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 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’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.

Another Year Wiser: Takeaways from REITWise 2017

By Brandon Landas and Jan Herringer

In mid-March, leaders throughout the industry gathered in sunny California for NAREIT’s annual Law, Accounting & Finance Conference. Presentations spanned financial, accounting, tax, legal and political issues for REITs and real estate companies. Here are some of the event’s top takeaways from REITWise 2017.

Accounting for New Standards: Lease Accounting & Revenue Recognition

Throughout the conference, the Financial Accounting Standards Board’s (FASB) new Lease Accounting Standard, ASC 842, was a key topic of discussion. While the lease accounting guidance will have a more direct impact on REITs’ tenants, the industry is closely monitoring how their tenants are adjusting to the new standard. That said, REITs with ground and equipment leases will be directly impacted by the new standard. The changing guidance around revenue recognition under ASC Topic 606: Revenue from Contracts with Customers was also discussed at length. The new revenue recognition accounting standard takes effect in 2018, and the new lease accounting standard will become effective for public companies in 2019. That means now is the time for REITs to adopt an implementation plan and assess each standard’s impact to their operations and bottom line.

Dusting up Disclosure Requirements:

As part of the SEC’s Disclosure Effectiveness initiative, designed to improve the disclosure regime for both companies and investors, the SEC issued a Disclosure Update and Simplification Release (DUSTER) proposed rule in July 2016. While the SEC is deliberating how to move forward with the disclosure requirements, there are voluntary steps companies can and should take. Proactive measures REITs can adopt now include eliminating some archaic information in filings and streamlining repetitive and complex document language. REITs would also be wise to closely review existing disclosures and take proactive measures to improve their effectiveness—with an eye toward making them easier for shareholders to read.

Going Concern Update – Implications for Management and Auditors:

Accounting Standards Update 2014-15, Presentation of Financial Statements – Going Concern (Subtopic 205-40) Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, became effective at the end of 2016, specifically, for annual periods ending after December 15, 2016, and for annual and interim periods thereafter. This update, among other matters, includes a new requirement for management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date the financial statements are issued (or within one year after the date that the financial statements are available to be issued, when applicable) and to provide certain related disclosures. Previously, there was no guidance in generally accepted accounting standards (GAAS) about management’s responsibility with respect to going concern.

In September 2014, the PCAOB issued Staff Audit Practice Alert (Staff Alert) No. 13, Matters Related to the Auditor’s Consideration of a Company’s Ability to Continue as a Going Concern. This Staff Alert reminded auditors of public entities to continue to look to the existing requirements of PCAOB AS 2415, Consideration of an Entity’s Ability to Continue as a Going Concern, when separately evaluating whether substantial doubt regarding the company’s ability to continue as a going concern exists for purposes of determining whether the auditor’s report should be modified.

More recently, in February 2017, the Auditing Standards Board of the AICPA issued Statement on Auditing Standards (SAS) No. 132, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern (SAS 132). This SAS will be effective for audits of statements of nonissuers for periods ending on or after December 15, 2017, and reviews of interim financial information for interim periods beginning after fiscal years ending on or after December 15, 2017. SAS 132 clarifies that the auditor’s objectives with respect to going concern matters include separate determinations and conclusions from management regarding (1) the appropriateness of management’s use of the going concern basis of accounting, when relevant, in the preparation of the financial statements, and (2) whether substantial doubt about an entity’s ability to continue as a going concern exists, based on the evidence obtained, for a reasonable period of time as defined in the applicable financial reporting framework.

Don’t Bet All Your Marbles on Infrastructure Investment:

A big topic of discussion throughout the conference was the much-lauded trillion-dollar investment in infrastructure candidate Donald Trump discussed last year on the campaign trail. Enthusiasm has waned, however, since the White House published its preliminary budget blueprint. The proposal includes a $2.4 billion, or 13 percent, cut to the Department of Transportation’s budget, raising alarm bells for the sector. Earlier this year, REITs and real estate companies were bullish on infrastructure development and public-private partnerships (P3s). In light of the recent developments, though, infrastructure investment is less of a surefire win, leading many REITs to reevaluate their next moves.

