President Trump signed the Tax Cuts and Jobs Act of 2017 (TCJA) on Dec. 22, 2017, ushering in major changes to the Internal Revenue Code of 1986, effective Jan. 1, 2018.These changes should have a significant positive impact on the private lending and construction sectors, including boosting demand for more deals and the supply of capital.

Some of the earlier incarnations of the legislation included provisions and changes that would have been worrisome for both industries. However, the final bill that was signed should help drive both the private lending and construction industries because it provides modest tax relief to consumers, maintains the nation’s fiscal commitment to affordable housing and reduces the tax burden on pass-through companies. It’s fair to say that, on balance, the policy changes will lead to higher after-tax returns, increased investment and lower capital costs. The core Republican contention that this massive amount of tax relief will boost gross domestic product remains to be seen, but overall it should provide a steady tailwind for our corner of the economy.

Let’s first look at the TCJA’s impact on issues specific to our industry and then widen to the larger, macroeconomic picture.

Lower Pass-Through Rates

By now, even the casual news reader is aware that the TCJA restructures individual and corporate tax rates, with particular benefit both for C corporations, where the top bracket is reduced to 21 percent, and for pass-through entities like limited liability companies (LLCs) and S corporations.

The TCJA effectively lowers the tax rate for individual and trust owners of certain “qualified” S corporations, LLCs, partnerships and sole proprietorships by providing a 20 percent deduction on qualified business income. The deduction is limited to 50 percent of the W-2 wages with respect to such business; or if greater, the sum of 25 percent of the W-2 wages plus 2.5 percent of the cost of qualified property acquired during the year. This is one of the most significant impacts on our industries. The benefit of these lower tax rates should make it possible for investors and developers alike to create new, more efficient ownership vehicles.

This benefit though is somewhat limited by a distinction for owners of “specified service businesses,” where the principal asset of the business is the reputation or skill of one or more of its employees or owners, such as businesses in the fields of health, law, consulting and financial services, as these pass-through entities are generally not eligible for the 20 percent deduction. There is a small taxpayer exception to both the wage limitation and the “specified service business” exclusion: Both generally do not begin phasing in until owners have adjusted taxable income of more than $157,500 ($315,000 for joint filers).

Overall, for the lending, real estate and construction industries, the new legislation should be highly beneficial. Before the TCJA, investors seeking the advantages associated with C-corporation status had to become a real estate investment trust (REIT); otherwise, they would be treated with high entity-level taxation. Under the new law, investors may enjoy some of the tax advantages previously enjoyed by an REIT, while gaining the ability to build capital through earnings retention and to engage in a variety of operating businesses that previously were not permissible for trusts.

In addition, investors will now have more flexibility to match depreciation schedules with real property economic value. This will reduce or eliminate the need to participate in “like-kind” exchanges to preserve their basis when they decide to sell. In this way, an owner would be free to reinvest the proceeds from a sale in any assets they want at the time, without facing the adverse tax consequences they used to contend with.

Impact on Housing Market

Overall, the TCJA should continue the nation’s longstanding fiscal support of individual homeownership and strengthen opportunities for homebuilders to add much-needed housing inventory to the market. There’s an argument that some downside effects may be felt for luxury housing with price tags above $1 million. This is particularly in the high-state tax areas like the Northeast and California, but this is subject to debate due to changes in the alternative minimum tax and other factors.

The housing industry could use the help. Even after eight consecutive years of growth, new residential construction in 2017 was well below the 1.4 to 1.5 million-unit annual rates averaged in the 1980s and 1990s, according to a study by the Joint Center for Housing Studies at Harvard University. In fact, even with the bounce-back from the effects of the Great Recession, housing completions in the past 10 years still just totaled 9 million units—4 million units fewer than in the next-worst 10-year period that began after the “stagflation” 1970s era, and despite today’s much larger population. Together with steady increases in demand, the low rate of new construction has kept the overall market tight, depressing the gross vacancy rate to its lowest point since 2000.

Compared to earlier versions of the legislation in the House—which proposed to eliminate the mortgage interest deduction—the TCJA should keep consumer demand stoked. It maintains most of the tax deductions most homeowners benefit from. Specifically, the new law:

• Maintains the mortgage interest deduction for new home purchases and the deduction for second homes, although it reduces the mortgage interest cap from $1 million to $750,000. 
• Retains, for existing housing indebtedness incurred before Dec. 15, 2017, the current-law limitations of $1,000,000 ($500,000 in the case of married taxpayers filing separately). However, no interest deduction is allowed for interest on home equity debt after 2017.
• Limits deductions for state and local income tax, including property tax and the choice of income or sales tax, to $10,000 per filer.
• Maintains the existing rule allowing homeowners to exclude up to $250,000 (or $500,000 for married couples) in capital gains on the profit from the sale of a home if they have lived in the house for two of the last five years. Earlier, the House and Senate each proposed to make this rule stricter, but neither provision made it through the final committee, to the relief of participants in the lending and construction industries.
• Retains the present maximum rates on net long-term capital gains and qualified dividends: 15 percent and 20 percent, depending on income levels.

Impact on Luxury Housing

There’s a fair amount of concern that one downside of the TCJA on the industry may be the $750,000 cap on the Mortgage

Interest Deduction (MID), which could be felt in the luxury residential real estate market since it reduces the nominal after-tax value of pricy primary residences. According to Bloomberg, there are currently more that 2 million homes worth greater than $1 million nationwide. Looking at the top 10 highest-cost markets, inflation-adjusted median home values climbed more than 60 percent over the last seven years, so increasing amounts of housing inventory are expected to push past that $1 million threshold each year.

In those top 10 real estate markets, million-dollar residences are relatively common, according to a report by the website Trulia. They compose more than half the residential stock in cities like San Francisco and San Jose, and represent a big share of Los Angeles (16 percent), New York (12 percent), Seattle (7 percent), metro D.C. (6 percent) as well as other markets. Even among nominally lower-cost regions like Atlanta or Nashville, there are still plenty of neighborhoods where plus-$1 million housing is common.

