Archive for May, 2010

It’s Time for FIRPTA Modification

Commercial real estate markets across the country are overleveraged. It is estimated that for the next several years, approximately $350 billion of commercial debt will mature annually, much of which will have difficulty finding replacement leverage given the reductions in value that we have seen coupled with today’s more conservative loan-to-value ratios being used by lenders. The deleveraging process that our markets must go through will require massive amounts of fresh equity.

Demand drivers are excellent today and, if you are a frequent StreetWise reader, you know that I have illustrated numerous times the acute supply / demand imbalance that exists today with little available product meeting extraordinary demand. High-net-worth domestic investors and families which have driven the markets for the past couple of years have met a resurgence of institutional capital which has come back to the commercial real estate sales market with a vengeance. Additionally, foreign investment is very apparent in today’s market and foreign high-net-worth investors are appearing in numbers not seen since the 1980s.

With this excessive demand, why would I be focused on a law that, if modified, would result in even greater foreign demand? There are several reasons we will discuss.

Foreign investors in U.S. real estate are disadvantaged by a law which should have never have been put into the tax code to begin with. The Foreign Investment in Real Property Tax Act of 1980 which is commonly referred to as FIRPTA. This U.S. tax law unfairly (relative to other non-real property investments in the U.S.) imposes excessive tax barriers on foreign capital investment in U.S. real estate and should be withdrawn or modified significantly. FIRPTA is the central obstacle to greater capital investment in U.S. real estate by non-U.S. investors.

Based upon the fears of some politicians in the Midwest, who were originally concerned about limiting foreign control over U.S. farm land, FIRPTA was proposed and passed by congress to limit what foreigners could do with “our property”.  FIRPTA requires foreign persons who dispose of U.S. real property interests to pay taxes in the U.S. on any gain realized on the disposition over and above the tax burden they would be faced with if they invested in any other type of asset.

This process imposes considerable administrative burdens, not only on foreign investors disposing of their U.S. real estate assets but also, on the purchasers of such properties who are responsible for administering withholding taxes. Additionally, the law requires foreign investors to file a U.S. income tax return at the end of the year in which they sell their real property interests.

Further political support for FIRPTA was seen noticeably in the mid 80’s when Japanese investors were actively purchasing trophy assets in New York City, most notably Rockefeller Center. It is hard to imagine that there is any fundamental basis for this concern. Properties controlled by foreign owners are generally managed by U.S. companies, leased by U.S. companies, serviced by U.S. companies and produce tax revenue paid to U.S. municipalities.

The attorneys representing these investors are likely U.S. firms, as are their title insurers. What is the basis of the fear people have about buildings being owned by overseas investors? In the 26 years that I have been selling properties, I have yet to witness a foreign investor acquiring a property in the United States, picking it up, and transplanting it back to their homeland.

By virtue of FIRPTA, real estate is discriminated against relative to other types of investments in the U.S. by foreign persons as they are not required to pay gains taxes upon the disposition of any other assets. Thus, FIRPTA unfairly treats U.S. real estate as an asset class. We believe that U.S. policy makers should move swiftly to eliminate or modernize FIRPTA.

Our markets need massive amounts of equity to accomplish the deleveraging we must go through. While there is tremendous demand currently existing, the need is going to grow over the next couple of years and the more capital we have in the market, the better for all participants. While many actions taken by policymakers over the past couple of years may lead you to think differently, we are still in a capitalistic, free-market society.

If  FIRPTA were to be eliminated or a tax holiday were given on transactions over the next few years, demand from foreign investors would undoubtedly increase. We need equity investments from any source as this would be stimulative to our market and our economy. The extent to which the U.S. and its citizens would benefit, is positive regardless of the benefits which might inure to foreign investors. The additional capital would be accretive to a healthy dynamic within our marketplace, would help to create jobs and allow for growth.

In January of this year, a bill ( H.R. 4539 – the Real Estate Revitalization Act of 2010 “RERA”) was introduced in congress to modify FIRPTA. The bill was touted as something which would reduce barriers to foreign investment in U.S. real estate. This legislation would amend FIRPTA by removing some the artificial tax barriers created by the law. These changes would go a long way towards rectifying the unfair treatment of real estate investments relative to other asset classes. This would allow property owners to access equity capital from around the world at a time when it is sorely needed.

