Uncertainty over pending and potential regulatory and tax changes may be slowing down the recovery of the institutional real estate sector, as Stephanie Schwartz-Driver reports
The many rules of the Dodd-Frank Act are an immediate concern. The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed by Congress and was signed into law in July this year. At 2,300 pages long, the Act is weighty, and its implementation is an ongoing and intricate process. According to a report by law firm Davis Polk, the federal government will be obliged to pass 243 new rules, to conduct 67 studies, and to generate 22 new periodic reports. Some observers believe this to be a conservative estimate, and estimates of new rules are as high as 530. Compare this with Sarbanes-Oxley, the last big attempt at financial re-regulation, which required the creation of 12 new SEC rules - Dodd-Frank is taking rule making to a new level, requiring around 120 new rules from the SEC.
Few provisions of the Act were designed to be effective immediately - Congress intended the legislation to be implemented in stages. The rule-making period will take up to 18 months and involves the input of multiple federal agencies. Implementation - and smoothing out irregularities and inconsistencies will take even longer. This means that investors and financial institutions have to continue to operate in an environment of regulatory uncertainty that might easily last until the end of 2011.
"A lot of investors are being very cautious. There is a feeling that we are in the eye of the hurricane right now," says David Krohn, a partner at DLA Piper in Washington DC. "In my view the implications of Dodd-Frank for pure commercial real estate investment are very uncertain. But it will touch every aspect of the financial markets."
A lot of very direct provisions touch on mortgage-backed securities, perhaps constraining recovery in that sector.
Other areas that touch on the real estate investment sector include:
• Those dealing with derivatives, which broadly might make that source of hedging more expensive;
• The role of the rating agencies;
• Regulations on the registration, record-keeping, and reporting obligations of investment advisers, with regular oversight by the SEC; some of the new constraints will not apply to smaller managers with less than $100m (€72m) of assets under management, which might lead a shift in the industry in their favour;
• Bank regulations that require them to keep more activity on their balance sheets;
• The Volker Rule, restricting banks from owning more than 3% of a private equity group or hedge fund and limit their sponsorship of alternative investment funds.
"There are challenges facing our industry in Washington DC right now," says Chip Rodgers, senior vice-president of the Real Estate Roundtable. "The phrase we keep emphasising is that it is important to lift the cloud of regulatory uncertainty."
The Dodd-Frank effect on the rating agencies is a good example of the labyrinthine process the regulators will have to go through in the process of implementation, explains Krohn. One section of the legislation imposes expert liability on a rating agency if its rating is published in the prospectus of a new issue. As a result the rating agencies declined to allow their ratings to be published. However, Regulation AB of the Securities and Exchange Commission (SEC) says that ratings must be disclosed; the SEC has granted six months' relief while the regulations are harmonised, and in the meantime, ratings are being made public online or in other ways rather than being published in the prospectuses. "The mechanics don't always work," points out Krohn, who adds that additional conflicts might arise with the development of global standards. Basle III, for example, includes clauses on ratings.
In terms of new securitisation regulations, a key provision of Dodd-Frank involves the retention of risk by originators of many types of securitised loan bundles. The Act requires them to retain 5% of the risk, in order to encourage better underwriting standards; securitisers cannot hedge or transfer the credit risk. However, the Act does not define how that 5% should be apportioned - whether it should come from a vertical sample of the various tranches, or just from the bottom tranche, or from some other distribution. The details of this regulation will not be finalised until early 2011 and will come into effect in 2012 for residential MBS and in 2013 for other asset classes.
However, despite the great complexity, Krohn emphasises that, "in many respects, investors will benefit. They need to remember that one big theme is additional information and transparency. Investors really want to understand the pools, they want more information, they are being more careful, trying to get that certainty." At the same time, the federal government is aware of the complexity of the task ahead. "Many regulators are listening to industry to figure out how to do it right. It will take a lot of work and industry input, so industry needs to be very involved and to pay a lot of attention," Krohn says. "We're just at the start of a two-year process."
Dodd-Frank is only one source of insecurity for institutional real estate investors and managers. Potential changes to the tax regime are also a major challenge, according to Rodgers of the Real Estate Roundtable. The carried interest tax proposal is perhaps the broadest threat.
Currently, general partners (GP) in limited partnerships are not taxed on the "carried interest, also known as the "promote" or the "carry" - a share in the profits, normally around 20%, received once the fund liquidates, which represents compensation for the additional risk borne by the general partner. The carried interest is paid in addition to any management fee received regularly by the GP over the duration of the partnership, and it is distinct because it is performance-based. The management fee is taxed as ordinary income, but the carried interest, as a profit interest in a partnership, does not have a determinable market value and therefore is not treated as taxable under current law.
The 2011 federal budget proposed by the White House calls for legislation to tax carried interest as income. "The bill has been portrayed as a tax on hedge funds and private equity managers, but nearly half the partnerships in the United States are real estate, and it will affect every one of them," warns Rodgers. A bill has already passed the House of Representatives and is being negotiated in the Senate, where some compromises have been discussed.
The outcome of the November elections will likely determine the nature of the final bill - if Republicans make their expected gains, the legislation is unlikely to pass, but could be pushed through during the "lame duck" period between the elections and January when newly elected members take their seats.
Were this legislation to pass, "it would represent the biggest tax hike for real estate since the 1986 tax bill," according to Rodgers, who says that "it will affect existing and new partnerships, big and small." To avoid the tax, a fundamental restructuring of the economic arrangement between GPs and LPs would be required. In addition the tax would be levied on any partnership being liquidated, even those partnerships that were set up a decade before the tax bill might take effect.
The Real Estate Roundtable maintains that "any change in the tax rate should be part of a broader tax policy review," Rodgers says. "We have raised the spectre of doubt, pointed out that it was have a negative effect on an already troubled industry. It will have a chilling effect on private real estate investment."