare assistance or works for the government.

- Source—Congressional Budget Office

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The real estate team at M a n c h e s t e r Capital remains very positive on the near- and i n t e r m e d i a t e -term investment

potential of U.S. commercial real estate, notwithstanding escalating valuations in this sector the past two years and market bubbling in certain international gateway cities.

Our viewpoint exists against a backdrop of expected tepid economic growth in the U.S. and existing capitalization rates approaching modern-era lows in certain markets. It is also our belief that increased tax rates will cause high-net-worth capital migration into the sector in the years ahead as investors search, perhaps frantically, for tax-effective investment alternatives. As a result, investment in real estate through the direct acquisition of commercial property by private investors should be considered.

Using the National Association of Real Estate Investment Trusts “All Equity REITs” index as a proxy for overall market performance, the real estate market bottomed out during the last cycle in February 2009, when the index hit 185.56.

The index closed at the end of November 2012 at 498.7, representing an approximate 170% increase in value. By comparison, the S&P stood at 735.09 at the end of February 2009 closing at 1,416.18 on November 30, 2012, an approximate 92% increase in value. The index has remained firm in recent months even though the REIT shares of the previously red-hot apartment component have softened, and even though rents and occupancy remain strong.

As we travel real estate markets around the country, we find similar value escalations for privately owned real estate assets. The most obvious reason for the recent increase, as with other asset classes, is the unprecedented low-interest-rate environment. Low-cost commercial mortgage availability, coupled with investor thirst for yield, is driving real estate capitalization rate properties to unprecedented lows. Stabilized properties, properties with high occupancy and in-place leases at current market rates, are selling in the 5.5% to 6.5% capitalization rate range, compared with historical “aggressive” capitalization rates in the 6.5% to 7.5% range for stabilized properties. In a deal reminiscent of the pre-crash times, Sam Zell’s Equity Residential, partnering with AvalonBay Communities, recently announced it is acquiring

will thiS oASiS of rEturn continuE?

by Jeff Hall, Managing Director— Real Estate Services

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Archstone properties in a deal valued at $16 billion, including the assumption of $9.5 billion in debt, making it the largest real estate transaction since Blackstone Group acquired Hilton Hotels in November 2007.

Why would anyone want to invest in commercial real estate on the heels of such performance? As we survey the market and consider underlying business fundamentals that drive rents, we see opportunity for further rent growth. As reported by the Federal Reserve in July, commercial real estate leasing activity and demand for multi-family units increased in Atlanta, Chicago, and San Francisco, while other markets such as New York and Richmond slowed and Philadelphia and Dallas held steady. Although these results are mixed, they are encouraging relative to current GDP growth.

Particularly in commercial offices, the amount of construction in the U.S. as reported by the Federal Reserve remains relatively lackluster. Increased commodity prices and union wages have resulted in construction cost increases outpacing the growth in lease rates, thereby inhibiting new construction economics. Opportunistic acquisition of property at a discount to replacement cost should continue to provide

acceptable returns into the foreseeable future.

Tax advantages associated with owning commercial real estate also add to the attraction, as income tax rates are sure to rise for those who can afford them. Typically, much of net operating income after mortgage interest expense is shielded with depreciation. Upon acquisition of a property on behalf of a client, we typically hire CPAs to perform cost segregation analyses, which aim to allocate as much of the purchase price as possible to five- and seven-year depreciation classes, because the cost allocable into the basic building is in a 39-year class, increasing the shield. If structured and financed properly, current taxable income can be minimized, producing distributable cash taxed at low rates. We also seek “value add” investments that tend to minimize income in early years as money is invested to improve the value of the property. Under this scenario, ultimate return is skewed to capital gain when the property is sold, making for more tax-advantaged investing.

In summary, thoughtfully structured direct acquisitions of commercial property continue to possess good investment fundamentals at this time. Expected increases in tax rate will add to these fundamentals.

pErcEnt of tAxpAyErS who wErE ExAminEd By thE irS

In an effort to raise additional revenue and make sure everyone is paying their share, the IRS has been increasing the percentage of taxpayers they subject to audits. While only about 1% of all individual taxpayers are subjected to audits, those at the top end of the income spectrum are much more likely to receive further examination.

