Trends and prospects
What are the current trends in and future prospects for the real estate market (both commercial and residential) in your jurisdiction?
The US real estate market had a mixed performance in 2016. While property prices remained high among most markets, debt markets were negatively affected during the first half of the year by market volatility, and the second half of the year saw a negative turn in major gateway markets (eg, New York, Los Angeles, Boston, Seattle and San Francisco) in office space absorption and leasing velocity, as well as a softening of residential multifamily rents; showing weaknesses in two sectors that had previously shown broad strengths. Overall, the broad, sustained real estate market growth which began with the economic recovery in 2010 may finally be running its course, and a period of slower growth and declines in transaction volumes may be setting in.
Equity activity in real estate remained strong in 2016, as investors sought yield and equity was in demand to cover the gaps in the capitalisation structure brought about by reduced loan-to-value ratios. As of June 2015, the total assets under management at private closed-end equity property funds totalled an all-time high of $743 billion and continued to post strong and steady returns, with over 22 straight quarters of net asset value growth. These funds include institutional equity commitments to real estate from pension funds, foundations and endowments – large capital sources which in recent years have increased their exposure to real estate in order to increase yield. Institutional investors are still largely focused on so-called ‘core’ properties with stable yields, but value-add properties are included in institutional portfolios, as well as strong competition for core properties, which has driven prices to extremely high levels. As of mid-2015, core properties – representing high-quality, well-leased income-generating assets in the major gateway cities – have yielded returns of approximately 13%. Of this, approximately 8% represents capital appreciation and 5% represents income. This compares with a return on US Treasury bonds of about 2.5%.
New development activity in New York City slowed considerably in 2016 from its 10-year high in 2015. While construction continued on both new office space and new residential condominium units, the pace of office leasing and ultra-luxury condominium sales slowed considerably, with office leasing in the final quarter of 2016 at its lowest level in seven years and well below the 10-year average, with a 10.4% vacancy rate. Nevertheless, office rents climbed to an all-time high of $73.01 per square foot average asking rate in Manhattan – up 2.2% from 2015. Leasing activity in the technology and media sector – which had led job growth and office demand since 2007 – slowed by 15% in 2016.
Rights and registration
What types of holding right over real estate are acknowledged by law in your jurisdiction?
Fee simple title and ground leasehold title are the most common forms of US commercial real estate ownership.
In fee simple title ownership, the ownership entity owns all rights, titles and interest in the real estate asset, including the right to free alienation of the asset. The fee simple estate is not limited in duration and there is no superior title-holding estate. A fee simple estate is subject only to liens and encumbrances that are superior to the estate by reason of an express grant of priority by the fee simple owner (eg, a mortgage or an easement that expressly encumbers the fee simple estate).
Where a fee simple owner wishes to convey a long-term interest in the real estate asset to a third party but retain the underlying fee title (typically for tax or inheritance reasons), the fee owner will commonly enter into a long-term ground lease that enables the third party to lease, develop and operate the real estate for the lessee’s account. Ground leases usually last for at least 49 years, and are often 99 years or longer.
US law also recognises many lesser estates in title, including:
- fee title for a term of years;
- fee title subject to termination upon a condition subsequent;
- life estate (ie, fee title for the life of an individual);
- future estates in land;
- leasehold estates; and
- easement interests.
Are rights to land and buildings on the land legally separable?
Yes, ownership of land and buildings are separable for tax purposes, in that the owner of a leasehold estate in land can be deemed the owner of a building for tax purposes provided that the land lessee expended the funds to build the building. However, if a leasehold estate in land is created, title to the building will typically revert to the landowner at the end of the land leasehold and cannot be removed from the land.
Which parties may hold and exercise rights over real estate? Are there restrictions on foreign ownership of property?
US real estate may be owned by:
- a natural person;
- a legally created domestic entity (eg, corporation, limited liability company, limited partnership or general partnership); or
- a foreign-domiciled persons or entity.
