West Coast Real Estate Update: November 2016 #3

by Holland & Knight LLP
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[co-author: Daniel Dow]

Owners, Developers Face Challenges Converting Parking to E-Commerce Delivery Space

Because millennials make up an increasing number of urban residents, owners and developers of apartment and condominium buildings are seeking to adapt their properties to the preferences of this powerful market segment. Developers in the San Francisco Bay area and beyond are contemplating converting residential parking areas into storage lockers for e-commerce and grocery delivery. However, the implementation of such conversions faces several obstacles.

Zoning ordinances that require minimum levels of parking can prohibit developers from reducing the number of parking spaces in their projects. Although parking requirements vary greatly from city to city, most zoning laws require one or two parking spaces per rental unit, and sometimes more for condominium units. Developers may be able to negotiate a deal with the city that allows them to provide fewer parking spaces than are required by the applicable zoning ordinance, but such negotiated outcomes are far from certain. 

Unpredictability is another hurdle facing developers. Given the competing conveniences of e-commerce and ride-sharing services, as well as the prospect of transportation systems based on driverless cars, the future demand for parking spaces versus e-commerce delivery space is not clear. At this time, driverless cars in particular are still largely prototypes and it is unclear when, if ever, they will become a staple of urban transportation and reduce the need for resident parking. This uncertainty can cause developers to hesitate before committing to a conversion project.

Finally, cost is a major issue facing developers who wish to convert parking spaces to use for e-commerce deliveries. Of course, there is the upfront cost of building the storage lockers, which can sometimes be a higher cost than if the lockers are built as a part of new construction. Another cost to owners and developers is the loss of revenue, since offering parking in densely populated urban areas can justify charging higher rents. In addition, some buildings in Los Angeles and San Francisco charge tenants separately for the parking spaces themselves. This potential loss of revenue is a deal breaker for many developers.

New IRS Regulations Will Mean Higher Tax Bills for Some REIT Transactions

The U.S. Department of the Treasury and the Internal Revenue Service (IRS) recently published temporary regulations that affect the taxability of certain distributions involved in real estate investment trust (REIT) transactions. The new regulations change the rules that apply to so-called bottom-dollar guarantees and similar arrangements, and thus will affect the tax planning of certain REIT transactions.

Prior to the new regulations, an owner of appreciated real estate could avoid tax by utilizing a leveraged partnership structure. In a leveraged partnership transaction, the owner of appreciated real estate could transfer the property to a joint venture in exchange for equity and cash. Ordinarily, a transferor would have to pay tax on the amount of cash received as a result of such a transaction, but the transferor in a leveraged partnership transaction could avoid this as long as a sufficient amount of the joint venture’s debt was recourse to the transferor. Under prior law, the debt could often be treated as recourse to the transferor to the extent that the transferor guaranteed the joint venture’s debt, including a relatively low-risk guarantee of only the bottom portion of the debt (i.e., a bottom-dollar guarantee) or similar arrangement. This guarantee would create tax basis in the transferor’s interest in the joint venture and allow the cash received from the transaction to be treated as a tax-deferred return of capital.

The new regulations effectively prohibit the tax deferrals previously enjoyed by users of the leveraged partnership structure. Under the new regulations, all debt of the joint venture is treated as non-recourse to the partners when determining whether a cash distribution by the joint venture is taxable. Likewise, the new regulations ignore the effect of “non-commercial” credit support (expressly including bottom-dollar guarantees) offered to the partnership by the transferor of the real property. Other arrangements intended to have the same effect as bottom-dollar guarantees, such as using tiered partnerships or dividing a single obligation into different tranches, are also targeted by the new regulations. Moreover, a partnership must provide the IRS with a detailed disclosure with respect to all bottom-dollar guarantee arrangements.

Some limited guarantees are still permitted under the new regulations, such as vertical slice guarantees (in which a portion of every dollar is guaranteed), first dollar guarantees up to a cap and certain bottom-dollar guarantees, as long as at least 90 percent of the principal amount is covered by the guarantee.

