Archives for April 2023

A recently updated study out of the University of California, Berkeley’s Institute of Governmental Studies has some bad news for CRE property owners in traditional downtown areas: pandemic recoveries are taking a longer time than those of other areas in cities. And the future without some significant changes isn’t looking favorable.

Using mobile phone data rather than the more traditional ones of office vacancy rates, public transportation ridership, and retail spending, the researchers looked at visits to 62 downtown areas in the largest cities in the U.S. and Canada.

“We find wide variation in the extent of recovery, with activity ranging from a low of 31% of pre-pandemic levels in San Francisco to a high of 135% in Salt Lake City,” the researchers wrote.

They continued to say that, as of the fall of 2022, the key factors correlated with improved recovery rates for downtowns were lower commute times and the presence of economic sectors such as accommodation, food, health care, and construction, creating an economic infrastructure. “To survive in the new era of remote work, downtowns will need to diversify their economic activity and land uses,” they wrote.

In other words, if the factors that seem to lead toward better recovery include more convenient commutes, given the realities of housing costs and commute times, the area most open to directed change would be an improvement of economic diversity.

Large metro older and denser downtowns that depend on professional or tech workers may need significant reinvention, said the researchers.

“In general, places with a higher share of employment in knowledge-based industries and occupations, and/or more highly paid workers, are more likely to shift towards remote work,” they wrote. “Surveys suggest this shift will be permanent for up to half of the workforce in cities that are large and congested (e.g., New York), or powered by the tech sector (e.g., San Francisco). This new increase in remote work may result more from long-term trends related to the affordable housing crisis in leading urban centers and the shortage of highly skilled labor than from the pandemic.”

Metro downtowns slowest to recover may need to reinvent themselves. “Most importantly, downtowns should look to diversify their economies to focus on resilient sectors such as education, health, and government,” they added. “Cities could help developers convert older (Class B and C) office buildings to residential, institutional, and recreational uses.”

Also important is to recreate downtowns to favor people. “This could mean creating outdoor spaces with cultural events; rethinking streets for transit, bikes and pedestrians; moving parking to the outskirts of downtown; and attracting diverse segments of the population to visit (both in terms of age and race/ethnicity). Unlike past recoveries, this may take significant public-private collaboration to accomplish, given the extensive intervention required to remake space.”

Soure: “To Resurrect Certain Downtowns It May Take More Than Workers Returning to the Office“

The coming banking crisis, and suggestions of an incoming bust in commercial real estate, has given rise to some questions about recourse versus non-recourse debt and what impact the differences in those types of debt may have on these areas of the economy. The bottom line is that it probably will not make much difference, if indeed any, to the banking crisis, but it may have some probably slight consequences for the commercial real estate market.

Let’s first start with the basic differences between recourse and non-recourse debt. We will start with recourse debt, because then it will be easy to distinguish and contrast non-recourse debt. All the debt (also known as loans or financing) is secured debt, meaning that the lender takes a security lien on the property being purchased with the loan proceeds.

The term recourse debt (or recourse loans or recourse financing) refers to debt where, in the event of the borrower’s default on the loan, the lender can satisfy the debt by both foreclosing on the collateral and also by pursuing the borrow for any shortfall (known as a deficiency). Thus, if there is a loan for $100 million and the borrower defaults, the lender will foreclose on the collateral, being the property purchased with the loan. When that property is sold, it only nets $80 million which goes to pay down the loan. That leaves a deficiency of $20 million and the lender may then pursue other assets of the borrower to satisfy that deficiency (plus, of course, attorney’s fees, costs, and interest). This ability of the lender to pursue the borrower for the deficiency is the recourse.

By contrast, non-recourse debt is fundamentally different to the extent that, as the name suggests, there is no ability of the lender to seek recourse by pursuing a deficiency against other assets of the lender. Basically, the totality of the lender’s recovery will be by foreclosing against the collateral put up for the loan. If the sale of the collateral does not equal the loan, well, too bad so sad. Note that even non-recourse loans have certain provisions where in some circumstances there can be recourse, usually involving misconduct by the borrower (which is why these carve-outs to the non-recourse provisions are known as Bad Boy Guarantees).

The differences between recourse and non-recourse debt usually differ in two predictable ways. The first is that with non-recourse debt, the lender will want to have liens against enough assets that it is adequately collateralized, if not outright over-collateralized, so that if there is a borrower default the collateral that is foreclosed upon will fully pay off the loan. By contrast, recourse debt will often not be as well collateralized because the lender may believe that the borrower will have other assets with which to make the lender whole.

Investment sales of data centers slowed dramatically toward the end of 2022 and through the first quarter of 2023, as rising interest rates and capital constraints impacted acquisition activity. However, the asset class has not fallen out of favor with investors who industry observers say are biding their time before jumping back into the market.

