US Real Estate Insights www.pwc.com/us/realestate Fall 2015

US Real Estate
Insights
www.pwc.com/us/realestate
Fall 2015
Dear Clients and Friends,
On behalf of PwC’s Real Estate Practice, it is our pleasure to offer another edition of US Real Estate Insights.
This publication provides perspectives on the latest market and economic trends, regulatory activities
and legislative changes affecting the real estate industry, as well as informed views of the most current
developments in operations, business strategy, taxation, compliance and financing.
Consistent with our global vision statement – to build trust and work toward solutions to the world’s biggest
problems – we continue to bring you thought leadership that is relevant to your industry, while also speaking
to your topical needs related to accounting and financial trends and updates. We are seeking to be more
than your accounting firm – we want to have a seat at your business table as a trusted advisor helping tackle
your biggest needs.
Continuing to build on the theme of technology’s impact on real estate, in the edition of US Real Estate
Insights, we are especially pleased to provide an article that discusses how technology is disrupting the
real estate landscape. In “Preparing for disruption in the real estate industry,” Drew Hall discusses how
technological innovations are impacting the real estate industry and how real estate organizations can
respond to remain competitive in a continuously changing environment.
Additionally, as uncertainty looms over public equity markets, the difference in valuation between public
and private real estate holdings has continued to expand. As a result, recent headlines have highlighted
numerous transactions where public REITs are taken private. In “Capital flows and robust fundamentals
drive disconnect between public and private market pricing and going private acquisition activity,”
Tim Bodner discusses trends that are driving these transactions, structures of common transactions,
and considerations for any company that is contemplating such a transaction.
We encourage you to read our flagship thought leadership piece, Emerging Trends in Real Estate 2016.
As the business cycle continues to evolve, the industry faces a number of fundamental shifts that will shape
its future. To help real estate managers and the investment community better plan, we have provided an
outlook on real estate investment and development trends, real estate finance and capital markets, property
sectors, metropolitan areas, and other real estate issues throughout the United States and Canada.
We hope you will find US Real Estate Insights to be informative and helpful to you in your business. As
always, we encourage you to share your thoughts, opinions and suggestions. For more information or to be
added to our distribution list, please feel free to contact the authors of this edition’s articles or your local
PwC representative.
Byron Carlock, Jr.
National Partner & Real Estate Practice Leader
[email protected]
(214) 754 7580
Table of contents
Preparing for disruption in the real estate industry
1
Emerging Trends in Real Estate 2016: Coordinating offense and defense 5
“Live, work, stay, play” – can the resident and tourist coexist? 9
Investors are selectively pursuing assets 13
Capital flows and robust fundamentals drive disconnect between public and private market
pricing and going private acquisition activity
16
The likely impact of recent US economic trends and tax reform proposals
20
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Preparing for
disruption in the real
estate industry
by Drew Hall
Overview
Technological evolutions have resulted
in new, emerging organizations
changing the way consumers interact
with certain services. We have seen
this evolution in the transportation
industry (i.e. ride sharing
applications) and music industry (i.e.
through various streaming services).
Technological innovations are now
spreading into the real estate industry
through innovative new organizations
that are challenging traditional
business models. How can real estate
organizations respond to this “market
disruption” and remain competitive
in a continuously changing
environment?
What is disruption?
In 2004, a large brick-and-mortar
video rental company had 60,000
employees, 9,000 stores, and a
market cap of $5B. Six short years
later the organization filed for
bankruptcy protection – initiating a
process that would close thousands
of stores, lay-off tens of thousands
of employees, and completely
wipe out the organization’s market
capitalization. Today, only a handful
of these third-party managed video
rental stores exist. The lessons retail
and other organizations can learn
from this organizations’s missteps are
obvious; ignore the competition and it
may one day be your downfall.
How can these same lessons be
applied to the real estate industry?
With a renewed interest in urban
living and investors pouring billions
of dollars into real estate assets, is
it conceivable that the real estate
industry (as a whole) is going to be
flipped on its head by some upstart
competitor? Could a real estate
organization emerge that would
fundamentally change how humanity
lives and works? At face value, the
obvious answer is no, real estate
organizations do not have to worry
about the industry evaporating
overnight. Individuals and families
will presumably continue to prefer to
live and work in functional buildings
near amenities and infrastructure
many decades from now. What may
differ in the future, and what real
estate organizations should continue
to think about, is the how. Some
questions that executive teams may
ask in order to be responsive to
changes in the environment include:
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1
• How will real estate organizations
deliver expected services like
office space, apartments, and
infrastructure?
• How will real estate organizations
adapt to changes in transportation?
• How will real estate organizations be
leaders in their multi-trillion dollar
asset class?
By asking questions such as these,
we can identify that disruption is,
ultimately, identifying new ways
to deliver products, services, and
experiences.
Disruption in action
Imagine the reaction a CEO, whose
real estate organization invests and
operates in the hospitality sector,
would have to the following scenario:
a new competitor, valued at $25B, is
opening thousands of new hotel rooms
across North America and Europe every
week; all without hiring new hotel
staff or paying for the underlying hotel
assets. This organization’s operating
model has not been seen before in the
hospitality industry but it is growing
more and more popular with millions
of customers every day.
The example CEO in this case would
likely try to understand how this new
super competitor is able to execute this
strategy while becoming increasingly
more nervous about the implications
such as the competitor’s effect on his
business, earnings, and the security of
the jobs of his company’s employees.
Now imagine the same CEO being
presented with a separate scenario: a
California startup is building an app
that lets people rent spare bedrooms
from strangers at rates below those of
local hotels. Would the example CEO
be as worried about this development?
What type of strategy would this
executive develop to address these
business risks?
In both examples, the “new” competitor
is the same: a new, technology driven
startup with an innovative business
model and backed by the deep pockets
of venture capitalists. This rapidly
growing startup is causing real and
significant disruption within the
hospitality industry by allowing any
property owner to become a boutique
hotel. The beauty of the system is
that it not only works for the average
property owner, but also the super
luxury owners – the ones with truly
unique spaces and locations – giving
this startup coverage at all levels of the
market.
Disruption isn’t just limited to hoteliers,
as the commercial office space sector
has also seen the explosive rise of
their own startup, one that is also well
financed and is forcing traditional
property managers to rethink their
target customers. This startup is
executing a new spin on the coworking
space business model that plays to
the hearts of startups, freelancers,
and small businesses. Targeting these
groups of workers creates a large pool
of potential tenants to draw from,
a pool that includes an estimated
34% of US workers.1 The operating
model isn’t different from those used
by other coworking organizations:
lease office space in bulk and extend
micro-leases to smaller organizations.
What is different is the execution of
the underlying idea and the target
audience.
Entering a the coworking space of
this startup property manager is not
like entering a traditional corporate
environment, it is more like landing
in the middle of a hip coffee shop
filled with common areas, video
games, conference rooms, and small
offices. This organization is building
destinations for those individuals and
organizations that may have otherwise
stayed in their apartments (or
garages!). A small property manager
targeting other startups and freelancers
may not seem like a threat to
established office real estate managers,
but as Clayton Christenson noted in his
critically acclaimed work at Harvard2,
those organizations that start at the
bottom, taking what the larger players
in the market don’t want, eventually
start moving up the food-chain.
Despite the challenges that disruptors
and new market entrants pose to
established members of the real estate
industry, there are several approaches
and strategies that management groups
can apply to keep their organizations in
front of these changes.
