Challenges When Dealing Internationally

The United States has numerous federal guidelines concerning international in­vestment which serve as roadblocks to investment. Specifically, the Patriot Act created a host of issues. Specifically the taxation issues breakdown into three categories: taxation of operations, estate taxation and income taxation upon dis­position.

Here is an overview of each issue:

Taxation of Operations

A foreign person is subject to US income taxation on income that is connected with the conduct of a business in the US. Such income is subject to regular graduated rates of taxation on his net income and the foreign person is entitled to regular deductions in relation to the property operations, such as deductions for real property taxes, mortgage interest and maintenance expenses. The graduated rates for 2010 reach as high as 35% for both individuals and corporations and are scheduled to increase to 39.6% in 2011 for individuals. However, a for­eign corporation also is subject to a branch profits tax at a 30% rate on its after regular corporate tax profits. If the foreign person is a mere passive owner, such as with respect to triple net leased property, his activities may not be considered the conduct of a business in the US. In that case, the foreign person will be subject to a 30% withholding tax on the gross rental income and no deductions are allowed. However, the foreign person can elect to treat such rental income as connected with a business in the US, so that he can be subject to the graduated rates and receive the ben­efit of deductions.

Estate Taxation

The estate of a foreign individual is subject to US estate taxation on US assets that are held by the foreign individual at his death. US real prop­erty interests are US assets for this purpose. Although Congress allowed the US estate tax to expire in 2010, it is scheduled to return in 2011 and ap­ply at rates ranging from 18% to 55% of the fair market value of his US asset including real property.

Income Taxation Upon Disposition

When a foreign person disposes of an interest in US real property, he is subject to tax on his gain. If the US real property interest is a capital as­set (not inventory held for sale to customers in the ordinary course of business) that has been held for more than one year, an individual for­eign person will be subject to tax at a maximum rate of 15% (scheduled to increase to 20% in 2011) on his gain. A foreign corporation gets no tax rate benefit for such long term capital gain and therefore is subject to tax at a maximum rate of 35%.

In order to collect, in part, the US tax on a foreign person’s gain from the disposition of a US real property in­terest, the US requires the buyer of real property from a foreign person to withhold 10% of the foreign per­son’s amount realized from the dispo­sition of the US real property interest. The foreign person must file a US tax return declaring his full gain and may apply the withheld amount as a cred­it against his final tax liability. There is a procedure to apply to the US In­ternal Revenue Service to request a reduced withholding amount if the foreign person can demonstrate that the tax on his gain is less than the 10% of the amount realized that is required to be withheld.

The previous was excerpted from Calkain Research's recent Broker Opinion Report "International Entities". View the full text here.

Insiders Look at the First Net Lease Book

This text comes from the “Tenant Profiling” section in the new book, “The Little Book of Triple Net Lease Investing”.

Tenant Profiling

This is an extremely important task for the simple reason that there must be a good fit between the tenant and the building. For example, putting a pharmacy in a building originally built for, say, an industrial purpose and located away from the general public, would be a fatal mistake. That’s because pharmacies are all about health and cleanliness and easy access. Industrial sites, on the other hand, represent the exact opposite of that. Such a mismatch of tenant and property is tantamount to business suicide, both for you and the tenant.

The investment team must profile prospective tenants in depth to ensure that the final selection involves a tenant who’s likely to reach maximum potential within the building. It must obey one of the ironclad “laws” of commercial real estate: the market value of a property is measured solely by its worth to the tenant it services.

The range of tenant options spans the local tenant providing a local service and operated by a local one-unit vendor, to a national brand tenant that’s a public company and listed on a stock exchange and which has billions of dollars in revenues, and everything in between.

Most national brand tenants can easily be profiled because so much public information is available on them, plus they’re rated by respected national agencies such as Moody’s, Fitch, and Standard and Poor’s. A local tenant can be just as good an investment as a national one; however, you need to evaluate this tenant in a different way since information isn’t as readily available. Here’s what you (or your investment team) would look for:

For more, read the full text of “The Little Book of Triple Net Lease Investing”.

