The Real Estate RoundtableWashington, DC

www.rer.org

How FIRPTA ReformCan Fill Commercial

Real Estate’s Equity Gap and Help Stabilize the Market

The Real Estate Roundtable

The Benefits of FIRPTA Reform1. An estimated $2.8 trillion of global capital is available for U.S. real estate investment. Putting

foreign investment in real estate equity on an equal tax footing with other asset classes will immediately unlock billions of dollars in investible capital into the commercial real estate market. International capital is vital to recapitalizing the $1.4 trillion of mortgage maturities.

2. With more capital available and less burdensome tax liabilities, the resulting increased investment activity would provide support to asset values, reducing the risk of billions of dollars in additional losses.

3. With approximately 14 million Americans still unemployed, FIRPTA reform will stimulate hiring in the wide variety of industries connected with commercial real estate, including sales, financing, operations, construction, and even the public sector.

4. Increased capital flows and enhanced liquidity will stem the erosion in commercial real estate asset values. Stabilizing these assets greatly reduces the risk of both government and taxpayer loss as well as the risk of bank failures. Low commercial real estate values continue to be the greatest threat to the US financial system.

5. Several hundred billion dollars worth of souring commercial real estate loans are on the books of smaller regional and community banks. Improving capital flows and stabilizing these assets would shore up these institutions, which are the primary source of funding for small business activity. Small businesses expand payrolls before large companies during economic recovery periods.

The Problem

• FIRPTA is completely at odds with the US tax treatment of other types of foreign investments in the United States.

• FIRPTA is virtually the only major provision of US tax law which subjects non-US investors to taxation on capital gains realized from investment in US assets.

• For example, a foreign investor is not subject to tax in the United States on the sale of stock in a US compnay.

The Real Estate Roundtable

Income From Sale $1,000,000

   Less:  Regular income tax at 35% rate ($350,000)

Income Net of Regular Tax $650,000

   Less:  Branch profits tax at 30% rate ($195,000)

Income Net of Regular and Branch Profits Taxes

$455,000

Effective combined tax rate 54.5%

Tax Effect to Foreign Investor on $1,000,000 of Income from Sale

The Equity Gap in CRE: Scope of the Problem

The Real Estate Roundtable

• In general, commercial real estate mortgages must be refinanced every 5-10 years. • Between 2010 and 2014, $1.4 trillion in commercial real estate mortgages are expected to

come due.• These loans currently sit on the balance sheets of banks, life insurance companies, CMBS

investors, and other investors.

The Real Estate Roundtable

The Equity Gap in CRE: Scope of the Problem

• The loans that are coming due over the next five years were generally written when property values were higher, loan-to-value (LTV) ratios were higher, and credit flowed more smoothly.

Source: Green Street Advisors

The Real Estate Roundtable

The Equity Gap in CRE: Scope of the Problem

• As these loans come due at a time of diminished property values, lower LTV ratios, and tighter underwriting standards, more of these loans are “under water.” Owners that wish to keep their property must find additional equity in order to refinance.

• Conservative estimates suggest that the cumulative “equity gap” facing property owners is over $1 trillion. (See Apendix slides 1-4 for an example of a distressed single loan.)

Note: This graph assumes a conservative 20% decline in property value, an original LTV of 70% and a refinancing LTV of 60%.

Estimated Size of CRE “Equity Gap”

The Real Estate Roundtable

Scope of the Problem

• The following (appendix) real life example represents the reality facing countless real estate owners.

• Between 2010 and 2014, $1.4 trillion in commercial real estate mortgages are expected to come due. By 2018, that number grows to over $2.4 trillion.

• At a time when the U.S. economy continues to recover, there simply are not enough domestic sources of capital to fill the looming equity gap.

Broader Economic Impact

• If the equity gap is not filled, building owners may default on their loans, causing lenders to foreclose. Local communities will suffer. More banks will be in danger of collapse.

• If they are able to plug the equity gap, owners will be able to refinance their property, which in turn would deleverage bank balance sheets. Owners would also be able to invest in leasehold improvements which, in turn, will create construction jobs and attract new tenants. Banks will be healthier and more able to lend.

