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What is the general climate of real estate investment in your jurisdiction?
The restructuring and refinancing of large and small loans and equity investments throughout all asset classes that have dominated the US real estate markets since 2008 were relatively smooth in 2016, with $126.8 billion in debt maturities refinanced through a combination of debt and equity. Substantial refinancing activity is expected to continue during 2017, as approximately $117.2 billion in additional maturing commercial mortgage-backed securities debt will need refinancing. Retail sector loans raise the most concern for refinancing, due to a large number of retailer bankruptcies and a reduction in store count by national retailers. The pattern of recapitalisations in recent years has employed substantial new equity infusions, as leverage levels have decreased from first-mortgage loan amounts that were commonly at 70% to 75% for stabilised commercial properties in the mid-2000s, to levels that are closer to 50% to 60% in today’s refinancing markets. Approximately 35% of office refinancings and 45% of retail refinancings are expected to be recapitalised with additional equity.
Who are the most common investors in real estate?
The most common investors in real estate are individual owners, including:
- high-net worth investors;
- pension funds;
- corporate and institutional owners;
- real estate investment trusts (REITs);
- private equity funds; and
- foreign investors of all types, including sovereign wealth funds and foreign pension funds.
Are there any restrictions on foreign investment in real estate?
Foreign investment in US commercial real estate is generally conducted through a US taxpaying entity in order to avoid the withholding tax provisions of Section 897 of the Internal Revenue Code (also known as the Foreign Investment in Real Property Tax Act). The most commonly used US taxpaying entities are US corporations that are wholly-owned subsidiaries of the foreign investor. As with limited liability companies (LLCs) and limited partnerships (LPs), corporations are organised under state law – usually either Delaware or the state in which the real estate is located. The foreign investor is thus subject to US income tax with respect to the ownership and operations of US real estate, including capital gains taxes on dispositions. At the end of 2015, long-sought amendments to the Foreign Investment in Real Property Tax Act were enacted into law, expanding exemptions from US taxes for foreign pension funds that invest in US REITs or directly in real estate, thereby putting foreign pension funds on a similar tax footing to US-based pension funds. This change is intended and expected to increase foreign pension fund investment in US real estate.
A loan by a foreign lender to an unrelated US borrower – where the lender is domiciled outside the United States and the loan is sourced and negotiated outside the United States – is not subject to US withholding tax.
What structures are typically used to invest in real estate and what are the advantages and disadvantages of each (including tax implications)?
Real estate ownership is typically structured so that an entity with limited liability is the owner of the direct fee title or ground leasehold interest in the real estate. Investors hold interests in these entities, rather than directly owning the title to the real estate. The most common types of limited liability entities that own real estate assets are LLCs, LPs and REITs.
LLCs and LPs are organised under state law – usually either Delaware or the state in which the real estate is located. An LLC is managed by a manager or a managing member and an LP is managed by a general partner. The investors are typically non-managing members or limited partners in the property-owning entities.
A major advantage of an LLC or LP structure is that an investor is not liable for the debts or liabilities of the title-holding entity beyond the funds invested in the entity. Thus, the investor is insulated from property liabilities – including property-level debt – through this investment structure. A second major advantage is that both LLCs and LPs are ‘pass-through’ entities for federal income tax purposes, meaning that all of the entity’s income and losses are passed through to – and taxed solely to – the members, with no second level of tax at the entity level. Investors can use income and losses of the property to offset income and losses of other real estate investments for tax purposes, and tax-exempt investors can enjoy fully tax-exempt income.
LP or LLC agreements typically include provisions for:
- the parties’ capital contributions and obligations (if any) to contribute additional capital to the entity, and rights and remedies if a party fails to make required future contributions;
- the entity’s decision-making process, including major decisions that will require all or a majority of the investors’ approval;
- the timing and priority of distributions of available cash and capital proceeds to the parties, including preferred returns and carried or promoted interests;
- allocations of income, gain and loss for tax purposes; and
- the parties’ exit rights, including buy-sell rights, forced-sale rights and provisions governing sales of interests and rights of first offer or refusal.
Another common structure for real estate ownership is the REIT. Defined by Section 856 of the Internal Revenue Code, this structure is used to hold interests in real estate where maximum liquidity is desired. REITs are organised as corporations with shareholders, in which the shares may be publicly or privately traded. In order to enjoy pass-through tax treatment similar to LLCs and LPs, REITs must meet prescribed Internal Revenue Service requirements, including:
- distributing 95% of their taxable income annually;
- investing at least 75% of their total assets’ value in real estate or real estate mortgages; and
- deriving at least 75% of their gross income from real property rents, interest, proceeds of sale and similar.
Most REITs that are traded on the US markets are large corporations with multiple property holdings, usually in a single asset class (residential or office), but often in multiple geographic markets to provide asset diversification to REIT investors.
In addition to their advantages as pass-through tax entities, REITs enjoy the marketplace advantage that they can finance acquisitions relatively inexpensively. Although REITs cannot retain earnings, REIT-property acquisitions are financed with corporate lines of credit, which provide a relatively less expensive source of financing than property-level debt or issuance of new stock.
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