Regulation, Taxes, and Commercial Real Estate Investment

Paper Session

Friday, Jan. 6, 2017 10:15 AM – 12:15 PM

Sheraton Grand Chicago, Huron
Hosted By: American Real Estate and Urban Economics Association
  • Chair: Timothy Riddiough, University of Wisconsin-Madison

How Taxes and Required Returns Drove Commercial Real Estate Valuations Over the Past Four Decades

David Ling
,
University of Florida
John V. Duca
,
Federal Reserve Bank of Dallas and Southern Methodist University
Patric Hendershott
,
DePaul University

Abstract

We document the evolution of U.S. tax law regarding commercial real estate (CRE) since 1975, noting changes in income and capital gains tax rates and tax depreciation methods. The most prominent changes were the 1981 and 1986 tax acts, but numerous significant changes occurred in the last dozen years. We then compute the present value of tax depreciation per dollar of acquisition price and an effective tax rate for CRE. We explain the quarterly variation in CRE capitalization rates using an error correction framework and find that the long run estimates are statistically significant in the way theory would suggest. Moreover, the required financial asset return and the tax depreciation variable temporally predict (“cause”) capitalization rates in the long run, but not vice versa.

Liquidity, Capital Constraints, and Rating Migration in Structured Fixed Income

Stephen Buschbom
,
University of Georgia
Evan Eastman
,
University of Georgia

Abstract

This study examines the investment decisions of regulated financial institutions. Specifically, we examine the selling behavior of insurers following a rating downgrade of a commercial mortgage-backed security (CMBS). The regulatory environment in the insurance industry creates a setting where firms must consider not only the regulatory impact of selling a security, but also the price of the security. By modeling the selling decision using a hazard model we can capture a dynamic characterization of the firm- and bond-specific attributes which affect the selling decision. Similar to prior studies we control for an insurer's aggregate portfolio risk exposure but we also introduce an important variable: price. By estimating each security's price we are able to include a proxy for an insurer's unrealized gain or loss. Our results provide evidence that insurers are not primarily motivated by regulatory capital, but instead by the riskiness of their portfolio and the size of the unrealized gain or loss which we find to be non-linear and asymmetric between high- and low-risk exposure insurers.

A Theory of Commercial Real Estate Development, REIT Investments and Taxes

Jaime Luque
,
University of Wisconsin-Madison
Marta Faias
,
Nova University of Lisbon

Abstract

We consider a two-stage general equilibrium model of commercial real estate (CRE) development in a multi jurisdictions economy with segmented markets. Local CRE assets produce consumption goods that are sold to households in the jurisdiction. The developer's capital structure, CRE cash flows, as well as the equity, debt and commodity prices are all endogenous. Strategic jurisdiction authorities choose property taxes to attract global REIT investors. An equilibrium
exists and demand differentiability holds even when CRE assets are co-linear among jurisdictions. We provide examples of our model, and discuss the role of taxes, including the
Tax Incremental Financing (TIF), in attracting CRE investments and promoting development.

The Impact of Tax Incentives on Investment: A Cost-Benefit Analysis of Real Estate Tax-Deferred Exchanges

Milena Petrova
,
Syracuse University
David Ling
,
University of Florida

Abstract

Section 1031 of the Internal Revenue Code permits corporate and individual taxpayers to defer the recognition of taxable gains on dispositions of business-use or real property investment. Section 1031 exchanges are widely used, especially in states with high income tax rates. The economic rational associated with providing enhanced capital gain deferral benefits to one class of investments has been questioned by academics and practitioners but the commercial real estate industry has long argued that by reducing potential lock-in effects the availability of tax-deferred exchanges increase the ability of investors to redeploy capital to other uses and/or geographic areas. Proponents also argue the tax savings produced by exchanges allow owners to upgrade and expand the productivity of buildings and facilities, reduce the use of leverage, and otherwise engage in more income and job creating spending with positive spillover effects to related industries. Despite these claims, careful estimates of the magnitude of exchange tax-deferral benefits are lacking and no direct evidence exists on the extent to which the availability of Section 1031 exchanges alters investor behavior. This paper addresses these gaps in the literature. We first develop a “micro” model that quantifies the present value of an exchange to the property owner. We estimate that the incremental value of a CRE exchange as a percentage of the investor’s deferred tax liability ranges from 10 percent to 62 percent. Next, using unique property level transaction data, we examine empirically the effects of tax deferral on investment, transaction activity, the use of leverage, and other borrower behavior
Discussant(s)
Eva Steiner
,
Cornell University
Xudong An
,
Federal Reserve Bank of Philadelphia
Jiro Yoshida
,
Pennsylvania State University
David Barker
,
University of Iowa
JEL Classifications
  • G1 - Asset Markets and Pricing
  • H2 - Taxation, Subsidies, and Revenue