Economic Turbulence Ahead? Global Reits Confident They’ll Weather the Storm

By Stuart Eisenberg, national leader of BDO’s Real Estate & Construction practice

“What goes up, must come down.” That familiar refrain echoes in the back of economists’ mind every time the Dow soars to new record-breaking heights, a quasi-regular occurrence last year. After more than 70 record closes in 2017, the markets fell in early February and major indices posted their worst weekly declines in more than two years. REITs declined in tandem, with the FTSE Nareit All Equity REITs Index hitting its lowest level in 14 months.

Steep declines were short-lived, and the market started posting gains within the week. While indexes bucked the downturn in the immediate term, the dip is expected to usher in a period of increased volatility to an uncharacteristically calm market.

The culprit for the sudden drop? A culmination of economic factors stirred the pot with two core concerns bubbling to the surface: interest rates and inflation. Tax cuts, a plan for increased federal spending, and strong monthly wage growth in January reported by the U.S. Bureau of Labor Department stoked investors’ inflation anxieties. The 10-year Treasury note—an important indicator for the market—also reached a four-year high of 2.88 percent.

In an environment with newly-ignited market jitters, what is the overall sentiment for REITs? Data suggests that the global real estate market could be reaching the end of its upward climb as well. More than two-thirds of global REIT executives (68 percent) felt that the real estate cycle in their market was at or past its peak, according to the BDO Global REIT Report. The recently published report takes the pulse of the international REIT landscape, surveying 35 REIT executives at companies with a combined market capitalization of $130 billion.

Continued low yields for prime assets and interest rate concerns are likely contributing to the expectation that real estate is reaching its peak. Two-thirds of the global respondents said the movement of interest rates would have the greatest short-term impact on REITs. The U.S. Federal Reserve forecasted three gradual rate increases throughout the remainder of the year.

Interest rate increases are almost always a double-edged sword for REITs. The potential negatives include steeper financing costs and depreciation of real estate values. Rising rates can also lead investors to reallocate their shares to bonds and other assets whose returns see a bump with increased rates. In response to the market movement and expected rate increases, some publicly-traded REITs have started refinancing debt and taking other measures to reduce their exposure.

Conversely, the Federal Reserve sets interest rate programs based on the overall health of the economy and rate increases suggest renewed economic confidence. An environment of strong economic fundamentals is overwhelmingly positive for REITs, leading to increased rents and occupancy rates that could offset the negatives.

Despite a consensus that the good times can’t keep rolling forever, 87 percent of REIT executives expressed confidence in their business prospects and ability to meet any challenges or market shifts head on. REITs have demonstrated steady growth over the last decade. According to NAREIT, the sector’s market capitalization more than tripled in that span, reaching $1 trillion. Nearly half of the global REIT executives (46 percent) expect continued growth in the next two years.

The bottom line for the industry? Come what may, REITs are ready.

The Potential Impacts of Tax Reform to Reits and Real Estate & Construction Companies

On December 22, President Trump signed the tax reform bill, “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018,” into law, marking the largest change to U.S. tax policy since the 1980s.

With most of the provisions already in effect, it’s important that real estate and construction executives review the changes that occurred during the conference process to understand the impact to their companies.

To help them navigate the key provisions affecting the real estate and construction industries, we’ve summarized the top considerations and implications below.

PROVISION SUMMARY OF CHANGES IMPLICATIONS FOR REAL ESTATE AND CONSTRUCTION COMPANIES IMPLICATIONS FOR REITS
Reduce the corporate tax rate Reduces the top corporate tax rate from 35 to 21%.

Effective date: Effective for taxable years after Dec. 31, 2017.

Industry View: Positive

What’s at stake: Reduced tax burden for real estate and construction companies.

Industry View: Positive

What’s at stake: REITs won’t see direct tax relief, but REITs that have taxable REIT subsidiaries (TRS) will see a positive impact.

Lower Taxes on Pass-Through Business Income Creates a deduction available to pass-through filers of 20% on pass-through income subject to certain limitations. This includes “qualified real estate investment dividends.” Qualified REIT dividends do not include any portion of a dividend to which capital gain tax rates are applied. Industry View: Positive

What’s at stake: Reduced tax burden for real estate and construction companies structured as pass-through entities. This is a big win for real estate.

Industry View: Positive

What’s at stake: Reduces the overall effective tax rate on REIT dividends received by individuals.

Changes to the Depreciation of Commercial Assets Eliminates the separate definitions of qualified leasehold improvement, qualified restaurant, and qualified retail improvement property, and provides a general 15-year recovery period for qualified improvement property, unchanged from current law. Depreciable life of commercial assets is unchanged from current law.

Retains the existing 40-year alternative depreciation system (ADS) cost recovery period for nonresidential real property, but would contain a reduced 30-year ADS period for residential property and a 20-year ADS period for qualified property improvement.

Expands bonus depreciation for new qualified property investments to 100% from 50%. Applies to both new and used property.

Effective date: Effective for property placed in service

Industry View:  Positive-to-Neutral

What’s at stake: The impact of this provision differs based on a real estate company’s cost recovery structures.

The change is positive for real estate companies that rely on full expensing for personal property and new qualified improvement property with a 15-year recovery period and bonus depreciation.

For real estate companies with cost recovery structures under regular depreciation, this change is neutral.

Taxpayers that have elected to use the real property trade or business exception to the interest limitation would be required to use the longer ADS periods for depreciation.

Additionally, if the property is depreciated under ADS, it is not eligible for a bonus.

Industry View: Positive-to-Neutral

What’s at stake: Since REITs are limited in the amount of tangible personal property owned, the expensing for equipment is not a huge win for REITs. Furthermore, REITs generally elect ADS for tax depreciation purposes, so it would continue to depreciate over the longer lives, with the exception of REITs that hold residential property.

REITs that have elected to use the real property trade or business exception to the interest limitation would be required to use the longer ADS periods for depreciation and would not be eligible for the bonus.

There is no real impact from bonus depreciation as REITs generally elect out of bonus depreciation.

Expansion of Section 179 deduction Expands the definition of qualified real property to include improvements to nonresidential real property including roofs, heating, ventilation, air conditioning, fire protection, alarm systems, and security systems.

Increases the amount companies can deduct in purchases from the current ceiling of $510,000 to $1 million and increases the phase out threshold to $2.5 million.

Industry View: Positive

What’s at stake: Eases the tax burden of financing property improvements.

Industry View: Neutral

There is no real impact from the increased Section 179 deduction as REITs generally do not elect Section 179 expensing.

