Commercial real estate professionals are certainly keeping a close eye on the economy, including interest rates, the Fed’s next move, capitalization rates, the multifamily housing and residential markets, and of course companies’ ongoing decision whether or not to return to the office.  With these issues in mind, Baker Tilly’s real estate advisory team hosted a webinar, “State of the commercial real estate market 2023.” We were joined by a panel featuring Stephen Zsigray, Senior Vice President of Corporate Finance and Strategy at Ashford, Inc.; Chris Fogle, Principal and Portfolio Manager at The Carlyle Group; and Ashley Grigsby, Managing Director, Capital Markets of Transwestern Development Company.  The webinar recording can be found here, and a summary of the key topics discussed and recent trends can be found below.  An impending recession  During the February webinar, regarding his expectations for the rest of the year, Zsigray said, “As far as overall risk of a recession, I think the chances of that, at least in 2023, are certainly subsiding. The labor market is still strong, [and] if the Fed intends to not inflict a ton of harm on the entire economy, I think the likelihood of a recession is pretty low.” However, sitting here in May in the wake of the turmoil facing First Republic and other banks across the U.S., more and more signs are now pointing to a potential recession in the near future.  One thing is clear: There will continue to be a lot of uncertainty for the remainder of the year. The answer regarding a potential recession may have been simpler before the recent banking chaos, but now it is just very difficult to project where the economy is going to go from here. The future of capitalization rates  There was a compression of capitalization rates at the beginning of 2022, but then we saw those bottom out. Ever since, there has been upward pressure – and that is likely to continue as we get deeper into 2023.   Cap rates likely will increase over the next several years, although the increase will vary by product type. We expect office cap rates to increase the most, followed by retail, multifamily and industrial, which could increase moderately. Factors that will drive cap rate expectations are cost of debt, rent and margin growth, while technology could enhance properties’ margins, thereby lowering the capitalization rates.  The state of the multifamily and residential market   As it pertains to the current state of the multifamily and residential markets, Fogle said: “We’ve seen rent growth in many cases run in double digits for going on two years now. We’ve seen a little bit of slowing of growth, in particular in late 2022 into the early part of 2023. But looking at year-over-year growth, it’s been extremely strong in the face of inflation. … From a real estate investor’s standpoint, though, we have seen values hold up relatively well in various forms of rental housing because you are seeing rent with high growth that is generally paced with inflation, or paced ahead of inflation, which provides some level of defense to rising interest rates and cap rates, generally.”  Returning to the office?  We expect to see more occurrences of office loan defaults in cities such as New York, San Francisco and Chicago, as these markets typically feature flagship offices. Additionally, these cities were generally the slowest to return to the office initially in 2020, and even as of today, many of these major cities have proven to be among the slowest in returning to the office. So, the defaults in these markets could be outsized in comparison to some of their peers, particularly those cities in the southern part of the U.S.  Furthermore, if the labor market switches to an employer’s market due to a recession (or a combination of other reasons), employers will take this opportunity to get people back to the office for culture/mentorship reasons. That doesn’t necessarily mean that workers will return to the office four or five days a week – it might be one day, it might be two – but for many companies, that is still considered a “return to the office” at this point.  It’s difficult to see the majority of companies insisting on a return to the office five days a week at this point. It appears that the concept of working from the office on Fridays is largely off the table for most organizations, at least in the short term and probably in the long run, as well.   What is going to drive this demand for office space in the future? From our perspective, it’ll be flight-to-quality amenities and user experience. The youngest generation of workers continues to make it clear that they want to work in urban settings – at least early in their careers – and companies certainly are taking note of this as they desperately try to attract and retain talented people.  Still, it is fair to expect some choppy waters as companies attempt to navigate their return to the office. It certainly will be interesting to see where things stand in 5-to-10 years. At this point, it’s very hard to predict. There is such a wide variety of market sizes, geopolitical issues and government responses throughout the country – not to mention the unpredictability of the pandemic itself – that this was always going to be difficult to anticipate.   The reality is that office did relatively well in the early stages of the pandemic. Tenants were still paying their rent at the time, even while they were unsure about their workspace needs moving forward. However, now more and more companies are reevaluating their space needs and, in many cases, letting their leases expire.  2023 and beyond  There is a significant amount of capital parked on the sidelines seeking the right opportunity. We continue to see an appetite for mixed-use projects on a market-by-market basis, and there has been a strong outflow of capital to the suburbs to these mixed-use developments.  Regarding the current state of transaction activity and the outlook for the rest of 2023, Grigsby noted: “We’re seeing if you have a construction loan that you need – that is $30 million or less – there are lenders out there for that. But as you start to go over $30 million, it’s going to have to be some type of participation versus syndication. And most of the lenders are not willing to fully underwrite and accept that risk, so they want to come in knowing they have a partner or bring in a participating lender group, on the front end.”  Stay up to date on notable commercial real estate transaction activity, data and analytics by reading our quarterly Commercial Real Estate Market Report. 