A foreign entity that owns real estate must typically register to do business in the state jurisdiction in which the property is located. Foreign entities that own real estate are subject to certain state law-reporting requirements regarding ownership, and foreign entities and persons are subject to US federal income tax under the Foreign Investors in Real Property Tax Act.
How are rights, encumbrances and other interests over real estate prioritised?
Interests over real estate are prioritised by both estate (regarding equity interests) and lien priority order (regarding debt interests). For equity ownership, a fee simple estate is superior to a leasehold estate, as well as to easements and other lesser fee estates described above.
Regarding debt, both fee owners and lessees may grant mortgages on their respective estates. Mortgages are prioritised by the first in line, first in right principle (eg, recorded first mortgages have absolute priority over second mortgages). Between a fee mortgage and a leasehold mortgage, the leasehold mortgage is subordinate in that the lessee – and the leasehold mortgage holder – must pay leasehold rent and perform leasehold covenants in order to maintain the leasehold that its mortgage encumbers.
A fee or leasehold owner may grant both a mortgage loan security interest and a mezzanine loan security interest on its real property estate. A mortgage is a debt instrument secured by the real property itself. A mezzanine loan is a debt instrument secured by a pledge of the ownership interests in an entity that owns real property. A mortgage is thus structurally superior to a mezzanine loan security interest.
Must real estate rights, interests and transactions be registered in your jurisdiction? What are the legal effects of registration?
Yes. All fee interests in real estate – and all mortgages – must be registered in the land records, which are maintained for each state and county throughout the United States. Notices of ground leases and major space leases are also recorded to ensure that the estates are recognised in title transfer or fee mortgage foreclosure cases. Mezzanine loan security interests are considered personal property, not real property, and are therefore perfected through filings in state and county records under the Uniform Commercial Code, rather than the land records.
What are the procedural and documentary requirements for entry into the national real estate register(s)? Can registration be completed electronically?
Title registries in the United States are maintained on a county (a subdivision of a state) basis. Registration processes differ from state to state and from county to county within each state. There is no single national title registry. Typically, an original executed document must be presented for recording. Modern counties maintain electronic registries of land records; less advanced counties have manual journals in which titles are recorded.
What information is recorded in the national real estate register(s) and to what extent is such information publicly available?
County real estate registers will show:
- memorandums of leases; and
- other title encumbrances.
Is there a state guarantee of title?
No. Title is typically insured by private title insurers after reviewing the county title records for the respective property. It is customary for a buyer or a lender in US real estate transactions to engage:
- a title insurer at the time of entering into the purchase contract to examine the local title registries to determine the ownership of real estate and any encumbrances of record; and
- a surveyor to determine land boundaries and locations of improvements and easements.
At the closing of title transactions, it is customary to purchase title insurance to insure that good title is acquired by the purchaser, subject only to identified encumbrances. Most mortgage lenders also require title insurance to insure that the lender’s mortgage is a first-priority lien on the real estate. The premiums for title insurance vary by state, as do the specific endorsements that title insurers can underwrite.
Sale and purchase
How are real estate brokers regulated in your jurisdiction (eg, through caps on commission or disclosure obligations)?
Brokers must register under state laws in each jurisdiction in order to claim commission, and the state law sets standards as to when brokers are entitled to commission. However, state law does not set the commission amount, which is negotiated between the broker and the owner.
What due diligence should be conducted before conclusion of a real estate sale contract?
The general US law of commercial real estate is ‘caveat emptor’, which means ‘buyer beware’. In typical US commercial real estate transactions, the buyer must conduct all due diligence (eg, title, survey, physical condition, environmental, zoning, code compliance, litigation, leases and contracts) and the seller makes few representations and warranties. In residential real estate transactions, state law often provides additional warranties and protections to the buyer.
Are any preliminary agreements typically entered into before conclusion of a sale contract?
A sales contract is typically the first binding contract in a transaction. Term sheets or letters of intent are typically non-binding.