Those arguing that the TCJA puts pressure on the luxury market point to the new rule that limits deductions for nonbusiness state and local tax expenses (SALT), including property and income taxes, to $10,000 ($5,000 for married filing separately). California, for example, has among the highest taxes in the nation in addition to its pricy real estate. Its base sales tax rate of 7.5 percent is higher than that of any other state, and its top marginal income tax rate is 13.3 percent, the highest state income tax rate in the country. Given the political and economic divide between red and blue states, the changes to MID and SALT deductions have received their fair share of negative press.

Although these arguments are politically saleable, it is fair to say that the extent of the impact on the high-end residential housing remains open for debate. Most likely this is a wait-and-see issue due to three significant, countervailing factors:

1. Because the bill also doubles the standard deduction, fewer people will claim the MID and SALT deduction overall. The weakened MID and SALT deductions could be a wash for a lot of taxpayers, given the new standard deduction.
2. For taxpayers in the coastal blue states where prices and SALT rates are high, those who can afford luxury real estate mostly have been subject to the AMT anyway, which historically wiped out a lot of their MID and SALT deductions. Under the TCJA, the AMT exemption amounts are going up, which may offset part or, for some people, all the lost benefit of the reduced MID and SALT deductions. The AMT exemption amounts will increase to $70,300 for single filers and $109,400 for joint filers, and they will phase out for those taxpayers at $500,000 and $1 million, respectively. This is significantly better than the status quo AMT exemption amount for single filers of $54,300, which begins to phase out at $120,700; and for joint filers, where it is $84,500 and begins to phase out at $160,900. Although these changes will end after 2025, the new AMT thresholds may well offset any risks to luxury real estate that the mortgage interest and SALT limitations pose, at least for the foreseeable future.
3. The luxury residential real estate market historically correlates positively with the major stock market indices, which are likely to continue to climb due to the much lower marginal tax rates for corporations. This may sound counterintuitive at first because, according to Case Schiller and many other analysts, over the long term the overall housing market is negatively correlated to equities. When stock markets plunge, investors typically move money into real estate and REITs. However, when it comes to luxury residences, the correlation is positive historically, because bull markets supply high net worth buyers of real estate with both liquidity and consumer confidence. 

Impact on Affordable Housing Programs

Many investors, builders and private lenders were relieved to see the TCJA protected various affordable housing options by protecting private activity bonds (PABs), which had been in the firing line in earlier incarnations of the bill. PABs are tax-exempt bonds issued by or on behalf of local or state government for providing special financing benefits for qualified projects. The financing is most often for projects of a private user, and the government generally does not pledge its credit.

Without PABs, economists with the National Affordable Housing Bureau trade group had estimated that the inventory of lower cost rental property would have plunged by more than 750,000 units over the next decade. Fortunately for the industry and lower income families alike, the final TCJA retains PABs so that programs that include the 4 percent Low-Income Housing Tax Credit (LIHTC) and the Historic Tax Credit (HTC) maintain their effectiveness as tools to produce affordable housing. The 4 percent LIHTC funds a third of affordable housing construction, while the HTC has been used to fund renovations to more than 40,000 historic structures since 1981.

LIHTC and HTC tax credits were created by the 1986 Tax Reform Act to incentivize private equity to fund low-income housing development. The credits, also known as Section 42 credits, are attractive because they reduce a taxpayer’s federal taxes on a dollar-for-dollar basis, much more beneficial than tax deductions that simply reduce the amount of income the tax rate is applied against. The “passive loss rules” and similar tax changes made in 1986 reduced the value of tax credits and deductions to individual taxpayers, so individual investors claim less than 10 percent of current credit expenditures.

But despite these benefits for affordable housing, the National Association of Local Housing Finance Agencies pointed to a macro issue concerning the reduction of the corporate tax rate. The concern is that the greater attractiveness of public company equity (and debt) due to the lower marginal tax rates will reduce demand for LIHTC. Because the bill also cuts the corporate tax rate from 35 percent to 21 percent, this will inherently lower the value of both credits and lead to fewer affordable housing units and renovated historic buildings.

“Unlike previous versions of the legislation, important affordable housing tools, including private activity bonds, the low-income housing tax credit, the New Markets Tax Credit and the Historic Tax Credit were fully preserved in the final bill,” NALHFA Executive Director Jonathan Paine said. “The corporate tax rate will be lowered from 35 percent to 21 percent, however, which will likely cause a reduction in housing credit equity.”

Other Provisions

Some other details in the final bill are very interesting to both industries and to their tax advisers, who are sure to be busy during the next 12 months:

• Carried Interest Rule // This was retained in the final Act, but assets must be held for three years.
• Real Estate Interest Deduction // Now developers have a choice between the following:
• Limiting their interest deduction to 30 percent of net income without regard to depreciation, amortization and depletion. This distinction makes the limitation less restrictive than one based on adjusted gross income.
• A 100 percent deduction for business interest, but with certain trade-offs.
• Depreciation Election // Beginning in 2018, the TCJA provides real estate investors and owners of
• multifamily units with a choice for depreciation, with the option of either a 27.5-year or a 30-year depreciation schedule, depending on how they elect to treat their business interests. This is a valuable tool to help customize cash flow and retirement/estate planning according to individual preferences.
• Small Business Methods of Accounting // Beginning after 2018, small businesses with average gross receipts of $25 million or less will be allowed to use the cash method of accounting, regardless of whether it is
• a C corporation or a partnership with a C corporation partner. Moreover, taxpayers that meet the $25 million gross receipts test are not required to account for inventories.
• Revenue Recognition // TCJA generally requires accrual method taxpayers subject to the “all events test” for revenue recognition to be in conformity with its “applicable financial statements,” if such are prepared by the taxpayers.
• Business Interest Expense Limitations // The TCJA limits the deduction of net interest expense for businesses with average gross receipts in excess of $25 million. The deduction is generally limited to 30 percent of adjusted taxable income (after adding back depreciation and amortization expense).
• Corporate Net Operating Losses (NOL) // For losses generated after 2017, the TCJA limits the NOL deduction to 80 percent of taxable income and disallows most carrybacks, but generally allows indefinite carry forwards.
• Business Entertainment Expenses // The TCJA generally repeals the business deduction for entertainment, amusement or recreation expenses. The 50 percent deduction for business meals is generally retained.
• Domestic Production Deduction // The TCJA repeals this popular deduction.
• Affordable Care Act (ACA) or “Obamacare” // The TCJA repeals the ACA’s individual mandate to buy health insurance by making any required payment $0 beginning in 2019.