The new rules became effective with respect to the use of bottom-dollar guarantees after Oct. 5, 2016, and will be effective with respect to any leveraged partnership transaction that occurs on or after Jan. 3, 2017.

Commercial Real Estate Loans See Trouble as Maturities Loom

Analysts see potential pitfalls for commercial real estate (CRE) loans set to mature at the end of this year, and in 2017, these could result in a slowdown of the $11 trillion commercial property sector. Many CRE loans made in the years immediately preceding the 2008 credit crisis are set to mature soon, but market pressures, increased borrowing costs and increased regulation could make it more difficult for borrowers of those loans to either repay or refinance them.

Nationally, an increase in vacancy rates has decreased cash available to service debt, and a slowdown in sales volume has made it more difficult to sell properties whose loans are about to mature. According to Real Capital Analytics, commercial property sales volume was down 8.6 percent at the national level for the first three quarters of 2016. However, major West Coast markets are seemingly bucking the national trend when it comes to vacancy rates. According to data from CBRE Group, vacancy rates in office and retail properties in the greater Los Angeles area are trending downward, and the vacancy rate for offices in San Francisco decreased 0.6 percent from the second quarter to the third quarter of 2016 alone.

An increase in interest rates is adding to fears that refinancing maturing CRE loans may be difficult. Interest rates have already increased since Donald Trump was elected president, and even before the election, forecasters were calling for interest rates to increase over the next two years.

Finally, new regulations as part of the Dodd-Frank legislation go into effect on Dec. 24, 2016. These regulations require issuers of commercial mortgage-backed securities to keep at least 5 percent of the securities they create. These so-called risk-retention rules likely will make borrowing more costly and complicated, raising the chances that some commercial property owners will be unable to refinance loans made during the boom years. Although President-Elect Trump has indicated that repealing Dodd-Frank is one of his top priorities, doing so would take time, and some provisions – such as the risk-retention rules – could remain.

Even as these factors have yet to fully impact the borrowers, defaults of CRE loans are already on the rise. According to Moody’s Investors Service, more than 5.6 percent of approximately $390 billion worth of commercial property mortgages that have been packaged into securities was more than 60 days late in payment in September, up from a 4.6 percent delinquency rate earlier this year. With the headwinds currently facing CRE loans, such a trend could continue.

Seattle Releases Draft Zoning Plans as Next Step in Affordable Housing Overhaul

As part of its continuing efforts to increase affordable housing in Seattle, the Housing Affordability and Livability Advisory Committee (HALA) is seeking public comments on draft zoning plans recently released by the city.

In August 2016, the Seattle City Council passed framework legislation for a program called Mandatory Housing Affordability (MHA). The program is the result of an agreement between developers and the city that allows developers to construct taller buildings in exchange for including affordable units in new apartment complexes or paying to help build affordable units elsewhere. Seattle’s mayor says the MHA will generate about 6,000 affordable units built or preserved over the next 10 years.

The requirements of the MHA will not take effect until Seattle makes zoning changes to allow for the taller buildings contemplated by the MHA. To that end, the city recently released draft plans for rezoning sizeable portions of its urban centers and urban villages. The plans direct approximately 80 percent of Seattle’s growth into these areas, which include Capitol Hill, First Hill, Eastlake, Ballard, Columbia City, Fremont, Wallingford, Upper Queen Anne and Northgate. The number of units that developers will be required to set aside as affordable, and the payment in lieu thereof, vary based upon whether the development is residential or commercial, the increase in development capacity in the rezoned area and the location of the development. Under the draft plan, developers building in the areas receiving the largest increase in development capacity are required to set aside 11 percent of their units as affordable or pay an affordable development fee of $32.75 per square foot. HALA is expected to propose final MHA implementation maps to the Seattle City Council in Spring 2017.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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