A Clear Winner from Tax Reform

Commercial Real Estate

A Clear Winner from Tax Reform

It's increasingly clear that U.S. commercial real estate is benefiting from the preservation and expansion of many key provisions under the country's new tax law -- with positive consequences for investors.

To the broad relief of the industry, U.S. commercial real estate has emerged as a clear winner from recent tax reform. Many of the provisions regarding real estate investment/ownership have been preserved or have become more favorable:

  • Like-kind exchanges (aka 1031 exchanges) for real property are preserved.
  • Interest deductibility for property is unchanged, although election will impact depreciation.
  • Offshore corporate investors subject to the Foreign Investment in Real Property Tax Act (FIRPTA) are eligible for reduced withholding on real estate investment trust (REIT) capital gains distributions attributable to the sale of domestic real property. 
  • Both public and private REIT dividends are taxed at a lower rate for domestic investors. 
  • Low-income housing tax credits are preserved.
  • Individual investors in real estate partnerships may be eligible for a reduced effective tax rate on their share of income.

Coming at a time when consumer and business confidence are high, the cash savings due to the TCJA (Tax Cut and Jobs Act) will likely be spent rather than saved, unlike prior instances of government stimulus. Tax reform should therefore act as a ‘direct injection’ into the economy and labor markets. This has brightened our demand outlook for 2018 and 2019, because owners and investors in U.S. real estate should benefit from the resulting influx of capital, which will help drive income growth and value appreciation.

Consumer and Business Confidence at Cyclical Highs

Sources: The Conference Board, National Federation of Independent Business, January 2018

 

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Benefits by Property Sector

Industrial: Higher consumption spending should further boost record demand for industrial warehouse space. The sector is already the best performing of the NCREIF Property Index (NPI) over the last five years and will experience additional tailwinds resulting from tax reform that could extend its dominant return performance. Investor focus on infill ‘last-mile’ facilities has picked up, although appetite for big-box warehouse space remains elevated as e-commerce continues to revolutionize the purchase and delivery of consumer goods. As households and businesses spend more, the share of retail sales will continue to shift in favor of e-commerce over physical stores. Even prior to the passage of new tax legislation, industrial vacancy was at record lows across most markets, justifying low cap rates due to high expected rent growth. With the boost from tax reform, tenant demand could rise further, keeping supply and demand fundamentals favorable even in markets with active construction pipelines.

Apartment: Nationally, higher discretionary income from tax savings will likely translate into an increased capacity to pay higher rents. One of the most controversial provisions of the tax act deals with the cap on State and Local Tax (SALT) deductions of $10,000 and the $750,000 cap on mortgage interest deduction. High-cost for-sale housing markets in coastal gateway metros will be the most impacted. In an analysis of mortgages and property taxes across more than 1,700 counties nationwide, Attom Data Solutions found that three out of the top five counties with the most home loan originations above $750,000 are in Southern California and the Bay Area. Three of the top five counties with the most homes paying property taxes above $10,000 are in the New York/New Jersey area.[i] Housing prices in high-cost metro areas are likely to readjust, as the tax incentives for homeownership have been reduced. This disruption to the for-sale housing market could give first-time homebuyers pause. Therefore, we expect marginally higher demand for rental housing over the near-term.

Office: With more cash on their balance sheets, many firms are in a better position to buy, renovate, or build better office space. Overall, however, demand will likely be uneven for the office sector. Traditional users remain under pressure as office employment growth continues to moderate, although this trend could stabilize over the coming years as the result of increased business investment. Nonetheless, the co-working space-use paradigm that attempts to foster collaboration and efficiency will continue to shrink tenant footprints. Fortunately, tenants are investing in construction of new space and redevelopment, even at a considerably higher price point per square foot. ‘Creative’ office and co-working layouts are highly sought after, and ‘bite-sized’ office redevelopment or ground-up construction may be an attractive risk-adjusted opportunity due to a shorter development timeframe and manageable scale.

Retail: In recent years, the excellent dynamics of the industrial property sector have come at the expense of retail. Even with 2017’s strong holiday sales growth, the trend towards store rationalization continues as retailers rush to build out their omni-channel platforms to accommodate the growing proportion of online sales. Recently, Walmart announced wage hikes for its hourly employees, but also moved to close 10% of its Sam’s Club stores. Consumer households may not be more inclined to spend in a store, even with their tax savings, and we do not expect retailers to accelerate store openings or slow store closings simply because of tax reform. However, retailers have long complained that the tax code puts them at a disadvantage relative to other firms, both domestically and abroad. The National Retail Federation reports that retail is the most heavily-taxed industry, owing to the lack of loopholes that other firms take advantage of and the high percentage of retailers that are small businesses. Tax reform should help level the playing field and moderate the rapid shift of shopping from physical stores to online channels.

[i] Attom Data Solutions, Which Local Housing Markets Would Be Most Impacted by the GOP Tax Plan, December 2017.

 

Legg Mason, Inc., its affiliates, and its employees are not in the business of providing tax or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Tax-related statements, if any, may have been written in connection with the "promotion or marketing" of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor

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