Disruption, Industry Variability, and Opportunities in the Real Estate Market

February 25, 2019

By Michael Torhan, CPA

The annual ULI New York Real Estate Outlook conference included a wide variety of discussions in regard to the current state of the real estate industry as well the outlook for this year. Throughout the panel sessions, a few key themes became the favored discussion topics: the changing dynamic of how we live and the resulting disruption in the real estate industry, the movement of industries into and out of cities, and opportunities for economic and social development were three key topics talked about amongst the panels.

Disruption in the real estate industry

Disruption in the real estate industry, specifically how the historical design and construction of real estate have not kept up with social, technological, and industrial advancements, was a common topic at the event. The convenience of Amazon has changed the way many people live with its easy online shopping experience and lightning-fast shipping service. However, the way real estate has historically been developed is not conducive to this shopping model. Mail boxes have historically been made to only hold standard-size envelopes. This has led to a common suburban scene of Amazon packages piled up high in front of residences. The delivery of packages to other locations, such as lobbies in apartment and office buildings, also illustrates incompatibility; most buildings have not been designed with package holding rooms. The question of who is responsible for the transitory custody of such packages also arises and can create concerns for both landlords and tenants.

Transportation as both a cause and effect of disruption was also discussed at the event. The increasing usage of bicycles in urban settings has impacted city landscapes. The growth of this mode of transportation creates a need for the storage of bicycles. Most urban streets and sidewalks are generally busy with vehicular and pedestrian traffic, removing any potential for the storage of bicycles. Furthermore, historically, buildings have not been designed with bicycle storage in mind.

Other modes of transportation and their effects on cities were also included in the discussions. Rachel Loeb, COO of the NYC Economic Development Corporation (“EDC”), discussed the importance of improving how people move around NYC. Part of her vision includes untapping capacity that already exists but is not fully utilized, for example, reverse commuting is one such opportunity. She stressed that the acts of changing how people move around the city and increasing transportation access also improve the provision of quality jobs and housing for residents at all income levels.

James Wong, executive director with the NYC Ferry Division of the EDC, shared his experience with the ferry system, which has been very successful in improving transportation access for NYC residents. However, he did provide an important reminder regarding the limitations of the system. His largest vessel holds 350 people, the equivalent of only two individual subway cars, and only is able to accommodate riders with service every 20 minutes as compared to the common and expected two minute frequency for subway trains.  While limited as a primary form of transportation for all NYC residents, the ferry clearly has the potential to be a great complementary source of transportation.

Movement of industries into and out of cities

The movement of industries into and out of cities was seen as a driver of real estate economic development and investing activity. Hilary Spann, managing director at the Canada Pension Plan Investment Board, discussed how investments in various markets are driven by the underlying primary industries located in those markets. For example, investments in New York real estate provide investors with exposure to the financial services industry. Therefore, as industries come and go, investing activity could be impacted as well. Ms. Loeb provided the example of Amazon’s interest in Long Island City to demonstrate the growth of new industries in cities. The growth of technology-focused companies in NYC was discussed as leading a shift of the dominant industry in NYC away from financial services. Furthermore, as the availability of talent was a key factor considered by Amazon, the strength of the talent pool in NYC has become more evident than ever. One statistic mentioned during the panel discussion was that NYC residents hold more bachelor of science degrees than residents in Boston, San Francisco, and Washington D.C., combined.

Also discussed was that a key factor driving interest in U.S. real estate, and the underlying industries, continues to be capital from foreign investments. Melissa Román Burch, executive general manager at Lend Lease Americas, discussed how while there may appear to be economic concerns in the U.S., its risk profile from a global perspective continues to make the U.S. look attractive. Ms. Spann also stated that although some may feel that density in areas such as NYC may be overwhelming, it is still far from the density in places such as Sao Paola, Brazil. Due to these factors, Ms. Spann explained that a 6% return in the U.S. should be considered equivalent, if not better than, an 8 - 10% return from another country.

Economic and social improvement opportunities

A recent common topic of discussion in the real estate market, and discussed in detail at the event, is the tax incentive of qualified opportunity zones (“QOZs”) which was created by the recent tax act. Interest in QOZs continues to increase in the real estate market as more details are learned about the mechanical rules that investors must follow for compliance. (You can find detailed information about QOZs here.)

