Andrew J. Nelson, Chief Economist | USA

U.S. Special ReportThe New Tax BillJanuary 2018

Washington’s Holiday Gift: Implications for the New Tax Bill on Commercial Real Estate

After working through differences between the House and Senate versions of the Republican tax bill, Congress passed the final bill just before Christmas, which the President then promptly signed into law. The bill represents not only a major tax cut for businesses (and a modest cut for households), but also the most sweeping tax overhaul since the Tax Reform Act of 1986 under the Reagan Administration.

Key impacts on the property sector include:

> Tax liabilities for most commercial property owners and investors will decline under the new tax bill as tax rates are lowered for all businesses and most individuals, while most prevailing special tax benefits enjoyed by the real estate sectors have been retained.

> The tax bill should improve property fundamentals for commercial real estate in the near term due to an improving economy as well as favorable tax treatment for businesses in several key industrial sectors that lease commercial real estate. The retail and industrial sectors should be clear winners here. However, the relatively minor cut for individual taxpayers will limit net additional consumer spending, and thus the potential boon for these sectors.

> The multifamily sector looks to gain from tax law changes that will reduce the benefits of homeownership in many markets, and thereby raise the incentives for apartment rentals for some households.

> The office sector looks to benefit the least of the major property sectors. Key office tenants will gain only limited to average tax savings from the new tax code. Moreover, many corporations will distribute much of their tax savings to shareholders instead of investing in new facilities.

> Impacts on real estate capital markets are less clear. Uncertainty as to the timing and nature of the tax reform likely kept some capital on the sidelines this year, so enactment of the tax act could encourage more transactions now that the uncertainty has been lifted. However, the act does not confer any new significant benefits specifically to real estate owners, blunting any potential capital inflow to the sector.

> Interest rates may rise faster after the tax cut due to the greater national debt and more aggressive fed rate hikes. Impacts for the property sector could include lower returns on interest-sensitive investments (like REITs), more costly acquisition costs and slower leasing once the interest rates eventually slow economic growth (likely in late 2019 or 2020).

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provisions phase out over time, including the bonus depreciation (accelerated depreciation on eligible business equipment), thereby raising the average ETR over time to 18.9% by 2027—still below the 23% rate that would have been in effect under the old tax law, but more than double the ETR in 2018 under the new code.

In sum, the cumulative average tax bill over the next 10 years will be almost one-third lower than under the prevailing law, again averaged across all industries and weighted by size of industry. However, the decline will be much greater in asset-heavy industries like mining, which will benefit from immediate expensing for spending on short-lived capital equipment. On the other hand, some industries will see their tax bills rise on average. Heavily indebted firms, particularly those with lower credit ratings, will see the limits on interest and operating losses wipe out the gains from the lower tax rates.

Introduction

The 2017 budget reconciliation act (formerly known as the Tax Cuts and Jobs Act) will have far-reaching impacts throughout the economy, affecting just about every taxpayer and business in the nation. While the full implications will not be understood for years owing to the complexity of the legislation—and the ingenuity of motivated tax accountants—much of the bill is clear enough to gauge its major impacts.

By just about any measure, the commercial real estate (CRE) sector emerged fairly well from the legislative process. (See “Key Provisions of the 2017 Tax Act Impacting Commercial Real Estate” below.) Most directly, many of the industry’s most important benefits under the prior tax code—notably tax-free 1031 exchanges, commercial mortgage interest deductibility, asset depreciation and carried interest—saw limited material changes in the new law.

At various points over the last year, all these special benefits for the real estate sector seemed threatened. So even if the industry was not awarded many special new benefits under the tax law, CRE gained just by not losing its special privileges. Combine that with lower rates on both corporate and individual income, and it’s clear that tax liabilities for owners of commercial property will be lower going forward.

But the impacts of this tax law will be greater and broader than just these direct impacts. As discussed briefly in our State of the U.S. Market and 2018 Outlook, the primary impact for the real estate sector may well be through improved property fundamentals. The tax cut is likely to foster at least somewhat stronger economic and job growth this year, though most economists expect the boost to be both modest and short lived. Building owners can expect stronger leasing from several industrial sectors that will benefit disproportionately from the new tax law. And finally, the multifamily sector looks to gain from tax law changes that will reduce the benefits of homeownership in many markets, and thereby raise the incentives for apartment rentals for some households.

Almost everyone gains, but some more than others

Though all businesses will enjoy lower tax rates under the revised tax code, some industrial sectors will fare far better than will others. The net impact for individual companies will vary significantly depending on its source and type of income, its use of debt financing and the extent to which its revenue depends on investments in depreciable physical assets, among other factors.