Impact on Lenders

The TCJA is mostly good news for lenders given the lower tax rates for corporations and pass-throughs and potential stimulus for the economy. However, near term there is a certain amount of pain because many lenders will need to take big charges in the fourth quarter of 2017 because of the pending changes. This pain is just temporary—the lower corporate tax rate in the legislation will sharply lower the value of tax-deferred assets, forcing write-downs. Lenders will have to immediately shrink the size of an asset on their balance sheet because the future value of the tax deductions will be worth less. Nearly all lenders should feel some short-term effect since a tax-deferred asset is generated through loan-loss reserves, but the amount of the charge-offs will vary considerably based on the level of reserves and other factors.

Among the large banks, only Citibank has indicated the size of its charge. Citi estimates it will take a short-term $16 billion to $17 billion hit, but even for regional banks, the charges could be sizable. Capital One Financial, for example, may record a charge of about $976 million, according to an estimate by FIG Partners. For other major banks, the impact is significant too. FIG Partners estimated that U.S. Bancorp’s charge could total $514 million; the $19 billion-asset First National Bank of Omaha may record a $50 million charge; the $30 billion-asset Associated Banc-Corp may take a $36 million charge; and the $27 billion-asset Hancock Holding in Gulfport, Mississippi, could record a $29 million charge.

The Case for Economic Growth

The main premise of the TCJA is to boost economic growth and funnel overseas corporate profits back to U.S. soil, ultimately to benefit workers, households and investors and, of course, the construction and private lending industries. For individuals, the TCJA retains seven tax brackets, with rates ranging from 10 percent to 37 percent, with the top rate down from its previous rate of 39.6 percent. This will represent a net tax cut for most taxpayers. It doubles the standard deduction for individuals, and increases the child tax credit to $2,000 per qualifying child, up to $1,400 of which may be refundable. There is also a $500 nonrefundable credit for qualifying dependents other than qualifying children. The adjusted gross income threshold for phasing out the credits is increased to $400,000 for joint filers and $200,000 for others. The effect of these reductions should be expansionary for the economy until these elements sunset in 2025. However, it remains to be seen how other external factors will play out, not the least of which is the Federal Reserve’s policy over the next several years. Before passage of the TCJA (and continuing through press time), the Fed was expected to maintain its policy of steady

but modest rate increases. So far, the consensus is that status quo is likely, but any deviation from this path that results in a stricter monetary policy from the Fed could undo the expected GDP benefits of tax reform. It’s a high-wire balancing act, because the combination of profit repatriation and tax relief could goose inflation above current expectations, essentially robbing Peter to pay Paul.

Even just some early signs of creeping inflation as a result of this tax relief could have the effect of causing the Fed to alter its course. Jay Powell, the incoming chairman of the Federal Reserve Board nominated by President Trump, is a bit of a wild card. He is expected to stay the course on monetary policy if the economy continues its steady growth, but it’s less certain where Powell would lead the Fed if inflation rises more than expected. Powell, a member of the Fed’s board of governors since 2012, has consistently voted with current Fed chair Janet Yellen to slowly raise interest rates and sell off assets that the Fed bought up in the wake of the severe recession of 2008 and 2009. Colleagues consider him to be a centrist and a pragmatist, but he lacks the deep background in economics that some of his predecessors had. He also has expressed skepticism in the past about the unconventional measures that the Fed took after the recession.

Fed aside, economists are all over the map regarding the potential for the TCJA to boost GDP over the long term. The optimistic view is that tax reform will bring solid economic expansion, although the amount of growth acceleration is unknown at this juncture. For example, economists at Fannie Mae expect it could add a half percent or more to annualized economic growth above baseline each of the next couple of years, due to investment increases driving productivity gains resulting in real income growth.

The pessimistic view is that there may be no incremental expansion as a result of the TCJA because most of the personal income tax reductions are temporary, while the permanent reductions for corporations may fail to deliver the promised economic expansion. The fear is that corporations, to whom much of the dollar share of the tax revenue reduction applies, will mostly use their lower tax burden to buy back their stock and cut larger dividends, yielding no tangible improvement in GDP nor unleash job growth, boost middle class income levels or lead to increasing capital investments. The pessimists include in their gloomy assessments the impact of the growing deficit and national debt and the potential for interest payments on the national debt to begin crowding out private capital down the road.

At the end of the day, a prudent professional in the private lending or construction industry is wise to stay on top of the details even if the true endgame with GDP is not knowable at this stage. There’s plenty of work to keep tax planners and investment strategists awake for nights on end. This is the most significant new change to the tax code in more than three decades, and it offers tremendous possibilities for those who keep abreast of the developments and tailor strategies to take advantage of all the new twists and turns.

This article was originally published in Private Lender Magazine. Check out the full magazine along with other great articles.

 

The Trump administration and the Republican Congressional leadership spent the last several months preparing to tackle legislation for corporate and personal income tax reform. As the 115th Congress sets out to take up this issue during the fall term, the operative questions are whether reform will actually materialize and, if it does, how extensive it will be. Unfortunately, the potential for reform legislation is not looking all that promising. Instead of reform, it’s more likely that Congress will try to push through new, but temporary, tax cuts — a far cry from actual reform. Businesses in the specialty lending and construction industries should keep a close eye on how the tax reform process ends up rolling out, as any significant restructuring of the tax code has the potential to unleash robust economic growth. On the other hand, in the current environment, not even modest tax cuts are a sure thing as even implementing temporary tax cuts takes lots of political muscle and some cooperation, both of which are currently in short supply in Washington. And, failure to pass even temporary tax cuts could have a detrimental effect on the economy.

The kick off for reform took place in July of this year, right before Congress left Washington for the summer recess when the group called the “Big Six” – the White House and Republican Party Congressional leaders charged with developing tax policies – released a statement outlining their joint vision for reform. The Big Six is composed of House Speaker Paul Ryan (RWI), Senate Majority Leader Mitch McConnell (R-KY), Treasury Secretary   Steven Mnuchin, National Economic Council Director Gary Cohn, Senate Finance Committee Chairman Orrin Hatch (R-UT), and House Ways and Means Committee Chairman Kevin Brady (R-TX). The joint statement was not a policy document, but rather a five-paragraph expression of their guiding principles, which had the effect of raising more questions than it settled. Previous plans released by both House Republicans and the administration were more detailed and specific policy documents, conversely, this statement was designed to provide a template for what Republicans will take up during the fall term.

