A plan to save commercial real estate

NEW YORK (Fortune) -- Economists have long been predicting commercial real estate could be the next day of reckoning for the financial markets, with a wave of defaults looming as billions of dollars in troubled loans come due in the coming months.

But a little-noticed bill introduced in January could help bring a new source of desperately-needed liquidity to the sector: foreign investment.

Introduced by Joseph Crowley, a six-term Democratic congressman representing parts of New York City's Queens and Bronx boroughs, the Real Estate Revitalization Act of 2010 would eliminate certain taxes that were part of the Foreign Investment Real Estate Property Tax of 1980, or FIRPTA -- which requires foreign investors to pay as much as a 55% tax on capital gains from the sale of U.S. real estate or shares in real estate investment trusts and real estate operating companies.

Repealing the tax, Crowley and the bill's supporters say, would get rid of a major impediment to foreign investment in the sector -- and could open the floodgates to new liquidity at a time when commercial real estate loan defaults pose a serious risk to the nation's fragile economic recovery.

The FIRPTA tax, the bill's supporters say, penalizes foreign investors who want to put cash into U.S. real estate because those same investors don't face such taxes when they buy into other U.S. assets, like Treasury securities, corporate equities or corporate bonds.

If a British citizen buys stock in IBM (IBM, Fortune 500) and sells stock in IBM, for instance, that person is not subject to tax in the U.S. and only pays UK-levied taxes. But if he buys and sells REIT shares, he will pay an additional tax on the sale of those shares.

Foreign investors also don't pay added taxes when they make real estate investments in other foreign markets. "London doesn't have this FIRPTA layer of tax, so comparing a London building to a [Washington] DC building -- it makes the London building more attractive, and that is enough to tilt the needle," says Laine Kenan, Atlanta-based executive director of Arcapita, a Bahrain-based global private equity firm with a large real estate investment portfolio. Currently, only about $3 billion of his firm's $10 billion in real estate exposure is in the U.S. If the tax was lifted, "it would make a difference," Kenan says.

A recession doesn't help

Investors have become particularly sensitive to the tax in the current environment, where property values, occupancies and rents have fallen, which increases risk and lowers potential returns. "We're talking about bringing in foreign investment to be on equal footing if they invest in real estate versus non real estate," says Jeffrey DeBoer, chief executive of the Real Estate Roundtable, a real estate think tank in Washington.

Industry analysts say there is a pent-up demand from foreign investors looking for opportunistic investments. "There is a tremendous amount of foreign capital out there," says Robert O'Brien, head of the U.S. real estate practice at Deloitte LLP. Removing the tax, he says, would "level the playing field."

Currently, foreign investors make up only about 10% of the acquisitions of U.S. commercial real estate, says Dan Fasulo, managing director of Real Capital Analytics. In the UK, it represents over half of overall capital flows. "Could [removing the tax] double the amount of investment activity in the U.S.?" he says. "Sure."

The chances of its success

Just how likely the bill is to pass is still unclear. There are no vocal opponents, but it hasn't gotten much attention, either, largely due to Congress' preoccupation with the health-care agenda. "Every time we meet with a congressman, they're looking at their watch and saying they've got to go to a health-care meeting," says Arcapita's Kenan who has been a vocal supporter of the bill. The bill's authors are pushing to have it added to more timely legislation, such as the estate tax bill or the bill dealing with the expiring Bush tax cuts, both of which must be passed in 2010.

Peter Peyser, managing principal at Blank Rome Government Relations LLC, a lobbying firm in Washington, says the bill will likely need to be tacked onto a larger piece of legislation to get passed in 2010. "A small targeted provision like this one would need to be part of a larger package because it's unlikely that something like this is going to gather enough steam to get through on its own," he says.

James Stuckey, divisional dean at New York University's Schack Institute of Real Estate, concurs the bill may have a tough time gaining political momentum on its own at a time when so much focus is on healthcare.

"Obviously a lot of political energy is being used on healthcare, so it does raise legitimate questions on whether or not there will be the political will, energy and clout, particularly in a mid-term election, to start focusing on these kinds of real estate initiatives," he says.

Also, the idea of giving tax exemptions to foreign companies on real estate may be a tough sell to some congressmen and taxpayers. "You can imagine how that could be spun to the taxpayers," he says. Still, he notes that the bill's passage could bring badly-needed liquidity into the real estate sector, which would help to stabilize both real estate and the overall economy.

Stuckey believes the bill's best shot at quick passage is being tied to an existing bill that's already got political legs in Congress. "In this environment, yes, I think it would stand a greater chance being tied onto something that has a lot of political movement to it."

Who stands to benefit

If it does pass, U.S. REITs and real estate operating companies could be big winners. Many property owners, who purchased real estate at the cycle's peak in the go-go years of 2005 through 2007, are now facing debt calls at a time when property prices have fallen about 40% from their peak, and the commercial mortgage-backed securities market has dried up. Experts predict values will fall another 10% to 20% on average before the sector bottoms, with even steeper declines in weaker markets.

Approximately $1.4 trillion in U.S. real estate loans will come due between 2010 and 2014, with nearly half of those loans currently "underwater," according to a Congressional Oversight Panel report released earlier this month.

Of course, scrapping the tax would also eliminate a source of government revenue at a time when politicians are scrounging for ways to pay down the deficit. Experts estimate the cost of repealing the tax at about $8.3 billion over 10 years. But proponents argue the benefits the bill would offer the country's fragile real estate market and overall economy would more than offset the lost revenue.

"A wave of commercial real estate loan failures could threaten America's already-weakened financial system ... and... trigger economic damage that could touch the lives of nearly every American," according to the Congressional Oversight Panel report.

Still, some are doubtful removing the tax will lead to a surge in foreign investment dollars into U.S. real estate if only for one reason: The fundamentals are still weak. "Foreigners aren't any stupider than U.S. investors," says Dean Baker, co-director of the Center for Economic and Policy Research, a Washington think tank, who notes that U.S. investors who don't face the tax aren't exactly jumping into real estate these days.

"There'd be plenty of U.S. investors who'd be willing to buy the stuff -- even at higher prices if they commanded that -- but they don't," he says. "So the idea that somehow we're going to make it more conducive to foreigners and we'll get them to be suckers -- I mean, that's silly."