Limitations on Interest Deductibility Revises Section 163(j) and expands its applicability to every business, including partnerships. Generally, caps deduction of interest expense to interest income plus 30% of adjusted taxable income, which is computed without regard to deductions allowable for depreciation, amortization, or depletion. Disallowed interest is carried forward indefinitely. Contains a small business exception.

Effective date: Effective for taxable years after Dec. 31, 2017.

Industry View: Neutral

What’s at stake: Real property trades or businesses are allowed to elect out of the limitation since they do not benefit from full expensing provided to tangible personal property.

Generally, any real property trade or business, including ones conducted by widely-held corporations and REITs, may be considered real property trades or business. Taxpayers electing to use the real property trade or business exception to the limitation on interest deductibility would be required to use ADS methods for depreciation for residential, nonresidential, and qualified improvement property.

Industry View: Neutral

What’s at stake:  Consistent with the impact to real estate and construction companies. The limitation would not generally apply to REITs to the extent that they elect out.

Eliminate ability to carryback Net Operating Losses (NOLs) Generally, eliminates taxpayers’ abilities to carryback NOLs, and will limit the use of NOLs to 80% of taxable income. NOLs will no longer have an expiration period.

Effective date: The elimination of carrybacks is effective in taxable years after Dec. 31, 2017.

Industry View: Negative

What’s at stake: Potential cash flow obstacle.

Industry View: Neutral-to-Negative

What’s at stake: REITS are not taxpaying entities and most likely would only have NOL carryforwards if they have historically been operating at a loss. For REITs that have been historically operating at a loss, this provision would have a negative impact.

Limit 1031 “like-kind” exchanges to real property Eliminates the exemption for like-kind exchanges except for real property.

Effective date: Effective for taxable years after Dec. 31, 2017.

An exception is provided if the property in the exchange is disposed of or received by the taxpayer on or before December 31, 2017.

Industry View: Neutral-to-Negative

What’s at stake: No material impact for straight real estate sales or replacements such as land for land. However, many transactions involve multi-asset exchanges where a taxpayer sells both real and personal property. Without the deferral for personal property, taxpayers are more likely to recognize some amount of taxable gain. This will put pressure on the allocation of purchase price to minimize potential taxable gain. Additionally, taxpayers may avoid an exchange depending on the amount of recognized taxable gain attributable to personal property.

Industry View: Neutral-to-Negative

What’s at stake: Same challenges with multi-asset exchanges.

Limits Mortgage & Property Tax Deductions Under current law, taxpayers can take a combined acquisition and home equity indebtedness interest expense deduction on $1,100,000 of debt. The new legislation only permits the deduction of interest on acquisition indebtedness not exceeding $750,000 and repeals the additional interest deduction for home equity indebtedness through 2025.

Effective date: Effective for taxable years after Dec. 31, 2017.

Debt incurred on or before Dec. 15, 2017, is grandfathered into the limitations under current law. Taxpayers who entered into a written binding contract before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, and who purchase such residence before April 1, 2018, are also eligible for the current higher limitations.

Industry View:Neutral-to-Positive

What’s at stake:For commercial real estate and construction companies, this could be a positive in the long term. The limited deductions could reduce the attractiveness of homeownership, which could lead to increased demand for single and multifamily rentals.

However, homebuilders and residential land developers may see a reduction in demand.

Industry View:Neutral-to-Positive

What’s at stake:For REITs that hold multifamily rental properties, this could be a positive in the long term. The limited deductions could reduce the attractiveness of homeownership, which could lead to increased demand for single and multifamily rentals.

Scale Back the State and Local Tax Deduction for Individuals Limits the itemized deduction for state and local taxes to $10,000 for the aggregate sum of real property taxes, personal property taxes, and either state or local income taxes or state and local sales tax. Currently, each of those state and local taxes is a separate itemized deduction with no limitation.

Effective date: The bill prohibits a deduction in excess of the $10,000 limitation for 2018 state and local taxes actually paid in 2017.

Industry View: Neutral-to-Positive

What’s at stake: Similar to the above, could reduce the attractiveness of homeownership in high-tax states, which could lead to increased demand for single and multifamily rentals in those areas.

However, homebuilders and residential land developers may see a reduction in demand.

Industry View: Neutral-to-Positive

What’s at stake:  Similar to the above, could reduce the attractiveness of homeownership in high-tax states, which could lead to increased demand for single and multifamily rentals in those areas—a boon to REITs in the multifamily rental space.

Carried Interest Changes Carry from investments held for under three years will be taxed at the higher ordinary income rate rather than the lower capital gains rate. Previously, the threshold was one year. The capital gains tax rate was kept as is, at a maximum of 20%.

Effective date: Effective for taxable years after Dec. 31, 2017.

Industry View: Negative

What’s at stake: This would potentially have a negative impact for service partners of real estate investment funds that sell property that has less than a three-year holding period or service partners who sell their partnership interest without holding it more than three years.

Industry View: Negative-to-Neutral

What’s at stake: This would potentially have a negative impact on service partners of REIT’s lower tier partnerships. However, it would likely not affect the REIT itself as corporations are not subject to this provision.

Expansion of Cash Method of Accounting Raises the average annual gross receipts threshold from $5 million to $25 million for C corporations, partnerships with a C corporation partner, or a tax-exempt trust or corporation with unrelated business income, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor.

Effective date: Effective for taxable years after Dec. 31, 2017.

Industry View: Positive

What’s at stake: Reduced tax and recordkeeping burden for smaller real estate and construction companies.

Industry View: Positive

What’s at stake: This provision is unlikely to affect REITs since most REITs would still likely be over the increased threshold limits. However, smaller private REITs may see reduced tax and recordkeeping burdens from this provision.

Expansion of Exemption from Percentage-of-Completion Method (PCM) Raises the average annual gross receipts threshold from $10 million to $25 million to exempt small construction contracts from the requirement to use the PCM.  Contracts within this exception are those contracts for the construction or improvement of real property if the contract: (1) is expected to be completed within 2 years of contract commencement and (2) is performed by a taxpayer who meets the $25 million gross receipts test.

Effective date: Effective for taxable years after Dec. 31, 2017.

Industry View: Positive

What’s at stake: Reduced tax and recordkeeping burden for smaller real estate and construction companies. Increased ability to use completed contract method, exempt-contract percentage-of-completion method, or any other permissible method.

Industry View: Neutral

What’s at stake:  This provision is unlikely to affect REITs, since REITs generally don’t enter into long-term contracts due to restrictions on the type of income they can generate. However, REITs that have taxable REIT subsidiaries (TRS) that do enter into long-term contracts could potentially benefit from this provision.