Last year, sales of data centers in the U.S. totaled more than $9.0 billion, according to research firm MSCI Real Assets, surpassing the $8.2 billion total reached in 2021. But the first quarter accounted for vast majority of that volume—before Fed began its quest to raise interest rates to combat inflation. In the fourth quarter of last year, only $453.6 million in data centers traded hands, the lowest volume recorded since the third quarter of 2020. MSCI’s transaction volume figures include individual property sales, portfolio sales and entity-level mergers and acquisitions.

The market remains in a price discovery phase with buyers and sellers attempting to get a pulse on market values for data center properties, according to Raul Saavedra, executive vice president, data center advisory, with commercial real estate services firm Colliers. “If you are well-capitalized right now, and you’re an investor, why would you do anything right now? You’re going to take the mentality of ‘Let’s wait for the bad times to come.’”

Still, when CBRE will release its annual Investor Sentiment Report for 2023, the expectation is that it will show that investor interest in data centers “remains very robust,” said Kristina Metzger, executive vice president and leader of data center capital markets team with commercial real estate services firm CBRE. “Many institutional groups are looking to allocate more in the sector.”

Nearly all investors CBRE surveyed for the report—some 89 percent—said they intend to increase their investment in data centers in 2023. Only 2% said they intend to decrease allocations.

One of the most meaningful statistics shows that the majority of those surveyed said that data centers make up less than 5% of their managed assets. But in five years’ time, almost all of them said they would like for that share to be greater than 5%.

“Moving from under 5% to 5% to 10% is a tremendous amount of additional capital that’s looking to get in this space,” Metzger said.

There were some concerns raised in the past year over available power supply and land for data center development, as well as competition from major cloud firms. Hedge fund manager James Chanos said he’s made a bet against data center REITs, noting they face growing competition from major tenants like of Amazon Web Services, Google and Microsoft, who prefer to build their own facilities.

Of the $9.0 billion in U.S. data center transactions last year, MSCI reported that $6.9 billion involved institutional buyers; $1.69 billion involved private buyers; $149.5 million were made by end-users; $130.7 million were made by foreign investors; $96.7 million involved unknown sources; and $34 million were REIT buyers.

“There’s a lot of funds looking to diversify what their allocations are to different real estate asset types, and across the board we’ve seen a lot of funds reduce exposure to asset classes like office and retail and increase exposure to variety of alternative asset types, and a prominent one amongst those is data centers,” said Jacob Albers, research manager with commercial real estate firm Cushman & Wakefield.

In 2022, the top investors in the U.S. data center space included private equity firm KKR; global infrastructure fund manager Global Infrastructure Partners; data center operator DataBank Ltd.; private equity firm GI Partners and pension fund CalPERS, according to MSCI data. Other players include Lincoln Rackhouse, the data center division of Lincoln Property Group, Brookfield Asset Management and Peterson Companies. Saavedra noted he has heard that even some large sovereign wealth funds are looking into data center investment.

Carl Beardsley, managing director and JLL’s capital markets data center lead, said the team currently has nine data center deals in the market, including both investment sales and debt transactions. In the first quarter, they closed $160 million in data center transactions.

“The data center space remains extremely attractive to capital sources looking for higher returns versus other asset classes,” Beardsley said. “However, there are barriers to entry and limited opportunities in comparison to the core real estate asset classes.”

The typical buyers targeting data centers today are infrastructure funds, data center operators, data center REITs and cloud companies/end-users, Beardsley noted.

Cap rates in the sector are rising. MSCI reported the trailing 12-month cap rate on data centers expanded by 230 basis points, to 7.1% from the first to the fourth quarter of 2022. While investor appetite for data centers remains robust, it can be difficult to break into the sector due the limited direct investment opportunities, according to Metzger.

It’s clear that higher interest rates have cooled investment activity in the data center space, according to BJ Feller, managing director and senior vice president with capital services provider Northmarq. If interest in a property type was measured from zero to 100, during the pandemic data centers were at 95, he noted. Today, they are closer to 75 on that scale, in Feller’s example, but he doesn’t see current capital markets condition interrupting a decade-long trend of data centers being in demand among investors.

“It’s been the beneficiary of retail and office falling out of favor,” Feller said. “That pushed a lot of capital over the last decade into the segment, and I also think it’s the beneficiary of how aggressive pricing got in industrial over the last 36 months. As that happened, people said data centers are way closer to industrial than any other product type, and that led to the thesis for people to go in and get it.”

Investor interest is also driven by the fact that property fundamentals for data centers remain at their peaks, noted Metzger. With historic high demand, record low vacancy rates and development costs and timelines increasing, the firm is seeing strong rental growth across nearly all major markets, with some exceeding average rent growth of 20% year-over-year. In addition, vacancy is also averaging below 5% in many major markets, according to Cushman & Wakefield data.

JLL released its Global Data Center Outlook report Thursday that showed that the data center industry continues to thrive despite economic uncertainty. The pandemic served “as the ultimate wake-up call for organizations to take their IT infrastructure to new heights and accelerate their timelines to become fully transformed enterprises,” according to Andy Cvengros, managing director at JLL. In turn, the mass adoption of cloud computing and artificial intelligence is driving “exponential growth” for the data center industry, with hyperscale and edge computing leading investor demand, Cvengros said.