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

Making Real Estate Investments Attractive To Tax-Exempt Organizations

By David Patch

Organizations described in sections 401(a) and 501 are generally exempt from federal income tax, except with respect to income from businesses that are unrelated to their tax-exempt purpose, known as unrelated business taxable income (UBTI).[1]

Rents from real property are specifically excluded from UBTI, making rental real estate partnerships a potentially attractive investment for many exempt entities. Otherwise excluded rental income, however, becomes taxable UBTI to the extent the property is funded with debt.[2]  Given that leverage is ubiquitous in real estate investments, this presents a problem for exempt entities except in those rare situations where the real estate is entirely funded with equity.

Some types of exempt entities can avoid UBTI on debt-financed real estate investments if certain requirements are met. In order to attract such investors, many real estate funds carefully structure the terms of their operating agreements to meet these requirements and advertise their compliance in offering documents. This opens up a new source of funding for syndicated real estate investment partnerships that might otherwise have appealed mainly to taxable investors.

The types of tax-exempt entities to which these rules apply include educational organizations and their affiliated support organizations, qualified trusts under section 401 (pension, profit sharing and stock bonus plans), certain title holding companies, [3] and retirement income accounts of churches (collectively, Qualified Organizations or QOs).

In order for a QO’s investment in a real estate rental partnership to qualify for the exclusion, the partnership must meet one of the following requirements:

  1. All the partners of the partnership must be QOs;
  2. Each QO’s distributive share of each item of income, gain, loss, deduction, credit and basis of the partnership must be the same and must remain constant during the entire period the entity is a partner in the partnership; or
  3. Each partnership allocation must have substantial economic effect and satisfy the “fractions rule.”[4]

Partnerships in which all the partners are QO’s are rare, so the first requirement would not generally be met by a syndicated real estate fund. The second requirement is extremely restrictive and could limit the ability to structure deals in a way that will be of broad appeal. Therefore, real estate funds hoping to attract QOs as investors will generally want to meet the third test.

One requirement of this test is that the allocations provided for by the partnership agreement have substantial economic effect.[5] Among other things, partnership agreements must generally provide for liquidating distributions in accordance with positive capital accounts in order to meet this requirement. Partnership agreements frequently define liquidating distribution rights in other ways, and such an agreement would generally fail this requirement.[6] A real estate partnership hoping to attract QOs would need to ensure that its partnership agreement is drafted in a way that causes its allocations to have substantial economic effect. Virtually any partnership’s economic arrangement can be defined in this manner so meeting this requirement should not be a particular hardship, but the desire to do so must be communicated to the drafting attorney.

The more difficult requirement is that the partnership’s allocations satisfy the fractions rule. The fractions rule is met only if “the allocation of items to any partner that is a qualified organization cannot result in such partner having a share of the overall partnership income for any taxable year greater than such partner’s share of the overall partnership loss for the taxable year for which such partner’s loss share will be the smallest.”[7]  Thus, for example, a QO could not generally be allocated 10 percent of the partnership’s loss in one year and 11 percent of the partnership’s income in another. This seemingly simple requirement may prove difficult to achieve in practice because most real estate funds have allocations that vary or have different classes of interests that cause allocations to change from year to year. The promoter’s interest will generally also vary depending on whether and when investment return hurdles are reached. In recognition of these common issues, the regulations provide a number of exceptions under which certain variances are ignored, including:

  1. Allocations reflecting a preferred return or guaranteed payments for capital computed at a commercially reasonable rate.
  2. Guaranteed payments to the tax-exempt member for services if reasonable in amount.
  3. Allocations of income made to reverse prior disproportionately large allocations of overall partnership loss or disproportionately small allocations of partnership income to a QO.
  4. Special allocations required by the Internal Revenue Code or regulations such as minimum gain chargebacks and qualified income offsets, as well as provisions that prevent allocations of loss to a QO if it would create a deficit capital account.
  5. Special allocations of certain partner-specific expenditures such as the costs of additional record-keeping and accounting incurred in connection with the transfer of a partnership interest, additional administrative costs that result from having a foreign partner or state and local taxes.
  6. Special allocations of certain unlikely losses, such as litigation costs or casualty losses.[8]

In addition, the regulations make the fractions rule inapplicable if (1) QOs do not collectively hold interests of greater than five percent in the capital or profits of the partnership; and (2) taxable partners own substantial interests in the partnership through which they participate in the partnership on substantially the same terms as the qualified organization partners.[9]

In 2016, regulations were proposed that would modify several of these exceptions in ways that should generally make them easier to satisfy and add additional exceptions. For example, the proposed regulations would:

  1. Remove a requirement in the existing regulations that preferred returns be distributed currently in favor of a requirement that unpaid amounts compound and be distributed first.
  2. Allow special allocations of management (and similar) fees to account for separately negotiated economic arrangements.
  3. Allow for special allocations intended to reverse prior special allocations of unlikely losses.
  4. Allow certain allocations to account for changes in ownership due to staged closings.
  5. Allow for changes in allocations due to unanticipated defaults on or reductions in capital contribution commitments.
  6. Clarify how allocations from lower-tier partnerships are taken into account.
  7. Add a de minimis exception for partnerships in which non-QO partners do not own in the aggregate interests of greater than five percent in capital or profits.

