The Impact of Tax Reform on Real Estate

Cushman & Wakefield have posted The Great Tax Race: How the World’s Fastest Tax Reform Package Could Impact Commercial Real Estate. There is a lot of interesting insights in the report, notwithstanding the fact that ultimate fate of the Republicans’ tax reform is still a bit up in the air. Indeed, C&W estimates that there is a 1 in 5 chance that a bill will not pass this year.

Commercial Real Estate

C&W states that history

suggests that tax law changes by themselves are often not key drivers for transactions or for investment performance. However, there is likely to be a period of transition and market flux as investors restructure to optimize tax outcomes with implications for the underlying asset classes. Corporations are likely to separate the real estate aspects of their businesses. (2)

The commercial real estate industry is largely exempt from the biggest changes contained in the House and Senate bills. 1031 exchanges, for instance, have not been touched. C&W sees corporations being big beneficiaries, with a net tax cut of $400 billion over the next 10 years; however, they “anticipate that the tax cut will be preferentially used to return capital to shareholders or reduce debt, rather than to increase corporate spending.” (2)

Residential Real Estate

C&W sees a different effect in the residential real estate sector, with a short-term drag on home values in areas with high SALT (state and local tax) deductions, including California, NY and NJ:

The 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%. (6)

C&W also evaluated tax reform’s impact on housing market liquidity and buy v. rent economics:

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. (7-8)

Foreign Funding for Real Estate Projects

Jeanne Calderon and Gary Friedland have posted A Roadmap to the Use of EB-5 Capital: An Alternative Financing Tool for Commercial Real Estate Projects. The paper provides a great overview of a relatively new source of funding for real estate deals. The introduction opens,

From an immigrant’s perspective, the EB-5 Immigrant Investor Program (“EB-5” or the “Program”) represents merely one of several paths to obtain a visa.  The EB-5 visa is based on the immigrant’s investment of capital in a business that creates new jobs. However, from a real estate developer’s perspective, the immigrant’s investment to qualify for the visa creates an alternative capital source for the developer’s project (“EB-5 capital” or “EB-5 financing”).

Despite the Program’s enactment by Congress in 1990, for many years EB-5 was not a common path followed by immigrants to seek a visa. However, when the traditional capital markets evaporated during the Great Recession, developers’ demand for alternate capital sources rejuvenated the Program. Since 2008, the number of EB-5 visas sought, and hence the use of EB-5 capital, has skyrocketed. EB-5 capital has become a capital source providing extraordinary flexibility and attractive terms, especially to finance commercial real estate projects. Consequently, many developers routinely consider EB-5 capital as a potential source to fill a major space in the capital stack. As the financing tool becomes more widely known and understood, this source of capital should become even more popular.

The EB-5 investor’s motivation for making the investment accounts for the relative flexibility and favorable terms afforded by EB-5 capital compared to conventional capital sources. Unlike that of the conventional capital providers (such as banks, private equity funds, REITs, life insurance companies and pension funds), the EB-5 investor’s reason for making the investment is to secure a visa. Thus, his primary objective at the time of making the investment is to satisfy the EB-5 visa requirements. Consequently, so long as the investor believes that the investment will qualify for the visa and result in the safe return of his capital, he is willing to accept a below market, if not minimal, return on the investment. Furthermore, the investor might not require some of the other protections that more sophisticated, conventional real estate investors typically seek.

*     *     *

Simply stated, the Program requires that the immigrant make a capital investment of $500,000 or $1,000,000 (depending on whether the project is located in a “Targeted Employment Area”) in a business located within the United States. The business must directly create 10 new, full-time jobs per investor. Thus, the number of jobs that a project will create is a key determinant of the amount of the potential EB-5 capital raise. (3-4)

This once exotic funding technique is now becoming quite mainstream. Of interest to some readers of this blog, the paper describes at various points how EB-5 funds have been used in residential projects. The paper is a useful introduction for those who want to know more about this program.