UPDATED: New Survey Shows That Pensions Other Non-Listed Global Funds Seek to Boost CRE Portfolios. U.S. Tax Break For Qualifying Foreign Pension Funds Could Help
In a major year-end gift to the real estate industry, Congress approved a long-sought change to the tax rules for foreign investment in U.S. property and REITs, making it easier to attract more cross-border capital from pension funds and other investors in Asia, the Middle East and Europe -- just as funds seek to raise their targeted allocations to global real estate by at least 13% in 2016.
Now, everyone is waiting to see if the revised Foreign Investment in Real Estate Property Tax Act (FIRPTA) will help extend the rally in U.S. property sales. Initial estimates suggested the new FIRPTA changes will generate an additional $20 billion to $30 billion in investment in U.S. commercial real estate in 2016, according to Ken Rosen, professor of economics and chairman of the Fisher Center for Real Estate and Urban Economics at the University of California, Berkeley.
With many groups of foreign investors seeking a 'safe haven' in a volatile world, Henry Chin, head of research for CBRE Research, Asia Pacific in Hong Kong, said the changes to FIRPTA are certainly "a positive step toward attracting more overseas capital into the U.S. real estate market."
"The previous tax rules under FIRPTA resulted in high transaction costs and had been cited as a major barrier for foreign investors looking to purchase real estate in the U.S.," Chin said.
Chin acknowledged the benefits of the reforms is largely limited by qualified pension funds and would have a more significant impact if the tax advantages were extended to apply to other foreign institutional investors, such as sovereign wealth funds and insurance companies.
However, as the latest annual survey of the Association of Foreign Investors in Real Estate (AFIRE) confirmed, investors from just about all overseas investment groups continue to view the U.S. as the safest global haven for their capital.
A survey of investor sentiment released today by the Pension Real Estate Association (PREA) and its European and Asia-Pacific partners also indicates that
investors expect to commit at least $52.1 billion to real estate around the world in 2016, 13% higher than 2015's projection of $46.1 billion, according to the 2016 Investment Intentions Survey. The average investor is targeting a 10.3% allocation to real estate, up from the current average allocation of 9.4%.
While Europe is the largest desination for capital at nearly 42%, more than 35% of investment dollars is expected to land in U.S. properties, according to the survey conducted jointly with the Asian Association for Investors in Nonlisted Real Estate Vehicles (ANREV) and the European Association for Investors in Nonlisted Real Estate Vehicles (INREV).
That's fresh off of a record year for foreign acquisitions of U.S. commercial real estate. Total dollar volume for deals valued at over $10 million increased in 2015 to $39.3 billion or 15.6% of total sales volume, from about $24 billion, or 10.6% of all sales -- both 10-year highs, according to CoStar data.
The FIRPTA amendments may boost sales volumes for multifamily and other property types, said Ethan Vaisman, real estate economist with CoStar Portfolio Strategy.
"We would expect foreign pension funds to increase their allocation of U.S. real estate in response," Vaisman said.
The changes to FIRPTA, included in the final version of the Protecting Americans from Tax Hikes (PATH) Act passed by Congress in mid-December as part of the federal government's $1.1 trillion omnibus spending bill, are intended to increase investment in the U.S. by qualified pension funds. Pensions accounted for 17% of the total turnover of Asia Pacific outbound capital invested into the U.S. real estate market between 2011 and third-quarter 2015 -- a total of $37.7 billion, according to CBRE's Chin.
Japanese pension funds, which are the largest in the region with a total $2.9 trillion in assets under management as of 2014, will potentially become a major buying force in the U.S. once again, Chin added.
South Korean and Australian pension funds, which have been investing in U.S. properties through joint ventures and asset management companies, will likely consider making direct investments to take advantage of the tax break, Chin said.
Meanwhile, Chin expects other Asian pension funds to remain on the sidelines due to continued domestic restrictions imposed on direct real estate investment.
When Is a Pension Fund Not a Pension Fund?
Foreign funds will first need to assess whether they meet the standard under U.S. tax law to quslify as a pension fund under the new rules, and provide the stringent reporting required by the U.S. Internal Revenue Service, to claim the exemption.
The FIRPTA reforms encourage foreign investment in U.S. real estate in two ways. First, sovereign wealth funds and other foreign investment groups can now own as much as 10% (up from a previous 5%) of a publicly traded U.S. REIT without triggering the FIRTPA tax upon selling the REIT stock or when receiving proceeds from the REIT's required disposition of 90% of its taxable income.
Second, the PATH Act exempts "qualified foreign pension funds" from FIRPTA taxation, putting foreign funds on even footing with domestic pension funds for the first time.