RERA would eliminate the “U.S. Real Property Holding Corporation” provisions of FIRPTA and characterize REIT capital gains distributions to foreign shareholders as ordinary dividends. It would also treat REIT liquidating distributions as ordinary dividends to the extent that a distribution exceeds the foreign investor’s basis in its REIT stock.

Under RERA, shares in REITS and other real property holding corporations would not longer be “U.S. real property interests”, thereby eliminating part of the discrimination against real estate investments. FIRPTA would, however, continue to apply to gains from the disposition of direct foreign investment in U.S. real estate; therefore, we do not believe this legislation goes far enough to meet the objectives we seek. 

The U.S. has much more to gain than to lose by embracing and working with the global community. Technology has changed the way world commerce functions and there is much to gain from working with other nations. While total economic growth is not dependant upon foreign real estate investment, our real estate market would be enhanced significantly by the elimination or modification to the FIRPTA laws. All this would do is to put real estate on a level playing field with every other type of investment that foreign investors can make in the U.S.                             

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having an aggregate market value in excess of $6.2 billion.


The Implications of a Falling Euro


The European Central Bank is the central bank for Europe’s single currency, the “euro”. The euro was first used in 1999 at which time there were 11 member nations in the European Union. Today, there are 16 countries which are members.

The credit crisis we have experienced in the U.S. was not isolated. Counties all over the globe have been affected and, most recently, the so-called PIIGS nations have been suffering significantly. Economies in Portugal, Italy, Ireland, Greece and Spain have seen debt to GDP ratios explode and needed austerity measures have already prompted both strikes and riots, most notably, in Greece. All of the uncertainty surrounding many of the EU economies has exerted substantial downward pressure on the euro.

Last Friday, the euro closed at 1.2381 to the dollar, its lowest level since April of 2006. So, what are the implications for the commercial real estate sales market of a euro at this level?

Many participants in the market felt that the strength of the euro (or conversely the weak U.S. dollar) was the main reason for the increase of foreign investment in the U.S., and particularly New York and Washington D.C., markets in 2008. From February 2008 through the end of the year, the euro was hovering slightly above or slightly below $1.50. During this period, we saw a tangible increase in the number of foreign high-net-worth investors looking to purchase investment properties in New York, which has continued since. Those who thought that the strong euro was the reason for increase foreign demand have speculated that the falling euro would cause a reduction in the amount of foreign demand. We do not, however, believe that the weak U.S. dollar was the primary stimulus for this foreign interest and that this factor is highly overemphasized as the reason for foreign demand.  

Consider the following: If a foreign investor is purchasing an investment property in the U.S. because the dollar is weak relative to their currency, they are receiving gross rents in the weak currency, they received net operating income and cash flow in the same weak currency and, if they choose to sell the property, they receive their profit in the same weak currency. Therefore, the only way the weak U.S. dollar creates an incentive to invest here is if the foreign investor is utilizing a currency arbitrage strategy whereby they believe the value of the U.S. dollar will increase at a greater rate than their own currency over the holding period.

We believe that foreign investment in the U.S. is much more a function of the relative economic and political stability that the U.S. offers. The present uncertainty oversees is driving investment capital into America in quantities not seen since the mid-1980s. We have closed numerous transactions with foreign investors recently with many more looking to deploy capital here. The number of foreign investors looking to purchase real estate is simply staggering and adds to the overwhelming demand that exists today.

Perhaps the most impactful implication of the falling euro is its impact on interest rates. This is significant as rising interest rates are one of the biggest downside risks the market is looking at.

When the fed ended its asset buying program at the end of March, it exerted upward pressure on interest rates. We saw the 10-year treasury rise from about 3.5% to over 4%. About 3 weeks ago, the fed announced that it would begin a program to sell its $1.3 trillion of assets over time. This method of exiting the market would also serve to exert upward pressure on interest rates. However, with all of the debt problems and uncertainty in global economies, and particularly in Europe (as illustrated by the falling euro), there has been a flight to quality and safety which means a flight to U.S. treasuries. Given the overwhelming demand for treasuries, we saw the 10-year close at 3.44% on Friday.