Must sale contracts be concluded in writing? If so, must they be notarised?
Yes, sales contracts must be in writing to be enforced. No, they need not be notarised.
Can sale contracts be concluded electronically?
Yes, many state laws recognise electronic signatures on a contract.
What provisions are usually included in a sale contract?
A sale contract usually includes:
- description of property;
- sale price;
- closing date and place;
- title matters;
- representations and warranties of seller;
- closing financial prorations;
- conditions to closing;
- brokerage fees;
- transaction costs; and
- seller and buyer remedies for default and governing law.
Obligations and liabilities
What are the seller’s disclosure obligations and other liabilities, and what are the consequences of breach?
A seller in a commercial property contract typically has no disclosure obligations by law, but customarily makes representations and warranties regarding matters not readily ascertainable by the buyer through due diligence. If the seller breaches the representations and warranties that it makes to the buyer, the buyer’s remedies are typically either:
- not to close and instead to receive a deposit refund, if the breach is discovered before closing and cannot be cured within a specified cure period; or
- to sue the seller for damages, if the breach is discovered post-closing during the period in which the representation or warranty survives. Such suit is typically subject to a cap on seller damages.
What contractual warranties are usually given by the seller?
The seller typically makes representations as to:
- the corporate authority to sell;
- the transaction consents to be obtained;
- the status of space leases;
- the existence and status of any ground leases;
- no breach of title encumbrances;
- no condemnation proceedings pending or threatened;
- no service contracts or labour agreements which will survive closing;
- no litigation affecting the property or the transaction;
- no violation notices outstanding;
- no environmental matter notices outstanding; and
- any similar matters which cannot be evidenced by due diligence.
A commercial property seller rarely makes representations as to the property’s physical condition.
Are there any other obligations on the buyer, aside from paying the purchase price?
Provided that the buyer is authorised to buy and comes to the closing with the purchase price, obligations are typically satisfied.
What taxes are payable on the sale and purchase of real estate? Are any exemptions available?
Real estate transfers are subject to state – and often to city or county – transfer taxes, which are typically a percentage of the gross consideration for the transfer. The seller’s capital gain from the real estate transfer is subject to a federal income tax.
Transfer of title
When does title in the property transfer?
Title transfers at the closing of the transaction.
What is the typical duration of a sale transaction?
For the sale of an operating property, the typical closing period is 45 to 90 days following contract.
Must a lease agreement be concluded in writing?
Are there any regulations setting out mandatory or prohibited provisions in lease agreements?
Under state law, commercial leases must typically provide provisions for landlord and tenant rights regarding:
- failure to deliver possession;
- casualty rebuilding;
- holdover following lease term; and
- right to quiet enjoyment of occupancy.
Statutory provisions are often permitted by the applicable statute to be overridden by negotiated terms between a commercial landlord and a commercial tenant. The right to quiet enjoyment, which means that the tenant’s right to the leasehold interest is not unlawfully interrupted, cannot be overridden. Residential rent-regulated leases, by contrast, are on prescribed forms and contain prescribed statutory terms, which cannot be overridden by negotiation.
What provisions are typically included in lease agreements?
Typical provisions of office leases are as follows:
- Term and renewals – terms are usually 10 to 15 years, often with options to renew for one or two additional five-year periods.
- Base rents and operating expenses – base rents are either fully net, where the tenant:
- pays a base rent plus its pro rata share of all operating expenses and real estate taxes attributable to the property; or
- pays a base rent plus its pro rata share of increases in operating expenses and real estate taxes over a stipulated base amount.
Base rents increase either on an annual basis or cumulatively over a five-year period at a stipulated amount sized to keep pace with anticipated inflation.
- Tenant improvements – an office landlord will pay for initial improvements to the office space or provide an allowance to the tenant to pay for improvements and a period of free rent at the beginning of the lease to enable the tenant to complete the work and move in. The cost of these concessions is factored into the rent.