The main goal behind the creation of the QOZ program was the economic and social development of the designated areas. While considering the vast tax benefits that are provided for investments in these zones, prudence and caution was advised by the panelists discussing this topic. Rachel Diller, managing partner at UrbanView Capital, discussed the importance of not using the tax benefits as a key driver of investment decisions. RXR Realty, a developer looking to launch a fund focused on QOZs, was represented by Seth Pinsky, executive vice president, who spoke about the rush of investors looking to make investments in QOZs. Mr. Pinsky discussed how while historically it had been very hard to raise equity for investments in these neighborhoods, the creation of this program has led to continual interest and phone calls from investors stating that they want to make these investments now. With this type of significant interest from investors, Mr. Pinsky described a significant benefit for developers. Specifically, the cost of capital should be lower and this may lead to viable projects in the QOZs.

Challenges currently facing QOZs were also discussed by various panelists. A significant issue that was noted centered on the future exit plan from such investments. One of the current uncertainties in the tax law relates to how an investor can exit from an investment after the ten-year holding period while still realizing all of the benefits offered. As currently written and understood by most professionals, the tax code requires investors to sell their interests in a QOZ fund. The QOZ fund itself would not just be able to sell its underlying assets. The question remains whether Treasury has the authority to fix this with future guidance or whether Congress would need to make changes to the statute. If the disposition of interest method of exit will be required in the future, as compared to the traditional fund exit where all assets are sold and cash is distributed in liquidation, a shift in the fundamentals of real estate fund structuring will occur so that investors looking to exit investments are accommodated.  

Due to the various requirements for compliance with the QOZ program, local and state governments have been looking to assist investors as well as attract them to the designated tracts in their respective areas.  Eric Clement, senior vice president of the Strategic Investments Group of the NYC EDC, discussed a NYC QOZ program which is in progress of being created. This program will aim to assist investors wishing to explore the QOZ program while also considering and taking steps to further the EDC goal of increasing affordable housing. Examples of benefits that such a program may provide would be low-cost financing for projects as well as expedited services that NYC could provide, such as the acceleration of administrative tasks including the permitting process.

While surveying the market and considering the plausibility of participating in QOZ investments, several panelists had observations as to the opportunities in the QOZs. Specifically, two types of QOZs were discussed.

Mr. Pinsky described the first type which consists of areas where economic activity has been challenged, however real estate development activity has already been taking place. This first category has received a lot of attention. Mr. Pinsky noted the demand for real estate is causing values to skyrocket. As a result of this spike in prices, plausible deals may be very limited in this category considering the significant additional investments that are required on top of original purchase prices (i.e., the substantial improvement requirement).

The second type of QOZ was described by Mr. Pinsky as including those areas with significant economic distress with no recent development activity, and was identified as the best opportunity to 1) participate in the QOZ program and 2) achieve success. In these zones, Mr. Pinsky was optimistic that development could work if the cost of capital was right. While the panelists were all enthusiastic about the potential for economic and social development with the QOZ program, there was also a discussion of the need for public help in certain areas. Mr. Pinsky stated that some areas in his second classification group might have governmental issues that are difficult to solve solely by private sector QOZ investments. Likewise, Ms. Diller shared her thoughts on certain areas designated as QOZs which might not be ready for private investment. Rather, she stated that there is a need for the public sector to first provide help to such areas.

Overall real estate outlook

The general sentiment at the event was that while this may be a late inning in the current cycle, key fundamentals are strong and opportunities still exist although the industry is undergoing a period of change. While technological advances have impacted almost every industry, it was noted that real estate has not been an early adopter and historical practices are now experiencing a period of disruption. Likewise, shifts in the tenant makeup within cities has the potential to reshape the definition of the key industries behind local and state economies.

Although the real estate industry is going through a period of rapid change which can have both positive and negative consequences, significant opportunities currently exist with the QOZ program. Through a combination of developers willing to make responsible impact investments and designated QOZ communities that are conducive for private sector development, positive social and economic impacts are possible.

About Michael Torhan

Michael Torhan is a Tax Partner in the Real Estate Services Group. He provides tax compliance and consulting services to clients in the real estate, hospitality, and financial services sectors.

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