The Real Estate guide provides expert legal commentary on the key issues for businesses involved in the real estate sector. The guide covers the important developments in the most significant jurisdictions.
Last Updated May 23, 2019
Sitting at the intersection of supply, demand, liquidity and capital markets, real estate is a barometer of the larger market in many ways. However, although the global economy experienced some significant slowing in the fourth quarter – highlighted by the sharp decline of the United States stock market – 2018 global commercial real estate sales achieved near-record levels, with the United States leading the way. While the outlook for the coming year generally remains positive, the combination of disruptive influencers, global political instability, rising interest rates and ongoing concerns regarding the 10+-year run of the current business cycle creates a growing sense of uncertainty about the future.
Commercial real estate lending remained strong in 2018. Worldwide commercial mortgage-backed securities approached USD90 billion and fourth quarter 2018 loan originations were 14% higher than a year earlier. The cost of capital to borrowers rose as the Federal Reserve increased rates and implemented tighter monetary policy. Yet banks continued to lend.
History suggests, however, that liquidity in the markets will be affected by global political uncertainty. It is hard to imagine a time of greater uncertainty than now – with the original Brexit deadline of 29 March 2019 extended to 31 October 2019 and still no clear path in sight; the upcoming retirement of Angela Merkel, arguably the strongest and most politically stable European leader of the past decade; Russia publishing an updated list of “nuclear targets in the US”; and the roller-coaster ride of the US financial markets in the first quarter of 2019 following the dismal performance of those markets in the fourth quarter of 2018 and the partial shut-down of the US government for 35 days earlier this year. In the past, capital has moved to the sidelines during periods of geopolitical uncertainty. Will the commercial real estate markets react differently in this cycle? The challenges facing the commercial real estate industry are not to be underestimated.
In 2018, the most significant regulatory development for US commercial real estate was the Tax Cuts and Jobs Act (TCJA), adopted at the end of 2017. The legislation had a number of implications for the US and global economies, affecting capital formation, allocation and investment decisions.
During 2018, many US real estate investors focused on the TCJA’s Opportunity Zone (OZ) provisions. The OZ legislation creates special incentives to attract capital investment to low-income communities designated as opportunity zones throughout the US, including Puerto Rico, where virtually the entire island is eligible for OZ investment. The programme provides investors two significant tax benefits: first, deferring and reducing – by up to 15% – capital gains generated from sales of all asset classes (ie, not limited to real estate) by reinvesting those proceeds in new development and substantial renovation projects in opportunity zones; second and more significantly, an investor will pay no federal income tax on gains realised from selling the investment in an OZ project if the investor has held the OZ investment for at least ten years. Although the programme is not limited to reinvestment in real estate, to date almost all deal activity has been focused on real estate projects because of uncertainties in interpretation of the OZ legislation. The IRS issued the much-anticipated second set of proposed OZ regulations on 17 April 2019. While not every question has been answered, it is clear that the US Treasury has thrown its full weight behind delivering taxpayer-favourable rules and guidance to promote the success of the OZ programme. The expectation is that funds will soon begin flowing into OZ deals.
2019 also marks the first year that the new lease accounting procedures adopted by the Financial Accounting Standards Board (FASB) require certain US businesses to disclose lease obligations for real estate and other major assets directly on the balance sheets. The new FASB rules are designed to ensure transparency and end off-balance sheet accounting for major liabilities. According to FASB, the world will add USD2 trillion of debt to company balance sheets over a five-year period. The new regulations affect how real estate is accounted for, potentially resulting in a shift to shorter lease terms and impacting lease-versus-buy decisions. With the new FASB rules in place, companies will need to recast accounting treatment of lease obligations, as well as review their bank covenants. These changes are expected to have a wide impact on both lessees and lessors.
Notwithstanding the regulatory changes of the past several years that affected debt capital providers (eg, Basel III and Dodd-Frank) and the increase in interest rates implemented by the US Federal Reserve Board during 2018, public REITs, pension funds, sovereign wealth funds and other capital providers have remained active investors in both US and global real estate. In addition to direct real estate investments, the increased sophistication of the capital market providers has brought more money into varying aspects of real estate debt, through CMBS as well as traditional and non-traditional (shadow bank) lenders. Although some traditional players are exiting the business, others continue to invest in real estate as a safe and secure vehicle that also diversifies their investment portfolios.
Foreign capital continues to be drawn to CRE investments in the US and other markets for many reasons, including predictability of cash flows, transparency of market information, relative downside risk protection and liquidity. While outbound China investment in US real estate dropped to its lowest level since 2012, due to the restrictions adopted by China's State Council in 2017 and the simmering trade tensions between the US and China, Asia investment dollars – led by Singapore, with strong support from Korea and Malaysia – remained strong throughout the year. In addition, Canadian investors and other international players remained very active. Commercial real estate sales worldwide in 2018 recorded the second-highest level since the Global Financial Crisis with US commercial real estate sales increasing by 12.6% (before taking into account the 83% spike in M&A activity in the CRE sector), helping to nudge up global acquisitions of income-producing property by 3% compared with 2017. However, the market has turned more bearish in the first quarter of 2019, with one recent prediction of a 5-10% fall in global CRE direct investment in 2019.
Dynamic Shifts in CRE
There can be little doubt that CRE markets, like most of the rest of the world, are in a dynamic state of disruption driven by rapid technological evolution, innovation and easy access to capital. Growth around the world of co-working spaces continues to dominate numerous major office markets where co-working providers have become the dominant tenants (including New York and London), helping to drive gross office absorption in 96 global markets to its highest level since 2007. Is co-working a permanent paradigm shift in the way people live and work? If so, what are the implications for future office development? How will traditional capital providers underwrite short-term lease commitments from many users? Will the overall demand for office space be reduced by the availability of co-working spaces, not only in traditional office buildings but also in hotels, multi-family and even retail locations? Have we entered a new era where business owners will approach facilities management with a transformed view of long-term commitments and expenditure of funds for build-out of tenant spaces?
In addition to the challenges in the office sector from co-working spaces, developers of both office and multi-family properties, together with urban planners and local land-use regulators, are working to understand the impact of autonomous vehicles coupled with the meteoric growth of ride-sharing services. Re-purposing existing parking garages, as well as designing the buildings of the future with – or without – traditional parking facilities, are among the most significant issues being considered by forward-looking owners, developers and investors.
Retail real estate continues to face the greatest challenges. Traditional brick and mortar retailers must adapt and innovate to survive, adopting omni-channel distribution strategies to compete with the dominant e-commerce providers. Regional malls must continue to adapt as 30-year operating covenants for anchor department stores expire, making repositioning strategies critical. Bankruptcies by major retailers such as Sears and Toys “R” Us, coupled with continued closings and retrenchments by other retailers, have created both challenges and opportunities in the US retail real estate market.
Finally, while the multifamily and logistics sectors continue to attract the most attention, the importance of demographic shifts and infrastructure investment cannot be ignored. The world’s population is growing and the great demographic shift from rural to urban, 18- and 24-hour mega-cities is unceasing. These factors, plus the aging of extant infrastructure, globalisation of supply chains and changing technology are creating sweeping opportunities for the public and private sectors. Indeed, these changing demographics demand increasing investment in infrastructure, virtually everywhere in the world – a major investment opportunity of possibly as much as USD9 trillion by 2025.
Real estate is subjected to extreme differences in legal, regulatory and tax matters across the globe, and this brief overview highlights only some of the most significant issues. In the end, real estate remains local by nature and, as a result, it is of utmost importance to consult with local counsel and other expert advisers in each jurisdiction where an investment will be made.