What Is "Carried Interest" and Why Will Taxing It At Higher Rates Cause Problems?

There is a storm brewing over the Obama administration’s and Congress’s plans to tax something called carried interest at a higher rate. Why? What’s carried interest? Should I care about this?

While the term “carried Interest” may sound like it has something to do with mortgages or other types of loans, it does not. It refers to an interest a real estate developer, as a partner in a real estate development project, may have in that project’s outcome.

For example, assume a developer, as a partner in a real estate partnership (as defined under the tax code), has an interest in that partnership based on services (in addition to any capital invested) he or she provides to it in steering the project from start to finish. To realize that gain:

First, the project has to be financially successful – always a risk in real estate development. 

Second, such projects necessarily are multiyear in nature – the land has to be acquired, the improvements constructed then leased, and finally sale has to occur in a future year.

Thus, the developer’s interest in the project is carried through to the termination of the venture, and then distributed to him or her. Currently, this interest is treated as long-term capital gain and taxed at the lower 15% rate. Under the proposed changes, carried interest would be taxed as high as 39.6% - more than 2 and a half times the current rate.

What does this mean to those who don’t invest in, or develop, real estate? At least two things:

1.   The developer’s carried interest, payable as it is on the backend, often is the impetus for putting in the years of effort and assuming the high degree of risk involved in creating real estate projects. The effort and risk remain unchanged, but the compensation will be greatly reduced by the tax bite; perhaps fatally skewing the risk/reward formula. This results in less development activity, in turn leading to an imbalance in supply and demand and, ultimately, higher residential and commercial rents.

2.   The disincentivizing effect of the higher tax bite on investors and developers also has a dampening effect on the pricing of investment real estate, which in turn adversely impacts the economy in which it is an important component.

The subject is discussed in greater length at the following web sites:

·             http://search2.comcast.com/?cat=dnsr&con=ds&url=www.on%20investors%20and%20developers.com

·             http://retailtrafficmag.com/news/carried_interest_060820

·             http://www.icsc.org/apps/news_item.php?id=2618

There are no coincidences!
Copyright 2010 by the Falbey Institute for the Development of Real Estate

What This Blog Addresses, and What It Doesn't

Some confusion seems to exist about the purposes of this blog. 
We draw on a great deal of experience in developing real estate - residential and commercial. By residential, we mean large master-planned communities, not individual residences. Neither do we discuss sales or brokerage activities nor speculative investments in single family residences. There are more than enough blogs, 'zines, and hard copy materials addressing those areas.
Commercial real estate development includes office, retail, industrial, hotel/resort, multifamily, entertainment, and mixed-use projects.
In this blog, we address the current state and emerging trends of residential and commercial development with emphasis on capital markets, real estate finance, land use regulations, and deal structuring.
We are primarily, but not exclusively, focused on the US market. We address the overall market situation, not the market aberrations in Washington, D.C. or New York City. Neither do we focus on the markets involving the multibillion dollar REITs and other investment funds. We are sensitive to the plight of the smaller-scale developers. They are more heavily impacted by capital requirements and land use regulations, and have to be more creative in structuring their projects.

There are no coincidences!
Copyright 2010 by The Falbey Institute for the Development of Real Estate

Increased Economic Problems in Florida?

There is an economic cancer on the ballot in Florida this fall. It’s known as Amendment 4, or “Hometown Democracy”.

It proposes to change our state constitution by requiring taxpayer-funded votes on every proposed change to every local government’s basic land use plan, rather than have those decisions made by the elected public representatives.

Thus, voters would be forced to decide hundreds of often minor, technical plan revisions on a single ballot. Each revision can be described in only 50 words. Busy voters likely will simply vote “no” across the board rather than study each proposed revision. Essentially, this will halt all growth and development within the State of Florida.

This won’t simply cause additional unemployment in the land use industry. Its effects will raise unemployment across Florida by trickling down to all businesses and industries including education, public safety, and other public sector jobs dependent on high employment in the population. On the private sector side, retail, food and beverage, entertainment, medical/dental, legal, and most other industries likewise will suffer losses. All this results in increased unemployment at a time when Florida is experiencing historic highs in unemployment.

Additionally, state services will shrink as revenues decline in tandem with the rising unemployment. Or, those still here will see their taxes raised significantly to cover the ensuing shortfall.

Don’t be fooled by the name “Hometown Democracy”. Encourage everyone you know to vote “NO” on Amendment 4.

For more information, go to: http://www.florida2010.org/index.cfm?fuseaction=news.details&ArticleId=7

There are no coincidences!
Copyright 2010 by The Falbey Institute for the Development of Real Estate.

Just When You Thought It Was Safe To Go Back In The Water

Over the next few years, a wave of commercial real estate loan failures could threaten America’s already-weakened financial system. The Congressional Oversight Panel is deeply concerned that commercial loan losses could jeopardize the stability of many banks, particularly the nation’s mid-size and smaller banks, and that as the damage spreads beyond individual banks that it will contribute to prolonged weakness throughout the economy.

Commercial real estate loans are taken out by developers to purchase, build, and maintain properties such as shopping centers, offices, hotels, and apartments. These loans have terms of three to ten years, but the monthly payments are not scheduled to repay the loan in that period. At the end of the initial term, the entire remaining balance of the loan comes due, and the borrower must take out a new loan to finance its continued ownership of the property. There are no easy solutions to these problems. Although it endorses no specific proposals, the Panel identifies a number of possible interventions to contain the problem until the commercial real estate market can return to health. The Panel is clear that government cannot and should not keep every bank afloat. But neither should it turn a blind eye to the dangers of unnecessary bank failures and their impact on communities. 

