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Q&A: An Economist’s Take On The U.S. Real Estate Industry

Posted on September 2021September 2021 by info

Mark Dotzour is a real estate economist who served for 18 years as Chief Economist of the Real Estate Center at Texas A&M University in College Station. He has clients in the banking, private equity and real estate industries, among others, and presents to audiences around the world. His research can be found in the Wall Street Journal, USA Today, Money Magazine and Bloomberg Businessweek.

In this Q&A, BDO National Real Estate & Construction Co-Lead Kristi Gibson speaks with Mark about his outlook for the industry.

Kristi: Hi Mark, thanks so much for participating in this Q&A. You joined us for our webcast in June, “Post-pandemic trends in private equity real estate,” where you talked in part about the recovery trajectories of different sectors of the real estate industry in light of macroeconomic dynamics. We wanted to continue the thread of that conversation here.

First, briefly, can you recap for us where you see the real estate sector today vis a vis the economy?

Mark: Sure, Kristi. Back at the beginning of 2021, I said that the economic recovery would be 100% correlated with the percentage of people who were vaccinated. That is playing out, but the percentage of people who have been vaccinated started to peak at just over half the population, so our economic recovery is peaking, too. With this new delta variant of the virus taking off, the risk is greater that health mandates get put back into place, which will restrict businesses’ ability to operate to the fullest of their ability and consequently slow down economic growth. The delta variant is becoming a real drag on the economy and is contributing to inflation fear.

In terms of economic recovery, I’ve mentioned how we might have two V-shapes and then a jobless recovery. We saw the first V-shape in the spring as vaccination rates increased. But the second leg of the V has been short-circuited by delta. We appear now to be moving into the jobless recovery, where job growth slows substantially.

“When inflation fears run high, global investment demand for real estate intensifies. … We’ll continue to see capital flow into real estate, with more and more institutional funds raising capital to invest in this space.”

Kristi: With that in mind, what’s the impact on the real estate industry?

Mark: The power of the initial recovery this spring caused a dramatic increase in the Consumer Price Index. CPI inflation is now running about 5% and this has exacerbated latent fears of “runaway inflation.” When inflation fears run high, global investment demand for real estate intensifies. That’s why we are still seeing cap rate compression and extraordinary price increases in houses. Unless Congress or the Fed does something to dampen inflation concerns, we’ll continue to see capital flow into real estate, with more and more institutional funds raising capital to invest in this space.

Kristi: Within real estate, capital is flowing to different sectors. The industrial and residential sectors have truly come out on top of this pandemic, but the response of other sectors is a bit more complex, isn’t it?

Mark: Definitely. Retail, for example—and I spoke about this in the webcast, but I’ll just summarize quickly here, too—is a mixed bag. Certain retailers are doing really well, and others aren’t. A triple net lease on a freestanding building leased out to a major pharmacy chain is gold plated. But a little shopping center two blocks down that used to have a small grocery store, a flower shop and other little stores is a totally different ballgame. But retail is more on the dance floor than it was just 90 days ago. Even if the fundamentals aren’t there, when the headlines come out that retail is performing better than expected, that piques investor interest again.

Kristi: The office market is another sector where judgment is being reserved a bit. Can you talk a bit about that?

Mark: Until delta, it appeared that after Labor Day, we would start to get a clearer picture of what stabilized office demand will look like. Now that clarity won’t be revealed until next spring. The office market hasn’t had price discovery yet, and I don’t think we’ll see that until we know what stabilized demand looks like. The back-to-office movement has plateaued in tandem with the vaccination rate, and if in the fall public schools are hybrid and parents have to stay home, that’ll put a further damper on the office sector.

The real darlings are industrial and multifamily. This has been pretty well covered. What I will say about industrial is that it’s the asset class most vulnerable to overbuilding. There’s capital available for building and it’s a very attractive asset right now in the U.S. It’s not overbuilt, but the risk there is higher than with the other asset classes.

Multifamily is my favorite in terms of the supply/demand balance. Investor demand is strong and cap rates are still compressing. Nobody can build class B and C apartments, and some are being torn down and replaced by other land uses, so it’s the only asset class that has a negative supply.

The last sector I’ll mention is single-family-built-for-rent, which has gained significant momentum in the last few years. There’s a housing shortage in every market that is experiencing job growth, and now there are homebuilders who build houses, even entire communities, that can then be bought up by companies that turn around and rent them out. I see a lot of positive momentum—and returns—in this sector.

