Assessing the Impact of Tax Revision on Real Estate

The good news is that “the other shoe” is about to drop. The bad news is that there are a lot of exposed and sensitive toes at the point of impact, ripe for crushing.

That’s the consensus as real estate developers, builders, and syndicators weigh the probable impact of the massive tax overhaul on the commercial real estate market.

While the uncertainty of trying to shape plans around an amorphous piece of legislation that might, or might not, ever see the light of day was pretty well laid to rest in May, when the Senate Finance Committee passed it, the reality of living with the outcome of that action is the sort of thing, observers say, that gives certainty a bad name.

Impact of Present Legislation

On the horizon, as the legislation now stands:

--Sharp, if not crippling, limitations on the losses that can be deducted for “passive activity” (such as the interest on construction loans and taxes incurred before a property is generating any income).

--A sharp stretch-out in the depreciation period (from 15 years which has been allowed since the Economic Recovery Tax of 1981, or the 18 years permitted under the Tax Reform Act of 1984, to either 30, 27 or 31 years, depending on whether the House or Senate version survives).

--At time of sale, elimination of the 20% capital gains provision on any profit in favor of the standard tax bracket prevailing for the investor/developer--either 38% or 27%, again depending on which version is passed.

The broad consequences of such sweeping changes, observers feel, are a fundamental shift in the basic pattern of the real estate market, as well as puting skyrocketing price tags on new projects everywhere, especially in Los Angles where, according to Joel M. Pashcow, senior executive vice president of Integrated Resources, the New York-based, $1-billion-in-assets packager of limited real estate partnerships, office rents will double, and in some areas triple, in short order.

Rents Seein Rising Sharply

Recently, according to Howard D. Sadowsky, senior vice president of Julien J. Studley Inc., prime downtown offices in Los Angeles rented in the $22-to-$23-a-foot range with amenities (concessions), and about $15 in the vicinity of Los Angeles International Airport.

But Pashcow warns, “It’s simply not going to be economical to build a new building in Los Angeles “unless you’re going to get about $40 to $50 a square foot a year out of it.” And this without amenities.

“What we have in this legislation, is a strong, giant push away from asset-oriented investments toward service-oriented investments. “In the past, Congress has felt that some desirable, but high-risk activities needed tax incentives. Like oil-well drilling. Now, that’s all over. This bill penalizes risk-taking, debt and entrepreneurship.

“It’s a ‘have-versus-have-not’ bill. It helps those who can afford to buy without leverage, and it moves the ownership of real estate into the hands of people with large amounts of capital. Fortunes are going to be made by the people who own large buildings already in place in cities like Los Angeles because it’s going to be so much more difficult for people to build new ones.”

Soaring Vacancy Rates

Apart from being billed as a revenue raiser, proponents of the changes in the tax code have pointed to “abuses” under the present system and cite as the most visible evidence of such abuses the glut of new office buildings dotting the countryside--including Los Angeles--and vacancy rates soaring as high as 25%, or more.

It’s an argument characterized as “just so much eyewash being used to pass this bill,” in the words of Joseph M. Cahn, a real estate specialist with the Century City law firm of Greenberg, Glusker, Fields, Claman and Machtinger.

“Buildings aren’t built for which there is no need--they aren’t built to lose money,” he said. “That’s ridiculous. They’re simply built a little earlier than they might have been, and the tax situation has helped cushion the impact when they’ve guessed wrong.

“They’re not going to sit there empty forever--they’re going to be there for 50 or 100 years and whether it would have been better if they’d been built a year or two later than they were is immaterial.”

Chase of Limited Space

A principal target of the legislation, in the opinion of William E. Greaney, a partner here in the accountancy firm of Deloitte, Haskins & Sells, are heavily-leveraged limited partnerships. “What some people in Washington believe is that there’s been a lot of syndication money chasing a limited amount of commercial and industrial space and prices have been driven up to an uneconomic level,” he said.

“So, what they’re saying is: You can offset your passive activity losses against your passive activity income, but not against wages or portfolio income--interest, dividends, royalties, profit from stock gains . . . that sort of thing.