Exemption from Requirement to Keep Inventory Exempts taxpayers that meet the $25 million average annual gross receipts threshold from the requirement to account for inventories under Section 471. Those taxpayers may use a method of accounting for inventories that either (1) treats inventories as non-incidental materials and supplies or (2) conforms to the taxpayer’s financial accounting treatment of inventories.

Effective date: Effective for taxable years after Dec. 31, 2017.

Industry View: Neutral-to-Positive

What’s at stake: Most real estate companies don’t generally have inventories. However, certain segments such as hospitality have limited inventories and may see reduced tax and recordkeeping burden as a result of this provision.

Industry View: Neutral

What’s at stake:  This provision is unlikely to affect REITs since REITs generally don’t carry inventory due to restrictions on the type of income they can generate. However, REITs that have taxable REIT subsidiaries (TRS) that do have inventory could potentially benefit from this provision.

Expansion of Exemption from Uniform Capitalization Rules (UNICAP) Raises the average annual gross receipts threshold from $10 million to $25 million for any resellers (as well as producers) to be exempted from the application of UNICAP under Section 263A.

Effective date: Effective for taxable years after Dec. 31, 2017.

Industry View: Positive

What’s at stake: Reduced tax and recordkeeping burden for smaller real estate and construction companies.

Industry View: Neutral

What’s at stake: This provision is unlikely to affect REITs since most REITs would still likely be over the increased threshold limits.  However, smaller private REITs may see reduced tax and recordkeeping burdens from this provision.

Tackling Tax Reform: 5 Initial Steps Companies Can Take Now

  1. Assess impact. Tax professionals will likely need to review the bill text manually and measure their company’s specific circumstances against it to assess the impact of each provision, as well as the holistic effect on their company’s bottom line.
  2. Assemble a team. While the heaviest burden may fall on accountants, companies and their finance teams will have an important role to play to gather all the necessary data.
  3. Dig into the data. Assessing the impact of tax reform requires a substantial amount of data to be readily available. Companies need to move from modeling the impact of tax reform to focusing on data collection and computations as soon as possible.
  4. Establish priorities. When considering which aspects of tax reform to tackle first, focus on the areas that could have the greatest impact on your company. For REITs, real estate and construction companies, landmark provisions include: changes that could influence entity choice (reduced corporate tax rates and lower taxes on pass-through business income) and the elimination of NOL carrybacks. As a preliminary step, taxpayers operating in the real estate and construction industries should consider their overall choice of entity to minimize tax liabilities under the new law.
  5. Initiate tax reform conversations with your tax advisor. Tax reform of this magnitude is the biggest change we’ve seen in a generation, and will require intense focus to understand not only how the changes apply at a federal level, but also navigate the ripple effect this is likely to have on state taxation as well.

This article originally appeared in BDO USA, LLP’s “BDO Real Estate and Construction Monitor” (Summer 2018). Copyright © 2018 BDO USA, LLP. All rights reserved. www.bdo.com

How Tax Reform Will Impact Construction

By Maureen McGetrick

Every type of industry is impacted by the passing of the bill known as the Tax Cuts and Jobs Act (TCJA), and the construction industry was not left out of the party.

However, the precise impact will depend upon the structure of the business and the nature of its operations. For construction businesses organized as C corporations, the most significant changes are the reduction in the corporate tax rate, the 100-percent bonus depreciation deduction, the elimination of the corporate AMT, modifications of rules for use of certain accounting methods, and the limitations on interest expense deductions. A number of these items also impact construction companies organized as pass-through entities, either S corporations or Limited Liability Corporations taxed as partnerships (including General Partnerships, Limited Partnerships or Limited Liability Partnerships), but there are also considerations specific to flow-through structures, including the applicability of the deduction for qualified business income, also referred to as the Section 199A deduction. This article focuses on a high-level discussion of the important considerations construction companies should focus on in the wake of tax reform.

Choice of Entity

Given the wide sweeping changes to both the corporate and individual tax systems brought on by the TCJA, it’s an opportune time for construction businesses to reconsider the tax structure chosen for the business, especially since construction businesses tend to be closely held and therefore organized as flow-through entities. This can be a complex analysis, and would largely be driven by determining the net effective rate as a C corporation versus the rate as a pass-through entity, which will be influenced by many factors including:

• The state(s) in which the corporation does business (i.e. state effective rate);
• Whether the owners materially participate in the business;
• The level of compensation paid or required to be paid to any owners who provide services to the business to ensure reasonable amount of compensation;
• Whether the entity makes distributions or profits regularly, or whether it would prefer to accumulate profits to grow the business;
• Whether there is a planned exit from the business in the near future;
• Whether the business has any international operations; and
• Whether the business would be eligible for the 199A deduction (discussed below in more detail).

Other factors should be considered in the choice of entity analysis as well, including legal implications and the associated compliance costs of each structure.

199A Deduction

The TCJA provides a 20-percent deduction for pass-through entities which generate “qualified business income,” subject to certain limitations. Qualified business income is generally active income from a qualified trade or business (this definition generally excludes investment income as well as any income for personal services provided by an owner or shareholder). A qualified trade or business is typically defined as any trade or business other than a specified service business which includes the following industries: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investment management, and brokerage services. There is also a broad category included in the definition of trade or business that applies to any business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. Architecture and engineering were specifically excluded from the qualified trade or business definition. There is much uncertainty around these definitions, and the practitioner community has requested guidance from the IRS and Treasury on these items quickly given that these changes will apply for 2018.

While most construction businesses might seem to fall within the definition of a qualified trade or business, it is uncertain how the law will be interpreted at this point. Assuming that you get over the hurdle for a qualified trade or business, the deduction for qualified business income will be limited to the greater of either: 1) 50 percent of W-2 wages with respect to the trade or business, or 2) 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis of qualified property. Qualified business property would generally include assets held at the end of the year, used in the trade or business during the year, and for which the depreciable period has not ended. The depreciable period is the later of 10 years from the original placed in service date or the last day of the last full year in the recovery period under Section 168.

Assuming a construction business is eligible for the 199A deduction, it could reduce the top federal rate on business income from 37 to 29.6 percent, therefore making a pass-through structure an attractive alternative. However, companies must first evaluate the many planning considerations as summarized above to understand the full impact of tax reform on their business.

This article originally appeared in BDO USA, LLP’s “BDO Knows Alert: Real Estate and Construction” (April 2018). Copyright © 2018 BDO USA, LLP. All rights reserved. www.bdo.com

Contractors, Don’t Wait to Act on Revenue Recognition

By Jody Hillenbrand and Luis Torres

Jan. 1, 2019, is quickly approaching. For most privately held construction companies, this is the implementation deadline for the new revenue recognition standard, Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers. The time to act is now, especially for contractors with projects lasting over 12 months. A contract that starts now, but extends into 2019, will be subject to the new standard.