- Assignment and subletting – tenants may sublet with landlord approval, with criteria as to the successor’s creditworthiness and non-competition with the landlord’s leasing of the building. The tenant must usually give or share any sublease profits with the landlord. Tenants are not relieved from lease liability by assigning or subletting, but remain jointly and severally liable with the sub-tenant.
- Building services – tenants must often purchase building services (eg, electricity, cleaning, air conditioning and building management) through the landlord.
- Default and termination – if a tenant defaults in lease performance, a landlord may terminate the lease and evict the tenant by court order from possession of the premises. After the lease is terminated and the tenant evicted, the tenant will remain liable for damages equal to the rent under the lease until the landlord finds a replacement tenant (and will thereafter remain liable for any shortfall between the lease rent and the new rent).
Retail leases Retail leases differ from office leases in the following respects:
- Base rent – base rent is usually fully triple-net and tenants are responsible to pay a pro rata share of property operating expenses and real estate taxes from dollar one, rather than over a stipulated base amount.
- Percentage rent – retail rents commonly include percentage rents, in which tenants pay – in addition to base rent and operating expenses and taxes – a percentage of their adjusted gross sales proceeds over a breakpoint. This enables the landlord to offer a lower going-in base rent and share in the upside if sales are robust.
- Common area maintenance charges – in shopping malls and other retail centres with large common areas and where tenants benefit from common marketing and promotional activities, tenants must pay a common area maintenance charge pro rata.
- Use clauses and continuous operation covenants – retail leases (particularly in shopping centres) generally contain strict-use clauses identifying the image, branding and products to be carried by the retailer, as well as the minimum and maximum hours of operation and a covenant to operate without interruption. Both the landlord and the tenant will be subject to radius restrictions on competing operations – the tenant will be restricted from having another identical brand store within a specified radius from the shopping centre and the landlord will be restricted from having competing brands within the shopping centre – to help ensure the success of the retail operations.
What are the standard forms of lease agreement used in your jurisdiction?
Each state has its own customary form of lease agreement. In New York, the Real Estate Board of New York promulgates standard forms of office lease and retail lease which are customised with extensive riders. In New York, residential rent-regulated tenants have a statutorily prescribed standard form of lease.
Length of term
Are there any regulations on minimum and maximum terms of leases?
No. Leases of less than one year are typically deemed licences, on a month-to-month basis, and long-term leases may be for any duration. An office lease term is usually 10 to 15 years, with options to review for one or two additional periods. A residential lease term is usually one or two years.
Are long-term tenants accorded any special rights as to extension or renewal of leases?
Extension rights are not legally required in a commercial context; however, it is customary to negotiate one or two renewal terms at fair market value for long-term tenants. In a residential context, state residential laws may provide for tenant renewal rights.
What regulations (if any) govern rent increases?
Typical commercial leases have no rent regulations. A few US cities and counties limit commercial rent increases in an effort to protect small businesses.
In cities and counties where residential rent regulations exist, rent increases are limited by a public body. Other than residential rent-regulated leases, there are no limits on rent increases in residential leases.
What regulations (if any) govern rent security deposits?
Security deposits must be held in a segregated account and the tenant notified of the account’s location. Interest on a security deposit – minus a small administrative fee – is payable to the tenant. The security deposit – minus amounts applied by the landlord for property damage or payment arrears – is typically returned to the tenant within 30 to 60 days after the lease terminates.
Can the tenant withhold rent payments on any legal grounds?
Yes, the tenant has the right to withhold rent for breach of a ‘warranty of habitability’ of the premises (ie, when the premises is essentially uninhabitable due to poor condition). Residential tenants are accorded greater latitude in withholding rent for poor conditions than commercial tenants. For commercial tenants, the standard is constructive eviction, which requires the tenant to vacate the uninhabitable premises.
Under what circumstances is sub-letting typically allowed?