The joint statement began with a mission statement that on its own is uncontroversial:

“Above all, the mission of the committees is to protect American jobs and make taxes simpler, fairer and lower for hard-working American families. We have always been in agreement that tax relief for American families should be at the heart of our plan.”

Next, the statement described three key matters that the tax reform effort will address, plus one earlier proposal that they have now taken off the table.

CORPORATE TAX REDUCTIONS

The statement repeatedly refers to reducing tax rates for corporations and in particular for small businesses. It states, “We also believe there should be a lower tax rate for small businesses so they can compete with larger ones, and lower rates for all American businesses so they can compete with foreign ones.”

It’s valuable to take a look at what U.S. corporations are paying in taxes as a backdrop to what reform may offer. For regular corporate income tax, a system of graduated marginal tax rates is applied to all taxable income, including capital gains. Through 2015, the marginal tax rates on a corporation’s taxable income ranged from 15 percent for corporations earning up to $50,000 of net income to 35 percent for corporations earning above $18.3 million.

Of course, it’s well reported that large corporations take advantage of a myriad of strategies and tax deductions that drastically reduce their marginal rates. These include attributing income to (and leaving the money in) foreign countries where the company operates, R&D tax credits, and stock-based compensation booked to capital. Even the largest and most profitable companies pay far less than the marginal rates.

The average effective tax rate among S&P companies is 24.11 percent — well below the current corporate top rate of 35 percent — according to data compiled by The Earnings Scout, a corporate earnings analysis firm. To underline how this works we note that in their most recent SEC filings, Amazon reserved 17.4 percent for annual federal income taxes, J&J reserved 14.9 percent, and the remarkably profitable Facebook reserved just 4.4 percent.

In contrast, small businesses corporations are generally the ones for whom the marginal tax rate makes a big difference in the amount they pay to the government. According to the SBA, small businesses in the United States pay an estimated average effective tax rate of approximately 19.8 percent on an average of $83,000 of net income. That’s a little over $16,000 per business sent annually to the IRS. According to the U.S. census bureau, there are 28 million small businesses in America and they tend to be job creation engines, so it’s not difficult to make a case to reduce their marginal rates based on both political and economic rationale.

The main inference of the joint statement is that revisions to the tax code should be made to encourage large corporations to repatriate capital they have been hoarding in international markets, and to lower tax rates for the small businesses that tend to be the big drivers of employment rolls. Taken together the document suggests that reductions in corporate tax rates would create new jobs and stimulate economic growth. There’s not much bipartisan support from the Democrats to reduce corporate tax rates and any legislation would have to pass muster with the Republican deficit hawks in both the House and Senate, the very ones who tripped up health care legislation due to disagreements over the long-term impact on the federal debt.

FIXING A “BROKEN” TAX CODE AND PROVIDING TAX BREAKS FOR FAMILIES

The joint statement describes an oft-repeated sentiment that the existing tax code is so complex that it is effectively broken, and in so doing, touches on the subject of tax relief for families. It calls for “a plan that reduces tax rates as much as possible,” but doesn’t go into any detail about potential tax breaks for families. The Democrats could have a field day by suggesting that the families the Republican Party has in mind are the super-rich Waltons, Trumps, and Koch brothers. However, previously released statements provide clues about Republican Party thinking around individual income taxes.

The House Republican tax reform plan championed by Speaker Ryan and released last year proposed to:

• Replace the existing seven tax brackets with three brackets.
• Nearly double the standard deduction, to reduce the incentive to file itemized returns.
• Eliminate most itemized deductions including for state and local tax payments, with exceptions only for charitable contributions and mortgage interest.
• Eliminate the alternative minimum tax.
• Replace personal exemptions with tax credits.

The White House tax reform statement from April was quite similar to the House plan on most of these points except for personal exemptions, although it didn’t close the door on replacing personal exemptions with tax credits. Otherwise, there are only minor differences in the specific details of the two plans. The House Republican plan proposed tax brackets of 12 percent, 25 percent, and 33 percent, while the White House plan proposed tax brackets of 10 percent, 25 percent and 35 percent. Since these two proposals were largely in agreement, it’s likely the upcoming tax reform legislation will look a lot like a marriage of the House Republican plan with the Trump proposal.

PERMANENT TAX REFORM

The joint statement stressed the need to develop permanent changes to the existing tax code, and not just temporary revisions. The purpose of developing permanent changes is to keep tax reform intact in future years, so Congress won’t have to decide annually whether or not to continue with the changes. Permanence, however, seems quite unlikely. It’s been a long time since Congress did the heavy lifting to pass and implement any kind of permanent tax changes. Getting tax reform done requires strong political leadership, significant technical expertise from government staffers, and a steady information campaign to galvanize the public around the need for the change to happen. These requirements are necessary to prevent the plethora of special interest groups from overturning the apple cart.

The last major tax reform was in 1986 and only made it through with the forceful leadership of luminaries including President Reagan, the chairs of the Congressional tax-writing committees Dan Rostenkowski and Bob Packwood, and public champions of tax reform like Senator Bill Bradley and Representative Jack Kemp. Behind the scenes, comprehensive work by the tax policy wonks at the Treasury Department and Congressional staffers was undertaken. From the bully pulpit to the media to the public at large, at the time the consensus was that tax rates were just too high and there were too many tax shelters.

However, in the current political climate, there is not a solid track record for enacting permanent legislation around taxes or spending. The American Recovery and Reinvestment Tax Act (ARRA) of 2009 created many temporary tax cuts, but several of them later expired when Congress decided not to renew them. The budget reconciliation rules do not allow Congress to pass any kind of legislation if it adds to the deficit after a ten year period, so permanent tax breaks must be bundled together with either expense cuts or other sources of revenue to balance the tax reform’s long-term impact on the federal debt.

That’s a political hot potato, and as recently seen with “replace and repeal,” the House Freedom Caucus is likely to block anything that adds to the national debt. Most recently, major legislative initiatives have not been able to achieve a plurality in one or the other branch of the legislature, despite Republican majorities, and President Trump has not demonstrated the kind of consistency in using the “bully pulpit” of the presidency to champion the cause among the public in the way that many presidents have before him.