1 Freelancing in America: A National
Survey of the New Workforce – http://
fu-web-storage-prod.s3.amazonaws.
com/content/filer_public/c2/06/c2065a8a7f00-46db-915a-2122965df7d9/fu_
freelancinginamericareport_v3-rgb.pdf
2 Disruptive Innovation – Clayton
Christenson: https://www.youtube.com/
watch?v=B5FxFfymI4g
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How can real estate companies
deal with disruption?
With trillions of dollars in assets and
hundreds of billions more projected
to be allocated to real estate over the
coming years, entrepreneurs and
investors alike are racing to bring
the next big ideas to the business
community. Venture capitalists have
taken an interest in these trends by
significantly increasing the funding of
new real estate technology companies
each year going back to 2010.3 These
factors all point to the ever increasing
potential that major changes could be
coming to the real estate industry.
Understanding where the world is
moving and identifying where new
opportunities may exist are the true
keys to preparing for disruption. As
straight-forward as that is on paper, in
practice, it is much harder to execute.
Fortunately, there are steps that
real estate organizations can take to
prepare for the inevitable.
First, real estate organizations should
understand how to identify early
predictors of disruption. The easiest
way to start this process is to ask the
question “what if?”
• What if driverless cars significantly
impact traffic patterns?
• What if virtual reality changes how
organizations choose office space?
3 Real Estate Startups Heating Up With
Venture Capital Investors: http://blogs.wsj.
com/venturecapital/2014/11/12/real-estatestartups-heating-up-with-venture-capitalinvestors/
• What if medical advances increase
the life expectancy of the average
American by 20 years?
• What if a new organization starts
delivering similar services to those
customer segments lower on the
value chain than our existing
customers?
Disruption isn’t just about companies
like those highlighted previously
interacting directly with the real estate
industry, it’s also about how society
acts on a daily basis. Asking the “what
if” questions, plotting out the potential
outcomes, and crafting strategies to
handle those potential results will help
organizations deal with significant
change.
Second, real estate organizations
should embrace the change that
disruption can bring. This can
mean adapting business processes,
implementing new technologies, or
forming new partnerships. Those
organizations that have been willing
to work with these new coworking
startups to provide the lease model and
tenant services that the organization
needed have benefited from having a
rapidly growing tenant base willing to
lease unique buildings and spaces.
The best way to think about embracing
change is to look at the consequences
that other organizations have faced
when fighting change – especially the
change that was broader than just
a specific industry – which includes
record labels and taxi companies. In
both cases, new technologies removed
traditional barriers to entry opening
the door to new competitors. When
change is inevitable, resources spent
to embrace the change are far more
impactful than those spent attempting
to prevent it.
More specifically, organizations
can consider current trends that are
causing disruption in the real estate
industry such as the adoption of cloud
technologies. Organizations that
have gotten out in front of this trend
by shifting applications and other
core systems to cloud providers or
infrastructure are realizing reductions
in the total cost of ownership as well
as better integration with key partners
and suppliers.4 Delivering tools and
services through the cloud also opens
up real estate organizations to new
ways of deploying their workforces.
The “anywhere, anytime” model gives
organizations access to remote workers
without having to create additional
workspaces. Larger talent pools and
lower operating costs could both lead to
the creation of competitive advantages
for the organizations willing to shift
toward the cloud. This development
is a two-way street, though, as many
real estate organizations will also
have tenants employing similar tools
potentially resulting in a reduced need
for office space.
Lastly, real estate organizations can
become disruptors themselves. With
assets that produce predictable cash
flow, real estate organizations are in a
prime position to fund the many ideas
that could evolve into competitive
advantages. Again, the answers to the
“what if” questions become important
4 Beyond ERP – New Technology, New
Options by PwC Strategy&
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3
starting points for organizations that
may be looking for the next opportunity
to disrupt the real estate sector. This
may also include allocating resources
to identify and invest in startups to stay
plugged into the industry’s innovators.
A large mall operator has taken this
approach to help diversify risk in the
organization’s tenant pool.5
The issue here, however, is not the
ability to identify a starting point, it is
the nature of organizations to say “no”
too quickly too often or come down too
hard on failure. Management teams
should take a more open approach
to new ideas that may be originating
within the organization. Further, in
those cases where an idea doesn’t work
out, it should not be a death sentence
for the individual or team’s careers. An
organization’s employees need to know
that they can fail when exploring new
ideas or they will never attempt them.
Final thought
Disruption does not have to strike
fear in the hearts of real estate
organizations. Society will always
need places to live, work, and play.
How those services are delivered
and the amenities that are combined
with them will ultimately separate
the successful organizations from
the laggards. By identifying potential
disruptions, embracing change, and
experimenting with new ideas, real
estate organizations may be better
prepared to stay ahead of both their
competitors and broader shifts in the
market.
Drew Hall is a Manager in PwC’s
Real Estate Advisory Practice
He can be reached at
[email protected]
5 Mall Operators Begin Cultivating Startups:
http://www.wsj.com/articles/SB1106434121
3388534269604581080473031895058
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US Real Estate Insights
Emerging Trends
in Real Estate 2016:
Coordinating offense
and defense
by Andrew Warren
The following is a summary of the
results of the 2016 edition of the
Emerging Trends in Real Estate.
The findings and opinions reflect those
of over 1,800 market participants
interviewed and/or surveyed and do not
necessarily reflect the views of PwC.
Introduction
Real estate market participants
have an optimistic outlook heading
into 2016. This positive sentiment
is apparently being driven by real
estate fundamentals that continue
to improve in a growing number of
markets across the country. Steady
employment growth combined with
limited amounts of new supply is
driving net operating incomes to
pre-global financial crisis levels in
more markets and property types.
The optimism surrounding the
continued improvement in multiple
real estate markets has many of
this year’s interviewees and survey
respondents expressing that now may
be the time to play a little offense
with their investment strategies.
While the majority of the market is
expressing confidence in the 2016
outlook for real estate, there are still
a few items on the horizon that they
are keeping an eye on. A few key items
are preventing the market from going
into full offense mode. Concern about
global uncertainty and questions
about how much momentum is left
in the current economic expansion
appear to be enough to keep some
market participants comfortable
with defensive focused investment
strategies.
With the market focused on
coordinating strategies focused on
offense and defense, a number of key
trends were identified as potentially
having an impact on the real estate
market in 2016. The top 10 trends
reflect the search for investment
opportunities in a growing number of
markets and property types, new uses
for existing real estate, and ways to
enhance operational efficiency in the
real estate industry.
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5
2016 top 10 trends
Figure 1: Emerging Trends outlook ranking change 2010 - 2016
1. 18-hour cities 2.0
Last year Emerging Trends identified
the rise of the 18-hour city. This year,
the real estate industry is expressing
growing confidence in the potential for
investment in these markets. Potential
workers are drawn to these markets
due to the availability of services and
amenities that replicate larger metro
areas, but typically at a more affordable
cost. Employers are following the
quality workforce and the lower cost
of doing business. The bottom line is
that these 18-hour cities are seriously
being considered as viable investment
alternatives to the traditional big six
markets.
30
20
10
0
-10
-20
-30
Source: Emerging Trends in Real Estate 2016
2. Next stop: the suburbs…what
is a suburb?
The suburbs are a long way from
being dead. Despite the continued
growth in urban environments, the
suburbs continue to employ and house
a large percentage of the population
base. The suburbs that are thriving
however, are not the suburbs of the
past. The successful suburbs of today
are more likely to mimic an urban
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US Real Estate Insights
environment with walkability, access
to public transportation, neighborhood
environment, and all the amenities
demanded by urban residents than
the traditional car-centric lifestyle of
traditional suburbs. The US population
is mobile again, and a growing amount
of evidence supports the idea that
millennials will eventually make their
way from the urban core to outer
neighborhoods and elect suburban
locations.
