How The New Tax Law Affect Commercial Real Estate
THE ECONOMY IS CURRENTLY GROWING, WITH UPWARD REVISIONS TO REAL GDP GROWTH FORECASTS.
The tax incentives and breaks that the CRE industry enjoys are a lubricant (or friction cost) for the transaction market, but often not a key driver of transactions themselves or investment performance.
Analysis notes that in May 2003, REITs outperformed the rest of the market despite an adverse tax change that disadvantaged them.
The economy is currently growing, with upward revisions to real GDP growth forecasts (expected to be an annualized 2.5% in the fourth quarter of 2017). The CRE industry is likely to benefit from a prolonged economic cycle. These factors will continue to drive investment decisions and transaction volumes.
Overall, CRE a winner; passage of tax reform legislation will prompt restructuring and short-term market flux as investors adapt to new regime.
A lot of the structuring around CRE transactions is dictated by the need to minimize taxes. Sweeping changes in the tax code could be the cause of material value leakage, and players in the industry are likely to respond by changing their behaviors and tax structures to minimize their tax exposure.
Overview of Provisions Affecting CRE Industry
Both the House bill and the Senate plan preserve like-kind exchanges (1031x) for real property. No material changes were made to the Foreign Investment in Real Property Tax Act (FIRPTA) in either version, although foreign investors do benefit from the overall reduction in the corporate tax rate. Changes in tax credits and elimination of exemption from income for contributions to capital are also expected to affect the real estate markets and participants.
Implications for CRE Asset Classes
ESTIMATES OF THE GDP GROWTH BOOST RANGE FROM 3-9 BPS PER YEAR OVER THE NEXT DECADE.
Modest growth at best
Some proponents claim that the proposed tax cuts will lift real GDP growth closer to 3% per annum from the approximately 2% that has prevailed during the current expansion. However, most of their analyses do not consider the likely effects of tax reform on a higher-than-expected trajectory for interest rates or the impact of higher levels of debt that deficit-financed tax cuts will entail. When these are factored in, estimates of the GDP growth boost range from 3-9 bps4 per year on average over the next decade. While exact figures may differ, it is believed that the relatively modest size of tax cuts provided for under the current proposals is unlikely to generate significant growth or push up inflation expectations significantly. Tax cuts can deliver growth when the economy is in recession. But with the economy at or near full-employment, multiplier effects are liable to be constrained, further reducing the potential impact on near-term growth.
Corporates are the key beneficiaries — but those benefits are unlikely to translate into increased spending
Lawmakers are planning a one-time tax on overseas profits, but at different rates in the legislation proposed by the two chambers. The House proposes a rate of 14% for liquid assets and 7% for other assets; the Senate version proposes rates of 14.49% for liquid assets and 7.49 % for other assets. The overseas cash hoard that came back into the country following the 2004 repatriation cuts was primarily used for share buybacks. However, relative to 2004, Cushman & Wakefield would expect to see relatively
Moving from a global to a territorial system, coupled with heightened tax cuts and incentives being made available to U.S.-based entities, is likely to diminish inversions by U.S.-based multinationals, ensuring more headquarters remain in the U.S. Our analysis indicates that in 2014, there were 4,139 U.S.-headquartered multinational corporations with domestic employment9 of 26.6 million. However, just 463 of those companies accounted for 76% of total domestic employment. These are the companies that were previously most likely to consider changing domicile for tax purposes. But under the proposed tax reform legislation, they are less likely to do so.
However, most large U.S. corporations have effective tax rates well below the statutory rate with a median S&P 500 tax rate of 27%7. In addition, history suggests that even large cuts are not transformative. The statutory corporate tax rate was cut from about 50% in the 1960s and 1970s to about 35% in 1988, but the rate of business investment did not substantially increase8. In the current economic environment, higher interest rates resulting either from increased deficit spending or a more aggressive Fed are liable to offset much of the intended reduction in the corporate after-tax cost of capital from lowering rates.
