effect of the Tax Reform Act of 1986 and overbuilt markets on commercial office property values, The

Journal of Real Estate Research, The, May/Jun 2000 by Smith, Stanley D, Woodward, Larry R, Schulman, Craig T

Abstract

This is the first empirical study to test the impact of the Tax Reform Act of 1986 on office property values and the impact of regional economic conditions. The results for the period 19831988 indicate that it had a significant negative effect on values in all four regions and the highest loss was in the South. The significantly higher losses in the South and the West are supportive of the argument that the effect of tax or regulatory changes on real estate will vary across regions based on vacancy rates and economic growth.

Introduction

The effect of the Tax Reform Act of 1986 (TRA86) on commercial office real estate values has been the subject of many previous studies-most of which have been theoretical in nature. It is the purpose of this article to empirically measure the effect of the TRA86 on commercial real estate values by analyzing the changes in appreciation returns to office property.

It is important to understand how changes in tax law can affect the value of commercial office property for three primary reasons. First, if tax law changes either add or subtract value from such property, it is of interest to know if such changes in value vary by region and local economic conditions. Such effects on office property value have important implications for portfolio diversification, appraisals, property tax assessments and risk analysis. Second, a large number of office building commercial mortgages are held in the portfolios of insured depository institutions. If only minimal equity is used to back such loans, as many were at the time of the TRA86, then a decline in value of property financed by such institutions of only a few percentage points might result in a default and a significant loss to the funding institution. Thus, federally insured depository institutions have a direct interest in tax law changes that might affect their capital adequacy. Finally, commercial mortgages and real estate were approximately 19% of the assets for life insurance companies in the United States in 1991 and play an important role in these institutions as well. See Life Insurance Fact Book for more details.

In this article, we ask two primary questions. First, did the TRA86 significantly affect office values? Second, if there was a significant effect, did the effect vary by region as categorized by economic growth and the degree of overbuilding of commercial office real estate in the region?

The effects of the TRA86 on commercial office values are estimated using the Seemingly Unrelated Regressions (SUR) methodology. This method allows for a direct test of the extent to which the effects of the TRA86 vary by region. We find that the TRA86 had a significant negative effect on commercial office values, that the effects vary by region and that the relative magnitude of the effects are consistent with those theorized by Ling (1992).

Relevant Literature

There has been considerable debate as to the overall net effect of the TRA86 on commercial real estate because the TRA86 contained many provisions, some of which had positive effects for commercial real estate and some of which were negative. The passive loss limitations, elimination of preferential treatment for capital gains, the lengthening of depreciation schedules, the lowering of investment tax credits and the limitations on the deductibility of interest expense have been seen as negatively related to real estate values. The lowering of individual and corporate tax brackets have been suggested to have both negative and positive effects on commercial real estate values. Ling (1992, 1993), Hendershott, Follain and Ling ( 1987; HFL hereafter) and Fisher and Lentz ( 1986) used simulation techniques to show the theoretical effects of the law on real estate values. HFL suggest that the TRA86 did contain provisions that were harmful to commercial real estate, but that the net effect of the law may be zero because of the downward pressure on interest rates resulting from the law. The positive effect of a decline in interest rates might totally offset the negative provisions of the law. In a simulation model where saving is independent of interest rates, HFL find that, "interest rates have to decline by 1.4 percentage points to offset the negative capital provisions of the act."

Ling (1992) suggests that the effect of the TRA86 should vary by the location of the property. Property located in regions with high economic growth and low vacancy rates should see less effect from any detrimental tax changes than property located in regions with low economic growth and high vacancy rates. His argument for this effect is that in areas with high growth and low vacancies, the property owner can quickly adjust rents to provide the required after tax rate of return. When tax changes occur, which remove tax benefits and hence value, rents can be raised quickly in such a market. Where a market is overbuilt and economic growth is low, raising rents to make up for lost benefits would be futile because tenants would move to previously unoccupied property. In such overbuilt markets, the rate at which rent increases can be implemented is a function of how quickly excess space can be filled. This in turn is said to be a function of: (1) obsolescence of a certain percentage of the existing space each year; (2) the degree of over building; and (3) the economic growth in the local area. If growth is stagnant, then rents will adjust upward to equilibrium only as obsolete space is removed from the market. If economic growth is high and vacancy rates are moderate, then the combination of the two will remove excess space more quickly and rents will rise to equilibrium sooner.