In commercial leases, the landlord’s consent must typically be obtained to a sublease or assignment to a third party, and the landlord and tenant will negotiate to split profits from subletting. If a tenant proposes a long-term sublet or assignment, the landlord will typically negotiate the right to take the space back from the tenant and to lease directly to the proposed subtenant (keeping all profits). In residential contexts, subletting is generally allowed only with landlord consent.
Obligations and liabilities
What are the general obligations and liabilities of the landlord in respect of the property and what are the consequences of breach?
Landlords take on lease obligations to:
- maintain the building in good repair;
- supply specified building services to the premises; and
- covenant quiet enjoyment to the tenant.
In a commercial lease, the tenant’s remedies for landlord breach are very limited. The tenant may claim constructive eviction and terminate a lease if it is deprived of all reasonable use and occupancy of the premises and vacates. Except in cases of constructive eviction, commercial tenants cannot generally under law withhold rent.
Residential tenants have more remedies. State and local government agencies often step in to enforce housing maintenance codes if building services are not provided. Tenants are given broader latitude to withhold rent for breach of a ‘warranty of habitability’ – a legal doctrine adopted in most states that requires landlords to maintain residential properties to a certain minimum standard.
What are the general obligations and liabilities of the tenant in respect of the property and what are the consequences of breach?
Tenants are obligated to:
- pay rent timely;
- keep the leased premises in good repair; and
- use the premises for only the uses permitted under the lease.
Tenants must also maintain liability insurance and indemnify the landlord against injuries or property damage caused by the tenant’s negligence. If the tenant breaches any of its covenants under the lease, the landlord can:
- terminate the lease for default;
- remove the tenant from the premises on court order of eviction; and
- collect damages equal to the monthly rent until the premises are re-leased, as well as any deficiency in the rent collected under a new lease (or under current market conditions) as compared with the rent in the lease, for the balance of the original lease term.
Are any taxes payable on rental income? If so, are any exemptions available?
Yes, the landlord must pay US and state income taxes on profits from rental income. No exemptions are available, unless the property operations (including depreciation) are not overall profitable.
Are the landlord and tenant bound by any insurance requirements?
Leases typically require both the landlord and the tenant to maintain insurance covering their respective interests in the property and their respective negligent acts and omissions.
Termination and eviction
What rules and procedures govern termination of the lease by the landlord and the tenant’s eviction from the property?
A lease will contain written provisions for a landlord to declare a tenant event of default and lease termination as a remedy for an uncured event of default. Every state has a court process that allows the landlord to obtain a judgment of eviction following the lease termination, in accordance with the lease terms. If the tenant has a defence to an event of default, it must be asserted before the lease termination and will be adjudicated by the court. Courts have great latitude in the timeframe that they will permit a tenant to remain in the premises following a lease termination. A tenant remaining in the premises following a lease termination must pay market rate use and occupancy charges, regardless of the rent under the lease term.
What are the typical providers of real estate financing in your jurisdiction? Are there any restrictions on who may provide financing?
Commercial mortgage-backed securities (CMBS), which are US public markets securities issuances, form over 20% of the real estate debt market capital. In addition, bank lenders provide the bulk of debt capital to the real estate markets, at approximately 40% (almost evenly split between domestic and foreign banks) and increasing potentially to a historic level of almost 60%. Bank lenders are followed by private/other sources at 18%, followed by life insurers, government supported entities (for multifamily assets) and non-bank sources, including real estate funds and real estate investment trusts.
CMBS underwriting became more conservative in 2016, with loan-to-value ratios declining from 64.3% in 2015 to 58.7% in 2016 and debt service coverage ratios increasing from 1.82 in 2015 to 2.14 in 2016. CMBS issuance as a source for debt refinancing is expected to decline further in market share in 2017, due to the effects of the risk-retention rule, which took effect in 2016 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The risk-retention rule requires that issuers retain a minimum of 5% of the risk in their CMBS issuances, as a ‘vertical slice’ across all tranches, a ‘horizontal slice’ at the lowest tranche, or an ‘L-shaped slice’ combining vertical and horizontal interests.