Commercial real estate professionals are keeping a close eye on the economy, including interest rates, the Fed’s next move, capitalization rates, the multifamily housing and residential markets, and of course companies’ ongoing decision whether or not to return to the office.

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Recession, capitalization rates and returning to the office are top of mind for commercial real estate professionals

On March 29, 2023, the IRS resolved one important question involving the commonly used “intentionally defective grantor trusts” (IDGTs) — irrevocable trusts specially designed to accept completed gifts yet be disregarded for income tax purposes. Contrary to arguments made by some tax practitioners, the IRS ruled IDGT assets are not eligible for a “step-up” in basis to fair market value at the trustor’s death. Internal Revenue Code section 1014 generally provides that the basis of property acquired from a decedent is equal to the fair market value of that property as of the decedent’s date of death (unless the property is otherwise disposed of prior to the decedent’s death).  For example, assume Winston leaves a baseball card in his will to Hudson that he bought for $1,000 (basis) and is worth $10,000 when he dies. In that case, Hudson inherits the baseball card with a $10,000 basis, and the $9,000 built-in gain ($10,000 fair market value minus $1,000 basis) is eliminated.  In Revenue Ruling 2023-2, the IRS concluded this basis step-up afforded by section 1014 does not apply to assets in an IDGT (unless those assets are included in the trustor’s gross estate). Planning opportunities  Substituting high tax basis assets for low tax basis assets in an IDGT may improve the tax results. Those who have established IDGTs should consider substituting high basis assets held by the trustor for low basis assets held in the trust. That way the high basis assets, which benefit only slightly from a basis step-up, are held in the trust and the low basis assets, which benefit significantly from a basis step-up, are included in the trustor’s gross estate.  For example, assume Lilly’s IDGT owns FounderCo stock with a basis of $250,000 and a fair market value of $1 million, and Lilly individually owns PubCo stock recently purchased for $900,000 with a fair market value of $1 million. If Lilly swaps the PubCo stock for the FounderCo stock, then when Lilly dies, the FounderCo stock (owned by her individually) will receive a basis step-up from $250,000 to the fair market value as of Lilly’s date of death (let’s assume $1 million). The PubCo stock will not receive a step-up in basis at her death and maintains basis of $900,000. Gift highly appreciated assets may also improve tax results. Those considering creating an IDGT (or making additional gifts to an IDGT) should select highly appreciated (or highly appreciating) assets to give away, all else being equal.  Questions?
 
 Please reach out to your Baker Tilly advisor if you have questions regarding how this revenue ruling affects you.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

The IRS ruled intentionally defective grantor trust (IDGT) assets are not eligible for a “step-up” in basis to fair market value at the trustor’s death.