The Equity Gap in CRE: Broader Economic Impact

Appendix

The Single Property Example

The Real Estate Roundtable

Background

• Building Owner buys a high quality office building in a research park in a dense market in early 2006 for $200 million.

• At the time of purchase, Building Owner invested $60 million cash equity and obtained a mortgage of $140 million at 70% loan to value.

• The loan was a typical five-year maturity, non amortizing CMBS loan expiring in April 2011.

• The building is 500,000 square feet and was fully leased to two existing tenants, with a capitalization rate of 6% (capitalization rate = income / value)

• Tenant A’s lease for 300,000 square feet @ $24/square foot expires in January 2011 and they intend to vacate the space.

• Tenant B’s lease for 200,000 square feet @ $24/square foot expires in 2015.

The Equity Gap in CRE: Single Property Example

The Real Estate Roundtable

Reduced Property Value Depletes Building Owner’s Cash Equity

• In 2011, the same office building is now valued at $144 million.

• The decrease in the building’s value drastically reduces Building Owner’s cash equity position from $60 million to $4 million.

2006 Financing, Loan:Equity

$60

$4

$140

$140

$0

$50

$100

$150

$200

$250

2006, $200m 2011, $144m

Year, Building Value

$ (

in m

illio

ns)

Loan

Cash Equity

The Equity Gap in CRE: Single Property Example

The Real Estate Roundtable

Reduced Equity, Tighter Lending Requirements, Create an Equity Gap

• In 2011, new debt underwriting standards will only support a 55% loan-to-value mortgage based on cash flows generated by Tenants, and a capitalization rate of 7.5%. Therefore, Building Owner can only obtain a mortgage for $79.2 million (55% of $144 million).

• Building Owner is immediately facing an equity gap of $60.8 million ($144 million building value – $79.2 million new loan - $4 million remaining cash equity). This equity is necessary to pay off the 2006 loan.

Equity Gap Created by Reduced Building Value and Tighter Lending Standards

$4 $4

$140

$79.2

$60.8

$0

$20

$40

$60

$80

$100

$120

$140

$160

Expiring 2006 Loan with DepletedCash Equity

2011 Loan with Depleted CashEquity

$ (

in m

illio

ns

Equity Gap

Loan

Cash Equity

The Equity Gap in CRE: Single Property Example

The Real Estate Roundtable

The Loan Depends on Leases

• Since the new loan is contingent on cash flows from Tenants, Building Owner must lease the space vacated by Tenant A when their agreement expired.

• Building Owner has identified Tenant C, who will pay only $20 / square foot, due to changed market conditions.

• Additionally, the Tenant C will sign a 10-year lease only if Building Owner makes $80 per square foot of leasehold improvements to make the space ready (leasehold improvements).

• This will require $24 million additional equity.

Building Owner Must Find Additional Capital

• Building Owner must raise $84.8 million in new capital to pay off the $60.8 million due on the 2006 mortgage, and to make the $24 million of leasehold improvements required by the new tenant in order to secure the necessary cash flows to support a new mortgage.

• To avoid default, foreclosure and/or bankruptcy, Building Owner must strike an agreement with its existing investors or attract new investors.

The Equity Gap in CRE: Single Property Example

The Real Estate Roundtable

2006 2011

Tenant A Annual Rent 7.2 mm n/a

Tenant B Annual Rent 4.8 mm 4.8 mm

Tenant C Annual Rent n/a 6.0 mm

Rental Annual Cash Flow $12.0 mm $10.8 mm

Capitalization rate 6.0% 7.5%

Building Value $200.0 mm $144.0 mm

Less: 2006 Mortgage 140.0 mm 140.0 mm

Equals: Existing Owner Equity $60.0 mm $4.0 mm

New 2011 Mortgage -- $79.2 mm

New Equity Required:

Mortgage pay down (shortfall) $60.8 mm

Building improvements 24.0 mm

Total New Equity Needed $84.8 mm

The Equity Gap in CRE: Single Property Example

The Real Estate Roundtable

www.rer.org