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. www.bdo.com

A Deeper Dive Into ASU 2016-14 Implementation Issues

By Tammy Ricciardella, CPA

As organizations look to implement ASU 2016-14 and meet its requirements, they must account for how these changes may impact how they collect information. This article will highlight three of these areas:

Investment Expenses

As we have noted, the ASU now requires the netting of investment expenses against investment return; in addition, only the net amount of the investment return is required to be presented in the statement of activities. The investment expenses that should be netted against the investment return are both internal and external. To comply with this presentation, organizations need to fully understand the definitions of these terms and then consider how to appropriately and accurately capture this information.

The ASU states that investment returns related to total return investing and not programmatic investing should be reported net of external and direct internal investment expenses. Programmatic investing is defined as “the activity of making loans or other investments that are directed at carrying out a not-for-profit entity’s purpose for existence rather than investing in the general production of income or appreciation of an asset.” An example of programmatic investing is a loan made to lower-income individuals to promote home ownership.

External investment expenses are those that are reported to the organization by the external money managers and other external investment management firms related to the management of the investment portfolio. This information will be obtained from the external investment firms based on what they have charged.

Direct internal investment expenses are defined in the ASU as those that involve the direct conduct or supervision of the strategic and tactical activities involved in generating investment return. These include, but are not limited to, the following:

  • Salaries, benefits, travel and other costs associated with the officer and staff responsible for the development and execution of investment strategy, and
  • Allocable costs associated with internal investment management and supervising, selecting, and monitoring of external investment management firms.

Direct internal investment expenses do not include items that are not associated with generating investment return. For example, the accounting staff costs associated with reconciling accounts, recording transactions, maintaining the unitization of pooled investment accounts and other such clerical staff time are not direct internal investment expenses, so they would not be included.

Accounting for investment expenses and the related allocation of costs is a process that organizations will have to develop to properly present these investment costs under the provisions of the ASU. The complexity of this will depend on the type of organization and the amount and nature of their investments. For example, the management of a large foundation that handles the strategic aspects of investing their assets internally will have to analyze and establish an allocation methodology for the salaries, benefits and travel related to the total return investing. Entities will need to identify all personnel who participate in the investment process and determine if they have a strategic role or not. In addition, entities may need to develop a process and make modifications to timesheets or other tracking methodologies to capture the time spent aiding the identification and allocation of these costs.

Liquidity and Availability Disclosures

Under the ASU, specific quantitative and qualitative information related to the new liquidity and availability requirements is required to be disclosed. Organizations should assess how they manage their liquid resources to ensure they can meet their cash needs for general expenditures as of and within one year, respectively, of the statement of financial position date. In addition, organizations will need to evaluate their financial assets to determine their availability to meet cash needs; consider the nature of the assets; examine the external limits imposed by donors, laws, and contracts; and account for any internal limits imposed by governing board decisions. These limitations need to be analyzed and tracked so the organization can identify its available financial assets and provide the necessary disclosures. Other qualitative issues including special borrowing arrangements or instances whereby the entity has not maintained appropriate amounts of cash as required by donor-imposed restrictions and limitations that result from contractual agreements with suppliers, creditors, loan covenants and other sources need to be identified and evaluated to prepare the appropriate disclosures.

Internal Net Asset Designations

Under ASU 2016-14, the accounting treatment for internally designated net assets hasn’t changed; however, the presentation of these amounts and the disclosures have. These changes require entities to properly track these amounts and their related purpose so they can meet the ASU’s disclosure requirements.

As we have noted in the past, organizations should review the ASU now and take these items and others into consideration when developing their implementation plan. Though the ASU does not have to be implemented until calendar year 2018 or fiscal year 2019 year ends, preparing for it takes careful planning, so organizations would be well advised to begin the process as soon as possible.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Winter 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

Gotta Get Away: Timeshares, Hotels and the Sharing Economy

By Kevin Riley

It’s a familiar tale: An entrepreneurial business model enters the real estate market, disrupting traditional players. Even now-ubiquitous chain hotels were once a disruptor and, in the 1970s, timeshare executives were the ones shaking up the hospitality market. Timeshares became such a competitive presence that every major hotel conglomerate entered the market and acquired existing, successful companies. Now, in the past few years, timeshare businesses have adapted to the digital age and rapidly diversified their offerings to appeal to a changing consumer base. Perhaps because of its entrepreneurial roots, the timeshare industry may be well-positioned to adapt and weather the market’s newest disruption: the sharing economy and the growth of online rental platforms offering an alternative—and in many cases, more affordable—hospitality experience.

