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Tax reform presents opportunities, challenges to US REITs

The tax reform package expected to be signed soon by President Donald Trump likely will have a mixed impact on real estate investment trusts, observers said, citing the numerous changes to the federal tax code, some of which work in REITs' favor, and others that work against it.

The U.S. REIT tax code survived the new legislation mostly intact, as did the 1031 exchanges that allow commercial real estate owners to defer capital gains taxes by reinvesting the proceeds in "like-kind" properties, so within the REIT landscape, most observers expect business as usual.

REIT dividends will be subject to a lower tax rate, with the maximum rate dropping to 29.6% from 39.6%. This reduction could drive incremental demand for REIT stocks, Mizuho analysts Richard Anderson and Haendel St. Juste said in a note, in which they declared that, ultimately, the legislation is "a net positive" for REITs. They cautioned, however, that a rise in the 10-year U.S. Treasury yield due to increased corporate profitability could put pressure on REITs, as investors explore other income options.

By sector, the Mizuho analysts said a reduction in the amount of personal mortgages eligible for interest-rate deductions — a cut to $750,000 from $1 million — could be an incremental positive for the multifamily sector, as some homeowners could elect to rent.

Some healthcare REITs could face a "thematic" headwind due to an expected $1.5 trillion cut to Medicare and Medicaid over the next 10 years and the repeal of the individual mandate, the Mizuho team noted.

Accelerated asset depreciation schedules could encourage cash-rich corporations to over-invest in real estate properties and developments, which could stimulate supply growth in "moribund" sectors like office and retail, Reis said. However, the resulting increase in construction costs and the threat from e-commerce are likely to put a damper on new malls. E-commerce companies, on the other hand, could accelerate plans to build their own warehouses and distribution facilities.

Putting more money in the hands of consumers through lower individual tax rates could provide a "first-derivative benefit" to the retail, industrial and hospitality sectors where consumption has a "direct, notable" impact, the Baird team said.

Given the drastic corporate rate cut — from 35% to 21% — REITs, which do not pay taxes on income as long as it is passed along as dividends, may lose some of their appeal, as corporations become more profitable, the Mizuho analysts said.

Further, capping the deduction of state and local taxes could have a negative knock-on effect for commercial property in high-tax markets that do not offer enough value proposition to keep homeowners from decamping to lower-tax locations, Reis Inc. said, naming California, New York and New Jersey as those states that could see population shifts.

Looking ahead, the Mizuho analysts noted that REITs could be "choppy" as the market digests higher corporate profits and Treasury yields.

"But once that settles, we think REITs could rally in the aftermath," the analyst said. "Timing that pivot will be the trick."