Outlook on REITs: Tax Reform, Interest Rates, and Foreign Investment

Real estate investment trusts (REITs) seemed to be the brightest star at Urban Land Institute’s Real Estate Outlook.  This is not surprising considering the many tax advantages under the new Tax Act. The impacts of tax reform, rising interest rates, and a shift in foreign investment were also discussed at length as possible influences on the industry.

The new tax law provides for a 20% deduction which taxpayers can apply against their REIT dividends. (For further discussion, see our eBook Tax Cuts and Jobs Act: Issues Affecting the Real Estate Industry.) This deduction, in conjunction with the new highest marginal tax rate of 37%, effectively reduces the net tax to 29.6%. This 10% reduction is a significant shift in the taxation of REIT income. Greta Guggenheim, CEO of TPG Real Estate Finance Trust, stated that this tax reform would be beneficial for REITs in the United States.  However, Scott Rechler, CEO and chairman at RXR Realty, expressed some optimistic caution. He noted that, looking back at the 1986 tax reform, there were unintended consequences which resulted. It remains to be seen whether any unintended consequences will result from the current tax reform.

Since REITs are required to distribute 90% of their taxable income to maintain their REIT status, the yield in relation to stock prices is an important factor in analyzing various companies in the industry. Similar to bonds, as interest rates rise, there is a risk that the price of REITs will fall. Mr. Rechler discussed the possibility of an acceleration in the rise of interest rates due to rising inflation, salaries, and prices of commodities. Ms. Guggenheim further discussed the risk of interest rates on REITs but also provided opportunities that some REITs may encounter. For example, TPG Real Estate Finance Trust operates as a floating rate lender and therefore may benefit from increases in interest rates.

Foreign capital has been a significant source of funding for real estate investments in the United States, both in the form of direct investments and public REIT investments. Jimmy Kuhn, president at Newmark Knight Frank, discussed one example of a recent renewed interest by Japanese investors directly in real estate. On the other hand, Ms. Guggenheim discussed a negative impact on public REITs. She discussed how whereas Japanese investors were previously significant 5% holders of REITs, there has been a significant sell-off in recent months. Therefore, future foreign investment, or lack thereof, may have an impact on public REITs.

Overall, it appears that the general outlook for REITs, public and private, is positive due to the impact of tax reform. Historically, REITs were often used in tax planning for tax-exempt and foreign investors due to the beneficial aspects that they provide. Domestic investors, however, were negatively impacted by the loss of the use of pass-through tax losses which are common in real estate, as well as the higher marginal tax rates. With the new tax benefits resulting from the recent tax reform, domestic investors will have an incentive to invest in REITs. The 10% decrease in federal taxation should provide a significant benefit to these investors.

Michael Torhan is a Senior Tax Manager in the Real Estate Services Group providing tax compliance and consulting services for businesses in a variety of industries including the real estate, hospitality, and financial services sectors.

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