According to the non-partisan Penn Wharton Budget Model, the effective tax rate (ETR) averaged across all industries and weighted by size of industry will decline this year from what would have been 21.2% to just 9.2%. The primary factor reducing the ETR is the drop in the corporate income tax rate from 35% to 21%. In addition, expensing and depreciation for various types of equipment and other eligible expenses will be more generous, and the corporate alternative minimum tax (AMT) was repealed. However, interest and operating losses deductions will be more limited (though, significantly, not for the property sector). Moreover, some of these

Sources: Penn Wharton Budget Model and Colliers International

Cumulative Tax Change by Sector2018-2027

In this context, owners of real estate will certainly benefit significantly, though a bit below average. The Penn Wharton model projects that taxes for the property sector will drop 30% in aggregate over the next decade against the baseline versus 32% for all industries. As noted previously, CRE managed to maintain most of its special benefits from the old tax law, but won few new additional benefits, beyond the lower individual and corporate tax rates applicable to all sectors.

An improving economy . . .

Beyond the lower taxes owners of commercial property will pay under the new tax code, the CRE industry will enjoy indirect benefits from the lower taxes as well. The economy already started growing faster in mid-2017, in part attributable to a significant pickup in business investment, as firms bet on the tax relief that Congress finally delivered in December. Thus, some of the boost that a tax cut could be expected to deliver has already been reflected in the economic pick-up last year.

-60% -40% -20% +0% +20%

UtilitiesArts and entertainment

Professional servicesHealth care

ManufacturingReal estateInformation

Total (all industries)Construction

Finance and insuranceAgricultureRetail trade

Wholesale tradeEducational services

Transport & warehousingOther services

Hotels & food servicesWaste managementHolding companies

Mining

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Additional stimulus will come from the fact that tax cuts are largely unfunded (that is, without offsetting spending cuts). This stimulus is variously estimated to total between $0.5 and $1.4 trillion once the effects of induced economic impacts of the $1.5 trillion tax cut are considered, with most independent estimates near the upper end of the range.

. . . but limited further upside potential

This impact is likely to be limited, however. First, the U.S. has an annual GDP of about $19 trillion, so a 10-year stimulus of $1 trillion amounts to only about 0.5%. Granted, some of the stimulus will be front-loaded into the early years as some of the tax cuts are phased out over time, so the 2018 stimulus will be a bit greater. But its net addition to the overall economy will still be relatively modest.

Moreover, the economy is already believed to be operating close to its full potential. Government stimulus tends to be more effective during a recession, when there is considerable slack in the economy. Adding fuel to an economy already at full employment will tend to raise inflation more than output.

Also limiting the potential impact: While consumers account for more than two-thirds of the U.S. economy, the tax cuts seem unlikely to induce much additional spending. The tax cuts are heavily weighted to favor businesses over consumers compared to their shares of the economy (Congressional Budget Office). Plus, the cuts are skewed to the upper end of the income scale (Joint Committee on Taxation). The affluent tend to save more of their income and spend less of their tax cuts than lower-income households, thereby limiting net additional consumption from this tax law.

Finally, the economic lift is likely to be short-lived, as most economists believe the tax bill will prompt the fed to raise interest rates more quickly to flow inflation. The greater national debt from the unfunded tax cuts also will tend to raise interest rates. In turn, higher interest rates would slow both business investment and consumption, thereby slowing economic growth.

Consensus economic forecasts show the economy growing by 2.5% in 2018, about the same as last year, but then slowing in 2019 and especially 2020, as the cumulative effect of fed rate hikes take full effect.

Winners in commercial real estate

In summary, landlords can expect at least a modest, short-term rise in leasing from faster economic growth. But some sectors of CRE should see even greater absorption as several tenant groups that will benefit disproportionately from the new tax law are key users of commercial real estate.

> Retailers and restaurants look to be among the biggest winners under the new tax law, which should benefit shopping centers in their battle with e-commerce. Retailers and restaurants currently

pay among the highest effective tax rates of any sector because they cannot take advantage of many of the tax credits available to other sectors. These sectors will benefit strongly and directly from the drop in the corporate tax rate.

> Similarly, warehousing and wholesale trade also pay some of the highest effective tax rates and will benefit disproportionately by the new lower tax rates. With stronger tenants, warehouse owners could see even greater demand for their product, which is already experiencing record demand due to e-commerce, economic growth and the logistics revolution.

> By contrast, the office sector should not expect much greater demand from occupiers beyond that from the overall pick-up in the economy. Some key office tenants, like tech and finance, will gain only average tax savings from the new tax code, while others, like health care and professional services, will see more limited gains. (See chart above.) Moreover, many corporations are expected to distribute much of their tax savings to shareholders through dividends and share buy-backs, instead of investing in new facilities.