Under the newly enacted legislation, a qualified foreign pension fund is defined as "any trust, corporation, or other organization or arrangement which is established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees of one or more employers."
Qualified funds must also not have an individual participant or beneficiary with a right to more than 5% of the funds’ assets or income, and the fund must be subject to government regulation and provide annual reporting about beneficiaries to the foreign country’s tax authorities.
So when might a pension fund not be a qualified pension fund?
"The impact on volumes will depend on whether a fund meets the standard for the exemption," notes a recent analyst report issued by Fitch Ratings. "For example, Norway's Government Pension Fund Global (GPFG) would appear to screen as a qualified fund based on its name; however, it has no formal pension liabilities and was set up to provide fiscal policy flexibility as changes in oil revenues and population demographics require."
The GPFG, formerly The Government Petroleum Fund is largely the country's repository for surplus wealth produced by the Norwegian oil industry.
Other foreign funds are also trying to determine that the FIRPTA reforms mean for their investments.
"We expect that German pension funds and their sponsors will need to reassess their U.S. real estate investment strategy and structures going forward," noted Andreas Walter, partner at WTS Legal Rechtsanwaltsgesellschaft mbH. "This could impact existing blocker structures and check-the-box planning. Funds of funds that attract pension fund capital should also be sensitive to this big change."
Another potential concern for foreign pension funds may be the intersection of the FIRPTA reforms with tax exemptions under another federal law, the Foreign Account Tax Compliance Act (FATCA). That law requires all non-U.S. financial institutions doing business in the U.S. to identify investments by U.S. citizens, who are required to report their investments in overseas entities.
"One of the requirements for non-U.S. pension funds to be exempt from both laws is that the fund provides annual information reporting about its beneficiaries to the relevant tax authorities in the country in which it is established or operates," said David W. Powell with Groom Law Group. "Few, if any, pension funds report on every single plan participant to the tax authorities every year. Thus, how narrowly the U.S. Treasury will interpret this language remains at issue."
Rampup in Private Buyout Funds?
U.S. REITs also stand to benefit from the new tax provision, although indirectly. Foreign investors, already a key source of capital for the current wave of REIT privatization transactions, are expected to invest more of their funds with private sources due to their ability to generate higher returns from lower taxes under FIRPTA, according to Fitch Ratings.
The lower cost of capital, less-stringent underwriting and maturing real estate cycle may create a good environment for public REITs to pursue go-private transactions, Fitch forecasts.
"We've seen a significant influx of foreign capital into U.S. real estate, despite the past hurdles presented by FIRPTA," Bob O'Brien, global and U.S. real estate industry sector leader for Deloitte, tells CoStar. "The reforms present opportunities for foreign capital to invest in U.S. properties over the longer term, through different stages of the real estate cycle, even in times of the most need."
Many of the private-equity companies that acquired REITs over the past few years raised a substantial amount of funds from institutional investors, including foreign pension funds and other cross-border investment groups. The changes to FIRPTA should provide a further boost, making an already robust fundraising environment for private equity even more so, O'Brien said.
Foreign pension funds that have not historically invested in U.S. real estate may be among the first to respond to the new law.
"I think you'll see those enter the market relatively quickly," Deloitte's O'Brien said.
AFIRE CEO James A. Fetgatter said many members were caught by surprise by the FIRPTA exemption for pension funds, and that it takes time for big funds with lots of investmment committees and oversight to change their investment strategies. Most changes would occur over the course of the year as they study the tax implications.
"It takes a while to decide how to structure and complete a real estate acquisition, and this [legislation] changes the way investors can structure their deals," Fetgatter said.
Not All Foreign Investors Will Benefit
Not all of the FIRPTA reforms are favorable to non-U.S. investors. The law requires foreign investors to withhold and pay 15% of the gross proceeds of any disposition of a U.S. real property interest that occurs on or after February 16, 2016 in taxes, up from 10% under the prior law.
"The increased withholding rate may have a chilling effect on direct and indirect investments in U.S. real estate by other non-U.S. persons" other than foreign pension funds, noted Matthew J. Norton, real estate law practice leader for K&L Gates based in Charleston, SC.
International investors may still avoid the FIRPTA tax by investing in and disposing of U.S. property through non-U.S. "blocker" C corporations, or by requesting a determination from the IRS that a lower amount of withholding is appropriate. However, non-U.S. investors other than qualified pension funds and investors in publicly traded REITs should carefully consider the PATH Act’s consequences on their U.S. real estate investment activities, Norton said.