A New Take on FASB Rules from Richard L. Podos

Mention the acronym “FASB” in the halls of commercial real estate and you may start a veritable shouting match. Like some impending disaster, the fear that FASB will turn the CRE world upon it head (while leaving no prisoners) is rampant and pervasive. Fortunately for us, it’s simply not true. Unfortunately, many have not got the memo.

Here are concerns that are often voiced in connection with the proposed FASB rule changes and why they will NOT have the disastrous effects envisioned:

Calkain: Two major marketplace impacts being posited are shorter-term leases and more corporate ownership. Are either or both going to become the trend?

RLP: In a word, NO (with certain exceptions at the margin). First, lease term from a tenant’s perspective is about occupancy strategy and economics. No major tenant is going to start doing large leases for 5 year terms, with all of the expense entailed in tenant improvement (TI) and moving, not to mention issues such as employee attraction and retention, customer proximity, risk of exposure to landlord leverage on renewal, etc. That said, will a low-cap ex renewal be short... yes, probably. As to corporate ownership, there has been an inexorable worldwide trend towards leasing over the last 20 years based on core competency and capital deployment drivers... accounting doesn’t change any of that.

Calkain: How will the industry build the proposed new standard into pricing?

RLP: Believe it or not, it’s been happening for years. Just because the lease accounting changes haven’t been officially formalized doesn’t mean the industry is keeping its head in the sand. Again, economic drivers are paramount. We’ve all seen a move towards shorter lease terms by occupiers with greater uncertainty; on the other hand, certain tenants, especially retailers, make long-term commitments because they *know* they will remain at a given location for a long time. And again, deals involving heavy amounts of tenant improvements (TI) suggest longer terms to deal with amortization, whether funded by landlord or tenant or my firm. Renewals with minimal capital investment will tend towards short, but that’s about it.

Calkain: What (if any) unintended consequences will result from the standard?

RLP: It certainly won’t have a major impact on tenants’ financials... with certain exceptions (e.g., retail, airlines), the impact on corporate reporting and ratios will be de minimus. Most importantly, the credit ratings agencies and the equity analysts have been capitalizing leases for over 20 years, actually around 2X of what the new lease accounting will require, so no major impact. The largest unintended consequence we foresee will be the impact on sale-leasebacks. Over the next two years, we expect to see a slow-down in those transactions, simply due to uncertainty, except where there are strategic concepts driving portfolio re-positioning (a big concept for another day). However, once the new standards are better digested, that trend will level off, and transaction velocity will resume.

The key thing to remember with the proposed lease accounting is that it does not change the strategy and business drivers that underlie tenants’ real estate deals. Our motto? “Economics trumps accounting”.

Richard Podos is the CEO and President of Lance LLC, a New York-based finance and investment firm focused on TI funding and asset-intensive build-to-suits, and is a thought leader at CoreNet Global regarding lease accounting.

Understanding Net Lease Investors

Certain types of investments appeal differently to investors and their varying needs. These needs might include offsetting tax liabilities and expanding one’s business. Another investor may be concerned with capital gains or bond-like income streams. An investor nearing retirement may be worried about hedging their money against inflation and wealth preservation.

As with any business, understanding the clientele is instrumental to mastering the trade. When it comes to net lease investments, we can roughly separate investors into three primary segments of interest:

Segment A – 1031 & 1033 Exchanges

• Interested in cost segregation and business expansion

Segment B – Capital Gains

• Looking for real estate exposure and capital gains

Segment C – Estate Planning

• Concerned with hedging for inflation and wealth preservation.

We can further analyze these three groups in terms of demographics, lifestyle and usage.

You can view a chart illustrating this here.

This classification schema is helpful because it gets at the roots of an investors interest. There will be numerous situations when these interests overlap and understanding how they interact is vital.

CVS Corporate Bond vs. CVS Net Lease

Where to invest is a question on many people’s minds today. Many are seeking to mitigate risk and avoid the costly mistakes of the past while still owning a lucrative investment. As such, a growing debate has emerged about where best to place capital. Although some would dismiss real estate as too costly; closer inspection reveals a well of opportunity.

