The Real Estate guide provides expert legal commentary on the key issues for businesses involved in real estate matters. The guide covers the important developments in the most significant jurisdictions.
Last Updated March 07, 2018
This introduction was written by Jay Epstien with contributions from Dale Ann Reiss, former Chair of the Ernst & Young Global Real Estate Practice.
Real estate is affected by global economics, regulatory issues, capital flows and interest rates. Probably more so than any other industry, it is the confluence of supply, demand, liquidity and capital markets.
A major change to real estate lending has been created by Basel III, which has reduced the amount of lending by banks to the real estate sector by imposing higher risk capital requirements. Under Basel III, the classification of loans as High Volatility in Commercial Real Estate (HVCRE) has been a major factor in reducing construction, real estate development and acquisition lending by commercial banks, as it requires banks to reserve more capital for each dollar lent, thus reducing the amount of dollars available for lending. At the same time, the volume of Commercial Mortgage Backed Securities (CMBS) has been reduced as a result of the Dodd-Frank requirement to retain a 5% portion (horizontal or vertical) of the loan by the initiating party. Additional retained risk requirements are under discussion which could further affect this situation. In 2016, total CMBS volume in the US was down 25% compared to the prior years.
On the positive side, the Protecting Americans from Tax Hikes (PATH) Act of 2015 has enhanced the ability of some very significant foreign capital sources to invest in US real estate through changes to the Foreign Investment In Real Property Tax Act of 1980 (FIRPTA). The high level changes created by the PATH Act include the following:
With all of the positive changes under the PATH Act, it is important to note that the law includes an increase from 10% to 15% in the rate of FIRPTA withholding on USRPI dispositions, but such withholding tax should generally offset the net income tax due from the non-US investor upon filing a US tax return.
Another factor that should increase investment in real estate is the creation of a new Real Estate Sector under the Global Industry Classification Standard (GICS) structure, effective August 31, 2016. Real Estate is being moved from the Financial Sector and promoted to its own sector − the “Equity Real Estate Investment Trust”. Mortgage REITs will remain in the Financial Sector under a newly created industry and sub-industry group called “Mortgage REITs”. For entities and investors looking to balance their portfolios, this could be a significant change on the road to achieving the desired levels of diversity across all sectors, and is recognition of the fact that, globally, real estate has increasingly become a public vehicle, either as a C-corp or, more commonly, as REITs.
Finally, while it may be too early to assess the impact of the recent BREXIT vote, the projected lengthy negotiations regarding the actual implementation of BREXIT will create a degree of uncertainty in the European and UK economies and, as a result, push some investors to the sidelines in Europe and the UK. The US commercial real estate market could then see an influx of capital from the UK and other countries whose investors might re-direct their investment focus.
The Financial Accounting Standards Board (FASB) recently issued a new ruling requiring US businesses to disclose lease obligations for real estate and other major assets directly on the balance sheet by 2019. The ruling was designed to ensure transparency and end off-balance sheet accounting for major liabilities. According to FASB, $2 trillion of debt will be added to company balance sheets around the world in the next five years. The new regulations will affect how real estate is accounted for, as well as debt covenants with banks, and may result in a shift to lease terms of less than one year in duration (office sharing) as well as having an impact on lease-versus-buy decisions. In order to comply by 2019, companies will need to begin recasting accounting treatment of lease obligations for 2017 and 2018, as well as reviewing their bank covenants. It is anticipated that these changes will have a wide impact on both lessees and lessors.
Another important regulatory scheme that affects capital flows is the use by numerous countries of visa programmes to attract high-dollar investment, most frequently in real estate. In the US, the EB-5 programme enables immigrants to make a capital investment of $500,000 or $1 million (depending on the exact location of the project). If the project can directly create 10 new, full-time jobs per immigrant investor, the immigrant and his or her family can secure a US green card. A recent paper identified 27 large-scale US projects where 11,200 immigrants invested (or committed to invest) $5.6 billion. Close to 20 other countries around the world have similar programmes in place, including Portugal, Ireland, Spain and several in the Caribbean. However, these programmes (including the US EB-5 programme) are under constant scrutiny regarding their continuation and the satisfaction of their objectives.
Another topic of interest in the regulatory space is the attempt to deal with tax inversions for US corporations. Proposed new tax regulations (under IRC Section 385) may affect real estate fund and REIT structures significantly. The pending regulations would affect inter-company debt, with significant implications for domestic REITs through their taxable REIT subsidiaries as well as those with international investments.
As a result of continued low interest rates around the world, public REITs, pension funds, sovereign wealth funds and other capital sources have increased allocations to real estate. In addition to direct investment in real estate, the increased sophistication of the debt market has brought more money into varying aspects of real estate debt, either through CMBS or through traditional or non-traditional (shadow) lenders. Although the popular press discusses players exiting the business (eg, GE and many banks), other investors continue to view real estate as a safe and secure vehicle that also acts to diversify their investment portfolios.
Foreign capital continues to be drawn to CRE investments in the US and other markets for many reasons, including predictability of cash flows, transparency of market information, relative downside risk protection and liquidity. As noted above, the new FIRPTA legislation and GICs classifications should increase these institutional flows of foreign capital to the US.
However, investment by high-net-worth individuals in luxury real estate is showing signs of slowing as the strong US dollar, weakening local currencies, declining oil prices and global economic uncertainty have affected buying power and the desire of wealthy individuals to invest. These signs are visible in London, Australia, Vancouver, New York, Miami and Southern California as foreign investors have seen the value of their currencies or the ease of movement of their funds touched by various global developments (including BREXIT).
Of further potential concern are the events unfolding in China, where increasing debt and internal investment in real estate could lead to a potential rise in non-performing loans in Chinese banks and the shadow banking system. Moreover, in late 2016, China tightened its monetary policy and restrictions on capital outflows. While these recent developments are expected to impact the global activities of Chinese investors, China likely will continue to be a major investor in real estate, in the USA and internationally.
Global Economics and Infrastructure Investment
In addition to bricks and mortar, currency is one of the raw materials that goes into real estate, meaning real estate is particularly sensitive to the rise and fall of interest rates. Inflation and deflation have the potential to significantly affect the flow of capital. Global terrorism is also a major concern, given the relatively soft targets of malls, restaurants and hotels. Through the Terrorism Risk Insurance Act, the US seeks to help provide insurance for buildings damaged in acts of terrorism; however, the global impact of terror attacks on real estate cannot be discounted. The same applies to tourism, hospitality and infrastructure – all of which are vulnerable targets.
The world’s population is growing and the great demographic shift from rural to urban, 18- and 24-hour mega-cities is unceasing. These factors, plus the aging of extant infrastructure, the globalisation of supply chains, and changing technology are creating sweeping opportunities for both the public and private sectors. Indeed, these changing demographics demand increasing investment in infrastructure, virtually everywhere in the world – a major investment opportunity of possibly as much as $9 trillion by 2025.
Real estate is subjected to extreme differences in legal, regulatory and tax schemes across the globe. This brief overview highlights only some of the most significant issues. In the end, real estate remains local by nature and, as a result, it is of the utmost importance to consult with local counsel and other expert advisers in each jurisdiction where an investment will be made.