The Big Winner Of The Tax Bill: Commercial Real Estate

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Includes: DRA, DRN, DRV, FREL, FRI, FTY, IARAX, ICF, IYR, JRS, KBWY, LRET, NRO, PSR, REK, RFI, RIF, RIT, RNP, RORE, RQI, RWR, SCHH, SRS, URE, USRT, VNQ, WREI, XLRE
by: John Engle

Summary

The full impacts of the GOP tax bill will take time to be felt, but commercial real estate investors look like major beneficiaries.

New deductions for pass-through entities benefit standard real estate investment vehicles.

Changes to capex deduction will make value-add strategies even more appealing.

Changes to carried interest will increase favorability of private real estate funds as compared with other managed funds.

The flood of private capital into real estate is likely to be spurred on in the year ahead, and private investment funds are likely beneficiaries.

With every tax bill there are winners and losers. Given the complexity of any major tax overhaul, it can take months or even years to figure out who those winners and losers actually are. Yet there is one indisputable winner we can point to immediately: commercial real estate investment.

On a range of points, real estate makes out like a bandit under the new law. Let’s take a look at a few of the provisions that will likely fuel the ongoing boom in commercial real estate.

Pass-Through Entities Get a Special Pass

Pass-through entities such as partnerships and limited liability companies are set to benefit greatly from the new law. These are companies that do not pay direct corporate tax, but instead “pass through” their gains and losses to the individual members of the company or partnership. Under the new law, investors in pass-through entities will benefit from a new 20% deduction.

Many businesses from an array of sectors are set to benefit from the deduction, since many use pass-through structures. Real estate investment is almost always conducted through such entities, so it will be a sector to benefit richly after the late-stage inclusion of property investment under the provisions of the bill.

Expanding Options for Expensing

Some commercial real estate, especially non-residential, will benefit from the new law’s expanded coverage and scale of Section 179 of the United States Internal Revenue Code, which covers certain kinds of depreciation deductions. Specifically, Section 179 states that a taxpayer may choose to deduct the cost of certain types of property as expenses, rather than capitalizing the cost of the property. The new tax law will double the current dollar limitation on the amount that can be expensed each year from $500,000 to $1 million.

None of this would matter to most property investors, since Section 179 is currently extremely restrictive on the types of real property that qualify for the special expensing deduction. Yet the new law widens the definition enough to present significant opportunities to investors. Alistair Nevius, writing in the Journal of Accountancy on December 18th, summed up the changes explained that the new law will “expand the definition of Sec. 179 property to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging.” He also pointed out that the expanded definition covers a range of improvements to non-residential real property, including “roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.”

The impact of the changes to Section 179 will depend on the strategy and sectoral exposure of the particular real estate investor. Already the most popular strategy among private real estate investors, value-add strategies will undoubtedly get even more attention, especially non-residential value-add scenarios.

Appreciation for Shortened Depreciation Schedules

Property investors of all stripes are no doubt rejoicing at the shortened depreciation schedules for buildings. Both residential and non-residential properties have had their depreciation schedules reduced to 25 years, from 27.5 years and 39 years, respectively.

The change is significant for residential property, but massive for non-residential real estate. It will allow investors to realize the tax benefits of the capital expenditure on property acquisitions more quickly.

Carried Interest Carries On

Some hedge fund managers got worried when Donald Trump excoriated them during his presidential campaign. In 2015, he said, "The hedge fund guys didn't build this country. These are guys that shift paper around and they get lucky." Trump promised to eliminate the carried interest provision, which allows fund managers to pay capital gains tax on their portion of their funds’ profits, rather than ordinary income tax. Such a move could have upended not only the hedge fund sector, but virtually all managed funds. Private equity and venture capital also operate using the carried interest provision, taking a part of total profits as part of their compensation.

Thankfully for the universe of fund managers, carried interest has survived into the new tax law. However, hedge fund managers may not go unscathed. Currently, to get taxed at the long-term capital gains rate, a fund must hold an investment for one year. The new law extends that to three years. With its faster investments and fund flows, hedge funds may feel some pain. Private equity funds, such as real estate funds, on the other hand, should do just fine, considering that they tend to hold investment assets for multiple years.

The impact of the carried interest changes is likely to further blunt the appeal of hedge funds, especially to those who manage them. But allocators, too, might raise eyebrows at allocating to funds holding out for the sake of their own tax breaks, rather than working solely in the interest of investors.

Outlook 2018: Further Ubiquity of Private Equity

I have written previously about the record amount of dry powder held by real estate private equity funds. That has been exacerbated by the massive exodus by wealthy individuals and other large-scale allocators abandoning hedge funds in favor of real property investment. A further flood of direct investment in property and of allocations to real estate funds could further drive up deal prices, especially in primary real estate markets.

There could be another significant impact on overall real estate deal-flow, one that stems from the change in the carried interest provision. As Vince DeCrow of Origin Investments, a Chicago-based real estate firm, puts it:

“There is the possibility that it could reduce the number of CRE transactions that occur on an aggregate basis. The reason for this is that the chunk of CRE investments that are typically held for less than 3 years, CRE developments for example, would then have comparably higher odds of changing hands at a slower relative pace once the construction is complete (if complete in less than 3 years).”

Essentially, the risk is that the new provision could constrict the number of properties on sale and consequently dry up deal-flow. If that is the case, then fights over existing deals could intensify further. The result is higher price tags for properties and compressed returns. That makes the decision of allocators on what funds to back even more pressing. One strategy for overpaying might be to allocate to smaller funds with strong track records, as I have discussed in a previous article. Value-add funds, especially, could serve investors well, provided that they seek out deals that are more under-the-radar and do not get caught up in the frenzy of chasing white whales.

In any event, the new tax law is set to help fuel the bonanza that has already engulfed private real estate investment. But as more and more capital floods in, investors must be ever wary of the dangers of an over-exuberant market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.