How the New Tax Law Impacts Commercial Real Estate Investment

January 17, 2018


How the New Tax Law Impacts Commercial Real Estate Investment

January 16, 2018 | James Sprow | Blue Vault

United States Capitol Building, Washington, DC

We can parse the impacts of the new tax law that President Trump signed recently into first effects and secondary effects. Put simply, some provisions are likely to directly affect the cash flows to investors from commercial real estate, while other provisions have more complicated effects via their long-term impacts on the supply and demand for different categories of commercial real estate.

First, the 1031 tax-deferred exchange, the mortgage interest deduction for real estate investment, and depreciation allowed for real estate changed very little. This means that some of the more obvious and important tax law provisions remain unchanged, and investors will not need to adjust their thinking or investment decisions to account for them.

One major positive effect of the tax law passage for both the economy in general and commercial real estate investment specifically is the removal of uncertainty. Investment decisions are always made in an environment of uncertainty and risk. When uncertainty is high, investment decision models are adjusted to require higher expected returns to compensate. When the tax bill passed, investors could more accurately forecast future after-tax cash flows, reducing the need to add an “uncertainty premium” to their models.

The 20% reduction of taxes on pass-through entities such as Limited Liability Companies (LLCs) in 2018 that will apply to 2019 tax filings could mean that, on an after-tax basis, commercial real estate could provide better risk-adjusted returns relative to dividend-paying stocks and bonds. More passive capital may be invested in the sector via syndications, partnerships and other pass-through funds.

The secondary or indirect effects of the tax law changes could be just as important as the direct effects. By increasing the standard deduction and capping the deductions for local property taxes and state income taxes, the demand for housing could be affected in higher-taxed states. 

By dropping the maximum corporate tax rate from 35 percent to 21 percent and granting businesses generous expensing and depreciation rules, we can expect increased capital expenditures by corporations, some of which will increase demand for industrial and office space. On the other hand, the elimination of the personal mandate in the Affordable Care Act could dampen long-term demand for healthcare-related real estate.

Marcus & Millichap estimate that the tax law, by raising the standard deduction and capping property and local and state income tax deductions for homeowners, raises the threshold home price that benefits from itemized deductions from the $200,000 range to $400,000 for married couples. This could reduce demand from first-time home buyers and raise demand for apartments.

The elimination of the personal mandate in the ACA is estimated to reduce the number of persons with health insurance by 5 percent, modestly reducing the demand for healthcare and inducing a slight downshift in demand for healthcare real estate. Still, the aging population will increase demand for healthcare services, but the net effect on demand will be less than it would have been with the personal mandate in place.

Marcus & Millichap also highlight single-tenant net-lease properties as a sector that could receive a disproportionate share of new investment. This asset class is often occupied by credit-worthy tenants on long leases and could give passive investors yields that fit well in investment funds that are structured to benefit from the new pass-through rules.

The newly expanded expensing rules that will allow business owners to fully expense up to $1 million of depreciable tangible personal property used to furnish lodgings will allow investors in hospitality, student housing, and seniors housing to deduct the full cost of furniture placed in service rather than depreciating them over multiple years. The rules will also apply to roofs, heating, ventilation and security systems in non-residential property, benefitting small businesses primarily as the deductions are phased out as business investment purchases exceed $2.5 million. 

Along with these other direct impacts, the secondary macroeconomic effects of the tax bill can be important as well. Consider:
•   Job creation has been positive for a record 86 months. Unemployment is in the low 4 percent range and wage growth may accelerate. Consumer and business confidence is high. Tax law changes will reinforce these trends.
•   Increased corporate investment due to the lower corporate tax rate and changes to depreciation and expensing rules will support higher rates of economic growth. Repatriation of overseas earnings will increase U.S. corporate liquidity and economic growth.
•   Most individuals will see a reduction in personal income taxes, boosting consumption, the main component of economic growth in the U.S.
•   The housing sector will likely be negatively impacted, more in high-tax jurisdictions, reducing the demand by first-time buyers.
•   The Fed will likely raise its benchmark interest rate three times in 2018 and reduce its balance sheet, keeping its eye on inflation and attempting to increase long-term rates.

Bottom line, the first major tax bill to be signed into law in decades will have many direct and indirect impacts on commercial real estate values and investors, mostly positive.

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