3. Offices: Barometer of change
The office property sector offers a
direct insight into how technology
disruption, generational transfer,
workflow reorganization can impact
real estate. Space per worker has been
steadily declining, but it hasn’t been
just a drive to cut costs. New space
design must be desirable to the workers
who companies hope to attract. This
has resulted in new layouts that cater
to the demands of the millennial
worker, who are quickly becoming the
largest percentage of the workforce.
But this new space isn’t just appealing
to the workers, it also addresses the
way work is being done. Technology
is allowing workers to be much more
flexible in what they can do and where
they can do it. The workforce is also
changing who they want to work for.
Anecdotal evidence suggests a growing
component of the workforce prefer to
go from project to project rather than
commit to a single employer. This has
led to growth in the use of collaboration
space where companies share space
and skills with other companies. This
is leading to a rise in small company
employment. Finally, we are witnessing
the beginning of the exit of the baby
boomers from the workforce, leaving
generation X in charge of the growing
millennial workforce.
Figure 2: % of total employment change by company size since 2013
9.8%
6.0%
46.5%
37.8%
1 to 49
50 to 499
500 to 999
1,000 +
Source: Bureau of Labor Statistics, PwC
4. A Housing option for everyone
5. Parking for change
The market has been waiting for the
single family housing market to return
to an ownership percentage near the
66% long-term historical average.
Changing demographics and household
preferences are moving in a direction
away from traditional homeownership.
This is creating opportunities for a
wider set of housing options. The single
family market continues to improve
in a number of markets, but first time
buyers have been slower to return
to the market. Single family rental
continues to develop as a preference
for a number of households, who like
the lower cost of entry and flexibility.
Going forward, the housing market will
see demand from aging baby boomers
who will be looking for homes where
they can age in place. While younger
millennials will look for affordable
options in higher cost urban areas.
For years, the search has been how to
provide enough parking. That trend
is changing to how do I profitably
repurpose the parking I have? Tenants
who once required a set number of
parking spaces per employee, are
reducing their demand as workers
expand their use of alternative
commuting methods. As the number of
workers commuting by auto declines,
mass transit, bicycles, ride sharing, and
walking are becoming more popular
ways to get to and from work. Building
owners and managers also are dealing
with how to provide parking to tenants
who have a large number of workers
with flexible work arrangements.
Building owners are looking for ways to
generate revenue from current parking
resources while planning for a future
where parking demands may look very
different.
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6. Infrastructure: Network it!
Brand it!
8. Consolidation breeds
specialization
In light of the urban population growth,
cities are looking to urgently prioritize
repair and maintenance, and at the
same time tackle critical needs in areas
such as water supply and distribution,
public education, aviation, vehicle and
pedestrian traffic, and rail safety. This
is leading to creative solutions such
as high-frequency bus networks and
green infrastructure. As the need to do
more with less becomes more acute,
innovative solutions to infrastructure
needs are being developed. These
inventive solutions take advantage
of increasing technology and can be
viewed as temporary solutions or could
be seen as permanent replacement to
traditional infrastructure ideas. These
solutions are good for the community,
and if designed appropriately can be
profitable for investors.
The evolutionary trends in
development, equity investment,
and lending are showing that “small
can be powerful.” Developers may
find it difficult to access sufficient
capital unless they have scale, but this
means fitting the quality demands of
conservative lenders. That requires
finding niche lenders and investors
willing to fund the smaller projects;
and small developers with their lenders
may be accessing the most innovative
parts of the business. Firms may find
themselves in the middle and will need
to choose which side – smaller or larger
– they wish to be on. This specialization
reminds us that real estate is still a
hands on investment that benefits from
local expertise. Specialization allows
developers, owners, service providers,
operators, and capital providers to
provide that expertise to a growing
variety of real estate investments.
7. Food is getting bigger and
closer
What do you do when you have
multiple generations that clearly
expresses a desire to eat fresh, more
nutritious foods but chooses to live
in large urban areas? One way to
meet this need is with urban farming.
Not only does urban farming utilize
rooftops, it is also bringing new life
to obsolete urban industrial and
municipal properties. An added
benefit to urban farming is the ability
to provide fresh produce to urban
neighborhoods where availability may
be limited due to a lack of providers.
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9. We raised the capital, now
what do we do with it?
Domestic and global capital continues
to flow into the US real estate market.
Global uncertainty and financial
market volatility continue to enhance
the attractiveness of hard assets in
relatively stable markets. The big six
markets that have been the number
one choice of many investors have seen
prices reach a level where investors are
now seriously considering expanding
to a wider market set and alternative
investment choices. The increase
in capital to the market is driving
investment in student housing, senior
housing, self-storage, data centers, and
lab space to name a few. In addition,
investors may take advantage of new
real estate investment vehicles.
10. Return of the human touch
Technology, big data, and increased
market transparency have led to the
perception that real estate investing
may be less hands on than it used to
be. While these tools have enhanced
the ability of investors to target specific
investments and increase confidence
in underwriting assumptions, it still
takes the human touch and experience
to make it work. The industry is
trending toward more intensive active
management. Risk management of
hacking issues is of critical concern
– and attention to cybersecurity will
penetrate more deeply into the real
estate business. Attention to individual
decision-making is needed as much as
ever. Direct real estate employment
has recovered from the global financial
crisis, but growth is still behind peak
levels. As a number of baby boomers
retire, the industry will be looking
to replace a significant amount of
institutional market experience.
Conclusion
Emerging Trends in Real Estate 2016
participants feel good about the coming
year, and are feel that investment
opportunities will be available in
a growing number of markets and
property types. The market seems to
be offering the opportunity to play
a little offense. This appears to be a
good thing, since it is expected that the
flow of capital into US real estate will
continue. Despite the optimism, there
are just enough items on the horizon to
keep some market participants focused
on being more defensive. In all, 2016
should offer the market opportunities
to coordinate both strategies.
Andrew Warren is a Director in
PwC’s Real Estate Practice
He can be reached at
[email protected]
“Live, work, stay, play”
– can the resident and
tourist coexist?
by Greg Pepitone
City centers in the United States
have evolved in scope over the past
century as a result of changes in
American society and commerce. As
the center of activity until the 1940s
when residential and office demand
began shifting outside the urban
core, this key submarket has begun
to claw back demand as community
leaders seek to re-concentrate market
activity, positioning the city center
as a more diversified destination for
workers, residents and visitors. The
repositioning of city centers may
represent an opportunity for investors
to identify opportunistic or value-add
investments in cities throughout the
United States.
A trend in city planning:
An emerging practice in the strategic
development of the urban core is the
“live, work, stay, play” model of land
use which concentrates residential,
office, entertainment and tourism
elements in a common district. This
relatively new mixed-use model
was preceded by related variations
of more limited scope such as “live,
work, play” and “work, stay, play”
combinations. Absent in most legacy
models, however, has been the
successful integration of “live” and
“stay” elements; raising the question
as to whether residents and tourists
can coexist in a single district.
The challenge
The resident-tourist relationship
can be likened to that of water and
oil; inharmonious and potentially
incompatible. Residents can form
negative views of tourism despite the
industry’s economic contributions
as a result of varying side effects
such as crowding and pollution
or unwelcomed changes to a
community’s cityscape or surrounding
natural landscape to accommodate
attractions and related infrastructure.