The proposed regulations will be effective when finalized, but partnerships may apply the rules for taxable years ending on or after November 23, 2016.


Syndicated real estate partnerships that fail to satisfy the fractions rule may be missing out on a valuable source of investment capital. By working closely with partnership specialists, syndicators can ensure that their funds meet the requirements for the exclusion of debt-financed income and present an attractive investment opportunity for QOs. Proposed regulations issued in 2016 will make it easier for real estate partnerships to satisfy the fractions rule, making this a great time to consider (or reconsider) taking the steps necessary to comply with the requirements.

[1]     Section 501(a), section 512.

[2]     Unrelated debt-financed income, Section 514.

[3]     As described in section 501(c)(25).

[4]     Section 514(c)(9)(B)(vi).

[5]     Section 514(c)(9)(E)(i).

[6]     Allocations provided by partnership agreements that do not call for liquidating distributions in accordance with positive capital accounts may meet this requirement only if they have substantial economic effect “equivalence.”  To qualify, the allocations must result in ending capital accounts that reflect liquidating distribution priorities at the end of the current and all future years.

[7]     Section 514(c)(9)(E)(i)(I).

[8]     See generally Treas. Reg. sections 1.514(c)-2(d) though (j).

[9]     Treas. Reg. section 1.514(c)-2(k)(2).

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

PropTech – Is 2017 The Year Things Change For The Property Industry?

By Ian Shapiro

Technology has been a disruptive force in most industries and sectors over recent years. But in the real estate and construction (REC) sector, widespread adoption of new technologies has lagged somewhat. Indeed, the adoption of technology in property – or ‘PropTech’ – has fallen a little short of its anticipated take-up. For example, in the U.S., the construction industry is several years behind many other industries with regards to technology with many companies still using manual systems for project planning and management. That’s why construction remains far behind in reaping the benefits of advanced data and analytics, drones, automation and robotics.

However, 2017 is set to be the year the floodgates open for PropTech in the global REC sector, and we’ve looked at some key technologies you should be keeping an eye on in the industry this year.

The Widespread Use of Drones

Drones have been in the news for various reasons recently – both good and bad. Thankfully, they are being put to good use in the construction industry and we’re seeing things get far more efficient on projects because of them. They can be used during surveys to check the condition of hard to reach places and can be equipped with lenses that are able to read serial or model numbers, meaning that surveys can be performed in detail.

Drones not only save time (and therefore money!) but also improve safety for construction workers. For example, a roof survey would normally involve human workers climbing onto the roof, which naturally involves considerable risk. By using drones, construction companies are able to bypass this risk, without losing much, if anything, in the way of accuracy.

For this reason, we are now seeing a wider adoption of drones by construction companies. However, the popularity of this technology has had the knock-on effect of bringing in increased regulation: aviation authorities around the world have introduced regulations for drones because of perceived privacy and security concerns, with many countries now demanding licenses or permits to use drones for certain activities or around important landmarks.

Virtual Reality – From Gimmick to Legitimate Tool

The use of virtual reality (VR) in property is already a $1 billion global industry and Goldman Sachs estimates that it is set to treble by 2020. VR has its obvious uses in the real estate sector: for example, VR is used for sales and marketing in the prime residential market, where investors often live miles away from the properties they want to view.

VR is also viewed as the next phase of Building Information Modeling (BIM), and as an enhancement to computer-aided design (CAD): developers can use VR to create more realistic and detailed renderings, which are now transitioning into virtual reality walkthroughs.

Certainly, 2017 will see virtual reality transition from gimmick to a legitimate tool across the REC sector as the emergence of VR headsets, interactive hand controllers and movement sensors revolutionize how designers and contractors experience the construction process.

The Cloud and Real‑Time Data

Increasingly, supervisors are turning to the cloud and real-time data to stay abreast of construction jobs. With the help of smart devices, such as an iPad or an iPhone, foremen and supervisors can follow a project in real time and identify specific “milestones” that can be checked off as a job progresses, causing invoices and payments to vendors or subcontractors to automatically generate accordingly.

