Is the next shoe ready to drop on commercial real estate?

    While many economists have predicted that the commercial real estate market is the last shoe to drop in the Great Recession and credit crisis the market in general has avoided the meltdown that was envisioned at the height of the panic.

    Default rates on all commercial mortgages are expected to more than double to a peak of 5.5 percent by the end of the year, but many prognosticators at this time last year were predicting that this number could hit 10 percent by the end of 2010.

    The meltdown may have been avoided, but the commercial real estate market is far from healthy. The peak of the market in 2007 saw $557 billion dollars in transactions completed in the United States. This was followed by the bust and a staggering drop in volume to only $54 billion dollars of transactions completed in 2009.

    Unemployment is projected to remain high, more businesses are looking to consolidate capacity than to expand, the rental market for landlords will remain extremely competitive, property values have fallen, and lending for real estate investors through banking institutions will remain difficult at best. To complicate matters, many of the three- to five-year commercial mortgages that were issued during the boom times will be coming due for refinancing through 2012 faced with the litany of problems stated above.

    It would appear that the commercial real estate market is far from out of the woods, but one more major road block to recovery is moving through congress and could be enacted by May 31. The House Ways and Means Committee headed by Sandy Levin and the Senate Finance Committee chaired by Max Baucus are proposing legislation to change the tax treatment on “carried interest” for the general partner(s) of a real estate investment fund from capital gains to ordinary income.

    Currently, the capital gains rate on “carried interest” is 15 percent. Changing the tax treatment to ordinary income would raise tax rates on carried interest to a proposed 35 percent. Due to the enormous amount of capital needed to finance real estate development and investment, real estate partnerships are often organized as limited partnerships (or LLC’s) in which the limited partners provide the capital infusion and the general partner(s) provide the operational expertise to maximize returns on investment.

    This model of investment is even more important given the current constrained lending conditions for real estate developers and investors. The impact of the “carried interest” tax is realized when the partnership property is eventually sold. The limited partners generally reap the profits of the deal in proportion to their capital investment. The general partner is granted an agreed upon percentage upon sale for managing the investment and maximizing income. This profits interest is known as a “carried interest” and it is designed to act as an incentive for a general partner to maintain and enhance the value of the real estate so that the operation of the property is a value-added proposition.

    The “carried interest” for a general partner can be a very lucrative pay out, however there is a great deal of risk and skill involved in effectively maximizing returns on commercial real estate investment. A study commissioned by the Real Estate Roundtable entitled "Commercial Real Estate and Changing the Tax Treatment of Carried Interest," by Dr. Douglas Holtz-Eakin, former director of the Congressional Budget Office from 2003-2005 and now a senior fellow at the Peterson Institute for International Economics presents the following facts and projections in regards to the magnitude of the economic impact of the real estate partnership model and increased taxation:

    • There are more than 2.5 million partnerships, managing $13.6 trillion dollars in assets, and generating income of roughly $450 billion.
    • Changing the tax treatment of carried interests, assuming no changes in investment behavior, would result in a tax increase of $5 billion on real estate transactions.
    • The lost economic income from distorting taxes on real estate partnership capital would be $15 to $20 billion annually, and as much as 10 to 25 times greater once the detrimental impact on entrepreneurial talent is incorporated.
    • Workers would bear the impact of higher taxes in the form of reduced jobs in construction and real estate activities and lower earnings overall.

    The impacts of this proposed tax increase will present another additional challenge to the recovery of the commercial real estate sector at a time when the Industry has arguably yet to hit a bottom. The U.S. Conference of Mayors has sent a letter to Congressman Levin and Senator Baucus denouncing this proposed legislation stating “

    A developer’s incentive to take on necessary risk associated with real estate development will be greatly diminished. Furthermore, higher capital gains rates will cause real estate owners to hold on to properties longer. The result of this behavior will lower tax revenues at the federal, state, and local levels and limit opportunities for redevelopment of underutilized properties, hindering job creation.”

    This proposal comes at the exact wrong time to create an additional impediment to investing in commercial real estate and the impacts of this tax increase could be the final straw in leading to the “meltdown” in commercial real estate markets that has been avoided to date. Please consider contacting your elected Congressional Representatives and tell them that it is the wrong time to place additional burdens on the fragile commercial real estate industry.

    Jeff Hoffman is a vice president of Judson & Associates,s.c., a Pewaukee-based commercial real estate firm, and he is acting president of the Independent Business Association (IBA) of Wisconsin.

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