- Source—IRS Data Book

will thiS oASiS of rEturn continuE?

by Jeff Hall, Managing Director— Real Estate Services

www.mcmllc.com 05

Absent an a g r e e m e n t between Congress and the White House in the waning weeks of this year, taxes on income and

investment will rise significantly beginning January 1, 2013. Because the Economic Growth and Tax Relief Reconciliation Act of 2001 (commonly known as the “Bush tax cuts”) reduced rates for all brackets, all brackets will see their rates rise when that law expires this year. The top marginal income tax rate will increase from 35% to 39.6% while the lowest rate will increase from 10% to 15%. Taxes on long-term capital gains will jump from 15% to 20%; meanwhile, qualified dividends will change from being taxed at the long-term capital gains tax rate of 15% to being taxed at ordinary income tax rates—15% to 39.6%, depending on your income tax bracket. Of course, there is movement in Washington on this issue, so stay tuned.

While income tax rates are uncertain, we do know the additional surtaxes on high-income earners (single filers with $200,000 adjusted gross income, married filers with $250,000) will take effect. The Patient Protection and Affordable Care Act (commonly known as “Obamacare”) tacks on a 0.9% Medicare payroll tax on earned

income. That may increase the top income tax rate to 40.5% and, according to 2009 tax data, would affect nearly 5% of all income tax filers.

Obamacare also bears a 3.8% Medicare surtax on investment income, effectively making the long-term capital gains tax rate 23.8% and pushing the tax on dividend income to a top rate of 43.4%. Since the cutoff levels are not indexed for inflation, the pool of “high earners” will grow each year, much like the Alternative Minimum Tax. And don’t forget state and local taxes.

In a market environment where 10-year Treasury bonds are yielding approximately 1.6% and the dividend yield on the S&P 500 is approximately 2.3%, raising dividend taxes to 43.4% will make generating after-tax investment an even more challenging task. The uncertainty created by Washington has already begun to alter short-term investor and corporate behavior. There are longer-term implications of higher tax rates as well.

Special one-time dividendsAs of this writing, Bloomberg reports that 150 companies—including Walmart, Wynn Resorts, and HCA—have declared special 2012 dividends. By distributing cash to investors before year-end, investors will pay 15% tax instead of next year’s rates of up to 43.4%.

c corporationsOwners of closely held C corporations face difficult decisions. Conventional tax planning wisdom recommends retaining earnings inside the business and deferring taxes as long as possible. But, by way of example, look at choices current businesses face. Assume a small-business C corp has $1 million of accumulated earnings that could be held in the business or paid out to the owner as a dividend. At today’s 15% rate, the owner would owe $150,000 in federal taxes. In 2013, that same owner would face a tax liability of $434,000, nearly triple the amount.

In both of these cases, large dividends paid in 2012 are cash not retained and/or not reinvested in the business. That cash is no longer available for investment in new facilities, new equipment, new employees, or mergers or acquisitions. Longer term, earnings may be retained, in part in the hope for a more favorable tax environment or a tax holiday when they can be paid out at a lower rate. In the short term, earnings and cash will be flushed out of companies in 2012, leaving less behind to support business growth.

high-dividend StocksMany are predicting that the hike in dividend tax rates will result in a sell-off in high-dividend-paying stocks as dividends are seen as less valuable to taxable investors, particularly high earners. High-

impAct of tAxES in 2013 And BEyond by Bart Earley, Director of Investment Research

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impAct of tAxES in 2013 And BEyond by Bart Earley, Director of Investment Research

dividend tax rates would also cause a shift to more dividend-paying assets being held in tax-deferred accounts, such as IRAs and 401(k)s. According to 2009 IRS data, 52% of all qualified dividends (approximately $58.9 billion) went to tax filers earning less than $250,000 or were held in tax-deferred accounts.

One can predict that the effects of higher dividend taxes will be, first, a greater proportion of dividend income sheltered in tax-deferred accounts; second, a reduction of dividend payments; and third, a reduction of dividend growth rates. As in the 1980s, companies will return to repurchasing their shares as a means of rewarding investors rather than paying dividends.