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IRS: No basis step-up at death for irrevocable grantor trust assets

Forced labor is a significant and alarming issue that has existed in various forms throughout human history. Two of the most famous examples are slavery in the United States and concentration camps in Nazi Germany, yet even as we sit here in 2023, the issue continues to make headlines, raise concerns and attract the attention of lawmakers across the United States and throughout the world.  The concept of forced labor encompasses any instance in which people are compelled or required to provide work or services against their will. Modern day estimates are that more than 27 million people in the world are currently being exploited by forced labor, including more than 17 million who are being forced into work by the private sector.   The issue certainly isn’t going away. In fact, in some parts of the world, it is getting worse. As a result, the U.S. government continues to keep a close eye on forced labor – not just on working to prevent the practice, but also on preventing the importation of goods that have passed through forced labor at any point during their manufacturing or distribution.  What do importers need to know?  One of the notable ways that the U.S. has cracked down on this abhorrent practice is through the Uyghur Forced Labor Prevention Act (UFLPA), which targets the Xinjiang region of China. The UFLPA prohibits the importation into the U.S. of any goods that were produced, manufactured or mined in the Xinjiang region, which has a history of human rights abuses against Uyghur Muslims.   U.S. Customs and Border Protection (CBP) maintains a list of entities that are known users of forced labor. In turn, any product that is found to be associated with any of these entities – or, the region, in the case of Xinjiang – is banned from importation into the U.S. The only exception is if the importer can prove through supply chain tracing, or an alternative method of comprehensive due diligence, that the product indeed did not pass through forced labor at any point in its lifecycle.   CBP recently published a dashboard that provides real-time statistics related to UFLPA reviews and enforcement actions. This statistical snapshot includes what goods have been detained and what the corresponding dollar amounts are.   Of course, that’s mentioned not to scare you. Rather, it’s important to understand that products are getting stopped by customs, goods are getting denied at the border, and importers are getting flagged for audits, which means their overall import program is getting examined. The ramifications are quite serious and not to be taken lightly.   However, it’s important to note that this issue does not simply affect goods that were manufactured using forced labor. Even beyond that, it’s about goods that have passed through or even touched forced labor at any point in the supply chain.   So, anyone who does business in China – and particularly the Xinjiang region – needs to fully grasp the importance of supply chain mapping.   Essentially, there are more eyes on a company’s supply chain than ever. Cybersecurity concerns and lingering pandemic ramifications are two of the reasons why supply chains are under particular scrutiny these days. But the increased emphasis on forced labor has truly placed a premium on supply chain mapping, particularly as far as U.S. imports are concerned.   Examining the ESG angle  There is a notable environmental, social and governance (ESG) element to this as well. ESG, an organizational framework and strategy regarding environmental, social and corporate governance issues, has seen a rapid rise in popularity over the last several years. Estimates are that up to 85% of investors consider ESG factors when researching potential targets. Companies are learning that their customers (and private equity firms) care about social issues more than ever – and the fair and ethical treatment of workers is a prominent matter under that umbrella.   Importers, in particular, are quickly realizing that they need to care about this issue just as much as their customers do. And on a larger scale, they need to care about it just as much as the United States government does. If they don’t, they’re going to face their own issues, including but not limited to potential financial penalties and the long list of hassles that comes with having products turned away at the U.S. border.  How Baker Tilly can help  Given the priority of preventing forced labor, Baker Tilly spends a significant amount of time helping clients in the ESG space as it pertains to forced labor prevention. Among other areas, our customs and global trade services practice can help determine products’ country of origin through supply chain mapping by way of GPS data visualization, or we can assist with understanding the complex elements of the UFLPA. Additionally, we can assist with the requirements imposed by CBP (including best practices and other due diligence strategies). And of course we also help clients take full advantage of government procurement programs such as the Buy American Act or the Inflation Reduction Act.   If you would like to discuss how Baker Tilly can help your organization, contact me here.  
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

Customs & Global Trade

U.S. continues to crack down on imported goods made using forced labor