While falling real estate values, uncertainty in the economy and a dys- functional CMBS market have crimped the U.S. commercial real estate industry’s recovery, the industry sees yet another obstacle in its path: a 1980s law designed to discourage cross-border equity investment
in U.S. real estate that needs to be modified or repealed to help boost the flow of
capital from investors outside the U.S., including sovereign wealth funds.
The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) subjects cross
border investors—both individuals and corporations—to a tax on their gains from the
sale of an interest in real estate. Generally, 10 percent of the gross proceeds from
real property are required to be withheld. However, capital gains distributions of
REITs are subject to a 35 percent withholding tax unless the shareholder owns
5 percent or less of a listed REIT’s shares, in which case the withholding rate is
the same as the rate on ordinary dividends. In addition to these withholding rates,
the interaction between FIRPTA and another arcane provision of the tax code called
“branch profits” can produce a total federal tax rate on non-U.S. investment in
real estate around 54%, and that is before any state and local tax burden!
One of the more important recent developments is a 2007 IRS ruling on REIT
liquidating distributions. Notice 2007-55 said that liquidating distributions should
be treated as a capital gain rather than as a sale of stock. A sale of stock in a
domestically-controlled REIT is not subjected to FIRPTA. The IRS change raised
the ire of non-U.S. investors, who had been treating liquidating distributions as
stock transactions.
FIRPTA was created out of fear U.S. farmland and other real estate would fall
under foreign control. Back in the 1980s, the United States was the first choice for
non-U.S. investors, says Jim Fetgatter, chief executive of Association of Foreign
Investors in Real Estate (AFIRE). Yet since then, a lot has changed, with overseas
investors much more willing to spread their capital around the globe.
On another front, U.S. real estate must compete with other asset classes
domestically, which aren’t subject to similar taxation on gains. That means
overseas investors often put their money in companies owning anything from
retail coffee chains to drug companies—as long as it isn’t property.
Call it a double whammy for U.S. real estate. “We are in competition not only
with alternative investments, but also with other countries,” Fetgatter says.
“That is one of the macro events that make this law so antiquated.”
Given the slowdown in capital flows, cross-border investors may have already
spoken. FIRPTA “complicates their investments in the U.S.,” Fetgatter says.
“It becomes a psychological issue, that it is difficult to invest in the U.S. because
it takes so much work and it is a hindrance monetarily.”
disclose its levels of investment in U.S. REITs, it had roughly
$4 billion invested as of mid-November, about 2 percent of the
market, according to Op’t Veld.
Lo W Volume
One thing slowing down the pace of all real estate deals is a
willingness by banks to extend commercial loans to owners of
troubled real estate. Some observers hold the view that until
regulators start forcing banks to call the loans and write off the
under-performing assets, prices will remain artificially high.
In this climate, owners don’t have an incentive to sell properties. Meanwhile, buyers have a hard time justifying meeting
current asking prices.
“Part of problem is there has been a pretty large delta in the
bid-ask spread,” Ackermann says. “Even though we are out
actively looking for new investments, we just haven’t found the
quality investments that we want for this fund.”
Of course, investors run the risk of
waiting for prices that may never present
themselves. “The question is, ‘What is
going to happen in the commercial mar-
kets?’” says Karin Shewer, partner and
president of Real Estate Capital Partners,
a New York firm that manages $8 bil-
lion in assets for German institutions
and high-net-worth investors. “Will the
banks continue extending? Is that going
to allow us to have the time for the
economy to return and avoid what some
experts are talking about: a huge problem
on the commercial side? We are begin-
ning to think that some of the amazing
opportunities that people are hoping for
may not materialize.”
Real Estate Capital has edged back
into the market after doing little last
year, Shewer says. She noted that this is a
compelling time to explore opportunities.
“This is a story of coming into the U.S. at
pricing below replacement cost and gen-
erating very attractive returns,” Shewer
says. “That is a compelling argument.”
Still, the overhang of debt on bank
balance sheets weighs on the minds of
foreigners. “The biggest threat is what
will go on with all the debt in the mar-
kets,” says Danne of Deka. “It is not only
a CMBS thing, but the bigger problem of
what the banks have on the loan books.
If you look at what will come due in the
next few years, I wonder sometimes how
that could all be financed.”
Investors also worry about the struggling
economy. PGGM, despite participating in many REIT recapital-
izations, sees a soft market. “We are quite cautious,” Op’t Veld says.
“Most of it relates to the job market still being quite weak. The cur-
rent pricing of most of the names in the sector is quite fully valued
when you look at the underlying economic figures.”
Others are concerned about the fall of the dollar, real estate
experts say. While some investors hedge the dollar using currency
swaps, others don’t. The dollar’s fall this year might look like a
good deal, but some worry about a continued drop.