Other effects of the combination of higher dividend and capital gains tax rates will be that individuals and corporations will move capital to more tax-friendly environments, including overseas. Holding periods will lengthen, turnover will fall, and invested capital will become sticky. These taxes act as a hurdle that capital must overcome on its way to its best, most efficient use. The higher the taxes, the higher the hurdle, the less likely capital is to reach its most efficient destination.

Municipal bonds are the potential big winner in this environment. Because of their tax-free status, the higher

tax rates go, the more attractive muni bond interest becomes. This has a beneficial effect for municipalities because greater demand means they can offer lower interest rates, reducing their borrowing cost. That said, among the “deductions and loopholes” potentially on the chopping block is the deduction of muni bond interest. If the deductibility is capped or otherwise limited, municipalities and high earners both lose.

It is said that the more you tax something, the less you get of it. Governments have used taxes like

fines, to influence behavior, typically through “sin” taxes on such items as cigarettes and alcohol. Unfortunately, the same effect results from increasing income and investment taxes—as producers devise new ways to hide and shelter their earnings, and investors seek more rewarding after-tax alternatives, there will be less income, and less investment.

www.mcmllc.com 07

inSidE mcm Welcome to the Team

mAnchEStEr, VErmont // 3657 Main STrEET // (P.O. BOx 416) // ManCHESTEr, VT 05254 // {TEl} 802.362.4410

montEcito, cAliforniA // 1157 COaST VillagE rOad // MOnTECiTO, Ca 93108 // {TEl} 805.969.5670

nEw yorK, nEw yorK // 410 ParK aVEnUE, SUiTE 1610 // nEW YOrK, nY 10022 // {TEl} 212.588.1120

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lila pellerin | Office Administrator

Lila joined Manchester Capital Management in August of 2012 and is responsible for all administrative tasks in the Vermont office, including reception, quarterly reporting, data entry for accounts payable, and support for our financial advisors and the operations team. She brings to our firm more than 15 years of experience in web design, marketing, office management, and IT in a wide range of industries (including international educational travel

and high-performance automotive parts), having worked with such groups as the National Wildlife Federation, Explorers Club, Oak Meadow School, and Sonnax. When not at work she enjoys traveling and trying to keep up with her two sons. Lila can be reached at 802.362.4410, ext. 101, or lpellerin@mcmllc.com.

hilary Burkemper | Executive Assistant to Chief Executive Officer

Hilary joined Manchester Capital Management in September of 2012 at the Montecito office location. She provides executive support for the CEO and assists with client and business relations. Hilary is originally from St. Louis, Missouri, and came to California to attend the University of California, Santa Barbara, where she graduated with a B.A. She then went on to obtain her J.D. at Pepperdine School of Law. Hilary practiced law at two

St. Louis firms before returning to Santa Barbara, where she was offered the role of Assistant Corporate Counsel at Fidelity National Financial, Inc. Hilary also served as Corporate Counsel at CKE Restaurants, Inc., where she practiced for over seven years. Prior to joining MCM, Hilary worked as a personal assistant for a very busy Montecito family, assisting with assignments as varied as publishing books to real estate acquisitions and divestitures. She is an avid equestrian in “three-day eventing” and was named to the long list of the USA’s 2012 Olympic team. She also loves hiking and being outdoors with her three very active dogs! Hilary can be reached at 805.969.5670, ext. 123, or hburkemper@mcmllc.com.

AccElErAtE gAinS?

The idea of accelerating long-term capital gains might seem a trifle odd, but in the 2012 tax year it may make sense to do so. Given that long-term capital gains tax rates are likely to increase from 15% to 20% (and potentially higher) and that an additional 3.8% will be added as a result of the Patient Protection and Affordable Care Act (Obamacare), investors may be wise to realize long-term gains this tax year rather than to defer them. Investors may also want to consider the extra flexibility they can create by selling enough securities to generate excess net capital losses. Losses can be carried forward to 2013 and later years to shelter gains recognized in those years. Your Manchester team is actively reviewing portfolios to determine whether accelerating gains in the 2012 tax year makes sense for individual clients. Please call us if you have any questions as we head into the end of the year.

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