Smart Tech for Smart Buildings

The term “smart building” has been in use for some time but smart technology is now making a real impact on the real estate sector. Buildings are now designed to be “smart,” which is making tenants’ and property managers’ lives easier.

By using smart devices to control things like heating and lighting, residents can decrease their bills and energy waste. Similarly, elevators can be programmed to reduce usage and automatically tell building managers when they need to be serviced. Here, PropTech is not only improving efficiency but also safety.

Robots in Real Estate

The construction industry has yet to really adopt robotics although human-controlled machine equipment is widely used. The use of robots for high-precision activities is not new (consider welding or vehicle painting) but advances that allow robots to “see” via sensors mean that robots can now be used to perform previously human-only tasks, such as “couriering,” cleaning or gardening in hotels, warehouses or office buildings. I was recently given a coffee by a robot at a PropTech conference!

Cyber Attacks Drive Interest in Security

In construction, cybersecurity issues are only now making an impression but in real estate, it is a real issue, especially as buildings become increasingly “smart” and therefore vulnerable. Thanks to the Internet of Things, everything down to your Christmas tree lights can now be controlled electronically; thus, buildings are becoming the new target of cyber attacks.

The use of ransomware is increasing and becoming more targeted to property. In recent years, it was claimed hackers stole the blueprints to Australia’s secret service agency HQ, presenting obvious terrorist threat concerns. It is therefore understandable that landlords and building owners would be concerned for the security of their assets, and must work with cybersecurity experts to protect their business.

Given the REC industry’s poor track record on innovation and the adoption of new technologies, tools and approaches, governments, developers and deliverers need to invest collectively to achieve these shared goals and future-proof the industry. In order to achieve this, firms need to develop digital road maps, appoint dedicated staff to think boldly about the digital agenda and partner with technology firms. BDO recently took a huge step toward this by partnering with Microsoft (read press release here).

This is the digital age of collaboration, and the industry will soon come to realize that digital tools can be more powerful than the ones in a rusty toolbox. We all need to embrace this catalyst for change to attract a new generation of talent.

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

Construction – Did You Know?

According to an Associated General Contractors of America survey, 73 percent of construction companies surveyed plan to hire new employees in 2017.

In the fourth quarter of 2016, home price gains accelerated in 89 percent of U.S. metropolitan areas, according to the National Association of Realtors.

Overall construction spending in 2016 was 4.5 percent higher than the prior year, according to the Commerce Department.

The data center and specialty REIT sectors outperformed the S&P Index’s 1.9 percent total return rate in January 2017, delivering returns of 8.05 percent and 9.42 percent respectively.

Total construction employment in January increased 2.6 percent from January 2016, or approximately 170,000 jobs year over year, the Associated General Contractors of America reported.

Cross-border transactions in the real estate industry accounted for $65.5 billion in sales—a decline of one-third from 2015 levels, but up from just $43.1 billion in 2014, according to Real Capital Analytics.

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

PErspective in Real Estate

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

REITs, Private Equity Look Beyond Core Properties in 2017

Private equity (PE) fund managers are growing bullish on the real estate industry. PE funds have already raised a combined $237 billion globally to invest in commercial real estate in 2017, outpacing the 2016 total of $202 billion, according to Preqin. With the Federal Reserve expected to introduce at least three interest rate increases in the year ahead, returns on real estate investments may decline. Investors face steeper competition for office, hotel and multi-family properties, and the dip in returns could lead many fund managers to embrace alternative real estate assets. REITs and private equity real estate funds are already sharpening their focus on non-traditional real estate assets.

Single-family rentals (SFR) is one niche area that has already shown hints of growth in 2017. In a deal that created the largest SFR REIT to date, private equity giant Blackstone raised $1.54 billion in a January IPO of its SFR portfolio, Invitation Homes. As of mid-February, the shares were trading at $20.88. PE and REIT interest in SFR took off during the housing crisis, with both investment vehicles buying up distressed homes. According to Hoya Capital Real Estate, the SFR sector performed well in 2016, with a 26 percent rate of return. Now that the housing market has stabilized, more fund managers are looking to exit and the momentum is likely to continue, perhaps with activity from strategic buyers picking up.