These lower rates have positive implications for our real estate market. When interest rates stay low, commercial mortgage lending rates stay low as well. This is a necessary and important factor for the health of the investment sales market. We still have a massive amount of deleveraging to deal with and low mortgage rates make dealing with deleveraging that much easier. Additionally, to the extent rates rise significantly, it will create even more negative equity and distress in the market as values fall based upon higher borrowing rates.

The falling euro has, therefore, had a beneficial impact on our market, not directly but indirectly. The causes of the euro’s fall have created a flight to quality and safety which has kept interest rates down and the falling euro has not eliminated any of the foreign purchasing demand from the marketplace.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty services in New York City and has brokered the sale of over 1,050 properties in his career having a market value in excess of $6.2 billion.

Note Sales are Taking Off!


As we have discussed in several previous StreetWise columns, the distressed asset pipeline, which has been clogged for nearly two years, is beginning to loosen up. Lenders and special servicers are faced with thousands of distressed assets on their balance sheets and in their portfolios, yet until recently, only a small number of these assets have made their way to the market.

Everything that has happened from a regulatory perspective has provided these entities with the ability to avoid having to make decisions relative to these distressed assets. These regulatory changes have included changes in the FASB market-to-market accounting rules, modifications to REMIC guidelines and bank regulators letting banks hold notes on their books at par even though they know the collateral is worth substantially less.

The Federal Reserve’s highly accommodative monetary policy is allowing for the recapitalization of the banking industry which is relieving pressure on lenders to deal with distressed assets quickly.

Additionally, the foreclosure process can be particularly long, cumbersome and complicated (particularly in states other than Texas and Georgia). Many holders of distressed assets are choosing to sell notes rather than wait for the foreclosure process to be completed which would allow them to sell the assets rather than the paper.

Note sales can take two forms. The first is simply a financial transaction in which a bank or special servicer will pool many disparate loans with disparate collateral spread throughout a state, region or the entire country. These loans will typically be sold to what we call a “financial engineer” which will look at each loan, determine where it is in the foreclosure process, what can be done to enhance the note’s value and how to maximize the value of the individual loans for resale. These buyers are simply buying on a percentage-of-par basis and are looking to make a profit on the slicing and dicing of these pools.

The other approach to note sales is to simply sell a single note, collateralized by a property or a portfolio of properties. The typical buyer here will be a real estate investor who is buying the paper to get to the title of the property and own the assets on a long-term basis. These buyers typically pay much more for the note than a financial engineer will because they don’t have to build a profit into the process of administrating the foreclosure process. This is the type of note sale transaction that Massey Knakal has focused on in our Special Assets Group.

If we look at the distressed assets that we have sold recently and are currently working on, 78 percent of them have been note sales as opposed to REO (“Real Estate Owned” is  a typical term used by lenders for properties they take title to after a foreclosure) sales.  We expect this percentage to decline as time goes on and the foreclosure process is allowed to finish. Our large percentage of note sales versus REO sales is not surprising when consideration is given to the percentage of recovery sellers are achieving on note sales relative to collateral value.

Collateral value is the key measuring stick by which we determine how effective a note sale recovery can be. I am often called by investors who claim that they want to buy distressed notes, however as soon as they tell me that they wish to buy paper at 50 cents on the dollar, meaning 50 percent of par value, I immediately know that they are not serious note buyers and let them know that they will be unsuccessful in this endeavor.

The reason I say this is because if the collateral value is only 40 percent of par, they will be overpaying at 50 percent and will lose money. If, however, the collateral is worth 90 percent of par, and they are only offering 50 percent, they are not going to be able to buy anything as savvy investors will certainly outbid them. Therefore, we see that par value is really irrelevant relative to what a recovery will be.

A much more important indicator is collateral value or what the asset is worth if the deed were to be delivered. When we are retained by an institution to sell a note, the first thing we do is calculate the value of the collateral. This amount is then discounted by a percentage which is derived based upon taking the entire scenario into consideration. The variables include how far along the institution is in the foreclosure process, whether the borrower is being cooperative and the quality of the documentation.

Clearly, if a foreclosure process is nearing its conclusion, it is a very different situation than if the foreclosure process has not even begun but the note is in default. Similarly, if a borrower is cooperative, it adds value to the recovery. We have done transactions in which the borrower had a completely adversarial relationship with the lender, such that we could not even gain access to the property. In cases like that, we may not even be aware of the the tenancy in the property. In a scenario like that, the discount for the note would be much more significant than if the borrower is cooperative and we have a sense of how the real estate is performing.