In discussing the implementation with many people in the industry, the responses range from “Can’t you just tell me what to do?” to “I just need to write a memo; we’re not changing anything.” Why is there such disparity in responses regarding the implementation of an accounting standard? In the U.S., there’s an expectation of specific, rules-based authoritative guidance from the Financial Accounting Standards Board (FASB). As we move toward convergence with international standards, the change from rules-based to principals-based guidance means there won’t always be black-and-white answers. Under ASC 606, there’s the potential that two companies could account for similar contracts differently—but both appropriately. This could cause significant issues with sureties and bankers, who have grown accustomed to percentage-of-completion accounting under the previous guidance, which has been consistent for 35 years.

What do contractors need to do NOW to make sure they are ready to implement the standard?

  1. Assemble your team. While revenue recognition is inherently an accounting topic, this evaluation will need to involve owners, accounting personnel, project managers and anyone else familiar with the company’s contracts.
  2. Identify whether a contract exists. Under ASC 606, a key step in the evaluation process is to identify the contract. Fortunately, the construction environment tends to make the identification of when a contract exists fairly clear.
  3. Take an inventory of contracts. Once the team has been identified, one of its first tasks is taking an inventory of contracts and segregating them by type. There are several issues that impact a contractor’s determination of when it has a contract. For master service agreements, job order contracts and other similar contracts, careful evaluation will need to be made to ensure all five criteria to account for a contract under ASC 606 are met. This is why the inventory of contracts is such an important process. It is the foundation of the evaluation for accounting under ASC 606.
  4. Evaluate contracts. Once the inventory is complete, a representative sample of contracts by type should be evaluated regarding implementation issues. Consideration should be made for multiple performance obligations (especially for master service agreements), uninstalled materials, termination clauses, warranties, liens, change orders and any other nuances that impact costs, collection and delivery of service.
  5. Evaluate impact on internal controls. In addition to accounting implementation issues, the impact on systems, internal controls over financial reporting and operations should also be evaluated.
  6. Engage software providers in the conversation. Software that was sufficient under the previous standard may not provide adequate information under the new standard. Contact with software providers early in the planning process is important to clarify system controls versus manual controls.
  7. Consider the potential tax implications now. In addition to the impact on book reporting and internal controls, there are many potentially significant tax implications that companies should consider up front. Because the new standard not only impacts how revenue is recognized, but also potentially when it is recognized, there are significant changes to book rules that may require your organization to put in place new data collection and retention policies to substantiate tax changes.

Possible tax implications could include:

  • Tax accounting method changes
  • Book-tax differences
  • Cash taxes
  • Accounting for income taxes (ASC 740): Deferred taxes, current/non-current taxes payable—at adoption/prospective
  • Federal, state, indirect and foreign taxes
  • Transfer pricing

What are the core differences between the new revenue recognition standard and the old?

Revenue will be recognized based on transfer of control:

Under ASC 606, we move from a model where revenue was recognized based on transfer of risks and rewards to a model where revenue will be recognized based on transfer of control. While this may result in many construction contracts being recognized in a pattern similar to percentage-of-completion, there are certain differentiating factors to consider. Revenue may now be recognized either over time or at a point in time. First, a contractor must determine if revenue for a contract must be recognized over time. To qualify, one of the following criteria must be met:

  1. The customer simultaneously receives and consumes all of the benefits,
  2. The entity’s work creates or enhances an asset controlled by the customer, or
  3. The entity’s performance does not create an asset with alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.

If none of these criteria are met, revenue will be recognized at a point in time. In some cases where the first two criteria are not met and it was believed that the third criteria would be met, upon further review of the contract terms it is not clear that the contractor has an enforceable right to payment. This has been the case with certain government contracts. If the contractor and legal counsel can’t support that there is an enforceable right, revenue for these contracts will have to be recognized at a point in time, which will be a significant change. Careful review of contracts and their terms is necessary and it’s best to do this well in advance of date of adoption.

Changes related to measuring performance:

Once a contractor concludes that recognition over time is appropriate, the method of measuring performance should be determined. Both output methods (surveys, appraisals of results, milestones, etc.) and input methods (labor hours, costs incurred, time, etc.) can be used to measure performance. Currently, under percentage-of-completion, the “cost-to-cost” method of measuring completion on a project is the most commonly used, which is similar to one of the input methods permitted under ASC 606. However, costs such as pre-contract costs, uninstalled materials and cost overruns from inefficiencies or re-work may be treated differently. These changes can shift when revenue is recognized during the project.

New guidance on the treatment of precontract costs:

Under current GAAP, contractors can capitalize precontract costs as long as recovery is probable. Once the contract is awarded, the costs are allocated to the project and are included in costs in evaluating percentage-of-completion. Under ASC 606, these same costs, along with mobilization costs, may be required to be capitalized and then amortized over the life of the contract as the performance obligation is satisfied. This will create another level of monthly adjustment to contract costs and a deferral of the incremental profit recognition.

Changes to accounting for uninstalled materials:

Currently, there is diversity in practice for how to account for uninstalled materials, which for many contracts can be significant and can greatly affect when revenue is recognized when a cost-to-cost method is applied. The new standard asserts that there may not be a direct relationship between these costs and the satisfaction of the contractor’s performance obligation. As a result, revenue may be recognized only up to the cost on uninstalled materials, but the incremental profit related to those costs will be deferred until the equipment is installed and the applicable costs will be excluded from the cost-to-cost calculation. This will result in timing differences in profit recognition.

In addition, for contractors recording percentage-of-completion adjustments monthly under cost-to-cost, there will need to be a two-part evaluation on revenue recognition for installed and uninstalled costs. Judgment will be required to determine how to treat the related costs in the cost-to-cost model after installation (e.g., should the costs be added back or excluded for the full length of the contract?) For many contractors, tracking this data will be a big change and conversations with software providers should be happening soon.

Increased disclosure requirements:

The new standard will require the gathering of information in new and different ways, which could be time-intensive to implement initially.  Remember that even if the timing of revenue recognition is not materially changed from current reporting, the new standard requires much more robust disclosures, even for private companies. Many contractors will have to change their processes and controls over contracts and job costs. Accounting departments will need greater understanding of the underlying contracts, including when the sales teams make modifications to the standard contract clauses.

With these complex considerations in mind, there is no time to waste. Contractors that haven’t started the process of implementing revenue recognition yet are already behind.