The power is in the hands of the consumer. With an expanding pool of options available for consumers, vacation rental providers are jockeying for travelers’ dollars. Online platforms, such as HomeAway, and its subsidiary VRBO, offer consumers a different travel experience, with accommodations available at their fingertips. The flexibility these platforms provide has particularly resonated with millennials and anyone traveling on a budget.

Because the traditional timeshare model offers an alternative to purchasing a second home, rental platforms have impacted timeshares differently than hotels. Timeshare buyers have long had access to a variety of travel destinations without the hassle of upkeep and maintenance. Destination choices, however, have evolved. For the past 15 years, some timeshare operators have prioritized expanding into urban areas, including major hubs like New York City and Miami, as well as secondary urban markets gaining popularity as cultural destinations, like Boston, San Diego, Vancouver and New Orleans. And competition could get fiercer in those markets, particularly because many customers are swayed by the authentic travel experience online rental platforms can offer via homestays and other non-traditional arrangements.

In addition to providing greater exposure for smaller competitors, the secure automated payment processing capabilities of online rental platforms also removed a barrier to entry into the market for these smaller players. Companies with a modest supply of vacation rentals, for example, may not have had the ability to obtain a merchant account to enable online transactions. While online rental platforms charge a host service fee for each transaction, that fee is a much cheaper alternative to a merchant account and allows small players to offer a convenience on par with larger hotels and timeshare companies.

As a testament to its financial adaptability, the timeshare industry has seen prominent deal activity in 2016. In June, private equity investment firm Apollo Global acquired Diamond Resorts International Inc. Following suit of other major hotel conglomerates, this December, Hilton Worldwide Holdings’ board of directors approved the spinoff of its timeshare business, Hilton Grand Vacations, which represented 12 percent of their top line, and Park Hotels & Resorts, Inc. The spinoffs are expected to be finalized in early January 2017. Starwood Hotels and Resorts also completed the spinoff and sale of its timeshare business, Vistana Signature Experiences this year, before finalizing its merger with Marriott, in September. Because the hotel industry is an entirely different business than timeshares, with different multiples and earnings, spinning off timeshares into a separate public entity is a common strategy.

All signs point to sustained growth of the sharing economy in the coming years. Hotel owners and timeshare operators alike would be wise to develop agile service offerings and adaptable marketing strategies to prepare for disruptions on the horizon and secure their share of the market.

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

 

PErspective in Manufacturing

A feature examining the role of private equity in the manufacturing space.

Private equity firms continue to exert influence on manufacturers’ global supply chains. There are a number of lucrative opportunities to create efficiencies and reduce operating costs along the entire supply chain, such as the impact of tax and duty on the bottom line.

Apollo Investment recently announced a partnership with Nike to build a regional apparel supply chain in the Americas for the sporting goods company, in contrast to the firm’s long-term strategy of overseas production. The new manufacturing and logistics company—in which Nike will not invest directly—aims to bring production closer to home, partly in response to growing demand for increased sustainability and domestic manufacturing. The vertically integrated manufacturing hub will enable Nike’s supply chain to be nimbler and will make it better suited to manufacture customized products, Forbes reports.

According to Supply and Demand Chain Executive, Apollo’s Special Situations I fund has so far acquired New Holland, a Pennsylvania-based apparel manufacturer, and ArtFX, a Virginia-based textile screen-printing and logistics company. Apollo plans to buy more apparel suppliers and textile firms in North and Central America, and build out new manufacturing plants, warehouses and logistics networks for Nike, Forbes reports.

In the auto manufacturing sector, Bain Capital is partnering with Japanese airbag manufacturer Daicel Group, and Carlyle Group is teaming up with Ningbo Joyson Electronic Corp.-owned Key Safety Systems to bid for Takata, an airbag supplier up for auction after a massive safety recall. KKR is also said to be mulling a bid, according to the Financial Times. With 70 million Takata airbag inflators globally scheduled for replacement by 2019, some of the bidders are considering bankruptcy proceedings to mitigate liabilities, Bloomberg reports. Because some of the world’s largest automakers are expected to spend the next few years recalling airbag parts, Takata set up a committee in February to negotiate with its carmaker customers and other stakeholders.

Following its 2015 purchase of Chinese plastics injection manufacturer Ying Shing Enterprises, Platinum Equity will acquire Singapore-based industrial parts distributor Broadway Industrial Group’s foam plastics and flow control devices divisions for $111 million, according to Mergers & Acquisitions. Platinum specializes in turning divestitures into stand-alone businesses, and has extensive experience in the Asian markets, according to a press release. The Los Angeles-based PE firm plans to grow the Asian business both organically and through strategic add-on acquisitions, Mergers & Acquisitions reports.