“And it applies to any rental activity, whether you materially participate in it or not. For instance: If an individual owns an apartment building--managing it, making repairs, whatever--the IRS is saying that any losses thrown off by that apartment are still regarded as passive activity losses.

“There’s just one small break here. If you have a rental property in which you actively participate, they’ll allow you to deduct up to $25,000 of losses without regard to the loss limitation rule, and that’s only after you’ve netted all your income and loss from passive activities. But that $25,000 gets phased out as the individual’s adjusted gross income increases--determined without regard to passive activity losses--from $100,000 to $150,000.”

All of which is some slight comfort to the small, actively participating, commercial real estate investor, but the combined impact of the constrictions on loss write-offs and the change in the depreciation rules can play hob with other developments--even, by the standards of the industry, relatively small ones.

That’s what real estate attorney Cahn found in working out a hypothetical transaction under existing tax rules and under the proposed changes.

“I assumed a property purchased for $1 million, with a $700,000 first trust deed, a second for $150,000 and a $150,000 down payment which, with points and closing costs, would come to about $190,000.

Giving an Example

“Using accelerated depreciation under the present law and the 19 years now allowable, I then keyed in expenses, taxes, maintenance and so forth as a percentage of gross income--which I arbitrarily picked as $125,000 a year (the price as eight times the gross, which is an accepted rule of thumb). Rental and cost appreciation were calculated at 4% a year and property appreciation was calculated at 4.8% a year.

“The incremental income tax rate was figured at 55% with the capital gains portion at 40% and with a 7 1/2% discount rate for net present value.”

The rate of return to the investor under this scenario?

“About 14 1/2% a year toward the end of the 10-year holding period--about 12% in year five and then gradually increasing to year 10. This was calculated with a 5% vacancy factor,” Cahn explains.

The same deal under the proposed tax changes? (Changing the straight line depreciation to 30 years, changing the incremental tax rate from 55% to 35%, and changing the capital gains to 100%).

Need Higher Return

“The rate of return,” Cahn adds, “levels out at about 7% at the end of 10 years--but there’s only a 4.4% internal rate of return at year six and only 5 1/2% at year seven.”

“In order to get back to the original rate of return,” he claims, “you’ve got to change the income--from eight times gross to seven or six. Otherwise, an individual wouldn’t go into a deal like this unless he could get the property at about a 25% discount. At a return of 7%, people are simply going to put their money into a CD (certificate of deposit).”

While, on one hand, it may exaggerate the problem since the changes in the tax code will be phased in over seven years, the same projection is also, perhaps, overly optimistic on other scores, Cahn adds, assuming, that is, a 5% vacancy factor and a 4.8% property appreciation.

Cahn’s hypothetical before/after scenarios--and the probable consequences of the changes in the code--were echoed by accountant Greaney who predicted that “the current overbuilding and the tax changes should bring commercial real estate prices down, at least initially, but then, as the market absorbs the existing oversupply, rents are going to be driven up and the impetus to build again will return.”

Changes in Buyers

But the character of tomorrow’s builder/buyer will have changed, Greaney feels. “The investors coming in aren’t going to be as sensitive to the backlog of buildings--they’ll be able to hold it. So, we’re talking about foreign money, pension funds and other institutional investors with deep pockets--who can afford to buy the building and just sit on it.”

While the builders and developers of existing buildings aren’t materially injured by the proposed changes--the impact will be on projects initiated after the first of 1987--one class of real estate investor is already in a real bind, retroactively: the buyers of units in limited partnerships, who are locked into syndications that were sold primarily for their tax benefits rather than any appreciable positive cash flow.

“Actually,” Integrated Resources Pashcow adds, “changes like these had been anticipated for some time and we, for one, haven’t been willing to put together any deals for some time that didn’t have a double-digit economical return.

“But the Senate bill is harsh, and many people feel is unfair to people who invested in good faith under existing rules--and especially unfair because a large percentage of those were in government-oriented transactions, various government-assisted housing projects where, essentially, the only benefit was the tax savings.