“Net domestic migration is the metric you want to be watching for when shopping for the right investment opportunity.”

Kristi: Let’s talk about another big influence: tax reform. Where do you think we will net out, and what do you think the impact on real estate will be?

Mark: Seven months before the tax reform bill was signed into law in 1986, transaction volume dried up. That’s going to be the signal for me. As long as transaction volume is holding up, the market is saying it isn’t going to happen. But as soon as transaction volume starts to stall, that’s the market saying tax reform is coming.

Currently, there is extra selling pressure in the market that wasn’t there four or five months ago—some investors are exiting investments now to get out ahead of anticipated tax law changes. If the momentum for tax reform builds, there will be more selling pressure between now and the end of the year. If there were ever going to be any distressed buying opportunities, this is going to be one of them. But for every investor with a distressed asset to sell, there are 100 investors who want to deploy capital, so a huge impact on prices is unlikely.

A slowdown in deal volume will occur if buyers see a greater probability for a tax law change, at which point they’ll either lower their bid prices or step to the sidelines until tax reform passes. Sellers are historically slow to respond to lower bid prices, so deal volume could be sluggish for months after tax reform is signed into law. Then, when the first sellers (likely distressed) come back into the market, the bid/ask spread will begin to narrow, and as that happens, deal volume will pick up again and the market will reach a new, lower equilibrium price.

“Work from home is opening up new development opportunities outside the traditional 45-minute commute radius.”

Kristi: How do you see the work-from-home paradigm changing the real estate landscape? I co-authored a piece on suburban migration and the impact population migration may have on the industry, so I’m interested in your thoughts as well.

Mark: Net domestic migration is the metric you want to be watching for when shopping for the right investment opportunity. Work from home is opening up new development opportunities outside the traditional 45-minute commute radius. That 45-minute rule of thumb came from studies done on how much time an employee commuting five times a week would tolerate. But if employees are working just two or three times per week in the office, perhaps that radius expands a bit as a moderately longer commute becomes more tolerable—say, 60 minutes. That means opportunity for all types of land development in that 15-minute geographical gap that just opened up—single family, apartment, retail, even office. People working in the same space together all day every day may find it beneficial to pay $500/month for office space outside their homes.

Kristi: You alluded to the urban office market earlier. Can you elaborate a bit on what the opportunities might be for big cities going forward? We’ve seen potential foreign investors expressing interest in the major cities—New York, San Francisco, Chicago—operating under the belief that there is enough of a bottom in the market now that they will benefit greatly from a market upswing over a five- to seven-year hold period.

Mark: That’s not surprising—those are considered the “gateway” cities for foreign investors. For people looking to invest in cities, it’s important to evaluate where there’s momentum behind a positive urban environment and look at the quality of urban lifestyle. When evaluating urban investments, you should be using a secondary set of criteria, other than population growth, because when you lose a positive urban environment, past historical population trends are moot.

Kristi: Do you have any last thoughts before we go?

Mark: For the first time in nearly 40 years, inflation is here. Whether it’s transient or not, current investor fervor for real estate is a reflection of that. The level of interest in all segments of real estate investment is going to rise in tandem with the fears that inflation is not transitory. Prices are high today and yields are low, but higher inflation expectations could push prices higher.

Kristi: Thanks for your time and for sharing your thoughts with us, Mark.

House Ways And Means Committee Advances Tax Legislation As Part Of Reconciliation Bill

Posted on September 2021September 2021 by info

After almost 40 hours of debate over four days, the House Ways and Means Committee on September 15 approved a tax package that would increase rates on high-net-worth individuals and corporations and affect cross-border activity and pass-through entities, advancing the tax elements of the Biden administration’s “Build Back Better” agenda.

The package advanced on a largely party-line 24-19 vote – no Republicans voted for it, and only one Democrat, Rep. Stephanie Murphy, D-Fla., voted against it.

As the next step in the legislative process, the legislation now goes to the House Budget Committee, where it will be combined with bills from other House committees and eventually brought before the full House for a vote as the reconciliation legislation.