Tourism activity can also cause
tension within a community as
residents, community leaders and
real estate developers debate related
policies and regulations; debates
which can ultimately affect a
community’s character and viability
as either a resident community or
tourism destination.
A model of success demonstrating
the polarizing relationship between
residents and tourists can be seen in
beach communities. Such destinations
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originate as a residential community
of year round primary residences and
supporting businesses; developing
a unique sense of community and
character which can appeal to visitors
along with the area’s natural landscape.
As tourists discover such a destination,
additional “stay” elements are typically
developed, including lodging and other
visitor-oriented businesses which may
not mesh with the community’s original
character if development is not properly
overseen by community leaders.
Further, the price of housing as well as
consumer goods and services may rise,
causing legacy residents to relocate and
the community’s sense of character to
diminish if growth and preservation
interests are not balanced.
Condo hotels further illustrate the
dichotomy of the “live” and “stay”
elements of mixed-use real estate
within the footprint of a single
structure. Hotel guests and condo
residents are accommodated under
the same roof in these projects, yet
are often divided, to an extent, by
physical layout and separate amenities
such as exclusive parking, entrance,
elevator, fitness center, and swimming
pool. While a viable concept overall,
certain condo hotel projects have
failed or underperformed for a variety
of reasons, including incompatible
demographic and lifestyle profiles of
the condo residents and hotel guests
which materialized.
Destination planning
Leading practice in tourism strategy
recognizes the role of the local resident
in positioning many destinations
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to visitors. “Live” elements should
therefore be prioritized, not
marginalized, or worse excluded in any
mixed-use project intended to generate
tourism demand. Destination leaders
can apply lessons learned around
authenticity, scope and seasonality to
mitigate issues which may otherwise
undermine the synergy of “live” and
“stay” elements.
Authenticity
Leisure and group travelers are
prioritizing authentic experiences
which are distinct to a destination,
including access to an area’s unique
“live” elements, and demonstrating a
preference for “stay” elements in close
proximity thereto. For instance, many
leisure travelers choose local bars and
restaurants and alternative lodging
in an effort to immerse themselves in
a community. Development practices
should consider the preservation and
promotion of a destination’s character
and personality as an integral aspect
of project planning. Austin, Texas and
Louisville, Kentucky are examples of
destinations focused on authenticity
through the development of iconic
attractions and delivery of unique
experiences.
Austin, Texas, home of the State Capital
and University of Texas, is an authentic
destination also known for creativity
with a strong base of resident artists.
Branded the Live Music Capital of the
World, Austin has a large portfolio
of live music venues and hosts major
festivals including South by Southwest
and Austin City Limits. Local musicians
also play at grocery stores, city council
meetings, and the airport. In addition
to music, Austin has a comprehensive
art scene, with many galleries,
museums, festivals, and street fairs.
The historic Main Street in Louisville,
Kentucky dates back more than 200
years and includes a mix of modern
amenities with a historic touch. Despite
building sports and entertainment
venues (Fourth Street Live!, KFC Yum!
Center, and Louisville Slugger Field),
museums (The Muhammad Ali Center
and Louisville Slugger Museum &
Factory) and other major developments,
Louisville was able to maintain its
historic integrity by keeping the
original facades of buildings. Whiskey
Row, for example, which once housed
whiskey and bourbon distillers, is
home to new bars, restaurants, event
space, and residential lofts behind the
building facades which have been in
place since the mid-1800s.
Mix, mass, and mesh
Three scope considerations initially
identified nearly two decades ago as the
“mix,” “mass,” and “mesh” of city center
development1, could today be cited as
the critical success factors for urban
mixed-use districts and the successful
combination of “live” and “stay”
elements therein.
Mix: First, a mixed-use district
should be diversified to the extent its
components are complementary to each
other and other strategic assets in the
surrounding urban core. A district’s
1 Peterson, David C., “Mix, Mass, and Mesh:
Revitalizing Our Center Cities,” 1998
program also requires both anchor and
supporting elements to first generate
demand and then accommodate and
extend the district visitation and
residency.
An appropriate mix of assets needs
to be incorporated throughout
development in order to generate
demand. Delaying construction
or waiting until the later stages to
incorporate the “live” elements may
hinder success. Although build-out of
supply is typically aligned with market
cycles, it is important that the “live”
elements pre-exist or be developed
early in a project’s phasing to provide
the foundation for an authentic
experience.
Mass: Second, while the precise mix of
products is unique to each destination,
critical “mass” (both in number and
size) of developments or elements
must exist in order to consistently and
effectively attract visitors. This could
relate to areas such as the number
of hotel rooms necessary to ensure
a successful convention center, the
number of restaurant establishments
needed to create a destination-dining
district, or the number of venues
needed to create a music district.
Mesh: Finally, individual products
should be developed in a way that
“mesh” well with existing and future
products. This could involve building
complementary products next to one
another (such as building a convention
center in a location that is conducive to
future hotel development or creating
a continuous “row” of restaurants and
outdoor dining experiences) and/
or ensuring that safe and convenient
transportation linkages (including
pedestrian walkability) exist between
them.
Table 1 provides a select sample of
mixed-use districts anchored by a
major sports venue(s); illustrating the
diversity of elements programmed
to support and enhance the
activity generated by the sports
venue anchor(s). Although various
components of the “live, work, stay,
play” model are included in each
Table 1
Gross square feet
Sports venue name(s)
Development name
Location
First year
Acreage
Lodging
Office
Retail
Residential
Golden 1 Center
TBD
Sacramento, CA
2016
184
85
475
600
70
PETCO Park
Ballpark District
San Diego, CA
2004
130
660
325
285
3,900
Paul Brown Stadium &
Great American Ballpark
The Banks
Cincinnati, OH
2011
89
400
1,000
400
1,800
American Airlines Center
Victory Park
Dallas, TX
2001
75
230
1,130
342
315
Nationwide Arena
Arena District
Columbus, OH
2000
75
0
1,500
300
320
Busch Stadium
Ballpark Village
St. Louis, MO
2014
35
0
750
660
2,160
Sprint Center
Power & Light District
Kansas City, MO
2008
35
0
1,200
475
2,160
AT&T Park
Mission Rock
San Francisco, CA
TBD
28
0
1,500
500
1,470
Staples Center
LA Live
Los Angeles, CA
2007
27
1,634
165
1,835
366
US Bank Stadium
Downtown East
Minneapolis, MN
2016
13
54
1,200
38
192
1.
Lodging, office, retail, and residential figures represent scope at project build-out and have been presented in thousands
2.
“Retail” includes entertainment venues and food & beverage establishments
Source: PwC
US Real Estate Insights
11
example, many legacy mixed-use
districts anchored by a major sports
venue(s) have a disproportionate
ratio of “live” and “stay” elements.
Numerous examples exclude lodging
amenities altogether, providing
potential opportunities for further
development of existing districts and
reconsideration of the appropriate mix
of “live” and “stay” elements in future
mixed-use districts.
Year round destinations
Mixed-use districts that are open
year round tend to experience more
long term success compared to their
counterparts, which essentially shut
down during the off season. This
further supports the concept that a
downtown or city center must first be a
great place to live. A development with
residence at its core will also address
challenges that otherwise exist from
tourism seasonality. Generally, local
businesses rely on a mix of residents
and tourists in order to be successful.
Although a significant portion of
income is generated during the tourism
season, residents are an important
contributor to a business’s stability and
year round success.