In an unusually large Japanese deal, PE firms Bain Capital, KKR and MBK Partners are submitting second-round bids for Nissan’s 41 percent stake in auto parts maker Calsonic Kansei, according to Reuters. The second bidding round is expected to close in October, so the value of bids cannot be ascertained. However, the parts maker has a market value of $2.4 billion, and therefore represents a rare opportunity for a large deal. The drastic restructuring methods often associated with PE have traditionally been a turn-off for Japanese companies, but Nissan invited buyout firms to submit bids after corporate buyers failed to materialize, Reuters reports.

Supply chain optimization is one of several ways PE firms can create value and efficiencies in the manufacturing industry. Whether it is building a manufacturing backbone that helps reduce transportation costs and import duties, or building a platform by acquiring similar supplier and distributor companies within a given industry across the globe, there are significant opportunities for PE firms with an interest in the sector.

Sources: Bloomberg News, Financial Times, Forbes, Insead, Mergers & Acquisitions, Reuters, Supply & Demand Chain Executive, Supply Chain Digest, Tompkins International

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Fall 2016). Copyright © 2016 BDO USA, LLP. All rights reserved. www.bdo.com

How Tax Law Changes May Impact Charitable Giving

By Laura Kalick, JD, LLM in Taxation

Whether we look at the blueprint for tax reform put forth by Republican House Ways and Means Committee members, the deliberations of the Senate Finance Committee’s bipartisan tax reform working groups or the tax proposals of President-elect Trump, there is a very real possibility that tax rates will be lowered in the near future. While the Internal Revenue Code (IRC) hasn’t seen a major overhaul since 1986, the tax law as we know it today may not be the tax law next year.

What does this mean for America’s charitable organizations? In a nutshell, charities should encourage donors to contribute before the end of the year to take advantage of more impactful deductions that may not be available if rates are lowered in the future. Accelerating charitable deductions now could be critical to maximize fundraising if near-term tax reforms include a dollar cap on total itemized deductions like charitable donations. Favorable provisions that now allow fair market value deductions for gifts of appreciated property to charity could come under scrutiny as well, further complicating fundraising potential.

Regardless of what unknown tax code changes are on the horizon, encouraging giving now—while the outcome is predictable—is imperative.

Below are some of the details of tax changes President-elect Trump proposed during his campaign:

Lowering the number of tax brackets for married joint filers from seven to three at the following rates:

• Less than $75,000: 12 percent
• More than $75,000 but less than $225,000: 25 percent
• More than $225,000: 33 percent

Capping itemized deductions and increasing the standard deduction:

• President-elect Trump proposed capping itemized deductions at $200,000 for married joint filers or $100,000 for single filers. These deductions would include charitable deductions, mortgage interest deductions, state tax deductions and others.

• The Trump plan would also increase the standard deduction for joint filers from $12,600 to $30,000, and the standard deduction for single filers will be $15,000. This means fewer people may be itemizing their deductions, and therefore may not be as concerned about generating deductions through charitable contributions.

Estate tax:

• Trump has also proposed eliminating the federal estate tax, currently at 40 percent. Charitable contributions from an estate reduce the overall taxable value of the estate. If there is no estate tax, charitable requests may be significantly reduced.

The future of charitable giving incentives

The charitable deduction is one of the ten largest tax expenditures in the IRC and has long been subject to proposed modifications, including extensive hearings held in 2013, which we covered here in the Nonprofit Standard blog. Proposals to limit the deduction have included dollar caps, floors below which contributions may not be deducted, credits instead of deductions and more. In addition to monetary contributions, many hearings have even included debate on whether the treatment of gifts of property to charities should be revisited. Every time changes are proposed, the nonprofit industry seeks to analyze how the proposals would raise revenue and impact charities.

Not all tax code changes negatively impact charities, however. Last year, Senators John Thune (R-S.D.) and Ron Wyden (D-Ore.) introduced the Charities Helping Americans Regularly Throughout the Year (CHARITY) Act. Among the provisions in the CHARITY Act, the Senate asserted that the promotion of charitable giving should be one of the goals of comprehensive tax reform. The House Tax Reform Blueprint would also provide incentives for charitable giving.

As charities make one final fundraising push to end 2016, they should encourage donors to make gifts now while the tax outcome is certain, rather than waiting until next year when the rules may be changed in a way that negatively affects their bottom line. Despite the interplay between tax deductions and charitable giving, the 2014 U.S. Trust Study of High Net Worth Philanthropy found that a desire to make a difference (73.5 percent) and personal satisfaction (73.1 percent) were the main motivators in giving, while tax benefit was cited by just 34.4 percent of respondents. In looking at those statistics, it’s clear that conveying a compelling mission is key to attracting and retaining donors.