Another attractive investment option is data warehouses. The explosion of wireless connectivity, cloud computing and data has led to more demand for storage space. An IDC study found the total amount of stored data is doubling approximately every two years. Data warehouses or data centers are one way investors can capitalize on the network of facilities sustaining the growth of the Internet of Things. This year, data center acquisitions amounted to $1.7 billion, and investment activity is forecast to ramp up in 2017. Data Center REIT Equinix’s $3.6 billion deal to acquire Verizon’s data center businesses, which include 24 facilities, is expected to close in mid-2017.

Although PE interest in real estate is expected to increase, the bulk of investments this year will likely stem from the larger players. Carlyle Group is in the early stage of raising $5 billion for its eighth real estate fund. Consistent with the sector-wide trend, Carlyle Group plans to focus on niche property types with this fund—specifically, senior housing investments and rental properties.

In addition to increased investment in niche properties, private equity has also moved into the debt financing space. Private equity firms and other non-bank lenders are increasingly raising debt funds, providing loans as an alternative to or in conjunction with traditional banks for construction projects and property renovations. Investing in real estate debt could become a more prevalent strategy for PE firms as interest rates rise.

While PE consistently attracts interest from institutional investors, pension and endowment fund managers have historically had some concerns with REITs’ volatility and ties to the stock market. But as real estate investing becomes more common, some institutional investors have started to take a closer look at REITs. South Carolina Retirement System Investment Commission, for example, made its first investment in REITs in 2016 by allocating about $728 million. As the types of investors funneling capital into PE and REITs converge, REIT fund managers would be wise to watch how PE interest develops in the sector and how it could spur more competition for assets.

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

In response to President Donald Trump’s pledge to invest heavily in nationwide infrastructure initiatives, PE and REITs are unsurprisingly bullish on infrastructure. In the president’s first week in office alone, his administration announced infrastructure projects totaling more than $137.5 billion.

As PE and sovereign wealth funds explore adding infrastructure assets to their portfolio, we may see them leverage public-private partnerships (P3s). Through P3s, private sector companies partner with government agencies to finance and implement some or all aspects of public projects, including infrastructure, such as transportation and municipal buildings. Already in 2017, the Los Angeles County Metrorail is reportedly considering leveraging P3s to fast-track a transportation initiative.

Fiscal stimulus, such as investment in infrastructure, is likely to drive economic growth and reflect positively upon real estate fundamentals. While the full extent of the new administration’s infrastructure priorities has yet to take shape, the real estate industry is keeping a close eye on opportunities as they evolve.

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

Effects of Potential Tax Reform on the Real Estate Industry

By Sean Brennan

Now that the dust of a contentious presidential election cycle is settling, tax reform may be more likely in 2017 than in past years. There are currently two plans we can look to for guidance on reform: President Donald Trump’s revised plan and the House GOP plan. Both contain significant reductions in individual and corporate tax rates, limitations on deductions and simplification of administration of the tax system. While the plans are summaries of proposed tax reform and give us a basic understanding of their intentions, neither plan answers all our questions concerning implementation for taxpayers.

Provisions of each proposal may affect the real estate industry in the long term, including the current write-off of acquired property, limitations on the deductibility of interest expense and the overall reduction of tax rates.

Tax Rate Reduction

Arguably the most important potential tax reform for both individuals and corporations is tax rate reduction. The president’s and the House GOP tax reform plans both call for significant tax rate reduction for both individuals and corporations. The two plans call for reduced corporate tax rates of 15 percent and 20 percent, respectively. Under the president’s plan, business income earned by pass-through entities would also be taxed at a 15 percent rate. Under the House GOP plan, income from pass-through entities would be taxed at a maximum rate of 25 percent. It’s not clear whether income from rental real estate would qualify as “business income” under the president’s plan. Both plans call for a repeal of the corporate alternative minimum tax (AMT).

To reduce business tax rates, the president’s plan calls for the elimination of most business deductions and credits, except the federal R&D credit. The House GOP plan also calls for reducing business deductions, including the deduction for interest expense in excess of interest income. However, there is a proposal under the House GOP plan to allow immediate write-off of investment of both tangible and intangible assets, including property.

Carried Interest

The president’s plan proposes altering the tax treatment of carried interest. Carried interests are commonly used when forming a real estate development partnership to compensate a promoter for services rendered to the partnership with an interest in the partnership. Ultimately, the promoter can be taxed using favorable capital gains tax rates. If carried interest taxation rules are changed, promoters may be required to pay taxes on receipt of carried interests using ordinary tax rates.