A year round “live” mixed-use district
should be part of a destination
strategy. Stakeholders should focus on
developing events and amenities that
attract residents and tourists during the
shoulder and off season in an effort to
reduce the seasonality effects.
Can the resident and tourist
coexist?
Residents and tourists can coexist
in a mixed-use district and in many
cases need to coexist to optimize
project returns, strengthening the
case of the “live, work, stay, play”
model as a potential opportunity for
investors going forward. With proper
planning and diligence, all components
of the model can be appropriately
incorporated into a mixed-use district.
A successfully executed, comprehensive
destination strategy can help develop
an authentic district anchored by a
strong resident base, a key element
in ensuring long term success of
the district and a positive return for
investors.
Greg Pepitone is a Manager in
PwC’s Hospitality Practice
He can be reached at
[email protected]
12
US Real Estate Insights
Investors are selectively
pursuing assets
by Susan Smith
The following is extracted from the
Third Quarter 2015 issue of the PwC
Real Estate Investor Survey, released on
September 14, 2015. The findings and
opinions reflect those of the investors
surveyed and do not necessarily reflect
the views of PwC.
Deploying capital into the US
commercial real estate (CRE) industry
remains a prime objective for domestic
and international investors even at a
time when some Survey participants
are expressing “some caution”
about its near-term performance
due to conversations of impending
interest rate hikes, rumblings of
economic troubles abroad, and
still-present concerns regarding
US macroeconomic conditions.
Nevertheless, many surveyed
investors are quick to point out that
the United States is looked at as a “safe
investment haven” by foreign CRE
investors, as well as by US investors
who currently see few comparable
investment alternatives. The end
result is a tremendous amount of
capital flooding the industry, keeping
buyer competition strong, overall
cap rates low, prices elevated, and
investors anxious (see Figure 1).
To combat the “optimistic fragility”
that some investors are feeling,
perspective CRE buyers are being
very selective in their placement
of capital. “Selectivity is crucial,”
says one Survey participant, who is
focused on high-tech cities with deep
tenant pools. For many investors in
the office sector, a cautionary buying
approach stems more from aggressive
pricing on the part of both stalwart
sellers and eager buyers than from the
sector’s tepid, but ongoing recovery.
One surveyed investor notes, “We are
seeing good things with the office
sector’s recovery, but we don’t want
to overpay if we sense interest rates
going up and tenant demand stalling,
which can lead to property value
declines.”
Construction trends in the apartment
sector are likewise prompting a need
for cautious bidding and selectivity
on the part of buyers. “We are
enthusiastic, but conservative in our
quest for apartment assets since it
remains a sellers’ market with lots of
new supply in the pipeline,” comments
a Survey participant. In the warehouse
sector, many buyers stress the need
for selectivity, as well as geographic
diversity, with regard to acquisitions
due to falling vacancy rates, swiftly
rising values and asking prices, and
“the layers of uncertainty throughout
the US economy.” In the retail sector,
limited additions to supply and a
rebounding economy have provided a
“much-needed boost” to its underlying
fundamentals, allowing potential
US Real Estate Insights
13
Figure 1: US CRE buyer composition and overall cap rate trends
50%
9.2%
45%
9.0%
40%
8.8%
35%
8.6%
30%
8.4%
25%
8.2%
20%
8.0%
15%
7.8%
10%
7.6%
5%
7.4%
0%
2011
User/other
2012
Private
2013
Public
Equity fund
2014
Institutional
Cross-border
2015
7.2%
Average overall cap rate
Source: Sales data is from Real Capital Analytics, Inc; overall cap rate data is from PwC Real Estate Investor Survey
buyers to look at perspective retail
acquisitions from a more offensive
viewpoint instead of a defensive one.
Still, being selective is well-advised by
our Survey participants when pursuing
investment opportunities in the retail
sector.
Overall cap rates
In the third quarter of 2015, the
average overall capitalization (cap)
rate decreases in 18 Survey markets,
holds steady in nine, and increases in
seven. The shifts are diverse and spread
across property sectors and locations
with the national CBD office market
and national power center market
posting the steepest drops this quarter.
In contrast, the Mid-Atlantic and
Southeast region apartment markets,
as well as the Houston office market,
report the largest increases in average
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US Real Estate Insights
overall cap rates. Overall, average
overall cap rate trends suggest growing
optimism for the warehouse and retail
sectors and waning enthusiasm for the
apartment sector.
Over the next six months, most
participants expect overall cap rates to
hold steady in the majority of Survey
markets with the exception of the
national CBD office market and the
Boston office market, where overall cap
rate forecasts vary between increasing,
decreasing, and holding steady.
CRE sector overviews
Office
While improving fundamentals
continue to draw investors to the office
sector, investment strategies vary from
buying core CBD office buildings as
part of large mixed-use, urban settings
to acquiring CBD office buildings that
appeal to tech-oriented firms. In the
suburbs, some surveyed investors are
cautiously optimistic and searching for
buying opportunities in top suburban
office metros, like San Diego, Portland,
and San Francisco, while other
investors are opting to prune existing
portfolios and sell certain suburban
office assets, especially in secondary
locales.
In the Survey’s national CBD and
national suburban office markets, shifts
in key cash flow assumptions suggest
investor optimism for the near term.
For the national CBD office market,
its average overall cap rate decreases
41 basis points to 5.66% – the first
time since 1994 that this average has
dropped below 6.00% for this market
in our Survey. In the national suburban
office market, the average overall cap
rate slips eight basis points to 6.42%,
but at the same time, the low end of the
range declines to 4.25%.
Improving fundamentals, lower overall
cap rates, and optimism on the part of
investors will likely keep this market’s
buying environment competitive for the
near term.
Retail
Slow, but steady improvement in
underlying fundamentals and a lack of
new supply are expected to finally move
most metros in the US retail sector out
of the recession phase of the real estate
cycle by year-end 2015. According to
our Survey participants, most wellsituated, Class-A [and above] regional
malls continue to perform well while
lesser-quality malls are struggling to
improve occupancy and retail sales in
order to appeal to prospective buyers.
For the national power center market,
a rebound in US retail sales and a lack
of new supply continue to brighten its
outlook among surveyed investors, who
note “improved fundamentals since the
start of this year,” “stronger balance
sheets,” and “more tenants looking to
expand into new locations.” Although
performances vary greatly between
metros, one Survey participant notes
that many power centers located in
coastal areas and rebounding housing
markets are doing very well.
In the US neighborhood and
community shopping center sector,
occupancy continues to slowly tick
upward, providing many investors a
sense that stronger fundamentals lie
ahead. As one Survey participant states,
“This asset class is gaining more and
more momentum as tenants are more
optimistic and consumers are spending
more money.”
While construction should increase as
its recovery progresses, new completion
figures will likely remain far below the
levels attained in cycles past. Overall, a
positive outlook exists for the Survey’s
national strip shopping center market
as highlighted by its average overall cap
rate, which slips ten basis points over
the past three months.
Industrial
The recovery of the national warehouse
market is surging ahead with many
individual cities posting strong leasing
and net absorption trends since
the start of the year. By the end of
2015, our survey results place most
of the US industrial sector in either
the recovery or expansion phase of
the real estate cycle. Even though a
significant amount of new warehouse
space is under construction, concerns
for overbuilding are minimal among
Survey participants. Specific cities
noted by investors as “top” warehouse
locations include both large metros,
like Chicago, Los Angeles, and Miami,
and smaller ones, like Indianapolis and
Memphis.