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Winter 2018). Copyright © 2018 BDO USA, LLP. All rights reserved. www.bdo.com

What WeWork’s Jump Into Retail Means For Reits

by Stuart Eisenberg

While lots of eyes and attention remain fixed on 2017’s string of retail bankruptcies and the growth of “clicks-to-bricks” retailers, WeWork may be quietly laying the foundation for a broader move into retail real estate.

There certainly appears to be no shortage of funding momentum for the $26 billion startup, following a $4.4 billion commitment from the SoftBank Vision Fund in August that is expected to fuel global expansion.

And REITs should be watching—WeWork’s model for expansion could disrupt not only office REITs, but REITs across some unexpected sectors.

Underscoring the company’s interest in potentially extending its business model into the retail space, The Wall Street Journal reported that WeWork Property Advisors would get a seat on the Hudson’s Bay Co.’s (HBC) board after WeWork and its private equity partner Rhone Group acquired the Lord & Taylor building in midtown Manhattan from HBC in October. It has also been reported that WeWork principals have invested in a retail technology startup and that several of the real estate company’s recent hires hail from an online electronics retailer.

Behind the Lord & Taylor Buy

One factor that makes the Lord & Taylor deal notable is the $850 million price tag. The property sold for 30 percent more than its appraised value last year. While the property’s location likely partially contributed to the deal value, it’s no secret that there’s a greater demand for spaces that can be converted to alternative uses, and the building’s flexibility might have also driven up the price. This suggests REITs that own buildings that can be readily converted to alternative use could see a bump in valuation based on an assumption that the highest and best use value exceeds the value based on the existing use. Retailers with flexible space in prime markets, where demand remains high, are likely to see the greatest benefit.

This trend isn’t limited to retail, though. On the hospitality front, WeWork has experimented with nightly rentals in its co-living space in lower Manhattan. During a recent panel at the Urban Land Institute fall meeting moderated by WeWork’s Liz Burow, several industry leaders pointed to the growing emphasis on short-term lease arrangements across industries. Panelists noted that space flexibility is now playing a key role in growth trajectory for many types of companies, with flexible lease terms allowing for the development of new groups within a company and greater experimentation with short-term projects.

Adaptability is the name of the game for a huge variety of tenants—think retailers, food pop-ups and boutique hotels, but also health care providers, as the care continuum expands far outside the walls of traditional hospitals. For REITs, this means potentially baking in greater flexibility to lease-term length in sectors beyond offices, and further blurring the lines in large mixed-use spaces. These changes could have significant implications for REITs’ maintenance and property management needs, as well.

When it comes to the co-everything movement, We(will be) Watching.

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Winter 2018). Copyright © 2018 BDO USA, LLP. All rights reserved. www.bdo.com

How Low Can You Go? CMBS Market In Limbo

By Stuart Eisenberg

A mountain of maturing CMBS loans hung overhead at the start of 2017, with legacy loans issued during the heart of the lending boom set to come due. An estimated $65.5 billion in CMBS debt reached maturity in the first half of the year and an additional $17.04 billion is expected to mature before year’s end, according to Trepp and Morningstar.

Despite early anxieties about the influx of maturing CMBS loans, the commercial real estate markets demonstrated resilience in the first half of the year. Delinquencies increased, but at lower rates than anticipated. In June, the delinquency rate rose 28 basis points to hit 5.75 percent, according to Trepp’s June CMBS Delinquency Report.

Midway through 2017, rising delinquency rates are no longer the chief concern. Instead, the CMBS market worries about the sustained slowdown in issuances. U.S. CMBS loans totaling $55.4 billion were issued through August and the market is expected to end the year with more than $70 billion issuances. While the forecast annual total is on pace to surpass 2016 numbers, it is far below historical levels. At the height of the CMBS market in 2007, Commercial Mortgage Alert reports a total of $228.56 billion loans were issued.

WHAT’S CAUSING THE SLOWDOWN?

The Dodd-Frank risk retention rules that went into effect last December are a contributing factor to the subdued state of the CMBS market. Under that regulation, lenders—or a third-party—are required to keep 5 percent of securities created in a transaction on their books for a period of 10 years. For lenders, this capital requirement poses a considerable barrier to increasing the volume of CMBS originations.
Shifting investor interest is also contributing to the slowdown. The CMBS market all but halted during the recession, as investors pulled out of the securities. While confidence in CMBS has recovered considerably, investors are still buying CMBS loans at less aggressive rates.

PRIVATE EQUITY, REITS & OTHER ALTERNATIVE LENDERS FILL THE GAP

CMBS accounted for about 23 percent of the trillion-dollar loan market at its height, but currently holds a 16 percent share, according to Trepp. During a year where CMBS loans reached maturity at such a rapid clip, the low issuance rate is even more striking.

In addition to traditional balance sheet lenders, alternative lenders, including private equity firms and REITs, which are not subject to risk retention rules, are increasingly stepping in to fund commercial real estate loans. Alternative lenders’ presence in the debt markets is not new, but is poised to grow and is likely to be at the expense of CMBS’s market share.

WHAT LIES AHEAD FOR CMBS?

The dynamics of the debt market are shifting, creating more channels for borrowers to obtain funds. While CMBS issuers appear to have addressed many of the regulatory concerns, they now find themselves facing a new hurdle: increased competition. As many new players provide financing, including first mortgage loans, mezzanine loans and bridge loans, CMBS issuers could see their slice of the debt financing pie shrink.

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Fall 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

Sustainability In Real Estate: Is It Easy To Be Green?

By Sebastian Stevens and Sjoerd Hubregtse

With sustainability a key trend in real estate and construction, BDO International asks, what are the key drivers of this trend, and what are the results?

Every year seems to bring with it more news of natural disasters around the world: hurricanes, forest fires, flooding and typhoons to name a few. Trump’s recent decision to back out of the Paris climate accord was swiftly followed by massive floods in the state of Missouri, so the battle against climate change is certainly a hot-button issue. In the global real estate and construction (REC) sector, green targets and environmental policies have far-reaching impact on the world around us and sustainability remains a key trend, worldwide.

Although sustainable or neutral building is widespread, the end results differ from country to country, driven often by profitability and the availability of space. It is easier and cheaper to build a new energy-efficient building than it is to retrofit an old one. In the U.S. or Australia, space is an accessible commodity but, in Europe, space is at a premium, particularly in its ancient cities.

Moreover, it is the older buildings that are often the root of environmental damage. In the U.K., for example, commercial properties account for 18 percent of the country’s carbon emissions. And by 2050, roughly six out of 10 commercial buildings will be more than 40 years old, according to research from the Building Research Establishment. In order to meet green targets, older buildings must be retrofitted, yet this will come with a significant cost.

