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Depreciation-Related Capital Gains, Differential Tax Rates, and the Market Value of Real Estate Investment Trusts

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Abstract

We develop a model for valuing U.S. real estate investment trusts (REITs) that considers the tax liability impounded in REITs’ property portfolios. This liability is a function of the portfolio’s accumulated depreciation and is driven by different tax rates applied to individual components of the total gain from property sales. These two components are the capital gain resulting from the sale of property at a price higher than its cost and the gain due to the recapture of depreciation taken during the use of the property. Our measure of value is the REIT’s net asset liquidation value (NALV). The metric of REIT value currently used by analysts is a REIT’s net asset value (NAV), but a REIT’s NAV will always be greater than the NALV and therefore overestimate market value, all else equal. Finally, using observed market prices for REITs, we provide evidence that NALVs give superior estimates of REIT market prices than do NAVs.

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Notes

  1. Of course, the firm’s profits resulting from those activities should overcome that “decline” so that the overall the firm value would rise.

  2. A building will not last forever, so real estate (improvement to land) does get “used up” over time. However, a properly maintained property should have a useful life that well exceeds and might even be several multiples of the depreciation life allowed by current tax and financial accounting standards. Therefore, the actual rate of economic depreciation of real property should be a fraction of standard depreciation allowances and can even approach zero.

  3. See Section V labeled “Evidence from Net Asset Values and Observed Market Prices” below.

  4. In our model, “net after-tax liquidation value” does not imply the forced, or distressed, sale (liquidation) of underlying assets as in Shleifer and Vishny (1992). Rather, we are simply referring to the idea of selling underlying assets at fair market value less any tax liabilities.

  5. Define a conduit firm as one that passes the taxability of its earnings through to its shareholders when paying dividends, without paying taxes itself on those earnings.

  6. In a closed-end funds setting, Malkiel (1977) derives a formula for the discount from NAV that arises solely because of the timing of the cash flows. The present value of the tax payable on the dividend stream is less than the present value of the future tax credit from the sale of shares resulting in a discount. However, even in the Malkiel framework, the discount is zero using the arbitrage argument of an immediate sale of the assets and disbursement of cash.

  7. The price paid includes the original price of the property plus any subsequent capital improvements on the property.

  8. See Internal Revenue Code §857(b)(3).

  9. http://www.irs.gov/instructions/i1099div/ar02.html#d0e410.

  10. See Internal Revenue Code §1(h)(1)(C) and §1(h)(1)(D). Additionally, Public Law 105–34, known as the “Taxpayer Relief Act of 1997”, introduced the concept of depreciation recapture and set the rate at 25 %. This law also reduced the marginal capital gains tax rate from 28 % to 20 %. The rate was further reduced to 15 % by Public Law 108–27, known as the “Jobs and Growth Tax Relief Reconciliation Act of 2003”.

  11. This remains the case even when considering that REITs can utilize tax deferred like-kind exchanges (the “1031 exchange” codified in Internal Revenue Code §1031.) Exchanges do not eliminate the associated tax liabilities; rather, they merely delay the realization of them while depreciation continues to accumulate. In practice there is much cross-sectional variation within the REIT industry in the extent to which firms utilize like-kind exchanges and/or pay section 1250 gains in any given year. We have confirmed this in conversations with REIT executives in addition to observing that, on average, the ratio of reported section 1250 gains to total capital gains is 0.41; indicating that some, but certainly not all, REIT property sales make use of tax-deferred exchanges.

  12. This explains how REITs, on average, pay out as dividends more than their taxable income. They are utilizing the cash flow generated by depreciation. Of course, most REITs do not pay out their entire cash flow generated by depreciation; a typical REIT pays a generous cash dividend that is somewhat more than its net income and then retains the remainder of its cash flow for additional investment.

  13. This component and the cash distribution it represents will never be negative.

  14. The distribution from this component cannot (by definition of a distribution) be negative. However, when this component is negative (i.e. there is a capital loss), the REIT can use it to reduce the gain in component 2 before making the actual distribution. The resulting net effect is equivalent to allowing component 3 to be negative. Therefore, we allow this component to be negative when necessary.

  15. Only a handful of REITs fall into the M – D – L < 0 category at any point in time. During our sample period, the number ranged from zero to eight in any 1 year with most occurring, as expected, during the 2008–2009 financial crisis years.

  16. We utilize the NALV Premium [Eq. (9)] in this specification, rather than simply using NALV [Eq. (11)], in order to avoid potential collinearity issues that could arise if we were to include NALV and NAV as independent variables in the same regression.

  17. We do not include debt (L) and preferred equity (BVPE) in the regressions in Table 5 because they are incorporated into the calculation of NALV Premium. Nonetheless, in unreported results we obtain the same signs, similar coefficient magnitudes, and strong significance for our variable of interest across all models when L and BVPE are included.

  18. Not taxing corporations, while it would achieve the same result, would likely be politically not feasible.

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Acknowledgments

The authors gratefully acknowledge helpful comments and suggestions from David Geltner, Peng (Peter) Liu, Tien Foo Sing, Sheridan Titman, an anonymous referee, and participants at the 2014 American Real Estate Society conference, where the paper received the best paper award for the REIT category, and the 2015 NUS/MIT/Maastricht conference. 

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Authors and Affiliations

  1. Department of Finance, Jeffrey E. Smith Institute of Real Estate, University of Missouri, Columbia, MO, 65211, USA

    Dan W. French

  2. Collins-Goodman Fellow in Real Estate Finance, Lehigh University, Bethlehem, PA, USA

    S. McKay Price

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  1. Dan W. French
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Correspondence to Dan W. French.

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French, D.W., Price, S.M. Depreciation-Related Capital Gains, Differential Tax Rates, and the Market Value of Real Estate Investment Trusts. J Real Estate Finan Econ 57, 43–63 (2018). https://doi.org/10.1007/s11146-016-9568-x

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