There is enormous competition for charitable donations. It’s essential to make your organization’s mission emotionally compelling and relevant to take advantage of current favorable giving arrangements that may not last.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Winter 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

2016 Year in Review: Top Tax Issues Impacting the Real Estate Industry, Part One

By Tanya Thomas and Jeff Bilsky

The next tax filing season may seem far away, but as 2016 ends, taxpayers will begin the task of year-end tax planning. While 2016 was not a year for major tax reform or legislative action, there have been some notable regulatory changes. 2016 saw several pieces of regulatory guidance that could have an impact on acquisition and disposition transactions, entity structuring activities, taxable income calculations and tax accounting method options. As real estate owners and operators, construction companies, developers and REITs embark on analyzing their tax situation for 2016 and beyond, it’s critical to be aware of these new developments.

Though many tax changes proposed or finalized in 2016 could impact the real estate industry, in this article we highlight two areas that should be top of mind for leaders in the real estate industry at the start of the new year, including IRC Section 385 regulations, and a series of final, temporary and proposed regulations under IRC Sections 704, 707 and 752.

IRC Section 385 Regulations

Debt equity regulations under IRC Section 385 were finalized in October. The proposed regulations, issued in April, were set to re-characterize certain intercompany debt instruments as equity, most likely preferred equity. If finalized as they were proposed, these regulations could have adversely impacted REITs and caused qualification issues with the REIT testing provisions. The finalized regulations significantly altered parts of the proposed regulations and, in general, give the IRS authority to re-characterize certain intercompany debt instruments as stock. The new IRC Section 385 regulations are intended to curb certain earnings stripping situations often used as domestic and international tax planning strategies. The regulations were specifically directed at curtailing inversion transactions, or those involving the movement of a multinational U.S. group’s tax residence outside of the United States.

While the new regulations do not appear to adversely impact SEC-registered REITs and their interaction with Taxable REIT Subsidiary (TRS) entities and subsidiary REITs, there is some impact to Foreign Investment in Real Property Tax Act (FIRPTA) “blocker” structures involving a C corporation owning controlling interests in subsidiary REITs. The final regulations exempt “non-controlled” REITs from all aspects of the regulations. As a result, unless controlled by 80 percent or more of vote or value by an includible member of an expanded group, such as a non-REIT C corporation, a REIT will not be part of a member of an expanded group. Based on this change, there will not be any requirement of additional documentation or re-characterization of debt for the following:

(1) Lower-tier REITs of non-controlled REITs; or
(2) Taxable REIT subsidiaries of non-controlled REITs.

However, a non-REIT C corporation and its 80 percent-or-more-owned REIT would be within the scope of the final regulations. Because of the new IRC Section 385 regulations, it is critical for taxpayers with “blocker” REIT structures to analyze the new regulations and consider their potential impact and requirements. For more in-depth details of the regulations and the various provisions, refer to our comprehensive alert on Section 385 issued in October.

Final, Temporary and Proposed Regulations under IRC Sections 704, 707 and 752

In October, the U.S. Treasury and the IRS released long-awaited guidance on liability allocations under IRC Section 752, disguised sales under IRC Section 707 and deficit restoration obligations under IRC Section 704. IRC Sections 704, 707 and 752 apply to entities that operate as partnerships, and given that many taxpayers in the real estate industry utilize partnerships in their structures, it is critical to evaluate these new rules. The regulations represent significant changes in partnership taxation and will have a critical impact on planning for partnership formation and restructuring transactions, as well as ongoing operations.

When the IRS proposed these regulations in January 2014, it was widely perceived that the regulations could change whether certain obligations resulted in a partner having economic risk of loss for a partnership liability under IRC Section 752. This, in turn, could impact a partner’s ability to deduct losses and receive tax-deferred cash distributions from the partnership. Additionally, the originally proposed disguised sale regulations and clarified certain aspects of existing exceptions. The final regulations take a multifaceted approach and address some of the provisions that were accepted when proposed, while withdrawing and re-proposing some of the aspects that tax advisors were concerned about.