BORDER ADJUSTABILITY

One noticeable reversal in the Big Six joint statement from earlier Republican Party tax strategy documents is the jettisoning of what is called “border adjustability,” which would have offered up increased taxes on imports. The border adjustment tax was a favorite of Speaker Ryan’s. As proposed by the House of Representatives it would have prevented businesses from deducting the cost of imports they purchased, while removing taxes on revenue from exports. The thinking behind it was to boost the U.S. domestic manufacturing sector, but it ran into early opposition from large global business interests including the energy industry, large retailers, and the powerful Koch brothers.

The joint statement articulated the retreat from Ryan’s pet project rather delicately, stating that the White House and Congressional leadership “… appreciate that there are many unknowns associated with it and have decided to set this policy aside in order to advance tax reform.” It’s very likely that border adjustability would have caused deep rifts in Congress and have been challenged as an illegal protectionist action by the World Trade Organization, so it was eliminated in order to give tax reform a better chance of making it through the House and Senate.

The early fate of the border adjustment tax serves as a cautionary tale and a good preview of how difficult it will be to make other big changes to the tax code. When the border tax was proposed, masses of lobbyists moved rapidly to dispatch it, and they are ready to ply their trade and battle either for or against whichever proposals benefit or harm their clients. Lobbying muscle will be particularly intense around the issues of taxation of small businesses, deductions for corporate interest expenses, and deductions for state and local taxes.

LOOKING AHEAD

Any tax bill, which reduces revenue will naturally raise worries about increasing the federal budget deficit and faces hurdles from congressional budget rules. Like the health care debate that preceded it, any tax legislation will need to stay as part of a budget reconciliation process to avoid being subject to a Senate filibuster that effectively would require 60 votes for passage. There are ways to get around the budgetary rules, including requiring the tax cuts to expire after 10 years, as was done in 2001, or using “dynamic scoring” with excessively optimistic assumptions about how economic growth will soar after tax cuts; the rising tide lifts all boats argument. These options have substantial drawbacks and are limited in how far they can propel the legislation, and scoring from the non-partisan Congressional Board Office will be taken more seriously.

Unfortunately for the public, the combination of political polarization and the narrow, one-party control of Congress will make it very hard to get any real tax reform done. The Republican majority is likely to work to enact reform without trying to get any bipartisan buy-in. Just as likely, the Democrats will remain unified in their opposition, with an eye to the midterm Congressional elections in 2018.

The anticipated absence of any real measure of bi-partisanship naturally empowers the deficit hawks and conservatives on the far right, including the House Freedom Caucus, which has sufficient votes in that chamber to torpedo any legislation assuming the Democrats vote “No” as a bloc. In the Senate, just three opposing Republican votes can topple their majority firewall as seen in the last round of health care legislation. The narrowness of this plurality, the strength of the conservative bloc, and the highly partisan approach of the lawmakers’ legislative work will make it tough for tax reform legislation to withstand opposition from all the special interest groups that will want to defeat it.

Instead, based on the joint statement and other information made public so far, legislation will likely center around short-term tax cuts with only partial revenue offsets. Certain tax breaks may be reduced if they are the ones that Republicans oppose on ideological or political grounds. For example, the legislation is likely to try to repeal the state and local income tax deduction, which promotes state and local public expenditures and largely benefits residents of states that have voted for Democrats in recent presidential elections. But even this repeal may be too challenging to ram through over the objections of Republican members from high-tax states like California, New York, and New Jersey.

Will we see real, permanent tax reform legislation being signed on President Trump’s desk this year? That is a highly unlikely outcome. Will we see some short-term cuts or the elimination of some deductions? That is a possibility. And will we see a bruising legislative battle, tweet storms, partisan wrangling and bare-knuckle politics? That is a certainty. It should be a very interesting autumn.

This article was originally published in Private Lender Magazine. Check out the full magazine with other great articles.

 

Impending reforms to the Act could represent a double-edged sword for private lenders to the housing and construction industries.

On the campaign trail, candidate Donald Trump frequently discussed the need to scrap the Dodd-Frank Act (the “Act”). Following the election, the President-elect’s transition team signaled that reform will most likely come incrementally. The area most likely to be tackled first encompasses the portions of the Act that have hampered lending by small lenders and community banks. Whether these provisions will be repealed or replaced remains to be seen. But either way, changes could represent a double- edged sword for private lenders to the housing and construction industries.

On the one hand, private lenders may benefit from easier lending requirements from community banks and other bank sources of capital—opening up more liquidity to do deals. On the other hand, the possible loosening of restrictions may create conditions where small lenders and community banks start competing more directly for the non-standard deals that are currently the domain of private lenders. To get a handle on what the future may hold, it’s valuable to look more closely at the Act to understand what its impact and legacy on bank lending has been up to now.

Is Dodd-Frank on the Chopping Block?

The President-elect’s argument to get rid of the controversial banking regulations was a populist message: that Dodd-Frank made the large Wall Street banks an even bigger threat to the nation’s economy and working families, the opposite of what it was intended to do as the government’s response to the 2008 financial crisis. According to a statement posted on the Trump official transition website, “Big banks got bigger while community financial institutions have disappeared at a rate of one per day, and taxpayers remain on the hook for bailing out financial firms deemed ‘too big to fail.’ The Financial Services Policy Implementation team will be working to dismantle the Dodd-Frank Act and replace it with new policies to encourage economic growth and job creation.”

The facts line up with the first part of the President-elect’s argument. Big banks have only gotten bigger since the law’s implementation, with the Big Four—JPMorgan Chase, Citigroup, Bank of America and Wells Fargo—now controlling about 45 percent of total bank assets. Meanwhile, smaller lenders struggle to compete as their compliance costs have gone through the roof, and, as a result, their growth rate for small business loans and individual mortgages has been significantly lower than for the larger banks.

However, repealing Dodd-Frank in its entirety would be an uphill battle since the vast majority of its provisions are now engrained in the banking system. Further, the political impetus to do so probably takes a back seat to other items on the Trump team’s to-do list, like replacing the Affordable Care Act and renegotiating trade agreements. Few on Capitol Hill actually understand the arcane labyrinth of provisions the Act contains, so the appetite of Congressional Republicans to take a hammer to Dodd-Frank is fairly limited.