Both the House and Senate proposals would give corporations a net tax cut of almost $400-$600 billion over 10 years on a static basis, with an effective tax rate estimated at less than 20%5. Pass-through entities will benefit from a tax cut of almost $300 billion in the Senate proposal, and around $450 billion in the House proposal6. The hoped-for result is that this will lead to an increase in capital spending and hiring.morecapex, M&A and, over a longer period, debt repayment backed by overseas cash.
The retail sector pays the highest effective corporate tax rate of any sector in the U.S. economy and indeed the world—at or close to the maximum 35%. This is thought to undermine retail’s international competitiveness. A lower corporate rate might encourage foreign retailers to invest more in their U.S. operations, larger corporations and consumers with larger tax savings to spend more and retailers to invest additional capital in their own businesses and employees—all favorable outcomes for the industry. Furthermore, about 98% of retailers are small businesses with 50 employees or less who would directly benefit from special provisions for small businesses such as higher eligibility limits for cash accounting, favorable pass-through provisions, and higher expensing provisions.
Along these lines, we expect a similarly modest positive impact on the eCommerce sector, which, apart from benefiting from the corporate tax rate reduction, also benefits from full expensing which is geared towards industrial business/capital goods/ manufacturing.
Investment in real estate by the healthcare industry is expected to be curtailed. The Senate’s provision to eliminate the “individual mandate,” is likely to raise health insurance premiums by 10% and increase numbers of un- and underinsured. This is liable to have a negative impact on overall demand for healthcare services. A countervailing effect of increased insurance premia, however, could be to further incentivize adoption of corporate wellness programs.
The House bill includes changes to the treatment of interest on qualified 501c(3) bonds, which many nonprofits use to finance construction and real estate projects. However, we do not expect this provision to be included in the final bill. Both bills reduce exemptions for charitable giving, which could significantly impact health systems’ philanthropic campaigns, many of which are used to fund new buildings.
THE DRAG ON HOME VALUES IS LIKELY TO BE LARGEST IN AREAS WITH HIGH PROPERTY TAXES AND MEDIUM-TO-HIGH HOME VALUES.
The increase in deficits under the plan could trigger automatic cuts in Medicare and Medicaid spending as soon as next year. Any cuts if implemented will further affect the financial health of healthcare companies.
Limited short-term potential drag on home values in certain markets
Home values tend to implicitly incorporate the dollar value of property tax and mortgage interest deductions (MID); therefore any limitations to such tax benefits may negatively affect home prices. Also,theThe
higher mortgage rates that result from the higher deficits and debt under the plans currently being reconciled weaken housing demand. Assuming full capitalization of the property tax deduction into home prices, the cap on (and lower usage of) the property tax deduction would lower nationwide home prices by 1-5%11. drag on home values is likely to be largest in areas with high property taxes and medium-to-high home values. There is also likely to be a larger impact in parts of the country where incomes are higher and where a disproportionate proportion of taxpayers itemize. Both versions of the tax reform limit property tax deductibility to $10,000. While only 9.2% of households nationally report property taxes above this threshold, this figure rises to as high as 46% in Long Island, 34% in Newark and 20% in San Francisco according to Trulia data.
The Mortgage Bankers Association (MBA) estimates that 22% of mortgages in the U.S. have balances over $500,000, with most of these concentrated in high costs areas such as Washington, DC, and Hawaii—where more than 40% of home purchase loans originated last year exceeded $500,000. This is followed by California at 27%, and New York and Massachusetts at 16%.
In the unlikely event that mortgage interest deductibility is ultimately eliminated, this would represent a short-term potential downside risk to home prices. An increase in interest rates is also likely to have a knock-on effect on home prices, as a larger proportion of mortgage payments is allocated to interest.
The increased effective tax differential between high and low-tax areas may increase movement from the former to the latter. An initial review of the academic literature on taxes and mobility reveals limited effects on low- and middle-income earners, but the median estimate suggests a 2%-4%13 decline in the number of top-income earners after 3-10 years per percentage point increase in the tax rate gap.
