Structuring the investment
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. The 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 the LLC, the LP and the REIT.
LLCs and LPs are organised under state laws, most commonly either Delaware law or the laws of 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, an investor is insulated from property liabilities through this investment structure, including property-level debt. A second major advantage is that both LLCs and LPs are 'pass-through' entities for federal income tax purposes, meaning that all income and losses of the entity are passed through to the members 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. The recently adopted US federal income tax overhaul further advantage the use of pass-through structures by providing for a 20 per cent deduction for all income earned through pass-through entities, before the individual tax rate is applied.
Typical provisions of the LP or LLC agreement describe:
- the capital contributions of the parties, obligations, if any, of the parties to contribute additional capital to the entity, and rights and remedies if a party fails to make required future contributions;
- the decision-making process of the entity, including major decisions that will require approval of all or a majority of the investors;
- 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
- exit rights of the parties, including buy-sell rights, forced-sale rights, and provisions governing sales of interests and rights of first offer or refusal.
Another relatively common structure for ownership of real estate is the REIT. This structure, defined by Section 856 of the Internal Revenue Code, is used to hold interests in real estate where maximum liquidity is desired. The REIT is organised as a corporation with shareholders, in which the shares may be publicly or privately traded. To enjoy a 'pass-through' tax treatment similar to LLCs and LPs, including the new 20 per cent deduction from taxable income, a REIT is required to meet prescribed IRS requirements, including that it distribute 95 per cent of its taxable income annually, that it invest at least 75 per cent of the value of its total assets in real estate or real estate mortgages, and that it derive at least 75 per cent of its gross income from real property rents, interest, proceeds of sale and similar. Most REITs traded on the US markets today 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 an advantage in the marketplace for acquisitions because of their ability to finance acquisitions relatively inexpensively. Although REITs are not permitted to 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 by issuance of new stock.
The US commercial real estate markets remain an attractive investment target for foreign capital seeking a stable political environment and stable currency. Commercial real estate remains a relatively attractively priced asset, with the potential to generate substantial operating income and capital gains as markets continue to expand. For the first half of 2017 (the latest period for which statistics are available), direct foreign investment in commercial real estate totalled US$19.8 billion, a slight decrease from 2016's pace, which totalled US$55.1 billion for the year. The major source of foreign capital remains Canadian pension funds, which accounted for 30 per cent of year-to-date foreign investor activity. Asian capital investment continues strong, with almost half of the offshore acquisitions in 2017 originating in Asian countries. Office space continues to be the asset of choice for foreign investors, with a focus on high-quality assets in primary office markets. China, Singapore and Japan, together with Canada and Germany, accounted for nearly 80 per cent of foreign investment in the US office space sector. In a change from prior years, however, there was a marked diversification of asset classes and location choices for foreign investors. Multifamily assets were the second strongest commercial asset class after office, and were located across markets. Following a trend that domestic investors also initiated this year, given the high pricing of real estate assets in primary markets, a full 42 per cent of foreign investment was deployed to purchase assets in secondary and tertiary US markets.
Foreign investment in luxury US residential real estate remained strong in 2017. For the year ended the first quarter of 2017, foreign homebuyers invested US$153 billion into US residential real estate, up 49 per cent from the previous year. Chinese buyers were the most active, with purchases of US$31.7 billion during this period, with Canadian buyers in second place with US$19.1 billion. Foreign buyers now account for 10 per cent of existing home sales within the United States. Florida, California and Texas were the top destinations for foreign home buyers. Notable were the declines in all-cash purchases, as well as the decline in purchases of ultra-luxury condominiums in New York City. Only 10 per cent of foreign buyers paid more than US$1 million for their residential property.
However, there are headwinds that are expected to reduce foreign direct investment in real estate in 2018 and 2019. Among other things, the low price of oil throughout 2018, with its effects on the Russian and Middle Eastern economies, the slowdown in the growth and imposition of capital export restrictions of the Chinese economy, and the trade policies and tariffs instituted by the US government significantly slowed down ultra-luxury US residential purchases by foreign buyers. Additionally, a programme instituted by the federal government in cooperation with New York City, requires disclosure of individual owners behind all-cash luxury apartment purchases and has led to a continued decline in all-cash transactions, typical of ultra-wealthy foreign buyers.i Foreign Investment in Real Property Tax Act
Foreign investment in US commercial real estate is generally done through a US-taxpaying entity, to avoid the 15 per cent withholding tax provisions of Internal Revenue Code Section 1445(a), implementing the provisions of IRC Section 897, the Foreign Investment in Real Property Tax Act (FIRPTA). The most commonly used US-taxpaying entity for foreign investment is a US corporation that is a wholly owned subsidiary of the foreign investor. As with LLCs and LPs, corporations are also organised under state law, usually either Delaware or the state in which the real estate is located. The foreign investor is thus subject to the 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 FIRPTA were enacted into law, expanding exemptions from US taxes for foreign pension funds that invest in US REITs or directly in real estate, thus putting foreign pension funds on similar tax footing to US-based pension funds. This change is intended to, and expected to, increase foreign pension fund investment in US real estate.
Loan activity by a foreign lender to an unrelated US borrower, where the lender is domiciled outside of the US, and where the loan is sourced and negotiated outside the US, is not subject to US withholding tax.ii EB-5 Immigration Program for Investment in Job Creation
An incentive for foreign investment that has become increasingly widespread in use over the past five years is the 'EB-5' programme, under which a foreign national becomes entitled to receive an employment-based fifth preference (EB-5) immigrant visa in return for investing in a new commercial enterprise within a US government-designated regional centre. The required investment is US$1 million of foreign capital, which is reduced to US$500,000 for an investment in an area of high unemployment or in a rural area. The investment must create at least 10 full-time US jobs. The EB-5 investment is structured either as a preferred equity investment with a fixed return, or as secured debt. EB-5 investment has become a primary source of low-cost investment capital for real estate development projects, where jobs are generated through construction activity as well as business occupancies. China is the main source of EB-5 investment dollars for US real estate transactions, exceeding 70 per cent of the EB-5 applications over the last three years. The EB-5 programme was recently extended through 15 February 2019, largely as a result of strong lobbying by the real estate industry. Its future after that point is uncertain.