Staying Ahead of Government’s Unintended Consequences

WASHINGTON, DC-If there is one certainty entering 2012, it’s that governments on all levels—federal, state and local—are strapped for funds and will be seeking new sources of revenue to make up the shortfall. Every industry, including and perhaps especially, the commercial real estate sector, is fair game.

The only question is how and where the axe will fall. In many cases, even when the answer to that question appears clear, longer-term ramifications may cloud the original assessment.  So it is with the two-month payroll tax cut extension Congress pushed through at the eleventh hour before recessing for the holidays.

Economists breathed a sigh of relief—projections of growth for 2012 took into account the continuation of this tax cut. However, to pay for the tax cut’s extension, Fannie Mae and Freddie Mac must now raise the fees they collect from lenders. Specifically, Fannie and Freddie will up their charges —typically a 0.26 percentage point of the loan’s value—by at least one-tenth of 1%, starting April 1.

Many are dismissive of the fee increase: with mortgage rates at record lows, anyone who can qualify for a mortgage will not be deterred by this incremental cost. The multifamily industry, with little other alternative, will also continue to tap the GSEs. 

Probably these conclusions are correct, but the fee is bound to have some impact on the struggling housing market, says Sam Chandan, president & chief economist of Chandan Economics.

“Home-buying is weak, even with rates at historic lows,” he says. “Financing costs are not the binding constraint on housing market outcomes today; while an increase in effective rates will not help housing to recover, nor with will it fundamentally alter housing market outcomes.”

But here is the rub: the fee increase also guarantees Fannie and Freddie’s continued existence for at least another 10 years. This, to say the least, is very welcome news for the multifamily finance industry.

The commercial real estate industry can expect to play this game of cause-and-effect for the rest of the year, says Rich Walter, president of the Irvine, CA-headquartered Faris Lee. A big concern is taxes—especially a revival of the proposal to change the tax characterization of carried interest, he notes.

Such a change “would have a significant impact on real estate transactions,” he says. Most private equity financed-transactions would be affected—at the very least, the sponsor would have to rethink the finances of the transaction, he says. Briefly, private equity pay only the capital gains rate of 15% on income generated from such deals, instead of the ordinary income rate, which is typically 35%. Carried interest is bound to be a focus this year, at least as long as Mitt Romney remains a presidential candidate. One of Republican candidate Newt Gingrich’s talking points has been about Romney’s tenure at Bain Capital, where he earned significant profits in part due to the current tax characterization of carried interest.

Property taxes are another area, although planning for the inevitable increases is at least straightforward. Once the rates are published, building owners will know what the bill will be. End of story.

No such luck with the myriad regulations required under Dodd-Frank, which is still largely a mystery to the industry. According to an analysis by law firm Davis Polk, of the 200 deadlines supposed to have been met in 2011, only 51 were actually achieved.  In other words, only 21.5% of the requirements have become finalized rules.

After a year of lollygagging, regulators are expected to step up the rule-writing pace in 2012. While the certainty of finalized rules will be a relief, the end result will almost certainly be an even tighter liquidity environment as lenders are forced to become more conservative.

This is not to say that this is a foregone conclusion. Industry associations such as the Real Estate Roundtable and the National Association of Realtors, to name just two, are pushing their own proposals—proposals that have gained respectable traction on the Hill.  The Roundtable has been aggressive in explaining the negative consequences of a carried interest tax change, and thus far has been successful at keeping a tax increase at bay. NAR, for its part, has been concentrating on increasing liquidity for real estate borrowers in specific circumstances. 

Proposals that NAR supported last year—and presumably will continue to lobby for in 2012—include legislation that would incentivize equity investment in distressed commercial real estate properties by granting investors a one-time 50% bonus depreciation. At least 80% of the investment would be used to reduce the outstanding balance of debt, with the remaining going towards capital improvements. NAR also supports legislation creating a covered bond market in the US, which would serve as an alternative to the securitization market and hopefully address the refinance gap of many property owners.

In the big picture, of course, the government could provide the ultimate boost to real estate owners by giving the economy an assist and thus, improving real estate fundamentals. For now, though, thanks to a stagnant economy, it is clearly a tenant’s market—and no amount of investment incentives will change that dynamic. “Times couldn’t be better for retail tenants right now, assuming they are in a healthy state themselves,” says Michael Wiener, president of Excess Space Retail Services in Lake Success, NY.

With the national retail vacancy rate still above 10%, give or take, tenants have been able to negotiate all kinds of concessions. In addition, he continues, rents are much lower than they have been in years. “This has meant some retailers have been able to make inroads into markets, or malls, that previously were too expensive for them,” Wiener says. “This has especially been the case in California, such as San Francisco where the rents are more affordable now.”

Indeed, he says, the last few years have provided healthy retailers with an unprecedented opportunity to reshape their real estate portfolios and secure significant savings. “A retailer could negotiate a rent savings over a five-year lease that could be the equivalent of $3 billion in additional sales,” he says.