Private equity real estate is an asset class that isn't used to being in the spotlight. Like their cousins in the LBO space, the recent unwelcome publicity— brought on by big deals and even bigger birthday parties—has brought scrutiny from newspaper editorial pages, men's magazines, cable TV pundits and, perhaps most alarming of all to investors, regulators in Washington, DC.
Two bills have been introduced in Congress that would drastically change the regulatory landscape for private equity investors in the US. Days before the initial public offering of The Blackstone Group, the Senate Finance Committee put forth a bill proposing a change to the tax code for publicly traded partnerships that manage financial assets.
But the vast majority of private equity real estate investors are losing sleep over a different bill: the far-reaching House bill—H.R. 2834—unveiled around the same time as the “Blackstone Bill.”
Similar to the Senate bill, this legislation would tax the carried interest generated by general partners as ordinary income at 35 percent—not the 15 percent capital gains rate.
Introduced by 14 House members, the bill would tax carried interest for any partnership at a higher rate: Similar to the Senate bill, this legislation would tax the carried interest generated by general partners as ordinary income at 35 percent—not the 15 percent capital gains rate.
Tax experts say the legislation, known in the District as the Levin-Rangel bill, could have a significant impact on private real estate funds, from GPs to local operating partners who get a piece of the carry.
Using the example of a partnership where one party brings the capital and another party contributes the expertise, Michael Frankel, global tax leader at Ernst and Young, says the law attempts to “say the sweat-equity partner is a glorified employee of the money partner.”
Charlie Temkin, a tax director at Deloitte, also says the effects could be far reaching. “It just permeates real estate where transactions are done as partnerships,” he says. “When you start recharacterizing the basic operating rules—that creates a lot of waves that bounce around.”
While the legislation was designed not to affect LPs— their passive stakes will still be considered capital gains—the law also has some provisions for real estate investments trusts. Experts say the new law will not recharacterize REITs for purposes of applying the REIT gross income test—the test to qualify as a REIT structure.
However, the new law will apply to REITs if the vehicle is receiving capital gains for actively managing assets in, say, a joint venture with a large LP: The back-end interest from that partnership would be considered income rather than capital gains.
In the past, REITs could pay the capital gains tax on the interest or pay out a capital gains dividend to investors. Frankel points out that this is one part of Levin-Rangel that trickles down to affect everyday investors.
Tax experts predict the new law would create all manner of confusion as affected partners work to determine the parameters of the new law and seek to minimize the impact of the legislation. “People will have to figure out the impact on existing deals and how to structure future deals,” Temkin says. “Whatever is enacted could be seen as the first round of legislation.”
The future of the legislation is unclear. The bill has the support of some heavy hitters in Congress, including Ways and Means Committee Chairman Charles Rangel, a Democrat from New York, and Financial Services Committee Chairman Barney Frank, a Democrat from Massachusetts. Many Democratic presidential candidates have come out in favor of the tax change, while, this August, President George W. Bush said he would be “very, very hesitant” when it came to raising taxes on private equity. The Treasury Department has also come out against the bill.
And attitudes in DC might be shifting in regards to the tax, no doubt helped by lobbying by the big New York firms and the recently established private equity trade association. Temkin points out that over the course of two Senate finance committee hearings, enthusiasm for the Senate bill seems to have cooled. “The extent of that [shift in attitude] may be coming as a surprise to people who were disposed to doing this.”
Still, real estate fund general partners feel the tax bill could have legs and aren't ruling it out completely. You can't blame them for feeling a bit nervous these days—the engine of their wealth creation is at stake.
CalSTRS, CalPERS report strong real estate returns
The California Public Employees' Retirement System (CalPERS) and the California State Teachers' Retirement System (CalSTRS) both reported their returns for the 2006 fiscal year and real estate continued to post outsized returns. CalPERS, the country's largest public pension, said its real estate portfolio returned 20.2 percent for the 12 months ending March 31, 2007, topping its benchmark of 12.5 percent. Core investments in the office, retail, multifamily and industrial sectors produced a 19.9 percent return, while non-core housing, land and urban investments in California posted a 20.2 percent return. Teacher pension CalSTRS also announced that its real estate investments had a 32.9 percent return for the past fiscal year; last year it achieved a 13.2 percent return on investments.
Hines secures $828m value-added fund
Texas-based real estate firm Hines has closed its US Office Value Added Fund II with approximately $828 million (€605 million) of equity. With leverage, the vehicle will have $2.7 billion in buying power. The fund will target office buildings in the top 20 US metro areas and will create value through repositioning, re-leasing and expanding the properties; it has already invested approximately 30 percent of its equity in five projects. Equity for the fund was raised from 17 institutional investors in the US, Europe and Japan.
BPG closes fund on $850m
Philadelphia-based BPG Properties has closed its latest fund on more than $850 million (€619 million) . The new fund, BPG Investment Partnership VIII, will invest in the office, multifamily, industrial and retail sectors in the US. Investors in the fund include public and corporate pensions, endowments, foundations, family trusts and financial institutions, according to the firm. BPG has raised more than $2.8 billion in equity over the course of eight close-ended funds and one co-investment vehicle.
IMT Capital closes real estate fund on $350m
Los Angeles-based private equity real estate firm IMT Capital has closed the IMT Capital Fund with more than $350 million (€255 million) in capital. The fund will target undervalued multifamily properties in the US. IMT Capital invests in the multi-family sector in the US, focusing on markets in California, Arizona, Texas and Florida. The firm was founded in 1992 by managing directors Michael Browne, John Tesoriero, Bryan Scher and Cory Thabit.
Harrison Street forms $350m senior housing JV
Chicago-based private equity real estate firm Harrison Street Real Estate Capital and New York-based senior housing developer Kaplan Development Group have joined forces to develop, redevelop and acquire senior housing properties throughout the Northeast and Southeast US. The $350 million (€255 million) venture was launched with the recapitalization of six senior housing properties, located in New Jersey, Pennsylvania, Delaware and Georgia, totaling 540 units.