Furthermore, on the other side of the aisle voluble legislators including Senators Chuck Schumer and Elizabeth Warren have pledged a bare-knuckle, no-holds-barred fight if President-elect Trump tries to make good on that campaign promise.

Guess Who’s Calling Most Loudly for Repeal?

The reality is that the loudest drumbeat to completely repeal Dodd-Frank is mostly coming from the large banks themselves. Given the uphill political battle, it’s likely that the new administration may choose instead to deal with portions of the law that have restricted lending across the broader system, and particularly for small community banks, which played little role, if any, in the 2008 crisis.

The Trump administration will most likely rely on a proposal from Rep. Jeb Hensarling, R-Texas, who leads the House Financial Services Committee and serves as an adviser to the President-elect. His bill—called the Choice Act—doesn’t call for abolishing Dodd-Frank altogether, but rather for eliminating several of its core parts, including a provision that lets the government dismantle failed banks. He also wants to do away with the Volcker Rule, which imposes restrictions on banks’ trading and investments, and to weaken the reach of the Consumer Financial Protection Bureau. The lowest-hanging fruit would be to tackle the portions of the Act that have restricted lending, particularly for those small lenders and community banks.

Although President-elect Trump’s nominee for Treasury Secretary comes from the big banks, even he has voiced support for reforming portions of Dodd-Frank along the lines of Hensarling’s proposal, rather than scrapping it completely. Nominee Steven Mnunchin is a Goldman Sachs alum who has voiced skepticism about Dodd-Frank. Mnunchin spent more than two decades at Goldman, and later became a movie producer and hedge fund manager. In a recent CNBC interview, the Treasury Secretary nominee said that Dodd-Frank was “way too complicated” and indicated that his agenda was to strip back portions of the law that prevent banks from lending.

Even one of the original authors of the bill, former Sen. Barney Frank, admits the Act has aspects that need to be reformed. Frank told a reporter from the Washington journal The Hill that he believes the law set too low a threshold—$50 billion in assets—for banks to face increased regulatory burdens.

“That was a mistake,” Frank told The Hill. “We should have made it much higher—$125 billion or more—and we should have indexed it.”

Other Democrats have signaled a willingness to work in a bipartisan way on modest reforms to alleviate the burden on smaller lenders, including Senators Sherrod Brown of Ohio and Jon Tester of Montana, according to a recent Morning Consult report. Even Fed Chairwoman Janet Yellen has signaled concern that the smaller lenders struggle to compete, due to the provisions of the Act.

Dodd-Frank and Community Banks

Despite the many worrisome headlines issued by Dodd-Frank skeptics, most community banks and small lenders with under $1 billion assets are actually in fairly good shape today. An easing of their regulatory burden would be a boon for them that would likely result in somewhat more opportunistic lending.

Dodd-Frank critics usually point to the reduced number of community banks in operation today as proof that the new regulations are strangling them. However, more objective analysis, including from the Brookings Institution, suggests the reduction in the sheer numbers of community banks is more a result of consolidation, driven by macro factors like regional population shifts and implementation of new technologies. Due mostly to industry consolidation, the number of community lenders with less than $100 million in assets has shrunk by nearly a third since 2003, while the number of institutions with greater than $300 million in assets has grown.

These community lenders already account for nearly half of all small business loans, particularly for the SBA program. However, they have been clearly held back with mortgage loans, where they represent only about 15 percent of all residential lending. Dodd-Frank dramatically reduced the willingness and ability of community banks to make mortgage loans due to the broad risk retention requirements that it imposes on everything sold into the secondary market. The Act requires lenders to show that borrowers met an “ability to repay” test—which can be challenged in court for the entire life of the loan, tremendously raising the risk of litigation for the lenders.

To understand how reforming or eliminating parts of Dodd-Frank will help those community lenders, it’s valuable to understand exactly how restrictive the Dodd-Frank rules have been for them. The Act provides only narrow exceptions to the risk retention requirements. It provides for a designation called the Qualified Mortgage (“QM”) definition for loans with pre-established characteristics that are deemed to meet the ability-to-repay test. Even with just QM loans on their balance sheet, lenders face risk of litigation or sanctions because it is unclear if the QM designation provides a “safe harbor” against legal challenges, or if it’s only a “rebuttable presumption,” meaning they could still be challenged in court.

Worse, the QM designation is a cookie-cutter approach that limits the lenders’ flexibility to accept borrowers that don’t meet the strict conditions. Most lenders do not want the financial or reputational risk associated with loans outside the QM designation and simply don’t make loans other than Qualified Mortgages. Other community banks have simply stopped providing mortgages altogether, as the requirements and compliance cost made it unreasonable without considerable volume.

More Competition for Private Lenders?

While much of the controversy about Dodd-Frank focuses on the notion that it has harmed these smaller lenders, in fact community banks and other lenders in the asset classes of $300 million to $1 billion have stronger balance sheets now than prior to 2008 due to all of the onerous FDIC and OCC capital requirement regulations. As a result, successful efforts to get rid of the Dodd-Frank restrictions on smaller traditional and community banks may well open a spigot of new lending.

When considering whether competition from banks could put a squeeze on private lender origination, it’s valuable to consider the size difference. Current estimates of the private lending industry range from $65 billion in annual mortgages to as high as $100 billion. While that’s an impressive range, it’s dwarfed by the conventional lending industry that totals about $1.6 trillion, according to the Mortgage Bankers Association. (Consider that Wells Fargo & Co. alone issued $43 billion in residential-mortgage loans just during the first quarter of 2016.)

Over the past few years private lenders have enjoyed a more robust growth rate than banks: in 2015, private lenders originated 68 percent more volume than in 2014, according to Mortgage Bankers Association’s Commercial/Multifamily Annual Volume Origination Summation. That annual growth rate is nearly double the 35 percent increase that commercial banks and savings institutions saw over the same time period.

However, with deregulation, banks’ growth rate will pick up speed. The loosening of the Dodd-Frank regulations may well increase origination and leverage for both commercial banks and independent mortgage lenders, causing a rise in the mortgage credit availability index that has been mostly flat for the last several years.

It remains to be seen how fully credit restrictions will be eased for the traditional banking industry, including for the small lenders and community banks. If the Act and its regulations, as well as other regulations like the Basel III standards, are eliminated or relaxed, private lenders will need to remain vigilant about increased competition from banks on mortgages and other loans.

