Foreign Investors Meeting in Cannes, but Eyeing US RealEstate

Sam Chandan PhD FRICS Real Capital Analyticsand the Wharton School Even while congregating inCannes for this week's MIPIM conference, foreign investors remainkeen on acquiring high-quality assets in the most liquid US realestate markets. In the 18th annual Foreign Investment Surveyof the Association of Foreign Investors in Real Estate (AFIRE),released in mid-January, 51 percent of survey participantsidentified the United States as the market offering the bestopportunity for long-term capital appreciation. Markedly higher caprates than in Europe and Asia have enhanced perceptions of the USvalue opportunity, pushing the Survey's positive response rate toits highest level since 2003. In 2006 and 2007, in contrast, whendomestic cap rates were at their cyclical lows, only one in fourrespondents identified the United States as the leading market forcapital appreciation. Legislative Support for ForeignInvestors In a departure from the negative perceptions ofJapanese investment in decades past, foreign investors incommercial real estate are finding support in Washington DC.According to the Senate Office of Public Records, the Coalition toReform the FIRPTA of 1980 spent half a million dollars on lobbyingactivities in 2009. House Resolution 4539, the Real EstateRevitalization Act of 2010, was introduced on January 27 andsubsequently referred to the House Committee on Ways and Means,where it now sits. The proposed act seeks to eliminate the RealProperty Holding Corporation provisions of FIRPTA and to treat REITcapital gains and liquidating distributions to foreign investors asordinary income. As part of its soon-to-be-refreshed 2009 policyagenda, the Real Estate Roundtable (RER) includes revisions to the1980 Foreign Investment in Real Property Tax Act (FIRPTA) among itskey objectives. Under FIRPTA's current provisions, foreign entitiesare subject to taxes on gains from the sale of US real estateassets. The Roundtable points out the distinct treatment of realestate in this regard: "Unlike all other asset classes, thisprotectionist tax provision creates a disincentive for non-USinvestors to invest in US commercial real estate. With a fewtechnical exceptions, FIRPTA is literally the only major provisionof U.S. tax law which subjects non-US investors to taxation oncapital gains realized from investment in US assets."Putting FIRPTA in Perspective This past December,Martin Neil Baily (the Brookings Institution) and Matthew Slaughter(Dartmouth College) - both of whom have served on the Council ofEconomic Advisors - released their own analysis of FIRPTA's impacton investment inflows. In their report, entitled "How FIRPTA ReformWould Benefit the US Economy," the authors recommend reforming thecurrent system: "... outright repeal or, less dramatically, aninitial holiday could be implemented: e.g., declare that newforeign investments in US commercial real estate over the next fiveyears would be exempt from FIRPTA. We think that the sizableeconomic benefits of reforming FIRPTA would exceed the small fiscalcosts it would entail." The basic notion that a relaxation ofFIRPTA will, all things being equal, enhance the returns toforeigners' investments in the United States is sound. Taxes oncommercial real estate gains will undoubtedly impact theattractiveness of US investments. In practice, however, it isdifficult to quantify the negative impact of FIRPTA or toconjecture that its repeal would open the floodgates to foreigncapital inflows. There is every reason to think that otherissues dominate investment outcomes and that FIRPTA onlycontributes on the margin. It is apparent that foreign investorsfind the American market attractive in spite of FIRPTA. And as longas investors maintain a positive discount rate, the discountedvalued of the tax impediment will diminish as the anticipated assetsale moves further into the future. For Foreign andDomestic Investors Alike, an Absence of Product Where theyhave failed to bring more dollars into the US, foreign investorsare more likely to cite an absence of investment opportunities thanthe tax code. AFIRE Chairman Werner Sohier describes foreigninvestors' conundrum as follows: "Although foreign investorsexpressed every intent to resume investing in 2009, like everyoneelse, their plans were sidelined by a paralyzed marketplace with noprecedent and limited investment opportunities." And so, whileefforts to level the tax code certainly deserve our industry'ssupport, we can afford to be cautious in our conjectures about theimpact of a change. According to AFIRE, foreign investors willincrease their activity in the US market in 2010, even in theabsence of changes to FIRPTA: "investors say they plan to increaseUS allocations above 2009 levels by 62 percent for equity and 83percent for debt; at least half the survey respondents report astronger appetite for both debt and equity investments in the USthan in other countries." Even so, because foreign investorstypically direct their capital to just a handful of cities - NewYork, Washington DC, San Francisco, Boston, and Los Angeles amongthem - many of the metropolitan areas that are most starved forcapital will remain wholly dependent on domestic investors andlenders.