While it is too soon to know the full impact of reform, recent legislative changes are likely to increase global investors’ interest in US REITs and real property, with potential implications for valuations, fund flows, and transactions in 2016 and beyond. On December 18, 2015, President Obama signed the Protecting Americans From Tax Hikes Act of 2015 (PATH 2015), which included provisions reforming the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). FIRPTA potentially taxes non-US investors on gains realized from US real property, including direct holdings and interests in US real property holding companies, at rates of 30% or more. The FIRPTA reform (1) increased the ownership threshold from 5% to 10% before non-US investors that own publicly traded REITs would be subject to FIRPTA, (2) made it clearer and easier for a REIT to qualify as domestically controlled and thus be exempt from FIRPTA, and (3) exempted qualified non-US pensions and retirement funds from FIRPTA. The first two have implications for US REITs in particular and the third for US real property more broadly.
Regarding US REITs, it is reasonable to expect marginal increased demand driven by incremental non-US interest in US real estate, particularly from investors seeking high-yielding assets in the current low-yield environment. It may be some time before this increase in demand occurs, as investors may be focused on other investment priorities and might require time to assess appropriate investment options for their portfolios. Nonetheless, as investors reallocate capital to US property, they could see some fund flows out of non-US REITs and other real estate securities.
The exemption of qualified non-US pensions and retirement funds from FIRPTA is likely to be a larger driver of valuations than the relaxing of US REIT ownership thresholds. For those non-US pensions and retirement funds seeking to use real estate as an inflation hedge, this reform will likely be a non-event, as US real estate will not provide much hedge against inflation in investors’ local currency. For non-US pensions and retirement funds seeking yield, diversification, and/or growth in their portfolios, though, the opportunity to own marquee US real estate assets without the historically large tax impact will likely be alluring. These investors are expected to be more attracted to prime office, hotel, and certain retail assets in gateway cities such as Boston, Chicago, Los Angeles, New York, San Francisco, and Washington, DC. While such assets are already trading at historically low cap rates (i.e., high valuations), increased demand has the potential to drive cap rates even lower. This potential increase in valuation could benefit REITs and private equity real estate funds similarly, as non-US buyers are unlikely to discriminate by ownership structure; rather, they will likely buy from whoever owns high-quality, well-located properties.
Real estate operators have the potential to benefit from this legislative reform as well. Non-US pensions and retirement plans often prefer to own assets directly, rather than through private equity partnerships or REIT structures, but may lack the in-house resources to manage the properties. US real estate operators with local knowledge and proven asset and property management teams that can provide services to non-US owners may see increased opportunity as a result of FIRPTA reform.
What should global investors be thinking about as it relates to this legislation reform? Investors currently holding US REITs may have previously been considering paring back those positions, due to valuation concerns. In light of the anticipated increase in fund flows into US REITs and the potential rise in core real estate valuations, investors should consider continuing to hold. Those with existing REIT exposure should also evaluate their underlying property holdings by type, as not all REITs will experience the same increases in demand; those with more prime office, hotel, and retail properties in gateway markets are likely to experience a more significant pop than those more heavily weighted to senior living, apartments, industrial, data centers, and secondary markets.
Open-ended and closed-end core real estate funds would also benefit from a rise in valuations driven by new capital flows. However, this is a double-edged sword for funds with dry powder, as the competition for core real estate will grow more intense.
US private equity real estate funds pursuing value-add and opportunistic strategies that either have dry powder or are raising capital in the near term may also benefit from the reform. The strategy for many of these funds is to essentially “manufacture core real estate” by buying former trophy assets that have some type of impairment—e.g., they are not fully leased, need refurbishment, or have complicated capital structures that limit interest from non-US capital—and address those impairments and grow the buyer pool to include non-US investors interested in core real estate.
Overall, it is too soon to know the true impact of the recent FIRPTA reform. We will continue to monitor fund flows, valuations, transactions, and market trends and expect to revisit this topic with investors later in 2016.
Meagan Nichols is the Head of Real Assets Research for Cambridge Associates.