To compete with banks, private lenders will have to rely on their speed of origination, ability to find deals and overall market expertise. Even if Dodd-Frank reform gets held up by political backlash—don’t forget that many on both the right and left will interpret its repeal as a free pass for “too big to fail” lenders that played a big role in the 2008 crash—the industry will continue to reward those private lenders who are at the top of their game.

The most likely scenario is a repeal of portions of the Act that will help smaller lenders and community banks increase their balance sheet leverage and lend more. Rather than just more competition for deals, the flip side of deregulation may be that the easing of credit restrictions on banks becomes a boon for the private lenders that rely on them for liquidity.

Rather than expand into direct loans that don’t meet the QM designation, it’s quite possible that community banks and other lenders will prefer to make individual or warehouse loans to private lenders, letting them perform essentially as the banks’ intermediaries for non-QM mortgages and even the subprime parts of the construction sector. In that scenario, look for lower cost of capital and greater liquidity to prime the private lending industry for even more robust growth in the years ahead.

This article was originally published in Private Lender Magazine. Check out the full magazine with other great articles.

Interested in more? Check out my companies blog at Specialty Lending Group.

Retiring Baby Boomers are having a major impact on the construction and private lending industries.

Stop by a Sherwin-Williams store and you’ll see that gray is replacing beige as the go-to neutral color for interior decorating. This anecdote provides a platform for a plethora of bad puns, because the graying of the Baby Boomer population is having a major impact on the housing market.

The aging of Baby Boomers presents both an important opportunity and a series of challenges for real estate developers and the companies that finance them. The pattern of retiring workers selling the big family house and relocating to condos in Arizona or Florida is shifting. Over the past several decades, the number of retirees purchasing condos in multi-unit housing has been declining, according to Trulia. Some retirees are opting to rent, some want to “age in place,” and still others are looking to buy even larger houses. This, coupled with debt-laden Millennials holding off on purchasing, is upending a time-honored pattern of generational purchase activity. The good news is that this new dynamic is keeping the market humming.

Most Millennials and GenXers, like their parents before them, aspire to live in larger homes (excluding those folks attracted to tiny houses or hipster lofts). Their parents’ generation, however, is exhibiting an aspirational divide. While some in the over-54 category are upholding the honored tradition of downsizing and moving to warmer climates, other Baby Boomers are just as likely to buy a bigger home, even taking out a mortgage during retirement to buy it. This behavior is now as likely as downsizing to a condo in Florida. There are still other Boomers bucking tradition and deciding to rent, even though they could afford to buy. Now other factors including the shortage of available housing stocks in certain markets are coming into play.

Questions about when and where Boomers will retire—and what kind of houses they will buy—represent a complicated subject for economists making predictions on what’s in store for the housing market. Baby Boomers represent 31 percent of all homebuyers, second only to Millennials, who represent 35 percent. 53 percent of Boomers live in houses that are between 1,400 and 2,600 square feet, while a much smaller slice (12.5 percent) live in larger houses of 2,600 square feet or more, according to Trulia.

Will they trade up or down in size? Buy or rent? Those questions are complicated by the low inventory of housing stock that appears to be stalling home purchases across the country. Many analysts contend that the U.S. now faces an acute housing shortage: since 2012 the number of both starter homes and “trade-up” homes on the market have dropped by over 40 percent, according to Trulia.

Over the same period of time, price increases for higher-end premium homes have outpaced middle-tier homes, according to Trulia’s data. Today the median price of a premium home is $542,805, compared to a median for middle-tier homes of $267,845. That’s a significant impact for Boomers who were considering a move to a larger and more expensive home for retirement. As the price gap widens, it becomes more difficult for a buyer looking to trade up to justify and afford the price of a premium home. At the same time, the widening price gap may make it more difficult for retiring Boomers to find a buyer for their own existing homes.

 

FREDDIE MAC WEIGHS IN

The Federal Home Loan Mortgage Corporation, known as Freddie Mac, recently conducted a large survey of those over age 55 to investigate their housing perceptions and preferences. Among the homeowners who responded that they would consider moving, 12 percent believe their next home will be more expensive than their current one, while 37 percent believe it will be in the same price range.

About half of the respondents believe it will be less expensive. At the same time, 23 percent of homeowners say they would have to make major renovations in order to age in place in their current home.

In an interview with the trade magazine Mortgage News Daily, Freddie Mac’s Executive Vice President of Single- Family Business, Dave Lowman, pointed to the impact of Boomers on both the construction and finance industries.

“The decisions the nation’s Baby Boomers and other older homeowners make will have an enormous impact on the demand for housing and new mortgage credit for the foreseeable future,” Lowman said. “Whether they buy new homes or decide to refinance and renovate their current ones, the size of this generation and the fact that they hold close to two-thirds, approximately $8 trillion, of the nation’s home equity makes it very important that we watch what they do.”

The survey indicates that an estimated 6 million homeowners and nearly as many current renters may move again. Of those homeowners and renters who expect to move, more than 5 million say they are likely to rent by 2020.

 

CONDO DEVELOPERS DEVELOP NEW TRICKS

In the face of such currents, some premium condo developers are finding new ways to adapt. In Florida, they are focusing on retirees who can afford big houses but are interested in accepting much smaller spaces once the kids have left home – with the big caveat that the location must be cool and the amenities compelling. It’s a new approach to Baby Boomer downsizing that is becoming a lucrative niche. When they can find buyers for their homes, some retirees seem willing to give up traditional retirement homes for a hip urban lifestyle. Builders that traditionally focused on retiree housing are using such high-ticket condos to lure retirees to warmer climates.

Florida’s Kolter Group is known for diversified real estate developments and investments, with projects amounting to over $12 billion in value. At three Kolter condo developments—in Sarasota, St. Petersburg and north Palm Beach— condo units ranging from 1,800 to 2,400 square feet are priced from about $900,000 to $1.5 million, with penthouses priced at over $3 million.

For many Boomers who are potential buyers, there is some hesitation about the units because they are so much smaller than the houses they currently live in. “Our sales manager frequently gets the comment from the husband or the wife that they haven’t lived in something that small since their first house,” Bob Vail, president of Kolter’s Urban project, said in a recent article on Curbed.com. “But they still buy.”

