By: April Thompson
Added: 23rd July 2019
REITs continue to perform well in comparison to the broader stock market and S&P 500. As the 2017 Tax Cuts and Jobs Act has effectively made investing in REITs up to 20% more profitable via inclusion in the pass-thru deduction. The pass-thru deduction is scheduled to expire in 2026, however investors are expected to continue to increase allocations to commercial real estate for the foreseeable future.
Investors, both domestic and foreign, continue to seek opportunities to further diversify portfolios via stable investments, while minimizing risk. According to a 2019 Deloitte survey, 97% of investors surveyed intended to increase capital allocations to commercial real estate over the next 18 months. Deloitte approximates that this will result in an estimated 13% increase in capital commitments. This increased investment will most likely have positive implications in the short term including greater demand for REIT shares, leading to higher stock prices and thereby reducing the REITs cost of capital. A lower cost of capital allows REITs to acquire new assets, recycle assets that are no longer aligned with the business plan and reinvest in assets within the existing portfolio more efficiently.
Publicly traded REITs are currently challenged by the influx of private equity investment in real estate. This influx is creating a number of challenges for public REITs, but most notably higher asset values resulting from increased demand and significant downward pressure on cap rates. This increased competition makes it much more difficult for REITs to continue to invest at rates that allow for dividend yields in line with investor expectations.
As mentioned in the topic around how REITs are taxed, the 2017 Tax Cuts and Jobs Act also created an opportunity for a new subsector of REIT that has been gaining in popularity. The 2017 Tax Cuts and Jobs Act created Opportunity Zones to encourage private investment in underserved communities. The appeal to investors is a deferral of and reduction in an investor’s capital gain tax liability. Opportunity zone investment opportunities are unique and require compliance with a very specific set of parameters:
- Opportunity Zone Designation and Qualification: Opportunity Zones are distressed communities nominated by the Governor of each state, and officially designated by the US Treasury Department. To qualify as an opportunity zone a community must have a poverty rate of at least 20% or a median income of no more than 80% of the state average. This resulted in the designation of 8700 opportunity zones, encompassing 12% of US census tracts.
- Investments: Investors may invest in Opportunity Zone communities either via direct investment, or through a fund. Many of these funds are structuring as REITs and beginning to market to investors. In addition to real estate, investors also have the option of investing in opportunity zone businesses. However, the regulations state that investors, either of real estate or business must be actively engaged in the business of the opportunity zone investment, which means these new Opportunity Zone REITs can’t simply passively own real estate assets.
- Substantial Improvement: Investors are required to substantially improve properties acquired within opportunity zones within 30 months of their initial investment. Per regulations, substantial improvement is defined as doubling the basis of the property. For example, if a REIT were to acquire an asset in an opportunity zone, they would be required to invest an amount equal to the purchase price (excluding land value) in improvements.
- Holding Periods: A five-year hold results in a 10% step-up in basis on the deferred gain. A seven-year hold results in an additional 5% step-up in basis, for a total step-up of 15%. A ten-year hold would result in the elimination of any capital gain liability on the original investment and any appreciation in value during the hold period.
Opportunity Zones were created in December 2017 by the Tax Cuts and Jobs Act legislations and the US Treasury continues to define and release information regarding investments in these communities and Funds. Recent guidance has given many investors and managers the comfort needed to begin developing strategies and forming REITs targeting opportunity zone investments specifically. The number of opportunity zone REITs is expected to continue to increase as the Treasure Department continues to provide regulatory guidance.
Recent regulations have also changed with regard to taxable REIT subsidiaries. REITs are allowed to derive up to 25% of gross income from taxable REIT subsidiaries. Historically, however, REITs have been more restricted with regard to the types of services allowed. For example, development services have traditionally been classified as prohibited transactions. REITs now have the opportunity to capture income that would have traditionally been paid to external contractors. This also allows REITs to be more actively engaged in the management of their portfolios.
To conclude, REITs provide an effective means of facilitating investment in real estate and distributing income to shareholders. Shareholders bare the majority of the tax burden in REIT ownership. This, however, offers shareholders the ability to manage the tax liability in relation to the rest of their investment portfolio. Which, for many investors, creates an opportunity for greater balance.
Legislation and market trends have continued to provide a favorable environment for REIT growth. The continued growth in the US economy, low-interest rates and growing demand for US real estate investment via both domestic and foreign investors are expected to continue for the foreseeable future and continue the favorable environment for REITs.
Opportunity Zone REITs are the newest subsector of REIT and represent a great opportunity for investors to manage capital gain tax liabilities. Regulatory guidance on opportunity zones continues to evolve but offers significant tax advantages to shareholders.