Commercial real estate markets across the country are overleveraged. It is estimated that for the next several years, approximately $350 billion of commercial debt will mature annually, much of which will have difficulty finding replacement leverage given the reductions in value that we have seen coupled with today's more conservative loan-to-value ratios being used by lenders. The deleveraging process that our markets must go through will require massive amounts of fresh equity.
Demand drivers are excellent today and, if you are a frequent StreetWise reader, you know that I have illustrated numerous times the acute supply / demand imbalance that exists today with little available product meeting extraordinary demand. High-net-worth domestic investors and families which have driven the markets for the past couple of years have met a resurgence of institutional capital which has come back to the commercial real estate sales market with a vengeance. Additionally, foreign investment is very apparent in today's market and foreign high-net-worth investors are appearing in numbers not seen since the 1980s.
With this excessive demand, why would I be focused on a law that, if modified, would result in even greater foreign demand? There are several reasons we will discuss.
Foreign investors in U.S. real estate are disadvantaged by a law which should have never have been put into the tax code to begin with. The Foreign Investment in Real Property Tax Act of 1980 which is commonly referred to as FIRPTA. This U.S. tax law unfairly (relative to other non-real property investments in the U.S.) imposes excessive tax barriers on foreign capital investment in U.S. real estate and should be withdrawn or modified significantly. FIRPTA is the central obstacle to greater capital investment in U.S. real estate by non-U.S. investors.
Based upon the fears of some politicians in the Midwest, who were originally concerned about limiting foreign control over U.S. farm land, FIRPTA was proposed and passed by congress to limit what foreigners could do with "our property". FIRPTA requires foreign persons who dispose of U.S. real property interests to pay taxes in the U.S. on any gain realized on the disposition over and above the tax burden they would be faced with if they invested in any other type of asset.
This process imposes considerable administrative burdens, not only on foreign investors disposing of their U.S. real estate assets but also, on the purchasers of such properties who are responsible for administering withholding taxes. Additionally, the law requires foreign investors to file a U.S. income tax return at the end of the year in which they sell their real property interests.
Further political support for FIRPTA was seen noticeably in the mid 80's when Japanese investors were actively purchasing trophy assets in New York City, most notably Rockefeller Center. It is hard to imagine that there is any fundamental basis for this concern. Properties controlled by foreign owners are generally managed by U.S. companies, leased by U.S. companies, serviced by U.S. companies and produce tax revenue paid to U.S. municipalities.
The attorneys representing these investors are likely U.S. firms, as are their title insurers. What is the basis of the fear people have about buildings being owned by overseas investors? In the 26 years that I have been selling properties, I have yet to witness a foreign investor acquiring a property in the United States, picking it up, and transplanting it back to their homeland.
By virtue of FIRPTA, real estate is discriminated against relative to other types of investments in the U.S. by foreign persons as they are not required to pay gains taxes upon the disposition of any other assets. Thus, FIRPTA unfairly treats U.S. real estate as an asset class. We believe that U.S. policy makers should move swiftly to eliminate or modernize FIRPTA.
Our markets need massive amounts of equity to accomplish the deleveraging we must go through. While there is tremendous demand currently existing, the need is going to grow over the next couple of years and the more capital we have in the market, the better for all participants. While many actions taken by policymakers over the past couple of years may lead you to think differently, we are still in a capitalistic, free-market society.
If FIRPTA were to be eliminated or a tax holiday were given on transactions over the next few years, demand from foreign investors would undoubtedly increase. We need equity investments from any source as this would be stimulative to our market and our economy. The extent to which the U.S. and its citizens would benefit, is positive regardless of the benefits which might inure to foreign investors. The additional capital would be accretive to a healthy dynamic within our marketplace, would help to create jobs and allow for growth.
In January of this year, a bill ( H.R. 4539 - the Real Estate Revitalization Act of 2010 "RERA") was introduced in congress to modify FIRPTA. The bill was touted as something which would reduce barriers to foreign investment in U.S. real estate. This legislation would amend FIRPTA by removing some the artificial tax barriers created by the law. These changes would go a long way towards rectifying the unfair treatment of real estate investments relative to other asset classes. This would allow property owners to access equity capital from around the world at a time when it is sorely needed.
RERA would eliminate the "U.S. Real Property Holding Corporation" provisions of FIRPTA and characterize REIT capital gains distributions to foreign shareholders as ordinary dividends. It would also treat REIT liquidating distributions as ordinary dividends to the extent that a distribution exceeds the foreign investor's basis in its REIT stock.
Under RERA, shares in REITS and other real property holding corporations would not longer be "U.S. real property interests", thereby eliminating part of the discrimination against real estate investments. FIRPTA would, however, continue to apply to gains from the disposition of direct foreign investment in U.S. real estate; therefore, we do not believe this legislation goes far enough to meet the objectives we seek.
The U.S. has much more to gain than to lose by embracing and working with the global community. Technology has changed the way world commerce functions and there is much to gain from working with other nations. While total economic growth is not dependant upon foreign real estate investment, our real estate market would be enhanced significantly by the elimination or modification to the FIRPTA laws. All this would do is to put real estate on a level playing field with every other type of investment that foreign investors can make in the U.S.
Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having an aggregate market value in excess of $6.2 billion.