What attracts them are the urban locations of the developments, in midsized cities with many nearby walk-able destinations like cafes, parks and shops, or “center ice,” as Vail puts it.

At 41 stories and 450 feet, ONE St. Petersburg is the tallest building in downtown St. Petersburg, with gorgeous views of the bay and the downtown area. It boasts a 5,000-square-foot fitness complex and many other amenities. Vue Sarasota Bay will feature a dog park on top of its parking garage. In North Palm Beach, The Water Club offers three towers of 22 floors each, with a full-service marina alongside. All three buildings, which are in varying stages of construction, have water views.

Kolter has bought into a new trend in interior design that’s attracting downsizing Baby Boomers. Its units feature open floor plans rather than walls marking out a living room, family room or dining room. Instead, the units have a central “great room” with very few or no hallways, high ceilings and floor-to-ceiling windows. So far, this design strategy appears to be effective. In Sarasota, the Vue project has eight units left to sell out of its 141, from a three-bedroom for $1.5 million to a four-bedroom penthouse listed for $3.4 million. The Water Club has closed deals for three-quarters of its 164 units in the first building. And ONE St. Petersburg, which broke ground in mid- January, has contracts for just under half of its units, according to Vail.

 

RENTING INSTEAD OF BUYING –A NEW TREND FOR BOOMERS?

When Boomers consider downsizing, purchasing a condo or another home is not the only option. Renting pricey apartments, particularly in attractive urban locations, is also a new trend for them. The number of renters who are age 65 or older will reach 12.2 million by 2030, more than double the level in 2010, according to research by the Urban Institute in Washington. While Millennials have driven demand for apartments in recent years, Baby Boomers represent the next wave, pushing up rents and spurring construction of increased multifamily housing units.

An article in the July 21, 2015 issue of Bloomberg interviewed some of the participants in the front lines of this trend:

“It’s a combination of their sheer size and that they’re entering the age range where they increasingly downsize,” said Jordan Rappaport, a senior economist at the Federal Reserve Bank of Kansas City. As a result, “it will put upward pressure on rents for all types,” he said.

Rappaport’s research reported that people ages 50 to 70 accounted for nearly all the net increase in multi-unit occupancy from 2000 to 2013. As members of the Boomer generation are now entering their 70s and downsizing, “multifamily home construction is likely to continue to grow at a healthy rate through the end of the decade,” he wrote in a report published last year.

With combined demand from Boomers and Millennials, vacancy rates for rental properties are already near 21-year lows. That pushed the national median rental price up 27 percent to $1,381 in 2015 as compared to $1,090 in 2012, based on data from the United States Census Bureau.

According to the U.S. Commerce Department, last year saw the largest increase in construction starts for multi-dwelling properties featuring five or more units since 1987. These multi-unit buildings represented over 40 percent of total housing starts, compared to about 16 percent of starts in June 2009 when the recent economic expansion commenced.

Real estate developers such as Lennar Corp., Bozzuto Group and Alliance Residential Company are undertaking multi-unit projects for multiple generations. Should the supply of rental properties fail to keep up with demand, however, it’s likely there will be conditions where younger workers are competing for housing with the burgeoning population of retirees, and other lower income retirees are going to struggle to find suitable rentals.

Lennar Corp., a Miami-based builder that traditionally focused on single-family home construction, formed a $1.1 billion joint venture that will develop multifamily communities in 25 major U.S. metropolitan markets, according to the Bloomberg report.

Alliance Residential is designing buildings with smaller, more affordable units on ground floors to attract Millennials, and with larger and more expensive apartments on upper levels to attract Boomers, as reported in Bloomberg. The larger units feature amenities like wine refrigerators and touch-button window screens to lure away Boomers who might ordinarily be attracted to new single-family housing.

At Bozzuto, which manages over 50,000 units in cities including Washington, Chicago and Atlanta, about 10 percent of up from 8 percent in 2012. The Maryland based company expects the share of Boomers to continue growing. “Something’s happening,” Tony Bozzuto, CEO of his family company, said in an interview with Bloomberg, adding that the company is looking to add rental properties catering to residents 55 and older.

 

OPPORTUNITIES FOR PRIVATE LENDERS

With all this new demand for the multi-unit housing market, both for sale and rentals, you might think lending conditions would be terrific for developers. After all, pressure on supply should axiomatically lead to higher valuations and improved margins, which should make banks comfortable with lending. However, the opposite is becoming the case. Commercial banks are getting more cautious with development projects because regulators are looking at the industry’s robust growth and worrying about a potential bubble. Federal officials are concerned about construction lending, according to a letter sent last December by three federal agencies that regulate banks, the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation.

New regulations also limit how much construction risk commercial banks can put on their balance sheets. The Dodd-Frank Financial Reform and Consumer Financial Protection Act in the U.S. and “Basel III” banking standards were created years ago, and many of their provisions recently came into full effect. While the longevity of these new rules has come into question under a Trump presidency, currently these rules require banks to hold large capital reserves to cover potential losses on investments like commercial real estate loans. In many cases, smaller lenders simply move on to other types of lending with less stringent reserve requirements, like auto and student loans. In addition, construction lenders are worrying about rising costs of labor and land as the construction market stays frothy.

For private lenders, the upshot is that, in the short term, many new opportunities are going to emerge as some developers with solid plans for multi-unit projects struggle to obtain traditional financing. Banks offer construction loans with low interest rates that float 250 to 300 basis points over LIBOR, which is quite attractive. But if a commercial lender cannot get comfortable with a developer’s loan to value ratio, balance sheet, or other factor, a private lender can step in to save the day, while also earning a terrific premium by enabling the project to move forward.

Like all business practices, the key is to do your homework. Stay vigilant for new opportunities, while taking a systemic approach to analyzing the developer’s balance sheet and project plans. In addition, as the new administration settles in, it is anticipated that these stringent banking regulations will be relaxed so private lenders have to be ready to capitalize on the current framework and adapt to a changing one.

More and more good lending opportunities will be out there as the cohort of graying Baby Boomers transform the market and help drive new multi-unit construction starts for years to come. Private lenders have to be flexible and agile in order to capitalize on it.

 

This article was originally published in Private Lender Magazine. Check out the full magazine along with other great articles.