For the national flex/R&D market,
surveyed investors foresee little change
in its overall performance over the
near term. As a result, certain owners
plan to hold assets until fundamentals
More information on the PwC Real Estate Investor Survey™ can be found
at www.pwc.com/us/realestatesurvey or by calling 1-800-654-3387.
improve. While some current owners
believe that this asset class will attract
increased investor interest due to “the
lack of opportunities in warehouse
product, higher returns relative to
the same, and demand for suburban
office overflowing into this asset class,”
others feel that finding sound flex/R&D
investments is challenging due to
“fluctuating leasing trends and stale
rent growth.”
Apartment
Investors’ strong appetite for apartment
properties is grounded in the sector’s
robust fundamentals – despite the
addition of a high number of new units
last year and additional new units
through midyear 2015, this sector’s
vacancy rate remains quite low. While
some investors continue to look for
buying and building opportunities,
others have turned to divesting of
existing assets given strong buyer
demand.
Our Survey results reveal that 80.0% of
our investor participants view current
market conditions in the national
apartment market as favoring sellers,
an increase from 70.0% last quarter.
The remaining 20.0% of surveyed
investors believe market conditions
equally favor buyers and sellers. When
looking to acquire apartment assets,
investors stress that selectivity is key.
Over the next 12 months, forecast value
changes for apartment assets range
from a decrease of 15.0% to an increase
of 10.0%. The average expected value
appreciation is 3.2%.
Susan Smith is a Director in PwC’s
Real Estate Practice
She can be reached at
[email protected]
US Real Estate Insights
15
Capital flows and
robust fundamentals
drive disconnect
between public and
private market pricing
and going private
acquisition activity
by Tim Bodner and Dan Boyce
Commercial real estate valuations
have been steadily increasing.
Capitalization rates are compressed.
The United States economy continues
to rebound as evidenced by falling
unemployment, stable growth,
rising consumer confidence, and the
appreciation of the United States
dollar relative to other currencies.
Real estate industry operating
fundamentals continue to improve,
there is generally limited supply
growth across sectors, and a global
wave of capital is focused on real
estate assets.
While these conditions are the
underpinnings of a robust real estate
market, the optimal path for pubic real
estate companies (predominantly real
estate investment trusts, or REITs) to
maximize shareholder wealth is not
clear in all cases. This lack of clarity
is an effect of, among other matters,
the differential between public and
private market real estate valuations
which is estimated to be between
15% and 20% by a number of leading
industry sources.
One potential alternative, which
has been pursued in prior cycles, is
to pursue or effect a going private
transaction. We explore this
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US Real Estate Insights
alternative herein and, in particular,
recent market activity, transaction
drivers, potential transaction
structures, financial considerations,
conflicts of interest, and disclosure
obligations.
Recent market activity1
Through the first ten and a half
months of 2015, several REITs have
been taken private by institutional
providers of capital. Examples of such
transactions include:
• Lone Star Funds $7.6 billion
acquisition of Home Properties
Inc (Home Properties) – Home
Properties historically owned
and operated 121 apartment
communities with 41,917
apartment units in the suburbs of
major metropolitan areas mainly
along the east coast of the United
States.
• Brookfield Asset Management’s
$2.5 billion acquisition of
Associated Estates Realty
Corporation (Associated Estates)
– Associated Estates historically
was a REIT that owned and
1 Sources for example transactions are
acquiree company press releases
available on their websites as of
October 26, 2015.
operated 56 apartment communities
containing 15,004 units located in
10 states.
• Blackstone Group LP’s $3.9 billion
acquisition of Strategic Hotels &
Resorts Inc. (Strategic Hotels) –
Strategic Hotels historically was a
REIT which owned and provided
value enhancing asset management
of 17 high-end hotels and resorts in
the United States with an aggregate
of 7,921 rooms.
• Blackstone Group LP’s $8.0 billion
acquisition of BioMed Realty
Trust, Inc (Biomed) – BioMed
historically was a REIT focused
on the life sciences industry with
ownership interests in 18.8 million
rentable square feet of real estate.
• Harrison Street Real Estate
Capital’s $1.9 billion acquisition
of Campus Crest Communities
(Campus Crest) – Campus Crest was
historically a REIT and developer
and operator of student housing
properties with interests in 79
student housing properties and
42,000 beds across North America.
The merger and acquisition market
activity extends substantively beyond
the examples provided. And, based on
our observations of market activity and
commentary from leading industry
market participants, such activity is
expected to continue for the foreseeable
future.
A deeper look at transaction
drivers
A depressed share price relative to
the value of a real estate businesses’
underlying assets is a driver cited often
for taking a company private. However,
the characteristics of an ideal candidate
are broader and additional signs may
be representative of a company that is
fit for a public to private transaction
to be effected. These additional
characteristics include the following:
• Public to private market arbitrage:
Prevailing perceptions in today’s
real estate environment are creating
a dynamic whereby private market
real estate values exceed those in
the public markets by a margin
that is not insignificant (estimates
range from 15% to 20%2). Such a
dynamic is associated with an ability
to acquire a real estate business,
including a REIT, at a discount
to the value of its properties and
then turn around and dispose
of such properties in the private
market or hold the investments for
a substantial period of time and
realize the benefits of internal and
external value creation activities.
• Global capital: The availability
of capital from foreign sources –
including sovereign wealth funds
and insurance companies – has
created an availability of capital
that has not been observed for
some time and, given the relative
lack of alternative investment
opportunities with a suitable yield
as mentioned above, the amount
of capital deployed into real estate
is poised to accelerate (See also,
“The new sources of US real estate
capital” written by Jack Keating in
the Summer 2015 edition of US Real
Estate Insights).
• Activist investors: While activist
investors have played a prominent
role in the capital markets for a
significant period of time, today’s
environment creates a unique
backdrop for such a strategy given
the relative lack of alternative
investment opportunities with
a suitable yield and subpar
performance that may be attributed
to managerial complacency or
business models that are too
complex.
• Succession planning: Many public
real estate companies (particularly
REITs) are led by management
teams that have been in place since
these companies were founded in
the 1990’s REIT IPO boom. These
individuals are now approaching
the age of moving on to pursue
alternative endeavors and therefore
are seeking liquidity for what in
many instances is a substantial
investment. This “changing of
the guard” is not always a smooth
process.
2 Source: REITs Promise Shelter in a Stormy
Market; The New York Times, Commercial
Real Estate, October 20, 2015; www.
nytimes.com/2015/10/21/business/reitspromise-shelter-in-a-stormy-market.html.
US Real Estate Insights
17
Transaction structures
While structural considerations are
germane to each specific transaction,
generally going private transactions are
effected in one of four ways: by merger;
by reverse stock split and cash payment
for the resulting fractional shares or by
other amendment of the certificate of
incorporation; by an asset sale followed
by a dissolution; or a dissolution
followed by an asset sale. An overview
of each of these transaction structures
is provided below.
• Merger: The easiest and most
common transaction structure
of implementing a going private
transaction is a cash-out merger.
Cash-out mergers may be executed
in a variety of forms. A merger can
be implemented between the target
and a new corporation owned by
the acquiror as a result of which
the target’s shares not owned by
the acquiror are converted to cash
and the acquiror’s shares remain
outstanding. In an alternative, a
new corporation may form a new
wholly owned subsidiary and the
merger will be effected between the
new subsidiary and the target with
the shares of the target converted to
cash.