The median length of time people had owned their homes was 8.7 years in 2016—more than double what it had been 10 years earlier. Now that interest rates have begun to tick upward from their historic lows, the housing market may face a problem called the “lock-in” effect, where homeowners are reluctant to move since moving might entail taking out a new mortgage at a higher rate. This leads to the possibility of decreasing housing market liquidity in high-priced markets.
All things considered, the doubling of the standard deduction and the cap on the property tax deduction is likely to have the largest impact on the buy vs. rent incentive, especially as it seems likely that there will be minimal changes to the mortgage interest deduction in any final tax reform bill.
The homeownership rate in the U.S. is 64% and is already under pressure from millennials’ (the largest demographic group in the country) preference for renting.
However, mirroring the negative impact on buying condos and single-family homes, we see the tax reform bill as a positive driver for multifamily and single-family rentals (SFR). Given that elimination of the mortgage interest deduction for second homes and the impact on home equity would tend to reduce incentives for second homeownership, this could provide a further boost to scale/institutional SFR vehicles.
Implications for Key Players in the Direct CRE Market
Approximately 61% of investment in direct CRE in the U.S. is via passthrough entities that are not subject to corporate income tax. Another 29% flows through to tax-exempt entities either directly or via pass-through entities. Corporations hold just 9% of U.S. CRE assets.
The earnings of pass-through entities flow to their owners’ individual income tax returns. The current tax reform plans envisage a substantial reduction in rates for qualified pass-through income (25% top rate under the House plan and a 23% deduction under the Senate plan).
The largest categories of pass-through structures by share of real estate income are partnerships, followed by REITs and finally S corporations. Sole proprietorships, another form of pass-throughs, are not significantly represented.
THE FINAL PASS-THROUGH TAXATION RULES WILL HAVE SIGNIFICANT IMPLICATIONS FOR REAL ESTATE INVESTORS.
The final pass-through taxation rules will have significant implications for real estate investors. For passive investors, rental income is considered passive income and therefore would be eligible for the 25% rate under the House plan. This would apply to all pass-through vehicles—partnerships, S corporations and REITS—as well as to the owners/investors in those entities. Arguably, tax relief under the House plan would be greater for real estate investors than for investors in other asset classes, shifting the comparative after-tax IRR, which might result in a greater proportion of capital shifting to real estate over time.
The Senate plan has very different implications for real estate investors. As currently drafted, most real estate fund managers and investors would likely see little to no benefit from the 23% deduction as the deduction is limited to 50% of W-2 wages paid by a business. To illustrate, an investor in an LLC that owns a property but which has no employees (and therefore pays no wages) would not benefit from this provision. In the case of a management company, with employees and wages, the deduction would be allowed but would be circumscribed by provisions governing so-called “specified service businesses,” preventing owners with income of over $250K/$500K (single/ married) from claiming the deduction. Put simply, the Senate proposal leaves partnership and S corporation investors in real estate out in the cold.
PUT SIMPLY, THE SENATE PROPOSAL LEAVES PARTNERSHIP AND S CORPORATION INVESTORS IN REAL ESTATE OUT IN THE COLD.
REITs and publicly traded partnerships, however, are eligible for the full deduction without regard to the 50% wage limitation. Should this become law, we would expect to see a shift over time towards REITs as preferred means to access real estate as well as conversions to corporate structures. There would also likely be a meaningful amount of economically inefficient reorganization within partnerships. To provide just one example, properties would be consolidated within fewer tax reporting units and previously outsourced services would increasingly be internalized in order to increase the wage bill that could be used for deductions.
Implications for Key Pass-through Structures
• Some management companies may consider converting to C-corporations, given potentially lower corporate rates.
• Similarly, some funds may consider converting to REITs if Senate version is adopted.
• Uncertainty surrounding classification of triple net income.
– REITs (currently exempt from corporate taxes, top pass-through rate of 39.6%)
• REITs not eligible for overseas dividend deduction from non-U.S. entities.
– Tax-exempt investors