Individuals

The draft legislation would raise the top individual marginal tax rate from the current 37% to 39.6% for taxable income over $450,000 for married individuals filing jointly and surviving spouses, $425,000 for head of households, $400,000 for single individuals, $225,000 for married individuals filing separately, and $12,500 for estates and trusts. The proposal would be effective for taxable years beginning after December 31, 2021.

The capital gains tax rate would rise to 25% from 20% for transactions by high-income individuals made after Sept. 13, 2021.

The bill would also create a 3% surcharge on modified gross adjusted income above $5 million, and set a limit on contributions to large individual retirement accounts.

The bill would extend the holding period to obtain long-term capital gains treatment for gain allocated to carried interest partners from three to five years. The three-year holding period would remain in effect with respect to any income attributable to real property trades or businesses and for taxpayers (other than an estate or trust) with adjusted gross income of less than $400,000.

Business Provisions

The legislation would introduce a graduated income tax rate structure for most corporations, with a top corporate tax rate of 26.5%. Corporations with taxable income that does not exceed $400,000 would be subject to a new 18% tax rate (lower than the current 21% rate), while those with income that exceeds $400,000 but does not exceed $5 million would be subject to a 21% tax rate, and those with income in excess of $5 million would be subject to the top 26.5% rate.

On the international front, the bill would reduce the Section 250 deduction for global intangible low-taxed Income (GILTI) to 37.5%, resulting in an effective tax rate of 16.5% based on a corporate tax rate of 26.5%. The GILTI would be calculated on a country-by-country basis. Other international tax provisions include:

The deduction for qualified business asset investment (QBAI) would be reduced to 5%;
The foreign tax credit haircut would be reduced to 5%;
The tax on foreign-derived intangible income would rise to an effective rate of 20.7% based on a corporate tax rate of 26.5%;
Excess foreign tax credit carryforwards would be allowed for five years but carrybacks would be disallowed; and
A new limitation on interest expense deductions for some multinational corporations would be introduced.

What’s Not in the Bill

The Ways and Means tax bill does not include any changes to the cap on individual itemized deductions for state and local taxes, which was introduced in 2017’s tax reform. Ways and Means Chairman Richard Neal (D-MA) has said he is committed to include “meaningful SALT relief” in the final legislation.

A provision to end the tax-free step-up in basis above a $1 million threshold that was proposed by the Biden administration is also not included in the Ways and Means bill.

Tax Issues To Consider When Navigating A SPAC Transaction

Posted on September 2021September 2021 by info

The U.S. capital markets have seen record levels of merger and acquisition activity over the last few years, including record use of special purpose acquisition companies (SPACs) to facilitate initial public offerings (IPOs). Why are SPACs so popular? With proper planning, SPACs can make the process of going public faster and easier than the traditional IPO route as well as provide other benefits for the acquired company and investors.

Why Choose a SPAC?

SPACs are publicly traded companies formed for the sole purpose of raising capital through an IPO and using the proceeds to acquire one or more unspecified businesses at a future date. A SPAC can provide several benefits for target companies, including:

Access to significant capital;
Immediate liquidity;
Strategic partners and management expertise; and
Use of public company stock to fund add-on acquisitions.

The SPAC approach to an IPO takes much less time to complete as compared to a traditional IPO, therefore the amount of time needed to work with investment bankers, attorneys and other professionals to take a company public is potentially reduced. In addition, SPACs generally have a window of approximately two years or less to find a suitable acquisition target, which can increase competition and drive up the values being offered to target companies.

In addition to understanding the benefits of using a SPAC, it is important that SPAC sponsors and shareholders of target companies understand and plan for the federal income tax consequences associated with SPAC structures.

Tax Treatment of SPAC Sponsors

The SPAC sponsors (or founders) are responsible for forming the SPAC entity, raising capital with investment groups, and taking the SPAC public. Once the SPAC is public, the SPAC must identify potential acquisition targets, undertake due diligence, and complete the acquisition (known as the “de-SPAC” transaction) on terms that will maximize the sponsors’ return on investment.

The sponsors are generally granted an initial, separate class of “founders shares” for a nominal cost, which normally convert to public shares on the completion of the de-SPAC transaction. The timing of the issuance of the founders shares should be carefully planned to avoid undesirable tax consequences for the sponsors.