• Final and temporary regulations under IRC Sections 707 and 752 provide guidance around disguised sales of property to or by a partnership and impact existing regulatory exceptions. The regulations severely limit the effectiveness of the debt-financed distribution exception. This is accomplished by changing the way liabilities must be allocated under IRC Section 752 for purposes of the debt-financed distribution exception. Further, the regulations clarify that the preformation expenditure exception generally applies on an asset-by-asset basis with limited opportunity to aggregate assets. The regulations also eliminate the ability to apply the preformation expenditure exception to expenditures funded with qualified liabilities.

• Final and temporary regulations under IRC Section 752 provide rules around when certain obligations are recognized for the purpose of determining whether a liability is a recourse partnership liability. The regulations effectively eliminate a taxpayer’s ability to use “bottom-dollar guarantees” to create economic risk of loss. Without economic risk of loss, partners may be allocated fewer partnership liabilities, resulting in a lower overall tax basis. A lower tax basis may limit the ability of the partner to deduct allocated losses. Further, partners with negative tax capital accounts may be required to recognize taxable income to the extent at which they are allocated fewer partnership liabilities.

• Proposed regulations withdraw and re-propose regulations under IRC Sections 752 and 704. These proposed regulations strengthen anti-abuse rules in determining whether a partner bears economic risk of loss for partnership liabilities under IRC Section 752, and would create similar anti-abuse rules relating to certain obligations to restore a deficit in a partner’s capital account under IRC Section 704.
The new regulations are important because real estate taxpayers often operate in a partnership format or use partnerships in their organizational structures. Within the REIT industry, these new provisions could significantly impact the operating partnership under REITs or UPREITs, including the formation of UPREITs.

In October, BDO’s National Tax Office issued three alerts related to the new partnership regulations. For an in-depth discussion of these regulations and their applicability, refer to our alert addressing disguised sales under IRCS Section 707 and Section 752, our alert relating to the determination of recourse liabilities under Section 752, and our alert discussing the re-proposed regulations.

Conclusion

As we barrel toward the start of another year and a new president prepares to take office and potentially institute more significant tax reform, the time to review regulatory tax changes is now. Real estate owners and operators, construction companies, developers and REITs face an array of opportunities and challenges in the new year. With forthcoming uncertainty due to market fluctuations and a potential increase in interest rates, getting into compliance with new tax provisions now could establish a sturdier foundation for real estate companies to weather potential disruptions ahead.
Stay tuned for more of this series in future issues of the Real Estate & Construction Monitor, where we’ll continue this discussion, focusing on other key tax developments impacting the real estate industry and developments specifically applicable to REITs. In part two, we’ll examine several recent court decisions and rulings that could have an impact on the real estate industry with respect to acquisitions and dispositions and tax accounting methods.

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

How to Keep the Lid on your Finances when a Food Recall Strikes

By Clark Schweers & Rick Schreiber

Some of the biggest names in the grocery aisle have made headlines this year with high-profile recalls, including General Mills and Kellogg, among numerous other household staples. Major food manufacturers, including ConAgra, have also pulled their products from market with nationwide recalls. In fact, this year, the U.S. Department of Agriculture (USDA) has recorded 51 food safety and inspection recalls and alerts through Aug. 30, up a whopping 121.7 percent from the same period in 2015, when it recorded just 23. In 2014, the USDA recorded 39 recalls and alerts over the same time period, a figure approximately 30 percent lower than this year.

Manufacturers have noticed. According to the 2016 BDO Manufacturing RiskFactor Report, 100 percent of the largest publicly traded U.S. food manufacturers cite product quality, contamination issues or recalls as a significant business risk in their regulatory filings, up from 90 percent in 2015.

And it’s clear the stakes are high not just for manufacturers, but for suppliers, retailers and grocers up and down the entire supply chain. It’s important to understand why recalls are growing more common and to implement protective measures to mitigate risk before your supply chain sours.

What’s turning up the heat?

Often, upticks in regulatory action can simply be due to a more watchful eye from regulatory bodies. In 2015, President Obama signed into law the Food Safety Modernization Act (FSMA), arguably the most sweeping reform of food safety in more than 70 years. The FSMA provides the FDA with new legislative authority to establish preventive control standards and enforce compliance, as well as tools to better respond to problems when they do occur.

But while increased regulatory scrutiny is likely a contributor to the increase in product recalls and contamination issues, it’s not entirely to blame. Shifting consumer preferences are prompting dramatic changes in the industry as some food manufacturers remove pesticides, preservatives and other additives from their products to take advantage of the organic craze. While the popularity of organic food is driven by a trend toward greater consciousness of health and wellness, synthetic substances serve an important role in safeguarding against spoilage and foodborne illness. More recently, food manufacturers have also begun removing preservatives and artificial ingredients from non-organic food, in response to demand for “natural” foods. The long-term health benefits of organic or natural foods remain unclear, but there’s no question that the preservatives they exclude prevent bacterial growth during transport and distribution.