The Panel believes that Treasury and bank supervisors must address forthrightly and transparently the threats facing the commercial real estate markets. The coming trouble in commercial real estate could pose painful problems for the communities, small businesses, and American families already struggling to make ends meet in today’s exceptionally difficult economy.

According to the Congressional Oversight Panel's February oversight report, Commercial Real Estate Losses and the Risk to Financial Stability, there is genuine concern that “commercial loan losses could jeopardize the stability of many banks, particularly the nation’s mid-size and smaller banks, and that as the damage spreads beyond individual banks that it will contribute to prolonged weakness throughout the economy”. Commercial real estate loans (office, retail, hotel, industrial, and multifamily properties) made in the go-go days of 2002 - 2007 total some $1.4 trillion will mature in 2010 through 2014 and require refinancing.

In almost half of these cases, the amount of the maturing loan is greater than the value of the real property securing it.

The Panel found that "a significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American." When commercial properties fail, it creates a downward spiral of economic contraction: job losses; deteriorating store fronts, office buildings and apartments; and the failure of the banks serving those communities. Because community banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery and extend an already painful recession.

A few of the important statements in the Report are excerpted below: 

· Banks and other commercial property lenders bear two primary risks:

1. A borrower may not be able to pay interest and principal during the loan’s term, and
2. A borrower may not be able to get refinancing when the loan term ends. In either case, the loan will default and the property will face foreclosure.

· While some loans never should have been made, other loans were potentially sound when made but the severe recession has translated into an increased the likelihood of default on commercial real estate loans.

· Commercial property values have fallen more than 40* percent since the beginning of 2007. Increased vacancy rates, which now range from eight percent for multifamily housing to 18 percent for office buildings, and falling rents, which have declined 40 percent for office space and 33 percent for retail space, have exerted a powerful downward pressure on the value of commercial properties.

· A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American including more lost jobs. Foreclosures on apartment complexes could push families out of their residences, even if they had never missed a rent payment. Banks that suffer, or are afraid of suffering, commercial mortgage losses could grow even more reluctant to lend, which could in turn further reduce access to credit for more businesses and families and accelerate a negative economic cycle.

· In the worst-case scenario, hundreds more community and mid-sized banks could face insolvency. Because these banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery, and extend an already painful recession.

*44% according to latest ULI Real Estate Business Barometer

There are no coincidences!
Copyright 2010 The Falbey Institute for the Development of Real Estate

The Commercial Real Estate Mortgage Dilemma

As Steve Blank noted in the current issue of ULI’s Real Estate Business Barometer, “Liquidity remains a primary concern (in real estate markets) with approximately $300 billion in refinancing per year thru 2015.  De-leveraging by financial institutions continues; many remark that this will go on for many years. “

So, why aren’t banks clearing out their delinquent loans on commercial real estate, CRE, as expeditiously as in 1988-1991? Banks want to avoid:

1. Upsetting their balance sheets and financial ratios with REO (real estate owned), and
2. The liabilities attendant with REO (viz., condo and HOA fees, management and other operating expenses, liability for personal injury and property damage, etc.). Thus, they pretend and extend until something occurs to force their hands.

Eventually, if all else fails, bank shareholders – and there are millions of them – will pressure the bank directors to liquidate the bad loans, or they will replace the directors with those who will liquidate them.  In addition, the shareholders will pressure Congress – and after next January there should be a substantial number of new faces in Congress who were sent there by these shareholders and others disgusted with the incompetence of the current incumbents.

Congress will pressure the bank regulators, the FDIC, OCC, et al, to cause the banks to deal with these loan delinquencies and defaults. Under agency pressure, the banks will begin to liquidate those loans. There are a number of scenarios, but three in particular come to mind.

·             Sale of the notes evidencing the loans. This means the banks will have to steeply discount the notes in order to find a market. Sam Zell has said that he recently bought a number of such notes at 42.5 cents on the dollar.  That means, for example, a note in the amount of $1,000,000, and secured by a mortgage on real property, would sell for $425,000. The bank, its shareholders, and the taxpayers (via the FDIC bailouts of the bank’s losses) will have to eat $575,000.  And that’s just one note.  Banks and other federally insured or guaranteed entities hold hundreds of billions of dollars in notes that are or soon will be in default. Let’s be fair, however; because of the high level and varieties of risk (market risk, political risk, structural risk, “pig-in-a-poke risk”, etc,) market-clearing prices would be pennies-on-the-dollar.

·             Sale of the properties encumbered by mortgages that secure the bad loans. If done in volume, this would have a market clearing effect because the sheer volume of supply would depress prices, thus generating demand. This, together with the above-described risk elements, would result in pennies-on-the-dollar liquidations.

·             Government reorganization of the banks’ bad loan situation. This is somewhat analogous to the situation involving the Resolution Trust Corporation (RTC), which was a government–owned entity created to take possession of mortgages and properties held by failed savings and loan associations (thrifts) following the recession in the late 1980s. It was charged with the responsibility for disposing of these assets, which it did initially through bulk sales, and later through equity partnerships with certain selected private sector entities. This likely is how the government would respond in today’s situation. In other words, it would retain an interest in the properties, or more appropriately, the entities set up to own and manage the properties, just as it did in the bailout of the U.S. automotive manufacturers. Unfortunately, this is another paver in the path to socialism.

o   Caveat: the RTC was created to deal with the financial collapse of the thrifts and their resulting insolvency. This time around it is expected that the government would react prior to large-scale bank insolvency.

There are no coincidences!

Copyright 2010 The Falbey Institute for the Development of Real Estate