Environmental Legislation

In order to combat global warming, EU-member countries have taken on binding national targets, with the goal of increasing production and use of renewable energy by 2020. These measures have had considerable impact on the REC sector. In the Netherlands, the Dutch government has sought to encourage the production of renewable energy, and the reduction of energy consumption, by subsidizing and giving tax benefits to those that opt for renewable energy.

Although the share of renewable energy has increased significantly, the Netherlands has yet to meet its 2020 goals. Consequently, yet more legislation has come into force in recent years, which obligates companies to reduce their energy consumption. Larger firms are now legally required to regularly investigate new potential methods of boosting energy efficiency. And, from 2023, Dutch office buildings will be required to have an energy label with at least a C-rating; buildings with a D-rating or below will no longer be allowed to be used as offices. By imposing a minimum level of energy efficiency for office buildings, the Dutch government aims to drastically reduce the country’s carbon footprint. As a result, we are seeing significant investment in the renovation of commercial properties.

Profitability and Cost Effectiveness

In addition to legislation, another key driver of sustainability initiatives in the global REC sector is interest in profit and cost effectiveness. In Australia, “green,” new-building property construction is on the rise. These properties run on renewable energy and often use smart technology to monitor and reduce water consumption – an expensive commodity in Australia. In Sydney, a residential development has recently been built in which all the properties use Tesla Powerwalls, which store electricity for solar self-consumption, backup power and off-the-grid use. These green buildings are sometimes more expensive to build but are considerably less expensive to run long term.

In the Netherlands, companies that demonstrate efforts to improve energy efficiency or produce renewable energy can benefit from subsidies or tax benefits. These projects are therefore planned carefully to maximize tax benefits. Conversely, companies that choose not to implement green policies must consider the consequences: government legislation influences property value and investor decisions, not to mention tenants. Sustainability can thus affect all real estate owners and tenants, be it positively or negatively.

For REC businesses interested in cost-effective construction and building management, the durability of a building will have considerable impact. Companies worldwide are increasingly looking to use building materials that require minimal maintenance and need replacing less frequently. For example, Powerhouse Kjorbo in Oslo, Norway, is constructed with fire-treated wood, which is both fire and insect resistant; the material is extremely durable thanks to its low reactivity, and is expected to last 80 years. Durable materials generate cost savings, whilst also being more green than standard building materials, like concrete.

Often, the motivation for sustainability initiatives is pecuniary – but the results are inarguably positive. For example, smart monitoring is increasingly popular in Australia, where some businesses are now using smart-meter technology across multiple buildings. This means that energy usage can be monitored and, importantly, redistributed across a cluster of properties, depending on requirements, thus reducing waste, not just in individual buildings, but across an entire community or even city.

Conclusions

Of course, more immediate concerns are also driving environmental efforts. In Australia, increasing population density has resulted in legislation that requires buildings to have minimal impact on the local area in terms of traffic, air and noise pollution. Meanwhile, in Europe, gas extraction from one of the largest natural gas fields in Europe has caused a number of earthquakes in the Netherlands. To curb demand on gas and reduce tremors, the Dutch government has set a new target to have no houses heated by gas by 2050.

Looking to the future, legislation will continue to demand that the property industry shift away from traditional methods of construction and property maintenance, and employ clean, green technologies. To its clients, BDO Global would suggest that REC companies embrace this legislation, as environmental initiatives are, more often than not, highly cost effective; whilst ignoring legislation could later be costly. And, with the importance of BREEAM sustainability ratings and similar environmental assessments on the rise, green buildings can be seen as an asset and an accolade.

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Fall 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

Brick & Mortar Life Expectancy Isn’t What It Used To Be: Here’s How To Fight Obsolescence

By Dennis Duffy, MAI

Buyers, owners, investors and developers of real estate are facing questions regarding how properties are valued in the current market, especially where there are problems appraising a property’s highest and best use. More specifically, this question focuses on reversion value.

Multiple Cases

Recent Class B or lower valuation projects (as well as some lower level Class A properties) have presented serious, widespread questions from a valuation standpoint. The main question is simple: What should be done with “obsolete” buildings?

Historically, such a question became pertinent only after 50-100 years. Buildings were “built to last,” and most were designed to be updated over time. Part of the reason for that long horizon was that ample land was available for expansion. Another was that zoning was very prescriptive and clearly defined in many ways. Lastly, fixed real estate was a capital-intensive asset class.

In the past five years alone, that question, however, is now being asked about buildings that are only 20 to 30 years old. Many buildings that have been constructed in the last 30 years or so, like suburban office buildings and parks, retail centers and malls, some well-located industrial parks and even sports stadiums, now face the wrecking ball because they are, effectively, obsolete. Some investors report that many U.S. submarkets, for a variety of uses, are “under-demolished.”

What Has Driven This?

The short answer is technology. The longer answer is human interaction with technology.

Historically, most companies had fairly simple operations and spatial needs, so real estate decisions were driven by location and/or resources, with physical building changes limited by cost and location. The current digital revolution, however, is changing that—literally at the speed of light. Locations are not as “fixed” as they were previously, and businesses’ physical space needs tend to change quickly due to technological shifts. Flexibility will be the key to long-term survival in all industries, including real estate.

Traditionally, real estate has been a fixed asset acquired at high prices compared to most assets. Such requirements mandated long lead times, high fixed costs, significant capital resources, segregation of uses, long-term contracts (i.e., leases and mortgages) and zoning. The industry faces the challenge of adapting fixed physical space needs, and all that goes along with it, to meet the new reality of demand for change at the snap of a finger, and how to underwrite office or other spaces that will likely shift to “creative space” when re-financed (at lower rents, not higher).

What are Possible Solutions?

From a valuation standpoint, there are two traditional factors: zoning/legal issues and physical utility. To maintain real estate flexibility, underwriters, analysts, municipalities and all industries will have to consider:

  1. Revised zoning codes that stress density/form over use. The economic lives of buildings are getting shorter and it may be necessary to re-configure space more quickly. This change, however, often runs afoul of local zoning ordinances, minimally, as it relates to uses. If structures in the future are more generic in form, site-specific codes may have to be revised to reflect multiple future uses. By “pre-coding” such code requirements, one of the major impediments to re-development (generically, all permitting costs) can be streamlined for material cost savings and faster re-use. Urban areas already have an advantage in this regard due to greater densities and uses. Suburban areas will need to adapt this concept, or face an even stronger “back to the city” trend than currently in the market. Otherwise, suburban office parks and similar “obsolete concepts” could risk vacancy. All jurisdictions, in order to retain and attract industry—their tax base—will have to re-write zoning laws to allow rapid flexibility.
  2. In terms of physical utility, architects and engineers will have to design buildings that can be quickly adapted to alternate uses at a reasonable cost. Aesthetics will still be important. Those who are able to successfully design and build the most flexible buildings first will fare the best. Prime locations will also continue to have great importance. These locations, however, will not be limited strictly to traditional site selection parameters. The key will be how flexible the site and/or building improvements are perceived to be for needed changes due to technological shifts that dramatically alter market demand for that space.

