by Gabe Gonzales

commercial-real-estate-fiscal-cliff

 

We have witnessed that over leveraged real estate does not bode well in the midst of a recession.  While there is still over an estimated $57 billion of CMBS notes coming to maturity over the next three years, most of the problematic commercial real estate to date has been restructured, and expectations have been re-calibrated  Prudent underwriting and sensible decision-making, along with an improving market and increasing availability of capital, have loosened the “purse strings.” The “doom and gloom” that is portrayed by the media emphasizes the proposed effects from higher taxes and lower government spending, creating more uncertainty and leading to a mild form of chaos.  Experts say that the impact of the “fiscal cliff” on commercial real estate may be less than other forms of investments, such as short-term stocks and bonds.  Fortunately, commercial real estate values are determined over longer periods of time.   The chaos may translate into lower cap rates for CRE because investors will have fewer places to chase yields.  In a recovering economy, with little new supply of competitive space, the driver of these returns will be income growth rather than appreciation.

Common sense tells us that another recession will tighten the belts of companies leading to a decrease in the demand for commercial real estate.  Moreover, an increase in the capital gains tax may be the driver to more expensive equity.  But, what about real estate on a micro level?  A myriad of tax-incentivized programs were passed over the past five years to either stimulate or mitigate the pain of the real estate market and losses.  These incentives are now all on the chopping block as the fiscal cliff was more of a draconian way to “solve” the problem in Washington terms.

The increase of the capital gains tax and the expiration of the 2% payroll tax cut are the most publicized issues of the fiscal cliff.  The capital gains tax is expected to increase from 15% to 20%, which can increase the cost of capital and potentially lead to lower real estate values over time; however, the increase would likely be on all types of investments.  An investor selling assets based on tax rate assumptions would still be faced with the question of where to invest the liquidated capital.  The 2% payroll tax cut could affect consumer spending; however, people have already gone over their personal fiscal cliff by watching their home values plummet, their 401-K’s taking a precipitous fall and stagnant salaries with surging inflation ( which will continue if the government keeps spending).  The post-recession consumer has changed his perception of debt by paying down credit cards, increasing personal savings, and living within his means.  The more prudent consumer has adjusted expectations and may be able to to combat the expiration of the payroll tax.

The 2010 Tax Relief Act extended the 15-year Depreciation for leasehold improvements.  If not extended, it will revert back to the 39-year schedule, which will take longer for the landlord/owner to recover expenses through depreciation.  The resulting taxes on the ownership level may dis-incentivize landlords/owners to upgrade and address deferred maintenance on their buildings.

GAAP currently has several tests to classify whether a lease is an operating or capital lease, which determines whether the firm writes it as an operating expense or liability.  The government may begin to advocate putting an actual term limit on what would constitute a capital lease.  A shorter term limit may force companies to write the lease as a liability (capital lease) instead of an expense (operating lease), which would then increase the yearly taxable income.   This may influence companies to sign shorter-term leases.

Carried Interest is the “management fee” that fund managers charge (1-2% of total fund) to cover the costs of investing and managing the fund.  Carried interest has been treated as a capital gains tax because the fund managers would invest a portion of their capital into the fund and the carried interest would represent the managers “ROI.”  The loophole is that the fee charged is based on all the committed capital in the fund, not just the fund manager’s portion.  Proposed changes include treating the fee as ordinary income or considering only the portion invested as capital gains.  This change may indirectly lead to more expensive capital.

The implementation of the Affordable Healthcare Act will affect companies, investors, and citizens in different ways.  Investors are expecting to pay an additional tax of 3.8% on some investments.  Companies are beginning to decrease the availability of work hours to employees in order to avoid paying the healthcare taxes required for full-time employees.  However, the Act will now insure an additional 32 million citizens.  New development for   medical office buildings, clinics, wellness centers, and medical-related facilities will be needed in order to meet the demand from the increased number of new healthcare recipients.

The New Market Tax Credits was created in 2000 and supports $3.5 billion in development each year; however, this program is on the chopping block.  The NMTC provides capital to make a development in a lower-economic area feasible and was instrumental in making projects possible during the credit freeze.

Other real estate-related tax deductions up for extensions are the Brownfields and Conservation Easements deductions.  The Government has incentivized developers to build on Brownfields (environmentally hazardous areas such as old gas stations) by fully deducting the clean up expenses in the year they are sustained, rather than spreading it over time.  For example, 7-Eleven’s strategy is typically to purchase old convenience stores and clean up any issues that the Phase 2’s report.   Conservation Easements can be tax deductions for owners who offer land for conservation (parks, scenic views, water features, etc.).  The fiscal cliff may eliminate or cap the charitable donation in an effort to raise revenue.  The lack of deductions may be an incentive the landowner to sell or develop a property rather than to contribute it.  New development would also mean higher property taxes, increased business activity, and sales taxes.

The media portrays the “doom and gloom” on the effects on the economy on a national level.  We all know that real estate is localized and is used as an inflation hedge.  Texas has been resilient in weathering the effects of the national recession better than any other state, partly due to the diversity of industry sectors, moderate home values and business-friendly taxes.  The D/FW Metroplex continues to see development of all asset types throughout the area, which poses the question:  Is the fiscal cliff that serious, or is it just a political stunt?

Regardless of the outcome, Metropolitan Capital Advisors is confident with its ability to endure Washington politics and advise clients on the best sources of capital for their real estate endeavors.  MCA and its clients have taken advantage of record-low interest rates by refinancing over $400 million in 2012.  MCA stays up-to-date on current tax issues and implications to better advise our clients on the most appropriate capital structure.

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