Even in the most heated political climates, not every bill introduced in the House of Representatives calls for partisan division. Without public fanfare and by an overwhelming majority-401 to 11-the House passed legislation on July 30 that eases some impediments to foreign ownership of real estate investment trusts. Following on Dodd-Frank and in advance of GSE reform, this initial legislative victory for H.R. 5901 marks but one in a series of potential changes in the laws governing how and by whom the commercial real estate sector is financed.
The grandly named Real Estate Jobs and Investment Act of 2010 is, in fact, rather narrow in its application if not its title. Stated in simple terms, the legislation, introduced by Congressman Joe Crowley of New York City’s own 7th District, increases a foreign investor’s allowable ownership interest in a publicly traded REIT from 5 percent to 10 percent; holdings above this level subject the investor to the tax and administration provisions of the 1980 Foreign Investment in Real Property Tax Act (FIRPTA).
Having passed the House, FIRPTA reform has now been placed on the Senate’s legislative calendar. In part, the ease with which the bill passed the House may relate to its negligible but net positive budgetary impact. According to the Congressional Budget Office, the changes to FIRPTA will reduce the deficit by $143 million between 2010 and 2015. Related tax receipts fall in later years, so the 10-year impact of the legislation is a smaller $61 million decline in the deficit. Either way, the CBO’s estimates suggest that the marginal change in investment resulting from the tax code adjustment will be similarly modest in comparison to overall real estate capital flows.
Notwithstanding the CBO findings, the industry’s representatives in Washington have been proponents of FIRPTA reform for some time. The lion’s share has voiced its endorsement of Mr. Crowley’s proposal in recent letters of support. The Real Estate Roundtable, in particular, has included changes to the tax treatment of foreign investments among its 2010 legislative priorities.
But the House bill does not go as far as many in our industry would have anticipated. And so there is hope that the Senate, which is now in recess until mid-September, will broaden the scope of the act during its own deliberations.
Does FIRPTA Reform Matter?
To be sure, American commercial real estate assets are attractive to foreign investors. In the 18th annual Foreign Investment Survey of the Association of Foreign Investors in Real Estate (AFIRE), released in January 2010, 51 percent of survey participants identified the United States as the market offering the best opportunity for long-term capital appreciation. In 2006 and 2007, at the peak of the domestic commercial real estate cycle, roughly one in four respondents identified the United States as their top national market.
Sharp declines in prices in 2008 and 2009 have enhanced perceptions of value in the U.S. market, pushing the survey’s positive response rate to its highest level since 2003. Since January, well-publicized financial market instability in parts of Europe has reinforced the safe-haven draw of the United States.
To the question of whether FIRPTA reform holds real potential in fomenting an increase in foreign investment, I wrote in February that the Real Estate Roundtable had cited the findings of a report by Martin Neil Baily of the Brookings Institute and Matthew Slaughter of Dartmouth College. Professors Baily and Slaughter have both served on the Council of Economic Advisors, the former under President Clinton and the latter under the younger President Bush.
In their report, titled “How FIRPTA Reform Would Benefit the U.S. Economy,” the authors recommended reforming the current system: “… outright repeal or, less dramatically, an initial holiday could be implemented: e.g., declare that new foreign investments in U.S. commercial real estate over the next five years would be exempt from FIRPTA.” They further conclude that “… the sizable economic benefits of reforming FIRPTA would exceed the small fiscal costs it would entail.”
All things being equal, taxes on commercial real estate gains undoubtedly make foreign investment in U.S. assets less attractive. That is textbook public finance. And as the Congressional Oversight Panel pointed out in its February report, the inconsistent treatment of foreign investment in real estate means that “… a non-resident alien seeking to invest in the United States will have a financial incentive to choose stocks or bonds over real estate.”
The mechanics of tax disincentives are easier to demonstrate on a chalkboard than to assign dollar values to. Ultimately, we must be ready to concede that it is difficult to quantify the impact of FIRPTA on foreign inflows of capital to the sector or to conjecture that its repeal would open the floodgates to those inflows.
Foreign investment in U.S. real estate is a small share of total investment as compared to some other countries, but that may reflect a wide variety of factors, including strong domestic demand. Isolating causality is tricky at best. In the end, there is little empirical evidence that allows us to quantify the magnitude of the capital flow response to changes in this particular provision of the tax code. So we should be careful in assuming too much about the extent of the FIRPTA reform’s benefits.
What is apparent is that foreign investors find the American market attractive in spite of FIRPTA. And as long as investors maintain a positive discount rate, the discounted value of the tax impediment will diminish as the anticipated asset sale moves further into the future. To the extent they have failed to bring more dollars into the U.S., foreign investors are still more likely to cite an absence of high-quality investment opportunities in their preferred markets than they are the U.S. tax code.
And so, while efforts to level the tax code in ways that diminish inequitable treatment of real estate are worthy of our industry’s support, we can afford to be cautious in our conjectures about the impact of a change. Returning to the basics of property fundamentals, the gains from FIRPTA reform are likely overshadowed by the gains-to occupancy rates and property values-that will accrue from stronger private-sector economic growth.