Property Depreciation

The last rewrite of the Internal Revenue Code (IRC) in 1986 extended depreciable lives for commercial real estate from 19 years to 31 years. Depreciable lives now are set at 39 years for most properties acquired in 2017. As mentioned above, the House GOP plan includes immediate expensing of all acquisitions of tangible and intangible property. Therefore, commercial buildings and other real estate development would be fully written off in the year acquired or placed in service. A similar provision is included in the president’s revised plan, which proposes full expensing of plant and equipment for manufacturers. But the plans also call for the elimination of deductions for net interest expense on debt. Thus, interest expense deductions would be disallowed to the extent they exceed the taxpayer’s interest income. Taxpayers would have to weigh the benefits of the simplification of an immediate write-off of newly acquired property against the loss of tax deductions for interest on the debt used to acquire the asset. Net operating losses resulting from the immediate expensing of commercial real estate would be able to be carried forward indefinitely, with no carryback allowed.

Mortgage Interest Deduction

Currently, mortgage interest payments for acquisition debt up to $1 million and $100,000 in home equity debt are deductible. The president’s plan calls for limitations or phaseouts of itemized deductions at $100,000 for single filers and $200,000 for married filers. The House GOP plan calls for the elimination of nearly all deductions except the mortgage interest deduction and charitable contribution deduction.

Alternative Minimum Tax/Net Investment Income Tax

Under both the president’s plan and the House GOP plan, AMT and the net investment income tax (3.8 percent on net investment income) would be repealed.

Looking ahead: We’ll be watching

While it is very early in the process of rewriting the IRC, the prospects of reform continue to grow stronger with a Republican White House and Republican control of the House and Senate. Real estate companies can review potential reforms now to prepare for scenarios that could be ahead. We will continue to monitor these preliminary tax reform plans, as well as others that may arise, in the coming months as the process unfolds.

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

REIT IPO Watch: 2017 Progress Report

By Brent Horak

After IPO activity slowed to a trickle in 2016, the capital markets community projects a more positive forecast for IPOs across industries in 2017. Two-thirds (67 percent) of capital markets executives at leading investment banks predict an increase this year in IPOs on U.S. exchanges, BDO’s 2017 IPO Outlook study found, with 19 percent predicting a “substantial” uptick.

For the real estate industry, the IPO market may be marching ahead at a more measured clip, continuing to face many of the same hurdles that contributed to the recent downward trend in REIT IPOs, from nine in 2013 to four in 2016. BDO found executives’ predictions for real estate IPO activity fell in the middle of the pack among industries, with 37 percent expecting IPO activity to increase in the sector and 31 percent expecting activity to remain flat in 2017.

Publicly traded REITs posted positive returns of about 8 percent in 2016. Although the asset class underperformed the broader S&P Index for the year, NAREIT predicts a stronger 2017 for REITs and commercial real estate, driven by continued economic momentum and increased demand. Nonetheless, the sector will also grapple with big questions—most importantly, the possibility of a downturn as the current real estate cycle progresses. National Real Estate Investor notes REIT IPO activity this year could vary significantly across sectors and property types. Some REIT sectors are currently trading at a premium to their net asset values, so IPOs could be concentrated by sector this year. Of course, the decision to go public will ultimately be influenced by how the share price stacks up to the REIT’s net asset value.

Let’s take a look at REIT IPO activity so far this year and the factors that will impact how the rest of the year unfolds.

In January, Invitation Homes raised $1.54 billion in its offering, the largest U.S. IPO since October 2015 and the largest REIT IPO since November 2014. The company issued 77 million shares at $20. As of mid-March, the shares were trading at $21.40. Private equity group Blackstone purchased Invitation Homes in 2012 and spent approximately $10 billion to build Invitation’s portfolio of 48,000 homes, CNBC reported. Invitation’s homes are now 96 percent occupied and draw an average monthly rent of $1,623, according to Forbes.

Though this IPO comes after other recent bets on rental homes, including the merger of Starwood Capital and Colony Capital to form Colony Starwood Homes in January 2016, the window for IPO activity in the single-family home sector may be closing. Housing prices have rebounded significantly since the recession, but remain slightly below their pre-recession peak. Currently, there are 11 private single-family home rental businesses that own more than 1,000 homes each. Performance in the single-family REIT sector was strong in 2016 with 26 percent returns. But as the housing market steadies, portfolios are no longer available at “bargain prices,” so selling to a peer may generate better exit opportunity than an IPO for those businesses moving forward, Forbes predicts.