Finally, the multifamily sector stands to gain from the partial reduction of long-established benefits to homeownership, particularly in pricey, higher-taxed property markets:

> capping property tax deductions ($10,000 together with other state and local taxes)

> limiting mortgage interest deductions (to the first $750,000 of mortgage debt, down from $1 million and eliminating the interest deduction on home-equity loans)

> doubling the standard deduction, which reduces the incentive to itemize deductions on tax returns.

The housing sector did maintain its tax-free capital-gains exclusion on primary residences (up to $500,000 for married couples). But these three foregoing provisions will raise the effective, after-tax cost of purchasing or owning a home in higher-priced markets. Over time, the effect should be to slow or even reverse home price appreciation in these markets, ultimately making houses more affordable (though hurting current owners). But the more immediate effect will be to reduce the benefits of home-buying relative to renting, to the advantage of apartment owners and developers.

However, impacts on real estate capital markets are less clear. Anecdotal evidence suggests that some capital remained on the sidelines this year due to uncertainty as to the timing and nature of the tax reform. Enactment of the tax act could encourage more transactions now that the uncertainty has been lifted. However, the act does not confer any new significant benefits specifically to real estate owners, blunting any potential capital inflow to the sector. Moreover, interest rates are likely to rise faster, reducing returns on interest-sensitive investments and transaction volumes.

FOR MORE INFORMATIONAndrew J. Nelson

Chief Economist | USA+1 415 288 7864

andrew.nelson@colliers.com

Copyright © 2018 Colliers International.The information contained herein has been obtained from sources deemed reliable. While every reasonable effort has been made to ensure its accuracy, we cannot guarantee it. No responsibility is

assumed for any inaccuracies. Readers are encouraged to consult their professional advisors prior to acting on any of the material

contained in this report.

Key Provisions of the 2017 Tax Act Impacting Commercial Real EstateWeighing in at some 500 pages, the new tax reform act has numerous provisions that will touch virtually all aspects of the commercial real estate industry, including both general provisions as well as those targeted directly at our sector. Key terms include:

Lower corporate and individual tax rates – The corporate tax rate has been permanently reduced from 35% to 21%. The tax code reduces the number of tax brackets and marginal tax rates (MTR) paid by individuals and households have been reduced marginally for most filers, but raised for some. For example, the top rate declines from 39.6% to 37% and that rate kicks in for single filers at income above $400,000, compared to $427,000 previously. However, the 35% rate now starts at just $200,000, compared to $425,000 previously, effectively raising the MTR for single filers with income between those two thresholds. In addition, the lower MTRs expire in 2026 unless extended with new legislation.

Pass-Through Income – Individuals receiving income through pass-through entities such as LLCs and partnerships can deduct up to 20% of their “qualified business income,” effectively lowering their maximum MTR from 37% to 29.6%. However, this deduction is limited by various conditions, so many taxpayers will not be able to claim the full deduction, raising their tax rate. This treatment of pass-through income is one of the few in the new tax code specifically targeted to benefit owners of CRE; many pass-through entities are excluded from this provision, including service providers in the fields of financial services, law and accounting, among others. Importantly, real estate brokers are also excluded. And this provision, too, is set expire in 2026.

REIT Dividends – REITs may deduct 20% of their dividend payments, thereby lowering their maximum MTR from 37% to 29.6% on their dividends. This provision, too, is set expire in 2026.

Carried Interests, 1031 Tax-Free Exchanges, Interest Expense Deductions, and Asset Depreciation Provisions – All these prevailing provisions of the tax code survived more or less intact in the new tax law. Despite threats to treat carried interest as ordinary business income, carried interests continue to be treated as long-term capital gains at lower tax rates, though the minimum hold period has been increased from one to three years. 1031 exchanges were essentially unchanged, though personal property is now excluded.

And while most businesses now face a limit on their interest expense deductions equal to 30% of their adjusted taxable income, real estate businesses are generally excluded from this limitation, preserving a key benefit for CRE owners. However, businesses electing this treatment faced marginally slower depreciation of their real assets.

Provisions Affecting Homeownership – Three measures may affect the cost of owning a home, particularly in higher-taxed, pricey property markets: a cap on property tax deductions ($10,000 together with other state and local taxes), limits on mortgage interest deductions (to the first $750,000 of mortgage debt (down from $1 million plus eliminating the interest deduction on home-equity loans); and the doubling of the standard deduction, which reduces the incentive to itemize deductions on tax returns (which would normally include both mortgage interest and property tax deductions).