Let’s say you were looking to invest in either CVS bonds or real estate earlier this year (CVS rated BBB+ by Moody’s). A 10yr issuance that was done in March of 2009 has maturity date of 2019. It pays a coupon of 6.6% and is priced at $111.45; you would receive a yield to maturity of 5.04%, and an annual yield of 5.92%.

Now let’s look at an opportunity to purchase a brick and mortar store that CVS would lease from you. The lease runs through 2034, and property is for sale at $3.5Mil. Furthermore, there are .50/Sqft increases in rent every five years.

We’ll set the period of observation to 10 years and assume no increase in value (you can see the specifics here). Said differently, we’ll sell the property for what we paid for it, and the bond will just be redeemed for its face value. Also, to keep the playing field level we aren’t going to use any leverage, just cash.

In this example, the property would receive a 78% higher return over the bond. It achieves both a greater yield and cash flow for the same amount of money invested. Some of this is due to the tax benefits of depreciation expense, but even in a world without taxes the property still outperforms the bond. The risk profiles of the two investments are also virtually identical in that CVS is the guarantor of both streams of income. All things being equal if one had to make a mutually exclusive investment decision between the two choices the answer is obvious.

Lack of Inventory = Lower Cap Rates?

Today, the largest challenge the net lease market faces is a severe lack of inventory. Buyer demand for high quality net lease assets is high and cap rates have compressed in response to this. However, there is simply not enough high quality inventory to match demand. This is forcing cap rates down and clogging the market.

Buyers want the best assets available; risky assets are no longer popular. This means high credit tenants in major metro markets; such as Walgreens and McDonalds. These are coveted because they combine low risk with high returns and passivity. High net-worth buyers with excess cash are not satisfied with the 1% return they are receiving from banks, are leery of the turbulent stock market and worried about increased inflation. They desire to invest their cash into secure assets which produce high returns. In many ways, net lease investments are the perfect option. The problem is there are so few high quality net lease assets available.

The recession caused companies to halt construction; cutting the amount of new product in market down to a trickle. Even today, we are 6 months to 2 years away from new construction. This process has bottlenecked supply. Today we are seeing cap rates between 5.75-7.50% (they were at 6.75-8.5% six months ago). These are numbers not seen since the height of the market in 2006. This is not a long-term trend as much as the odd environment we are currently in. Lack of supply plus increases in demand has equaled lower cap rates.

Current conditions are projected to continue until construction picks up and new product beings entering the market. We can expect to see this in the next 6-24 months. Once substantial new product enters the market, we can expect to see a rise in cap rates and transactions. For now cap rates will remain low.

Seeking Shelter From New Health Care Tax

Many investors could be facing an unexpected extra tax. However, despite viral hoax emails to the contrary, it is not focused entirely on real estate transactions, in fact if you’re a real estate investor you’re probably in as a good a position as possible. Let’s examine:

The Health Care and Education Reconciliation Act of 2010 added IRC § 1411. Under this new regime, beginning in 2013 individuals with net investment income (interest, dividends, rental income etc...) and making over $200,000 and married couples making over $250,000 will face the specter of a 3.8% tax on the lesser of the amount their MAGI exceeds $200,000/$250,000 and their net investment income.

This new measure is an attempt to capture and subject the “unearned” income of the “wealthy” to the same Medicare payroll tax that earned income is.

If you’re a real estate investor you’re probably about as well positioned as you can be as stocks and bonds don’t provide nearly the sort of opportunities to shelter income that real estate does, mainly through depreciation expense.

Of note distributions from Pension Plans, 401K, 403B, and IRA’s are exempt from the tax. Also, for real estate investors who materially participate in their investments the ability to elect to become a Real Estate Professional and turn their passive income into earned income may present some planning opportunities.

Oh by the way, this tax is in addition to the more well known new “Hospital Insurance Tax” of 0.9% imposed on earned income in excess of the aforementioned MAGI thresholds. All in, these new taxes could amount to an almost 5% increase in taxes to the “wealthy”. I guess someone has to pay for healthcare reform though.....