The combination of these elements will require a shorter-term view, and investors and municipalities should incorporate some level of alternate use analysis, even from the original construction date. Underwriters would then have the benefit of downside underwriting (to consider future conversion costs)—on a current basis.

For many years, zoning and functional utility have simply been boxes to check during the valuation process. Moving forward, and given the rapid clip of technological change, it is now time to remove it from a box and think about a real exit strategy beyond the end of a lease or mortgage term.

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Fall 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

Mission Critical Infrastructure: Cyber Threats Shake the Nation’s Foundation

By Eric Chuang and Ian Shapiro

Increasing infrastructure spending to the tune of $1 trillion was a core pillar of Donald Trump’s campaign for office, and a welcome refrain for the construction industry. Whether the new administration will deliver on this promise remains to be seen. Despite some cuts to the Department of Transportation in the administration’s first budget blueprint for fiscal year 2018, the White House reaffirmed a commitment to support the nation’s critical infrastructure in subsequent proposals.

With infrastructure investment still on the president’s agenda, one vital consideration remains largely absent from the conversation: cybersecurity vulnerabilities in critical infrastructure.

What are the cyber risks?

Cybersecurity risks associated with infrastructure projects have recently received attention at the federal level. In March of 2017, the Department of Homeland Security (DHS) issued a cybersecurity alert for critical infrastructure owners and operators outlining top cyber threats. DHS asserted that “any sector that uses industrial control systems (ICS)”—ranging from energy to manufacturing to technology—could be susceptible to cyber attacks. ICS automates industrial distribution and processes, and comprises hardware and software components integrated via the Internet of Things (IoT).

Critical infrastructure encompasses 16 sectors—several of which are within the scope of the construction industry, including transportation systems, government and commercial facilities, energy and defense industrial bases. A cyber attack on firms involved in the construction of critical infrastructure, sensitive government facilities, or even facilities for emergency management, public health or medical providers, could jeopardize those services. Hackers could glean potentially vulnerable information housed in construction firms’ databases, including proprietary employee data, sensitive client data, tenant personally identifiable information and non-public material information. Construction firms also house computer-aided design drawings and blue prints to sensitive buildings, which hackers can exploit to inflict physical damage.

Triple Threat: IoT, DDoS and PDoS

Cybersecurity vulnerabilities in the construction industry are compounded by growing industry adoption of cloud computing and the IoT. Smart buildings technology, such as sensor-enabled heating and cooling systems, can be physically compromised or provide an entry point to the larger corporate network. With increased connectivity, the security (or lack thereof) of each individual device impacts the whole system’s integrity. And because IoT devices fall outside the traditional scope of IT, they are often overlooked.

The top threats specific to physical infrastructure are distributed denial of service (DDoS) and the emerging threat of permanent denial of service (PDoS) attacks. DDoS and PDoS attacks aim to temporarily disable or permanently destroy technology—such as power grids, heating and cooling systems and internet providers—by overwhelming the targeted system with traffic, thereby disrupting the distribution and delivery of a service.

And then there is ransomware, another type of denial of service (DoS) attack that uses encryption malware, generally downloaded via phishing emails, to block user access to computer files, potentially permanently if the victim is unable or unwilling to pay the ransom for the encryption key. Ransomware attacks quadrupled in 2016 with an average of 4,000 per day, according to data from the U.S. Justice Department. The problem from a critical infrastructure perspective? Ransomware could infect operational technology, disrupting essential processes or taking entire systems offline.

The NotPetya “wiper-ware” in June of 2017 demonstrated the next level of sophistication of malwares  that did not require the use of phishing emails to infect and propagate across the victims’ networks, and the non-reversible encryption of the victims’ hard drives have every indication that it was intended to be a PDoS attack and not for ransom.

Although DoS-style threats emerged nearly two decades ago, hackers have leveraged IoT to carry out much more sophisticated attacks in recent years. For example, the October 2016 attack against Domain Name System provider Dyn, used IoT and a Mirai botnet to increase the attack’s scope and impact. Mirai botnets are a strain of malware that infects internet-connected devices and corrals them into an IoT “army” to overwhelm a target’s servers with malicious traffic, shutting down highly trafficked websites for several hours. While the Dyn attack caused arguably little more than inconvenience, it spurred speculation about the chaos and physical harm a DDoS—or worse PDoS—attack of that scale, or bigger, on the nation’s infrastructure could potentially cause.

Cyber attacks to date on critical infrastructure have largely targeted power grids and the electrical sector. In 2016, ransomware and DDoS attacks of that nature stole headlines worldwide. In Finland, a DDoS attack targeted computerized heating distribution centers, disabling heat to apartment buildings. In December 2016, a cyber attack on the Ukrainian capitol’s power grid caused a power outage in various areas of the city. The attack has roots in malware—employees at Ukrainian power companies received infected emails, which allowed the hackers to seize control over their computers and carry out the attack. In June, 2017, the NotPetya wiper-ware infected the Chernobyl power plant’s radiation monitoring system, but this time, the attack was believed to have originated via the MEDoc accounting software’s update service, and no phishing email was used. Beyond the technical semantics of the attack, it appears both acts might have been cyber warfare. Multiple security and media sources reported that Russia was likely tied to both attacks, motivated by the war in Eastern Ukraine. With these incidents in mind, securing the U.S.’s critical infrastructure against cyber attacks becomes a matter of national security.

What role can contractors play in hedging against cyber warfare?

From a business perspective, construction companies would be wise to shore up their cybersecurity.  Construction firms looking to win federal or state government contracts under the much-anticipated infrastructure spend will be held to stringent cybersecurity standards. The U.S. government produces, collects, consumes and disseminates huge volumes of data and entrusts sensitive information to federal contractors. At the federal level, the Federal Acquisition Regulation (FAR) requires basic safeguarding of contractor information systems that process, store or transmit federal contract information, and contractors can face fines or contract termination if there are levels of cyber negligence. Construction companies contracting with the government must also consider their subcontractor’s cybersecurity standards: Any weak cyber link can create a vulnerability.