Additionally, it is important to do significant due diligence on the quality of the documentation that exists. All documents must be reviewed including the note, the mortgage and the intercreditor agreements (to the extent that there is subordinate debt on the property). A summary of all interaction between the borrower and the lender can also be helpful.

When marketing a note, we move down two parallel paths simultaneously in that we must not only perform due diligence on the real estate asset, we must perform due diligence on the documentation to fully understand what exactly it is we are selling. This takes tremendous amount of time and effort but is important to make sure that all participants in the transaction fully understand what they are stepping into.

Another factor which greatly affects the recovery on a note sale is the extent to which the seller of the note is prepared to make representations. Some lenders have very complete files and are willing to make substantial representations about what they have and what they have done. Here , recovery is enhanced.  

There are, however, some lenders that will only represent that they own the note and have authorization to sell the note. They will not make any representations beyond this. I am often asked by a lender or a special servicer if a note can be sold under those circumstances. My answer is always that everything can be sold and everything has a price; it is only a question of what the highest price will be. Understandably, the more definitive the representations a lender is willing to make, the higher the final price and, therefore, the recovery.

Note sales have been dominating the distressed asset market recently and are becoming more and more popular. This is particularly true as distressed asset holders attempt to take advantage of the supply / demand imbalance that I often refer to in this column which provides the seller the ability to achieve pricing higher than what current economic fundamentals would dictate. There is significantly more demand than there is supply which is resulting in dozens of investors competing for each availability.

Under these circumstances, there is no wonder why distressed asset holders are eagerly entering the note sale market.                

Mr. Knakal is the Chairman and Founding Partner of  Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having an aggregate market value in excess of $6.2 billion.

1031 Exchanges Come Roaring Back to the Market


Welcome back old friend! Yes, we have seen a re-emergence of the blessed 1031 tax-deferred exchange in recent weeks, and what a welcome sight it is.

The opportunity to protect hard earned equity in the sale of an investment has been available to investors since 1921. However, this part of the tax code was so complex that only a small segment of the investment community took advantage of this mechanism.

In 1990, the Omnibus Budget Act provided more widespread access to a broader set of investors as this option was clarified and simplified. Section 1031 exchanges are often mischaracterized as “tax free” when they are actually “tax deferred”.

The theory behind this mechanism is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay taxes. Only the form of investment has changed, therefore, it would be unfair to collect a tax on a “paper” gain.

When an investor utilizes this mechanism, the deferred gain is payable when the replacement property is sold and is not part of yet another exchange. At that point, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

1031 exchanges in the investment property market have been growing in popularity since the mid-90s and fueled a majority of transactions in the mid to late 2000s. With falling property values and transaction volumes beginning in late 2007, we saw a significant reduction in 1031 transactions.

In previous StreetWise columns, I have gone into detail about the supply / demand imbalance and the fact that the volume of sales was so low due, mainly, to lack of supply as opposed to waning demand. The supply of available properties for sale is generally fed by discretionary sellers. When value falls, as it has done since 2007, discretionary sellers withdraw from the market and the supply is then fed by distressed sellers. Distressed sellers have not fed the supply in numbers which were expected because everything that has occurred from a regulatory perspective has allowed these sellers to avoid dealing with their distressed assets.

Recently, we have seen the flow of distressed assets begin to loosen as banks and special servicers are beginning to clean up their balance sheets and portfolios. Simultaneously, we have seen discretionary sellers returning to the market. The tangible evidence that this is actually happening can be seen in the 1031 activity we have seen recently. Distressed sellers are rarely left with any equity to reinvest in the form of a 1031 exchange. Discretionary sellers, on the other hand, often have significant equity to redeploy via this tax-deferred vehicle. We are, once again, seeing sellers ask for flexibility in closing periods to provide them with better chances of being able to effectuate an exchange.

During the past 4 weeks alone, we have signed 12 contracts with purchasers who are investing 1031 funds. Moreover, we are receiving multiple calls each day from investors who are looking for properties to complete exchange transactions. This is certainly reminiscent of 2006 and 2007 when so many transactions were motivated by tax-deferment. The demand side has been very strong for quite a while as institutional capital has returned to the market, joining the high-net-worth individuals and families which have dominated the horizon for the past couple of years. Foreign high-net-worth investors are present in rapidly growing numbers and the re-emergence of 1031 capital adds more pressure to already overwhelming demand for investment properties.