What are the most common structures used to secure real estate financing and how are these security interests perfected?
The most common forms of security for a real estate loan are:
- a mortgage, which creates a security interest for the lender in the real estate; or
- a mezzanine pledge, which creates a security interest for the lender in the ownership interests in the entity that owns the real estate.
A first-priority mortgage is given to the most senior lender, typically with a loan that does not exceed 50% to 75% of the property value. If larger amounts are borrowed, the additional loan will be junior in priority to the mortgage loan and secured by a pledge of the ownership interests in the entity that owns the real estate, not the real estate itself.
What covenants are typically made in financing agreements?
Borrower covenants in mortgage financings include:
- payment of debt;
- grant of security interest in property and leases;
- rents and proceeds of mortgaged property;
- covenants against junior liens;
- maintenance of borrower entity as a single-purpose entity;
- maintenance of mortgaged property;
- operation and leasing of mortgaged property;
- rebuilding in the event of casualty and condemnation;
- use of the loan proceeds; and
- recourse to borrower or guarantor credit if certain adverse events occur.
Enforcement of security
How are security interests enforced in the event of default?
When a first-mortgage lender forecloses on a mortgage collateral to enforce its loan, it will hold a sale of property title to receive repayment on its loan and will wipe out all junior liens, including a mezzanine pledge, in the event that the sale proceeds are insufficient to pay off claims.
When a mezzanine lender forecloses on its security interest in the ownership entity, it will take title to the ownership interests of the property, subject to the mortgage, and the mortgage will remain intact. Both mortgages and security pledges are subject to – and enforced under – state law. While details of the enforcement process vary from state to state, lien priority issues are generally similar. In CMBS, where mortgage loans are pooled into a single trust and securities of differing priorities are created in the trust, enforcement of the underlying mortgages follows the same state law process as for single loans.
What is the typical timeframe for the enforcement of security?
Foreclosures are governed by state law for both mortgage collateral and mezzanine collateral. Mortgages are typically enforced through a court-ordered foreclosure process that can last from six to 18 months. Mezzanine loan enforcement, which involves a sale of the pledged ownership interests under the Uniform Commercial Code, is much quicker – typically 60 to 90 days. Notice procedures to all parties affected by the foreclosure are prescribed by state law and must be strictly adhered to.
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.
Planning and environmental issues
Which government authorities regulate planning and zoning for real estate development and use in your jurisdiction and what is the extent of their powers?
Planning and land use issues are largely controlled by states and municipalities through zoning laws adopted by local jurisdictions. In rural and suburban areas, zoning laws focus on master plans for large-scale developments and related infrastructure, with a focus on:
- controlling density;
- preserving open space; and
- ensuring that adequate water, sewer capacity and other necessary utilities are available for developments.
Preservation of wetlands and natural habitats of endangered plant and animal species are controlled by federal laws, in addition to local zoning laws.
In urban areas, zoning laws will prescribe for each specified zoning district:
- the uses to which real estate can be put (eg, industrial, commercial, residential or institutional);
- the density of development (eg, number of square feet of building space per unit of land area);
- the height, setback and overall architectural configuration of individual buildings;
- the sizes and configurations of yards and open space; and
- street frontages.
Zoning laws often contain incentives or requirements for developers to provide public goods, including affordable housing, parks and other public amenities in connection with new developments. Legal challenges to land use regulations can be brought in state and federal courts, which set the limits as to how far the government can go in regulating land use without constituting an unconstitutional “taking” of the landowner’s private property.
What are the eligibility, procedural and documentary requirements to obtain planning permission?
The application process for planning permission varies by jurisdiction. It typically includes:
- a site survey;
- a proposed site plan;
- an environmental site analysis;
- an environmental impact analysis; and
- an analysis of supporting infrastructure for the planning action.
Can planning decisions be appealed? If so, what is the appeal procedure?