Other REIT IPO activity so far includes Connecticut-based Mortgage REIT Sachem Capital and New York City-based Clipper Realty. Sachem Capital opened for trading this year on Feb. 10 at $4.90 for its offering of 2.6 million shares. Shares are trading at $5.00 as of mid-March. Clipper Realty also debuted on Feb. 10, offering 5.6 million shares priced at $13.50 per share. The shares have hovered around that price, increasing less than 1 percent.

With economic uncertainty ahead as legislative and regulatory policy play out under the new administration, it is difficult to know how the capital markets and IPO activity may be impacted. The real estate industry’s recovery is entering its ninth year, and all eyes will be on key measures such as vacancy rates and rent growth. Focusing on these measures alone, however, overlooks the strong sector fundamentals set to support growth for commercial real estate this year, NAREIT asserts. Notably, demand for leased space is outpacing supply despite an uptick in construction in recent years.

Healthcare, industrial, net lease and manufactured homes portfolios are performing particularly well in the current market as most REITs in those sectors are trading at premiums to their net asset value, according to National Real Estate Investor. Those types of portfolios may be particularly ripe for IPO activity this year. Last year was a challenging IPO environment with many companies electing to forgo a public offering. But if the cadence of REIT IPOs in Q1 is any indication, that sentiment is changing fast.

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

Cybersecurity: A Business Threat for Contractors

By Christopher Mellen and Ian Shapiro

Recent strides in the construction industry to automate processes—such as accounting, project management and Building Information Modeling (BIM) software—introduces a corresponding set of new cyber risks. Contractors are vulnerable to the same cyber threats that impact any industry—including phishing scams, ransomware attacks and distributed denial of service, to name a few. While larger construction firms have taken measures to increase cybersecurity, many small to mid-sized companies aren’t fully aware of what threats they could face, or how to start hedging against them.

Compared to the financial services and healthcare industries, construction companies may not seem like a prime target for hackers, but documented cyber attacks have proven otherwise. Nine construction companies reported experiencing cyber attacks in 2015, an increase from just three incidents the prior year, according to the 2016 Verizon Data Breach Investigations Report.

In addition to proprietary employee data, other potentially vulnerable information includes sensitive client data, tenant personally identifiable information (PII) and non-public material information. Construction firms also house computer-aided design (CAD) drawings and blueprints to sensitive buildings, which hackers can exploit to inflict physical damage. From a national security perspective, firms involved in the construction of sensitive government facilities, critical infrastructure or even facilities for emergency management, public health or medical providers, could also be vulnerable to a cyberattack that might jeopardize those services.

Cybersecurity vulnerabilities in the construction industry are compounded by the growth of cloud computing and the Internet of Things (IoT). For example, as contractors move management and accounting software to the cloud, employees can access those systems on their personal devices. A breach occurring at the personal level, without the proper cybersecurity, could have severe implications for the larger cloud-based ecosystem. The same principle applies for the growing demand for smart devices, such as heating and cooling systems. With increased connectivity, the security and/or vulnerability of each individual device factors into the whole system’s integrity.

Cyber under-investment and negligence can cause real financial harm to construction companies. Here are the two key ways lax cybersecurity could turn into a business problem before a breach takes place.

  1. The Company Can’t Survive An Initial Cyber Vetting.

New York’s Department of Financial Services (NYDFS) recently issued the “first-in-the-nation” cybersecurity regulation. Under this guidance, financial institutions are required to implement written third-party cyber risk policies and confirm strong due diligence practices are used to evaluate the adequacy of third parties’ cyber practices. Contractors are increasingly asked to demonstrate sound cybersecurity practices, whether under a law such as the NYDFS cybersecurity regulations or as an emerging best practice. In addition, the standardization of third-party cyber risk assessments makes it easier than ever for companies to vet third-party vendors and contractors. Construction companies that either lack these internal controls or are unable to effectively communicate them may be unable to survive many request for proposal (RFP) processes—or may even be ineligible to participate or prequalify for a project owner.

  1. Your Competitors Offer More Security.

All other things being equal and given the financial and reputational fallout from a cyber incident, clients will opt to entrust their data to contractors with strong, documented cybersecurity practices. To protect their own reputations, decision makers within the client’s enterprise are likely to place a high priority on this issue, making cybersecurity an important differentiator in the marketplace.