Technology has also changed the way we detect and report on foodborne illness. Individual incidents that historically would have been dismissed as one-off episodes and gone unreported can now be tracked and connected by Genome and DNA testing. This allows regulators to better pinpoint the source of foodborne illness outbreaks, which could be contributing to the number of product recalls. Social media and consumer-run websites have also become popular forums for bringing an outbreak to attention.

Gloves on: What protective measures can help?

Food processed at a single plant can be routed far and wide through the market — for example, a large processor’s fruit may be sold in frozen bulk, smoothie mixes and other products under various manufacturers’ brand names nationwide. This makes the process of a product recall potentially extensive and costly. And the consequences can persist long after the financial bleeding stops — reputation can also take a serious bruising.

To shield themselves from the consequences of a contamination incident or recall, food manufacturers should consider these protective measures:

  1. Implement strong supply chain management procedures.
    An ounce of prevention is worth a pound of cure. Thoroughly understanding where risk lies along the supply chain and implementing strong quality controls can help to mitigate and detect food contamination before an outbreak occurs. To proactively manage the risk of a food recall incident, food manufacturers should implement policies and procedures to ensure their suppliers’
    and their own compliance with Current Good Manufacturing Practice regulations and the latest food safety standards, including food allergen controls and routine food safety audits by third-party certification bodies.
  2. Review contracts.
    Heavyweights in the retail industry are increasingly including indemnifications against damages in the event of a product recall or critical incident in their contracts with suppliers and manufacturers. Food manufacturers should thoroughly evaluate their agreements with distributors and retailers to identify where responsibility lies in the event of a recall, and avoid risky business where possible.
  3. Expect the worst.
    Every food facility should have an up-to-date crisis management plan that establishes roles and responsibilities and outlines a strategy for every possible scenario.
  4. Invest in insurance protection.
    Product contamination policies have gained popularity in recent years — not only because of the increased spotlight on food safety, but because investors expect it. Fortunately, as more companies incorporate liability, property and product recall policies within their coverage, more carriers have entered the market and the growing demand has pushed premiums down.

Boiling over: How to limit the damage?

No manufacturer is entirely safe from the risk of a recall or contamination incident. It’s important to have a contingency plan in place to help identify the source of the contamination and isolate the problem to prevent further spread in plants and factories. Manufacturers should also have a response plan prepared to curb potential financial and reputational fallout. Consumers and investors alike are much more forgiving when companies react and respond quickly.

In the event of a contamination incident, it’s also important to factor in potential losses to financial forecasts to staunch the bleeding and avoid future surprises. With recalls on the rise, companies should take a close eye to their insurance policies and contracts with supply chain partners to pinpoint risk, and ensure the right protective measures are in place to keep the supply chain in check and limit damage in the event of a recall.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Fall 2016). Copyright © 2016 BDO USA, LLP. All rights reserved. www.bdo.com

Big Data: How Big An Impact for REITs?

By Stuart Eisenberg

Big Data is big-time ubiquitous in headlines across industries, but the real estate industry has been slow to take advantage. That’s all changing. Commercial real estate companies and REITs are embracing new technologies to harness the power of Big Data to elevate their investment and management strategies and optimize their operations.

When we talk about Big Data, we mean the exponential growth in volume, variety and velocity of structured and unstructured data. That data, however, is only as useful as our ability to interpret it—an ongoing challenge for every organization. But in recent years, advanced analytics and powerful business intelligence technologies have enabled us to extract real value from Big Data. And it’s about time, because Big Data is only getting bigger. Embedded sensor technology and wireless connectivity have opened up a whole new world of information—the so-called “Internet of Things.” In real estate, as in most industries, knowledge is power; those who not only have the information but know how to use it are empowered to make smarter decisions, faster.

Of course, all investment decisions ultimately hinge on investors’ future predictions. But there are several significant ways real estate developers and owners, REITs included, can gain an edge by turning Big Data into actionable insights.

On the investment front, property owners have access to unprecedented information and intelligence around demographics, supply and demand trends and economic nuances—and better algorithms to analyze that intelligence. At a time when REITs are wise to exercise restraint in their investment decisions and deploy capital sensibly, this could be a valuable tool to help them better understand and target certain markets. At the property level, many variables impact an asset’s value, and with the rise of Big Data, REITs are able to analyze demand for specific features within a property, including amenities, as well as LEED status and energy efficiency. This intelligence can help enhance value by better aligning with tenants’ demands.