Don’t mistake my perspective as I am not suggesting that market conditions are back to the go-go, bubble inflating, years of 2005 to 2007. I am, merely, passing along a trend that we are seeing which has, for the most part, been absent for quite a while. It is yet another sign that the recovery is upon us.

From an intermediary’s point of view, or anyone’s, who is reliant upon transaction volume for their livelihood, it is positive to see this type of activity returning to the market. To the extent that distressed sellers continue to dispose of assets and discretionary sellers return to the market, transaction volume has no choice but to increase. As sellers with real equity sell, each transaction is likely to stimulate another transaction as a 1031 is contemplated.

This trend certainly bodes well for our projection that transaction volume will increase by about 40% this year over last year. Welcome back old friend, indeed!

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having a market value in excess of $6.2 billion.

Can the Building Sales Market be Good and Bad at the Same Time?

In recent weeks, Streetwise has looked at the divergence of opinions and perspectives present in the marketplace. There is significant optimism and pessimism present at the same time so the question becomes, Can market conditions actually be positive and negative at the same time? I believe the answer is yes but it is dependent upon individual circumstances.

There are many indicators in the market which lead us to be optimistic. Unemployment, the metric which most profoundly impacts the fundamentals of real estate, appears to have bottomed and we are starting to see job growth. Inflation appears to be in check and even the most bearish economists don’t see inflation as a short-term problem. Interest rates, while edging up, have not caused any significant increase in borrowing rates. When the Fed ceased its asset buying program at the end of March, we saw upward pressure on interest rates, particularly at the long end of the curve as the 10-year T-bill, which had consistently hovered around 3.5%, rose to over 4% for a brief period. Last Friday it closed at 3.625%, a surprising result after the Fed announced 10 days ago that it would begin a program to sell a trillion dollars worth of assets over time.

Rental rates appear to have bottomed as well. In both the commercial and residential sectors, concessions are being reduced and, in a few cases rents are rising. I actually spoke to two bankers last week who told me that they were dropping commercial lending rates due to the competition with other banks to put money on the street. This, to me, was a remarkable and eye opening occurrence.

In our building sales business, the positive signs are abundant. The supply of available properties for sale is growing. This supply is increasing as lenders and specdial servicers are coming to terms with assets that are underwater and have little hope of being turned around. We have seen a tangible increase in notes and REO that these entities are coming to market with. Additionally, discretionary sellers are beginning to place assets on the market as they feel the palpable optimism that exists in the market.

While supply has increased, this additional supply has been met step-for-step by increasing demand. Activity on all of our listings continues to be excellent as all three of the demand “food groups” are in full swing. These include high-net-worth individuals and families, institutional capital and foreign buyers. Due to this overwhelming demand, we saw, for the first time in many quarters, prices rise in the first quarter of 2010 in some segments of the market. In other segments, prices continued to slide. This dynamic, however, is certainly indicative of a bottoming in pricing.

This all sounds very positive, but you may ask, What about all of the properties with negative equity in them? The fact is that, even with fundamentals becoming healthier, they will not revive at a pace quick enough to bail out most of the distressed assets that are in the market. Therefore, it is entirely likely that we will have improving positive conditions in the market while simultaneously seeing an active distressed asset component. Based upon the substantial number of distressed assets that exist, it would not be at all surprising to see distressed assets come to market over an extended period of time, two or three years perhaps.

One investor I spoke to last week told me that he believed distressed assets would be present in the market as far out as 2016 and 2017 when the 10-year CMBS loans that were originated in 2006 and 2007 mature. His belief was that growth will exist but will be too slow to recoup all of the losses experienced in this market downturn. I certainly hope he is not correct.

Presently, we see many positive signals in the market indicating that we are emerging from the malaise we have been living with.  Things are certainly looking up for our market; however, distressed assets will be part of our playing field for years to come. So the answer appears to be, “Yes”, things can actually be good and bad at the same time. It all depends upon which side of the fence you are sitting on.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having a market value in excess of $6.2 billion.