Companies of all sizes are at risk. In 2015, 43 percent of cyberattacks were against small businesses with less than 250 employees, according to data from Symantec. The reputational and fiscal damage resulting from a cyberattack is far more impactful for small businesses. In fact, a Cyber Security Alliance study found that 60 percent of small businesses that experience a substantial cyberattack are permanently put out of business within a six-month period. Cybercriminals may specifically target mid-sized and smaller construction companies, which may not have prioritized cybersecurity like their larger counterparts. Further, it may pose a risk to large general contractors who rely heavily on smaller subcontractors, who may not have properly assessed their cybersecurity.

As the construction industry ventures into the technological realm, companies can’t afford to ignore cybersecurity. The first step to strengthening cybersecurity is conducting a risk assessment to understand a company’s vulnerabilities and business risks. Once contractors have a baseline understanding of their cybersecurity needs, they can shore up their policies. Being able to demonstrate a commitment to strong cybersecurity practices is becoming a key issue for today’s contractors, even if they’ve never experienced a data breach.

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

PErspective in Real Estate

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

Federal regulators—the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC)—have increased their scrutiny of commercial real estate loans, urging lenders to strengthen terms amid fears of a real estate bubble. This is deterring small, local banks from issuing new loans, and many are selling off the loans they do own to PE firms, pension funds, foreign banks and other institutional lenders, according to The New York Times. Large banks are also retreating, as they can no longer count on selling portions of large loans to smaller banks.

The absence of other lenders is drawing PE firms, hedge funds and REITs into the debt investing space, with a particular focus on bridge and mezzanine loans. Last year, private equity real estate debt funds raised $15 billion, with just 5 percent of firms targeting bridge loans. Research firm Preqin predicts fundraising will be stronger this year, with 48 percent of firms targeting mezzanine loans and 23 percent considering bridge loans. Just 5 percent of firms were looking at bridge loans last year.

The last four years have seen a rush of new bridge lenders coming to market, including Calmwater Capital, Streamline Realty Funding, ACORE Capital, Amherst Capital and RealtyMogul, National Real Estate Investor reports. Existing private lenders—Blackstone and Starwood at the high end, as well as smaller lenders, including PrimeLending, Mesa West Capital and Garrison Investment Group—have increased issuance, providing non-recourse transitional or bridge loans.

Pension funds and institutional investors have been increasing allocations to real estate over the past several years, despite geopolitical uncertainty that has reduced confidence in the market. Average target allocation to real estate among global institutional investors will hit 10.3 percent in 2017 totaling more than $1.07 trillion, up from 9.9 percent in 2016, according to a study from real estate advisory firm Hodes Weill and Cornell University. However, as a defensive strategy ahead of a potential down cycle, these firms are increasingly focused on debt rather than equity, according to The Telegraph.

Despite the maturity of the market, capital will continue flowing into the sector in 2017 as institutional investors seek to achieve their return objectives in the continued low-yield environment, National Real Estate Investor reports. But class-B properties in secondary cities—which can offer higher yields, but are riskier—are becoming less popular. Instead, many core institutional investors are exercising more caution and flocking toward more reliable assets in major market areas with credit tenancy and sold leasing in place.

There is a potential for strong exits and fundraising in the current market. PE titan Blackstone sold $7.2 billion in real estate assets in the third quarter, and raised $68.5 billion in new funds during the first three quarters, lifting the firm’s assets under management to a record-high $361 billion, The Wall Street Journal reported.

As real estate becomes an increasingly mainstream alternative asset class, debt-related funds present a significant opportunity for PE firms and pension funds looking to achieve reliable returns and safeguard against a potential downturn in the real estate market.

Sources: Bloomberg, Mansion Global, National Real Estate Investor Online, New York Times, The Real Deal, The Telegraph, Wall Street Journal

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

Trump administration policy details are largely still unknown, but proposed tax cuts and infrastructure spending could be a boon for real estate development as well as the construction industry. However, if the tax rate on carried interest is increased, as President-elect Trump has previously advocated, it could dampen PE real estate deal flow, according to Bloomberg. On the other hand, a separate and contradictory proposal could reduce the tax burden for hedge fund, VC and PE fund managers dramatically, having the opposite effect. Meanwhile, protectionist policies could hurt international investment. Cross-border spending reached $100 billion in 2015—18 percent of total U.S. commercial real estate spending, Bloomberg reports. For the near future, uncertainty is the only certainty, and fund managers may seek to diversify their holdings, to the benefit of secondary markets like Melbourne, Amsterdam and Vancouver, according to Mansion Global.

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