The sponsors may also receive warrants to purchase additional SPAC shares. For federal income tax purposes, the warrants received are treated as investment warrants as long as the issuance of the warrants is not dependent on the sponsor’s employment status or in exchange for services provided as an employee of the SPAC. Investment warrants are not taxable when issued or exercised but result in taxable capital gain for the sponsor when the underlying shares are sold (a sale will result in long-term capital gain for the sponsor if the underlying stock is held for more than a year).

Warrants received by sponsors that have employment arrangements with the SPAC may be treated as compensatory warrants issued for services. Recipients of compensatory warrants generally do not recognize taxable income upon the grant of the warrant as long as the warrant provides for a fair market value (FMV) exercise price. However, the excess of the FMV of the warrant over its exercise price generally is taxable income to the sponsor at the time the warrant becomes transferable or is not subject to a substantial risk of forfeiture (generally when the warrant is exercised). This also marks the time when the issuing company is entitled to deduct the compensation expense on its corporate federal income tax return.

Tax Treatment of Target Shareholders

A traditional de-SPAC transaction is structured as a “reverse triangular merger” for federal income tax purposes. The SPAC creates a transitory merger subsidiary that merges with and into the target, with the target surviving as a subsidiary of the public SPAC. Shareholders of the target receive SPAC stock in exchange for their target shares.

The de-SPAC transaction is generally structured to be tax-free to the target shareholders, provided the merger meets the statutory requirements needed to qualify as a tax-free reorganization for federal income tax purposes. These requirements include:

The target company’s shareholders exchange stock constituting control of the target company for voting stock of the SPAC;
At least 80% of the total consideration paid to the target company’s shareholders is SPAC voting stock; and
After the merger, the target company holds “substantially all” of its assets.

In addition, the merger must meet certain continuity of shareholder interest, continuity of business enterprise and business purpose requirements.

Regardless of whether the merger qualifies as tax-free, any consideration received other than SPAC voting stock, i.e., cash or other property (referred to as “boot”), will be taxable to the target shareholders. The taxable amount is the FMV of the boot received.

The target entity that can be a party to a traditional de-SPAC transaction reorganization is normally an S corporation or a C corporation. An entity taxed as a partnership can participate in what is known as an “UP-SPAC” transaction (see discussion below). It is important to note that if the target is an S corporation, its S status will terminate in the de-SPAC transaction since a SPAC (which is taxed as a C corporation) is not an eligible S corporation shareholder.

Other Considerations

There are numerous other tax and non-tax considerations when planning for SPAC transactions. These include, for example:

The tax treatment of transaction costs and start-up expenses;
Potential limitations on net operating losses and other tax attributes due to a change in ownership of the target company;
International considerations such as selection of the jurisdiction where the SPAC is formed and the consequences of passive foreign investment company (PFIC) status; and
Additional financial reporting and accounting complexities for public companies, including SEC and Sarbanes-Oxley requirements.

Partnership IPOs: UP-Cs and UP-SPACs

While a partnership target cannot be acquired by a SPAC in a tax-free reverse triangular reorganization or merger, businesses operating as partnerships that want to go public have the option of a traditional incorporation and IPO, an umbrella partnership C corporation (“Up-C”) structure, or an umbrella partnership SPAC (“Up-SPAC”) structure, all of which have their own tax consequences. Both the Up-C and Up-SPAC structures allow the target to remain in pass-through entity form while also providing the target owners with easier access to future liquidity.

Under the Up-C/Up-SPAC structures, either a C corporation or a SPAC raises funds through an IPO, which are then used to acquire an interest in the target partnership. The target’s partners exchange their partnership interests for publicly traded shares. By electing to use a basis step-up adjustment mechanism and a tax receivable agreement, the partners are paid for a portion of the public company’s tax benefits in the form of an earnout.

Partners that materially participate in the business can avoid the net investment income tax on the exchange of their partnership interest for the publicly traded shares. In addition, the publicly traded shares will have a stepped-up basis when subsequently sold in the market. Therefore, gain may be avoided if the shares are sold immediately after the exchange.

Although SPACs can provide advantages over other deal structures, the SPAC IPO process and the de-SPAC transaction are highly regulated and complex transactions that require intensive planning and preparation. In addition, there are a number of tax challenges and complexities for financial statement and tax reporting purposes that should be considered up front. Rushing through the process without the right expertise can put a successful outcome at risk, not to mention loss of funding and reputation of the sponsors. Companies should employ trustworthy and experienced legal, capital, and accounting advisors to ensure a smooth transaction.