Hard-Hit Investors

“Now, they’re saying: ‘Well, that deal you bought two years ago when we told you that the law favored building for middle- or low-income families--forget it, you can’t use any of the tax benefits.’ ”

And particularly hard-hit are investors in tax-oriented limited partnerships who committed themselves to an annual pay-in over 5, 8 or 10 years and are faced with either continuing payments that can’t be written off (because no passive income is being generated by the partnership) or by defaulting--a course of action that could embroil them in expensive litigation, as well as shredding their credit record.

Ironies--both before the fact and after the fact--abound in the tax proposals now under consideration, all hands agree.

While the glut of office space is presumed by the tax-writers to be the result of abuses in the current law, observers put the blame instead, not on the builders or developers, but on different heads: the financial community and on the government.

“The idea that overbuilding is a direct result of the tax laws is ridiculous,” Pashcow snorts. “The real reason is the liberal lending practices that have been in effect. Give a builder the opportunity to build with little or no money up front--and he’s going to build. It’s as simple as that.”

Cut Depreciation Period

No less a factor, Cahn adds, was the Treasury Department’s own action in 1981, when absorption of available space had already fallen far behind the inventory of new property coming on line, and a period of digestion was very much in order.

Instead of allowing a natural slow-down in building activity, Treasury cut the depreciation period from the “useful life” of the property (commonly 30 years) to 15 years and then raised it nominally to 18 and then to 19 years. The result was like a shot of Adrenalin administered to an already hyperactive market, he said.

“It was very regressive,” Cahn said. “A totally undeserved and outrageous windfall.”

Ironies are already shaping up in the anticipation of the new tax legislation, too.

As Integrated Resources’ Pashcow notes: “The major trouble with the whole tax bill is that it assumes static behavior--a fundamental fallacy in Washington, where it is assumed that everyone will behave the same way after a tax bill like this. For instance, it’s already apparent that their estimates about the money they were going to raise through this measure weren’t very accurate.”

Pashcow’s example: Estimates of the new money that would be raised by denying limited partners the write-off of passive activity losses completely overlooked the fact that the only escape hatch available to investors locked into tax-oriented partnerships would be to buy offsetting partnerships in syndications that are virtually 100% income oriented. In so doing they gain the cash return against which their otherwise useless, highly leveraged partnership losses can be utilized.

Income-Oriented Partnerships

The result: A burgeoning boom in income-oriented partnerships, already well under way, that will “sop up” those passive losses that the Treasury had been counting on.

“It’s the same way with the capital gains tax,” Pashcow adds. “Historically, every time they raise it, they collect less money. Every time they lower it, the collect more money. And now, they are going to say that state sales taxes aren’t going to be deductible but that state income taxes are deductible. Why do they assume that the states aren’t going to change their patterns of taxation?”

Ahead, all agree, is an initial, perhaps sharp, decline in commercial real estate prices, followed by a fast absorption of today’s vacancies as new construction--except by deep-pocket, institutional investors--dries up; an acceleration in rents as builders strive to increase their positive cash flow for the purpose of offsetting passive activity losses, and a big boom in income-oriented real estate limited partnerships.

And, in attorney Cahn’s opinion, a heavy upsurge next year of money streaming into the stock market because “it’s the only place that it will have to go. Investors look at their rate of return only in terms of what they can get somewhere else.

Government Interference

“The tax bill is going to change us from a nation of real estate developers to a nation of widget developers--and the only difference is that the government figures we can sell widgets overseas and straighten out the trade imbalance.”

And it’s the government’s efforts to reduce risk taking and throttle entrepreneurship that bothers him.

“If you let the government decide these things, the Olympic Corridor and Century City would never have been built. If bureaucrats had made the decisions, all of our building in Los Angeles would probably have been downtown, because that’s the way it had always been done in the 19th Century.

“That’s the price you pay for a free enterprise economy: You allow people to build in the ‘wrong’ place and well before they’re needed.”