While the construction industry looks forward to the promise of financial boon from new infrastructure projects, cybersecurity should remain top-of-mind. Too often, contractors may have basic cyber defenses in place but don’t prepare any real coordinated response plan until after an incident occurs. Cybersecurity controls addressing current threats are essential, but with the rapidly emerging swath of risks, contractors need to set their sights on the future and invest in monitoring, responding to and mitigating the next big threat.

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Fall 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

 

Perspective in Real Estate

A feature examining the role of private equity in the real estate sector.

Brick & Mortar Retailer Woes Raise Concerns Despite Spiking M&A Activity

The retail model is undergoing a transformation that presents opportunities and risks for the real estate industry. Driven by changing consumer expectations about brand experience and convenience, traditional retailers are scrambling to expand their online and omnichannel offerings, while online retailers are laying down their first bricks and mortar. And despite recent headlines touting retail’s demise off the back of Q1 earnings, there’s been a sustained spike in e-commerce deal activity among strategic and financial buyers that suggest interest in transforming the current retail model is rapidly growing.

REITs operating in the retail industry are keeping a close eye on the sector’s fiscal health—which has a direct impact on their bottom line. While the retail industry is sending investors somewhat mixed signals, the future of retail will likely be less dependent on growing brick-and-mortar footprints and more focused on developing the right balance of consumer channels. Embracing e-commerce is not synonymous with shuttering physical locations, as storefronts remain an integral element of the retail mix. Retailers that take active steps to grow their multichannel offering while right-sizing their in-store footprint look to be better positioned than competitors who have yet to take steps to address the rise of e-commerce.

The Good

General retail e-commerce M&A activity topped out at $17 billion in 2016, representing about an eightfold increase from 2014’s $2.36 billion in M&A activity, according to BDO & Pitchbook’s Current State of E-Commerce, which was published in May and outlines strategic and financial deal activity across the sector. Furthermore, retailers expect deal activity to continue to rise in 2017. Nearly half (46 percent) of retail CFOs surveyed in BDO’s 2017 BDO Retail Compass Survey of CFOs forecast an uptick in retail M&A activity this year. More than two-thirds (38 percent) of these CFOs cite competition and consolidation as the driving factors for deals.

Strategic buyers account for the bulk of the increased deal activity in recent years. In fact, more than half of retail CFOs (56 percent) anticipate M&A activity will continue to be driven by strategic buyers in 2017, with an estimated average EBITDA multiple of 7.0, the highest in the Compass Survey’s history.

That means the retail industry is likely to see more deals: first, Walmart’s acquisition of Jet.com last year, then Amazon’s announcement in June of a $13.1 billion bid to acquire Whole Foods. Grocery has been a retail sector arguably more insulated from e-commerce disruption than others, as customers largely still prefer grocery shopping in stores. Bloomberg reported that Amazon focused heavily on Whole Foods’ distribution technology in negotiations, and experts say immediate cost reduction opportunities could be seen in warehouses. Walmart’s acquisition was made to immediately bolster its e-commerce presence and to compete with Amazon. Walmart paid a premium ($3.3 billion) compared to Jet.com’s valuation ($1.35 billion), but it appears to have paid off: The company’s global e-commerce sales for 2016 increased 15 percent from the previous year, and its U.S. e-commerce sales gained 36 percent.

The Not So Good

At the same time, there have been recent strategic acquisitions that have delivered less clear results. Look to examples like the 2015 flash-sale startup Gilt Groupe’s sale to Hudson’s Bay Co. for $250 million or Bed Bath & Beyond’s $100 million acquisition of One Kings Lane. Both deals enabled the buyers to enter the flash-sale space at a discounted rate, but the market ultimately slowed. Gilt Groupe’s sale now seems like a win; however, the brand was previously valued at $1 billion before losing steam as the flash-sale trend has slowed. A similar story was told for One Kings Lane. The total acquisition amount was never released, but estimates put the deal around $150 million, a far cry from the company’s previous valuation of $900 million.

The Ugly

The first quarter of 2017 saw the highest number of bankruptcy declarations by retailers since 2009, during the height of the Great Recession. The number of retailers that have filed for Chapter 11 bankruptcy protection so far this year has already surpassed the total 2016 number, according to reports by CNBC and USA Today. Financial challenges seem to be hitting mall clothing chains especially hard as consumers shift their spending to more agile online sellers. Of note, roughly half of retailers that have filed for Chapter 11 protection year-to-date were previously purchased by private equity firms, according to CNBC. And the number of retailers on Moody’s distressed list is also surpassing Great Recession levels. If this trend accelerates, REITs operating in the retail sector could be impacted by tenant loss or defaults and falling or flat lease values.

Still, surging M&A appetite and a determination by the majority of retailers to transform their business model to meet new customer preferences should provide an opportunity for evolution—for the better, ultimately—for REITs operating in the sector.  Retail as we know it is rapidly changing. Just as the industry is different today from what it was 50 years ago, it will be totally transformed by 2067. And our bet is that transformation will come relatively quickly, so there is a good opportunity for disruptors and innovators in the sector to shape what the future model of retail will look like. Identifying, courting and partnering with those disruptors would be a solid strategy for REIT executives.

Future PErspectives: What’s Next for Real Estate Investors?

The real estate industry, and particularly retail U.S. REITs are bracing for a bumpy road ahead. In fact, REITs’ concerns over foreclosure and bankruptcy have jumped in the last year, according to the 2017 BDO RiskFactor Report for REITs, which examines the risk factors in the most recent 10-K filings of the largest 100 publicly traded U.S. REITs. This year’s report reveals that 86 percent of REITs are concerned about the risk of foreclosure and bankruptcy, up from 80 percent in 2016. Roughly the same amount (84 percent) said falling or flat real estate values are a risk in the year ahead, up from 79 percent in 2016. Meanwhile, three out of four (76 percent) retail REITs point to the growth of e-commerce, specifically as a threat.

To reposition their model in light of the rise of retail e-commerce, some REITs have already begun to take active steps to redefine the consumer in-store experience across their properties. High-end mall REITs have found some success in moving up-market to fill vacancies created when struggling retail chains have moved out, as well as by cultivating a differentiated shopper experience by incorporating more entertainment, activity and dining venues.

The implication is that, while consumers are increasingly seeking to purchase a larger share of their goods online, they remain drawn to brands that deliver a consumer experience before, during and after the transaction. While there may be some right-sizing of retail brick-and-mortar footprints still left to be done, REITs should take comfort in the fact that a new retail model—one that focuses more on brand experience—has started to take shape across the sector. That model will be dependent on a well-defined and prominent in-store component.

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Summer 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com