From a management perspective, greater access to demographic and real-time local trend data can help landlords, including REITs, make decisions at the individual property level. When setting rents, for example, REITs might analyze traditional population data along with new, non-traditional data sources to determine if a certain property is a candidate for a rent increase, or if they’ll need to invest in upgrades or other perks to attract and keep tenants. Similarly, activity trackers and smart watches and phones mean more data is available than ever before at the individual level. If data indicates people in a certain population center are walking or biking more instead of driving, REITs might forecast increased demand for properties in their portfolios that are near walkable retail centers, entertainment and other amenities.

From an operational perspective, the application of the Internet of Things within properties themselves allows owners to capture and analyze data from physical objects. Many owners are upgrading their buildings and automating certain decision-making processes to build efficiencies. For example, many have installed smart sensors and devices that can track temperature, air quality and other metrics that proactively alert owners to maintenance or repair needs within their properties. Many are also automating back-office processes. As more new technologies come into the market, REITs and other property owners will be better able to monitor properties, trim costs and make their overall operations processes smarter.

It’s clear that Big Data affords real estate owners and REITs a big dose of opportunity to better predict, monitor and measure their investments, and could ultimately unlock more value for shareholders.

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

New Deferred Compensation Regulations: What Nonprofits Need to Know

By Joan Vines, CPA

The Internal Revenue Service (IRS) released proposed regulations that provide guidance for the nonqualified deferred compensation arrangements of tax-exempt organizations in June. The regulations, which have been anticipated by the industry since 2007, address the interplay between Internal Revenue Code Section 457 and Section 409A, which govern the nonqualified deferred compensation arrangements of all employers, including tax-exempt organizations. The newly proposed Section 457 regulations provide plan design opportunities specifically for tax-exempt employers, which could aid in the recruitment and retention of key executives.

The proposed regulations provide comprehensive guidance for nonprofit employers and offer several options for employers structuring deferred compensation plans. Section 457(f) requires the immediate taxation of nonqualified deferred compensation upon vesting. Its newly proposed regulations contain plan design features that effectively delay the vesting event, thereby avoiding immediate taxation and providing much-needed clarity to when compensation is subject to or exempt from Section 457(f).

The proposed regulations become effective upon finalization, but may be relied upon in the meantime.

The new regulations distinguish between for-profit and nonprofit deferred compensation requirements with changes specific to six aspects—risk of forfeiture, salary deferrals, noncompete agreements, short-term deferrals, severance pay and other welfare plans.

ROLLING RISK OF FORFEITURE
The proposed regulations permit an upcoming vesting date, as well as the point of taxation, to be extended, provided:

• The extension is made at least 90 days before the vesting date;

• The extended vesting is conditioned upon the employee’s provision of substantial services for at least two years (absent an intervening event such as death, disability or involuntary severance from employment); and

• The present value of the amount to be paid at vesting must be more than 125 percent of the amount the employee otherwise would have received in absence of the extended vesting date.

BDO Insight: Section 409A similarly disregards an extended risk of forfeiture, unless the present value of the deferral is materially greater than the amount otherwise payable absent such extension. However, Section 409A does not provide a bright line test to determine “materially greater” and does not require a two-year, service-based minimum extension. The Section 457 proposed regulations are more rigid with respect to tax-exempt employers. Where an employer is exempt from U.S. taxation, the employee derives a tax benefit from the deferral while the employer is indifferent. The additional payout required under the Section 457 proposed regulations is designed to constrain tax-motivated deferrals by employees. A tax-exempt employer may not be as willing to agree to the additional vesting period if the payout is significantly higher. For instance, an employer might prefer to pay $100,000 in 2018, rather than potentially more than $125,000 in 2020.

SALARY DEFERRALS
Under prior guidance, current compensation, including salary, commissions and certain bonuses, was considered vested and therefore ineligible for deferral under Section 457(f). However, the proposed regulations permit current compensation to be deferred under Section 457(f), provided the following rules are met:
• The deferral election must be made in writing before the beginning of the calendar year in which any services that give rise to the compensation are performed (or within 30 days after a new employee’s hire date for pay attributable to services rendered after the deferral election);

• Payment of the deferred amounts must be conditioned upon the employee’s substantial services for at least two years (absent an applicable intervening event); and

• The present value of the amount to be paid at vesting must be more than 125 percent of the amount the employee otherwise would have received in absence of the deferral.

BDO Insight: The two-year minimum deferral period applies separately to each payroll deferral. Additionally, an employer match of more than 25 percent may be required to satisfy the 125 percent rule for salary deferrals.