• Reverse stock split: Although
less frequently used to effect going
private transactions, corporations
are permitted to reverse split
their outstanding shares into a
lesser number of outstanding
shares thereby reducing their
outstanding shares to below the
statutory minimum. A reverse
stock split is a form of amendment
18
US Real Estate Insights
of a corporation’s certificate of
incorporation, and as such, may be
effected by a vote of a majority of
the issuer’s outstanding shares. A
stockholder meeting is a prerequisite
to amendment, and consequently, to
effect a reverse stock split.
• Asset sale and dissolution: The
third and fourth techniques for
going private are much less common
than the first two methods, and
involve combinations of an asset
sale and dissolution. An asset sale
involves the sale of the corporation’s
assets to a new corporation that is
capitalized by an acquiror. The cash
received by the selling corporation
in return for its assets is distributed
in a corporate dissolution to its
stockholders. As a general rule,
either a majority or supermajority
vote of the stockholders is required
to approve a corporation’s sale of
all or substantially all of its assets
not made in the ordinary course of
business.
Financial considerations
Taking a real estate company private is
an expensive proposition. Procedural
constraints, competition from other
bidders, and the need to deliver value
to shareholders will increase the price
of the deal. The transaction costs are
significant as well. The costs of going
private, including investment banking,
legal and accounting fees, as well as
the expense of soliciting proxies, may
exceed seven figures. Furthermore,
financing costs can be high albeit more
palatable in today’s low interest rate
environment.
Recent REIT transactions based
on a number of leading industry
sources have primarily been effected
by financial buyers (see above for
examples) whose principal objective
has been to obtain access to assets at a
discount to what they likely could be
acquired for in the private market. As a
result, changes are likely to be made to
the existing operating platform of the
acquiree.
Going private transactions can also be
structured financially as a leveraged
or management buyout. In such
transactions, some combination of
senior management, a significant
shareholder, and a financial or
strategic buyer form a group to acquire
the entire equity interest from the
target, financing the purchase with a
combination of debt and equity on the
strength of the company’s assets.
Conflicts of interest
Going private transactions may create
conflicts of interest among directors,
management, significant stockholders,
and unaffiliated stockholders. This is
particularly of concern in transactions
in which management or members of
the board of directors are part of the
acquiring group.
In these and other cases, procedures
are often implemented to ensure that
the potential conflicts do not impact
the fairness of the transaction. Going
private transactions can attract
shareholder litigation, which has the
potential to prohibit a transaction from
proceeding or expose the participants
to liability. As a result, special care
must be taken to not only have a fair
transaction but also have a fair process
and clear record.
Due to the preceding considerations,
transaction counsel often recommends
the transaction to be evaluated and
negotiated by a special committee of
directors who do not have a financial
or other interest of consequence in
the proposed transaction. Such a
committee often is, and should be,
formed as soon as possible after the
proposed transaction is initiated.
Disclosure obligations
Extensive disclosure is required by
the Securities Laws in respect of
going private transactions with such
disclosures being dependent upon the
structure and form of the transaction.
To the extent the acquirer group
includes management or any affiliate
of the business to be acquired, certain
additional disclosures may be required.
The information that may be required
to be disclosed includes:
• The purpose of the transaction,
whether the issuer or affiliate
considered any alternative means
of accomplishing these purposes,
and why those alternatives were
rejected;
• A detailed description, quantified
if possible, of the benefits and
detriments of the transaction,
including tax consequences, on
the issuer, its affiliates, and its
unaffiliated stockholders;
• Whether the issuer or affiliate
believes the transaction is fair to the
unaffiliated stockholders, and the
reasons for that belief;
• Whether any director abstained
from voting on the transaction and
why;
• Whether the approval of at least a
majority of unaffiliated stockholders
is required for the transaction to
proceed;
• Whether a majority of nonemployee
directors retained independent
advisors to negotiate and opine as to
the fairness of the transaction;
• Whether the transaction was
approved by a majority of
nonemployee directors; and
• Whether any other offers were
received by the issuer and, if so, the
reasons for their rejection.
To the extent the transaction includes
the solicitation of proxies or an
information statement, the additional
disclosures generally must be filed at
the same time as the preliminary or
definitive proxy or statement. However,
the timeline may be different based
on the applicable facts therefore
necessitating a need to consult with
transaction counsel early.
Summary
Today’s environment provides a
number of alternatives for real estate
companies, including REITs, to
consider in maximizing shareholder
value. We have recently observed going
private transactions occurring with
some frequency, and anticipate that
such transactions will continue to occur
for the foreseeable future.
Executing these transactions requires
addressing the complex considerations
discussed herein as well as others in
respect of the transaction structure,
financing, managing conflicts of
interest and disclosure obligations.
Accordingly, it is important that
companies pursuing such a transaction
have appropriate accounting, financial
and legal advisors to assist in – if
nothing else – navigating the myriad of
complexities. Remember, one doesn’t
have to go it alone.
Tim Bodner is a Managing
Director in PwC’s Real Estate Deals
Practice
He can be reached at
[email protected]
Dan Boyce is a Manager in PwC’s
Real Estate Deals Practice
He can be reached at
[email protected]
US Real Estate Insights
19
The likely impact of
recent US economic
trends and tax reform
proposals
20
US Real Estate Insights
Dmitriy: The US economy is finishing
its sixth year of recovery from what
was, by most measures, the worst
economic crisis since the Great
Depression. Although pundits have
predicted interest rate increases for
some time now, it really does appear
that the Federal Reserve may finally run
out of excuses not to raise interest rates
in 2016. Assuming interest rates do go
up, what impact will that have on the
real estate industry?
a cash-on-cash yield of 4.0 - 4.5%.
As the Federal Reserve is expected
to gradually nudge interest rates
upwards, investors express “some
caution” regarding the impact of
interest rate movements on the US real
estate sector (see article “Investors are
selectively pursuing assets”).
Paul: The Federal Reserve has kept
interest rates at historic lows for
a very long time in order to allow
the economic recovery to take root.
Having accomplished this, it is very
likely that the Federal Reserve will
begin to raise interest rates. When this
will happen and what impact this will
have on the US real estate industry
is unclear. A lot of capital has been
invested in US real estate recently
because of the yield advantage that
this market sector provides over 10
year US Treasuries and other types
of safe fixed income investments.
The logic is as follows: if you invest
in US Treasuries and earn a cash-oncash yield of 2.0%, you may as well
invest in core US real estate, which
also has a low risk profile, and earn
Paul:The Federal Reserve will phase
in any interest rate increases in
increments over a period that may
span several years, giving the market
time to adjust. So, the impact of
higher rates will be felt gradually. The
magnitude of the impact is hard to
predict. Interest rates are currently at
historic lows and would have to rise
significantly to have an appreciable
effect. In the near term, higher
interest rates may reduce some of the
frothiness in the real estate markets,
but are unlikely to lead to significant
retrenchment.
Dmitriy: How significant would you
expect the negative impact of higher
interest rates to be?
You also have to watch the stock
market, because what happens there
will impact the real estate industry.
Institutional investors generally have
a set allocation of investment capital
to different asset categories, including
real estate. If the stock market
drops significantly, this can create a
denominator issue for these investors.
Meaning that if their investment
portfolio becomes overweight in real
estate, institutional investors may
need to take steps to right-size their
investment allocations to comply
with internal risk diversification
requirements. This may take place
either through a redemption or sale
of existing real estate positions or
a decrease in the allocation of new
capital to real estate as an investment
class. Right now we are on the other
side of this curve: the bull market in
stocks has driven some of the increased
investment in real estate over the last
few years.