“Employees are looking to their companies to create a seamless experience wherever they choose to work, requiring intelligent technology solutions to bridge the gap between the physical and the digital,” he noted. “As this reliance on digital technology increases, the data center industry is experiencing impressive growth and catching the eyes of investors and lenders as a strong, alternative asset class that has been relatively unimpacted by continued economic uncertainty.”

Similarly, Moody’s Analytics Economist Ermengarde Jabir said that while investment sales transaction and new construction in the sector have fallen in recent months, the long-term growth prospects for data centers remain promising. “When you think about the needs that are served by data centers, those needs aren’t going away. We’re not going to become less digitally connected to each other. That’s only going to increase more and more as the population grows and as more services become available digitally.”

Source: “Institutional Investors Remain Interested in Data Centers. But They Are Waiting for the Right Moment.“

With remote work models prevailing and many tenants gravitating to Class A buildings with amenities, there are more than a few Class B and Class C property owners with high vacancy rates and significant imminent capital seriously considering giving the keys to their lenders in exchange for relieving the debt obligation.

However, even for properties with a dismal financial outlook, borrowers must consider the potential negative tax consequences of phantom gain and cancellation of debt.

Phantom Gain

Issue: A lender can force a transfer of title through a foreclosure action and a property owner can transfer the title to a lender voluntarily through a deed-in-lieu of foreclosure. However, either of these transactions is considered a sale of the property for federal and state income tax purposes (and local transfer tax purposes in most jurisdictions).

Under federal tax law, the owner is treated as selling the property for an amount equal to the outstanding debt. When nonrecourse debt is involved, the reported taxable gain would be an amount equal to the debt over the adjusted tax basis in the building.

For buildings owned for a long period of time that have been substantially depreciated (and those acquired more recently as replacement property for older depreciated properties in a like-kind exchange), a property owner could end up recognizing significant taxable gain with no cash proceeds.

By contrast, if recourse debt is involved, surrendering property is treated as two separate transactions for tax purposes, resulting in phantom gain and “cancellation of debt” (“COD”) income. Phantom gain would be realized to the extent that the property’s fair market value (FMV) exceeds the debtor’s adjusted tax basis (sale treatment). COD income would be realized to the extent that the principal amount of the debt exceeds the property’s FMV because that part of the recourse debt has essentially been forgiven (less any amounts paid as part of the recourse obligations).

For example, a debtor transfers an asset with a FMV of $12 million in discharge of $15 million of recourse debt, and the debtor’s tax basis in the asset is $7 million. The debtor will realize $3 million of COD income ($15 million of recourse debt minus FMV of $12 million), and $5 million of phantom gain ($12 FMV of the property less $7 million adjusted tax basis in the property).

With either nonrecourse or recourse debt, the phantom gain is generally taxed at favorable long-term capital gains rates (assuming the property has been held for at least one year).

Solutions: There are very few ways to defer phantom gain.

One possibility is doing a like-kind exchange into a new property. However, an exchange of property with no cash at closing means the owner must find fresh equity to buy a replacement property. Another option is to transfer title in a year when the owner has accumulated losses from other properties to offset any phantom gain.

Cancellation of Debt

Issue: It may be worthwhile to discuss the possibility of reducing or restructuring the debt.

However, if a lender agrees to reduce the outstanding principal balance, the property owner will have to report COD income in an amount equal to the debt reduction. This is the case regardless of whether the debt is nonrecourse or recourse. COD income is taxed at the higher ordinary income rates.

Solutions: Reduction of Basis. A property owner can defer COD income by electing to reduce the basis in the building. This only applies if the debt was used to acquire or improve the building and the debt currently exceeds its fair market value. If the building depreciable basis (land is excluded for this purpose) is not high enough to reduce the entire amount of the COD income, the owner may reduce the depreciable basis of other buildings it owns. Note that this results in lower depreciation deductions in the future, so reducing the depreciable basis in a building effectively amortizes the recognition of the COD income over future years.

Bankruptcy and Insolvency. A borrower that is either insolvent or in bankruptcy can exclude COD income to the extent the borrower is insolvent, or the debt is discharged in bankruptcy. However, the borrower must reduce certain tax “attributes” such as net operating losses, the adjusted tax basis of the building, and other depreciable assets.

COD Income and Partnerships. Since partnerships are considered “pass through” entities, any COD income resulting from restructuring partnership debt is passed through to the partners. Federal tax law requires that to take advantage of the bankruptcy and insolvency rules above, the partners (not the partnership) must be insolvent or receive the discharge in bankruptcy.

The bottom line: understand the tax implications of handing the lender those keys before acting on it. In certain cases, developing a plan with the lender can avert unanticipated, negative tax consequences and help owners maintain control of their properties—a solution both parties can buy into.

Source: “The Tax Consequences of Handing the Keys Back to Your Lender“