NONCOMPETE AGREEMENTS
Under prior guidance, the vesting schedule for deferred compensation served as a retention mechanism, requiring the employee’s continuous services through the vesting date as a condition to receive the amount. Under the newly proposed regulations, vesting may also serve as an enforcement mechanism for a noncompete covenant, requiring an employee to refrain from providing services to a competitor for a specified period. Provided the noncompete is a written, bona fide and enforceable covenant, the vesting period may be extended through the end of the restrictive period, allowing tax-exempt employers to make post-employment payments during such period. In addition, deferred compensation payable upon a voluntary termination is no longer treated as fully vested at all times if the amounts could be forfeited in accordance with the terms of a bona fide noncompete covenant.

BDO Insight: Among other factors applied to determine a bona fide noncompete covenant, the facts and circumstances must show that the employer has a substantial interest in preventing the employee from performing the prohibited services. To the extent the compensation paid to the employee for entering into a noncompete agreement exceeds the value of such agreement, (measured, for example, by the economic damages the organization would incur from an employee’s violation of that covenant), then the restrictive covenant may not be a bona fide noncompete agreement for purposes of Section 457. A valuation of the noncompete agreement may be in order to support an extension of the vesting date to the end of the restrictive period.

SHORT-TERM DEFERRALS
The proposed regulations provide that Section 457(f) does not apply to an arrangement in which payment is made within the “2 ½ month short-term deferral period” under Section 409A, which is generally March 15 of the first calendar year following the year of vesting.
BDO Insight: The Section 457 proposed regulations apply the Section 409A definition of short-term deferral, but substitute its own definition for “substantial risk of forfeiture.” Accordingly, a short-term deferral under Section 457 may not constitute a short-term deferral under Section 409A as is the case of a plan with a noncompete vesting provision. Technically, income taxes are due upon vesting under Section 457(f). However, the proposed regulations make clear that short-term deferrals are not subject to Section 457(f), thereby allowing income taxes to be collected upon distribution, which is administratively convenient where there is a gap between the vesting and distribution dates.

SEVERANCE PAY
The proposed regulations provide that Section 457(f) does not apply to severance pay in connection with an involuntary separation from service (including a voluntary termination by the employee for a pre-established, good reason condition that has not been remedied by the employer) or pursuant to a window program or an early retirement incentive plan. Payments under such “bona fide severance pay plans” must not exceed two times the employee’s annualized compensation for the preceding calendar year (or the current calendar year if the employee had no compensation from the employer in the preceding year) and payment must be made by the last day of the second calendar year following the calendar year in which the severance occurs.

BDO Insight: Pay due to an involuntary separation from service or participation in a window program is similarly exempt from Section 409A in limited amounts (the lesser of two times the employee’s annual rate of pay for the preceding year or two times the compensation limit set forth under Section 401(a) (17) for the year of separation).

OTHER WELFARE PLANS
The proposed regulations clarify that Section 457(f) does not apply to bona fide death benefit, disability pay, sick leave and vacation leave plans.

BDO Insight: Section 409A similarly exempts such welfare plans from its deferred compensation rules.

WHAT SHOULD I DO NOW?
Prior to the finalization of these regulations, tax-exempt organizations can take immediate action to align current deferred compensation procedures with the recent changes. Nonprofits, foundations and universities should review their current arrangements, severance plans and welfare benefit plans in light of these proposed regulations, and develop a plan to implement the necessary updates. Additionally, nonprofit executives should be proactive and take steps to effectively communicate with their employees in regards to the changes.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Fall 2016). Copyright © 2016 BDO USA, LLP. All rights reserved. www.bdo.com

Did you know…

According to the 2016 BDO Manufacturing RiskFactor Report, the top 100 U.S. manufacturers unanimously cited supply chain concerns as a key business risk for the third year running.

The manufacturing industry has been hit hardest by ransomware, with 54 percent of manufacturers reporting an attack, according to a recent survey by security company KnowBe4.

According to the latest survey from consulting firm J.D. Power, 21 of 33 automakers in the survey improved car quality. Scores improved 6 percent over 2015, marking the biggest jump in seven years.

Forty-seven percent of distributors report increasing their staff in the last 12 months, while 22 percent have reduced their staff in the same time, according to Industrial Distribution’s annual Survey of Distributor Operations.

Activity in the manufacturing sector expanded for the fourth month in a row in June, according to the Institute of Supply Management’s Report on Business.

This article originally appeared in BDO USA, LLP’s “Manufacturing & Distribution” newsletter (Summer 2016). Copyright © 2016 BDO USA, LLP. All rights reserved. www.bdo.com