Dmitriy: What impact do you see on real
estate debt funds and mortgage REITs?
Paul: There is tremendous demand in
the market for the financial products
offered by debt funds and mortgage
REITs. In a typical US real estate deal,
first priority mortgages represent
only 50 - 60% of the capital stack,
subordinated debt, mezzanine loans,
and preferred equity 30 - 40%, and
equity 10% - 20%. Following the 2008
financial crisis, however, banks have
largely restricted themselves to making
conservative first priority mortgages,
leaving a niche in the market for
subordinated financing to other
players. That niche has been filed by a
new crop of debt funds and mortgage
REITs which specialize in subordinated
real estate financing. These funds
generally hedge the interest rate risk
with respect to their borrowings.
Therefore, rising interest rate should
not have an immediate financial
impact, at least in terms of cash flow.
In the long term, higher interest rates
are may lead to downward pressure on
balance sheet asset valuations and to
reduced market demand for real estate
loans, which may negatively impact
real estate debt funds and mortgage
REITs.
Dmitriy: What kind of an impact should
we expect to see from higher interest
rates on the private equity real estate
fund space, particularly funds that
invest in core properties?
Paul: On the private equity side, the
core space right now is flooded with
capital and many large open-end real
estate funds have multi-billion dollar
subscription queues. Many investors
favor the open-end core and, more
recently, core plus strategies because
they offer long-term investment
horizons, stable and predictable
cash flow, diversification across
product types and geographies, and
liquidity through optional quarterly
redemptions. With this in mind, it
is hard to see interest rate increases
having a significant, immediate
negative impact, particularly in the
case of funds specializing in the
core sector. We may see a short term
moderation in investor interest from
rising interest rates, but barring other
shocks this should not lead to a rush to
redeem by existing investors.
Dmitriy: We have seen the Shanghai
Composite loose a substantial amount
of market cap over the last nine months,
a collapse in oil prices, and declines in
commodity prices more generally. Suffice
it to say, the rest of the world does not
appear to be doing quite as well as we
are economically. What ramifications do
you see from these trends for the US real
estate sector?
Paul:Middle Eastern oil producers, in
particular, have been big investors in
US real estate markets through their
sovereign wealth funds. With reduced
earnings from commodity sales, these
investors will likely reduce the pace
at which they invest in US real estate.
The bigger concern, is not so much with
the slowdown in new investment, but
what happens to all of the capital which
has been invested already. If foreign
investors decide to exit at the same
time, this could result in a compression
of pricing.
Dmitriy: US tax rules governing
foreign investment in US real estate are
very complex and present significant
challenges to foreign investors. Which of
these rules represent the biggest obstacle
to foreign investment in US real estate
markets?
Paul: Putting aside US taxes, US
real estate is a very attractive asset
class for foreign investors. Foreign
investors want to invest in US real
estate because, over the long-term,
this asset class has offered both safety
and stability. The US tax rules do
not up end that basic calculus. That
said, the US FIRPTA regime is a real
US Real Estate Insights
21
challenge. Most US tax treaties do not
cover FIRPTA, and the tax creates a
significant disincentive to investment
in US real estate. Although there are
innovative structures which can reduce
or eliminate FIRPTA taxes, they add
complexity and administrative cost and
may not be practical in every instance.
For smaller funds in particular, the
tax savings afforded by these special
investment structures may not justify
the added administrative expense to
the same degree as in the case of funds
that have greater economies of scale.
The rules under Section 892 of the
Internal Revenue Code, which govern
the exemption from US taxes for
foreign governmental investors, are
also very challenging. The existing
rules effectively penalize too much
investment in US real estate by
foreign governments. For example,
a “controlled entity” of a foreign
government can lose its exemption
from US tax, if its holdings of US real
estate equal or exceed 50% of the
combined fair market value of its US
real estate, non-US real estate, and
certain other kinds of assets. This rule
is known as the USRPHC kick-out rule
in industry parlance. The effect of this
rule is to place an artificial limit on the
proportionate amount of capital that
a sovereign wealth fund can deploy
in US real estate markets without
risking its US tax exemption. The
USRPHC kick-out rule also creates a
heavy compliance burden for sovereign
wealth funds that do invest in US real
estate, requiring them to constantly
monitor their investment portfolio for
compliance with the USRPHC fraction.
22
US Real Estate Insights
Dmitriy: What tax reform proposals
could impact foreign investment in US
real estate?
There has been no movement at all
from the IRS regarding the USRPHC
kick-out rule. It is unclear whether the
IRS is even aware of the magnitude of
the challenge that this rule creates for
foreign investors. Once the IRS become
aware of these issues it may release
guidance modifying or eliminating
USRPHC kick-out rule. There is
precedent for this in other Section 892
areas. In the past several years, for
example, the IRS released proposed
regulations that, once finalized, would
establish safe harbors from existing
rules that terminate the exempt status
of foreign governmental investors that
engage in, or are deemed to engage
in, commercial activities. These safe
harbors cover inadvertent commercial
activities and commercial activities
which arise as a result of investment
in limited partnerships. The proposed
regulations also clarify that while
FIRPTA gains do not qualify for the
Section 892 exemption, they do not
constitute a commercial activity which
would result in the loss of exempt
status.
Paul: There have been several
interesting legislative proposals
relating to FIRPTA from the Chairman
of the Senate Finance Committee,
Senator Max Baucus. These legislative
proposals are a mixed bag. Some
would serve to eliminate barriers
to investment in US real estate by
foreign investors and will be welcome,
while others have significant negative
implications. On balance, there are
more legislative reform proposals
that would have a negative impact
on foreign investment in US real
estate, than those which would tend
to encourage additional foreign
investment. The beneficial proposals
include the following:
• Exemption for foreign pension funds
from the tax on gains from US real
estate under FIRPTA;
• A partial repeal of IRS Notice
2007-55 which expressed the IRS
position that liquidating REIT
distributions are subject to tax under
FIRPTA; and
• An increase in the threshold for the
exemption from FIRPTA for publicly
traded REIT stock from 5% to 10%.
Legislative proposals that are likely to
negatively impact foreign investment in
US real estate include the following:
• Increase in the rate of tax applicable
to gains from depreciation
recapture;
• Elimination of tax deferral on likekind exchanges under Section 1031;
• Repeal of the portfolio interest
exemption;
• An increase in the rate of FIRPTA
withholding tax to 15% from 10%;
• Elimination of the FIRPTA cleansing
rule that allows corporate blockers
to eliminate FIRPTA taint by selling
off their real estate in a taxable
transaction prior to liquidation;
• Imposition of tax return and
shareholder disclosure of USRPHC
status.
There is also a proposal to incorporate
the general corporate constructive
ownership attribution rules in the
determination of whether a REIT is
“domestically controlled” (“DCREIT”).
Disposition of shares in a DCREIT
by foreign investors is not subject to
the FIRPTA tax. This legal change
would, therefore, effectively eliminate
strategies that utilize foreign-controlled
US corporations to create so-called
“synthetic” DCREITs in order to reduce
the effective US tax rate on foreign
investors in US real estate.
Paul Ryan is a Senior Partner in
PwC’s New York Metro Real Estate
Tax Practice
He can be reached at
[email protected]
Dmitriy Shamrakov is a Tax
Director in PwC’s New York Metro
Real Estate Tax Practice
He can be reached at
[email protected]
US Real Estate Insights
23
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(617) 530 7168
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Products and Real Estate Practice
(646) 471 5872
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(646) 471 3620
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(646) 471 3196
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US Real Estate Insights
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