Yes, all planning decisions have an appeal process. The first level of appeal is to a public body (eg, a zoning board of appeals) and thereafter to the state courts. Planning bodies are accorded deference by the courts; a court will not generally overturn a planning board decision unless it was “arbitrary or capricious”.
What are the consequences of failure to comply with planning decisions or regulations?
Violations will be imposed by state or local governments for failure to comply with planning decisions or regulations. The penalty for a violation can range from a fine to a court order of injunction to correct the condition, depending on the severity. Extremely hazardous building conditions can result in criminal penalties to property owners.
What regime governs the protection and development of historic and cultural buildings?
Many localities require preservation of designated landmark buildings, including oversight of alterations and demolition by a local historic preservation body. Federal and state income tax credits are available for historic restoration of significant historic landmarks.
What regime applies to government expropriation of real estate?
Federal, state and local governments can expropriate private real estate for public use under the federal and state constitution and statutes. There has been a great deal of jurisprudence under the US Constitution and state constitutions as to what the appropriate governmental purposes are for which property can be expropriated. The law is well established that the government can take private property for traditional public uses (eg, roads, schools, public transportation and other public facilities). However, the law varies state by state as to whether the state can also take property for a redevelopment project, where the property being taken is “blighted” and the taking will permit a publicly supported redevelopment project.
What is the required notice period for expropriation and how is compensation calculated?
Notice periods are established under the laws of each state. Expropriation must be conducted through a court procedure, unless a consensual conveyance is agreed to by the government and the private property owner. A timeframe is typically allowed for the private property owner to object to the government purpose for which the property is being taken, as well as to the compensation being paid. Compensation must be ‘just compensation’ under law, which is defined as fair market value for the highest and best use of the property. Just compensation must be paid by the government as a condition of taking the private property.
What environmental certifications are required for the development of real estate and how are they obtained?
If a property has previously been disclosed to a state or federal environmental agency as having been contaminated, the property’s redevelopment must be certified by the applicable agency and a completion or no-further-action certification is required.
What environmental disclosure obligations apply to real estate sales?
Disclosure obligations vary state by state. As part of the due diligence investigation for a property acquisition, the buyer will conduct a “Phase I” environmental study to determine previous uses of the land and whether any federal or state environmental violations have been noted. If the phase one study indicates possible environmental liability, a “Phase II” study in which soil and groundwater samples are studied will be undertaken before property acquisition. Some states require an approved environmental remediation plan to be in place before the owner can transfer title to any property that was used for industrial use.
What rules and procedures govern environmental clean-up of property? Which parties are responsible for clean-up and what is the extent of their liability?
A landowner’s liability for the contamination of land and water by hazardous substances is governed by both federal and state law, and is enforced concurrently by federal and state governments. The primary federal laws governing hazardous substances liability are:
- the Comprehensive Environmental Response, Compensation and Liability Act ; and
- the Resource Conservation and Recovery Act.
Both of these statutes hold the owner and the operator of land financially and legally responsible for hazardous substance contamination of land that they own or operate, as well as any contamination of neighbouring land or water caused by activities on the land that they own or operate. Most states have adopted environmental statutes requiring owners and operators to prepare specific plans for approval by the state environmental agencies for remediation of soil and water contamination caused by hazardous substances. A new property buyer becomes liable for clean-up obligations – even if they have already occurred – although the new owner has the right to claim against the prior owner or operator that caused the contamination. Several insurance products are available to property owners to protect against unknown liabilities for prior pollution and these are becoming the norm in transactions for sophisticated buyers.
Are there any regulations or incentive schemes in place to promote energy efficiency and emissions reductions in buildings?
Yes, most states and the federal tax code provide incentives for the use of alternative energy sources and promotion of energy efficiency in buildings. State and city building codes include an energy code, which requires new construction or renovation to be conducted with up-to-date energy efficiency building methods and materials. A private, voluntary energy efficiency rating system called LEED is also issued through the US Green Building Council, with which many publicly funded buildings and projects must comply.