As the housing sector continues its apparent recovery, some U.S. lawmakers are turning their attention to a looming crisis in the commercial real estate market, which is threatened by an avalanche of debt as loans made during the heady days of the early aughts start coming due over the next five years.
Reps. Kevin Brady, R-Texas and Joseph Crowley, D-N.Y., this week introduced a bill that would make it easier to finance this coming wave of debt. Following similar proposals in the Senate and President Obama's budget, it would stop penalizing foreign investors in U.S. commercial property.
Here's the problem they're trying to solve: colossal amounts of real estate loans – totaling more than $1.7 trillion – are due to mature from now to 2018. Commercial mortgages are not like your average home mortgage. They aren't fixed at a rate for 30 years. The standard commercial loan must be refinanced, paid down or sold after 10 years. What's coming now is a huge wave of commercial debt that originated in the bubble years between 2003-2008.
Back then, real estate values were inflated and lending standards much looser. That means we can expect significant volumes of maturing mortgages to be in some sort of distressed state. In a 2010 Congressional oversight report, lawmaker's panel served up this scary scenario:
A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American. Empty office complexes, hotels, and retail stores could lead directly to lost jobs. Foreclosures on apartment complexes could push families out of their residences, even if they had never missed a rent payment.
Underwater mortgages, which we know all too well from the housing crisis, may be just the beginning. According to the Mortgage Bankers Association, in three of the major commercial real estate sectors – multi-family, office and retail – the last two are continuing to experience all-time high vacancy rates as of the first quarter of 2013. That's right – as high as the apex of the crisis.
The new loans to replace this maturing debt will come from a handful of primary sources – commercial mortgage backed securities (CMBS), life insurance companies, banks, real estate investment trusts (REITs) and Fannie Mae and Freddie Mac (GSEs).
And as of now, the math does not add up.
According to The Real Estate Roundtable, there is a corresponding capital shortfall. Property owners and equity investors will need approximately $240 billion in credit for refinancing maturing mortgages in 2013. Yet only $162 billion is projected to be available from these primary sources – resulting in a $60-80 billion shortfall (some estimates reach as high as $100 billion per year).
This shortfall (or equity gap) is expected for the next several years due to various challenges each source faces. For instance, CMBS has been the hottest market, but is still a fraction of what it was pre-crisis, and rising interest rates have already slowed activity. Rates are expected to continue to rise this decade. The GSEs stepped in during the 2008 liquidity crisis and have been the primary support for the multi-family sector, but their regulator has mandated a draw back in their activity, starting with a 10 percent reduction in multi-family loan volume.
This deficit is a potential half a trillion dollar "donut hole" in the United States commercial real estate market by the end of the decade. This is a nasty headwind this economy can't afford to take on unnecessarily. But help may be on the way courtesy of the bill Brady and Crowley introduced on Wednesday. The primary objective is to relax restrictions on foreign investors of domestic real estate stemming from a decades-old law.
That law, the Foreign Investment in Real Property Tax Act, which acronym-crazed Washingtonians call FIRPTA, was intended originally to keep foreign buyers from scarfing up prime agricultural land. As time wore on, its provisions were extended to many forms of commercial real estate including hotels, non-farm producing land and office buildings.
Thanks to FIRPTA, foreign investors face heavy capital gain taxes when they dispose of property in the United States, upwards of a 35 percent levy that their domestic peers don't. That's a competitive disadvantage and a non-starter for many investors around the world. But repealing or reforming FIRPTA and leveling the playing field would encourage robust private capital investment from outside the United States by reducing these current tax impediments.
Many foreign investors are eager to buy prime commercial properties in the U.S. despite the financial crisis and volatility of the past five years. America is still seen as the only true "safe haven" for investors. But FIRPTA does what it was designed to do – put them at a competitive disadvantage to U.S. investors.
Practically speaking, FIRPTA needs to be defanged if we are to wind down the looming multi-trillion dollar commercial debt coming due in the next five years, not to mention helping to finance the massive infrastructure makeover our country desperately needs. President Obama's interest in FIRPTA reform, in fact, is mainly aimed at supporting large amounts of capital to flow towards much needed infrastructure projects.
Ultimately, bringing foreign investment into the country will drive competition for assets here at home, which has never been more important as we start to see increased competition for U.S. real estate investment dollars abroad, as well.
Increasing inflows of capital stimulates real estate demand and that drives construction, bringing the downstream benefits such as jobs associated with a continued recovery. Cities and towns would ultimately benefit by a steady stream of on-time tax revenue, which would bolster the recovery and help drive the elusive growth the recovery so desperately seeks.
Jason R. Gold is director of the Progressive Policy Institute's "Rebuilding Middle Class Wealth Project" and senior fellow for financial services policy. Keep up with his work at PPI here and follow him on Twitter at @PPI_JGold.
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