Navigating the US Economic and Real Estate Transition

This year is set to be a turning point for commercial property markets in the US. A gradual easing in inflationary pressures alongside a steady, if unspectacular, year for GDP and employment growth should help to ease the market through the final leg of the post-COVID adjustment.

We shall delve into four areas which are likely to have a bearing on returns, funding markets and the differing demand by property types.

Can we expect rate cuts in 2024?

Despite current speculations and recent inflation showing a modest re-acceleration, as well as growth in the economy remaining resilient despite higher interest rates, we don’t think it likely that the Fed will refrain from cutting rates until next year.

Global supply chains continue to normalize and remain consistent with ongoing goods price disinflation, at least for the next few months. Commodity prices also seem to have settled at higher levels, implying falling inflation, and although consumer prices are concentrated in the service sector are rising, recent surges in productivity and declining wage growth point to lower services price inflation ahead.

Considering the expectation of returning to 2% inflation, three reasons support the potential for the Fed to cut rates.

Firstly, the time for monetary policy to impact the real economy has lengthened, necessitating prompt easing to prevent further economic slowdown and potential undershooting of the inflation target.

Secondly, even if the Fed reduces rates by 75 basis points this year, monetary policy would remain restrictive, above levels considered neutral. Thirdly, the substantial reduction in fiscal policy stimulus compared to the previous year is anticipated in 2024, potentially facilitating the Fed’s control over inflation.

Can AI lift the long-term outlook?

The US is likely to be at the forefront of adoption of Generative AI, and it will drive a wedge between real estate returns and economic growth. The economic gains will come slowly over the next decade, and it could significantly raise the outlook for US GDP, but this will be driven by productivity rather than employment.

This growth will be accompanied by a reduction in demand for some types of space ¬– most notably office, but also life sciences and manufacturing as these areas have the highest exposure to generative AI.

Is globalisation over?

Although geopolitics may seem somewhat academic in the highly localised world of real estate, the magnitude of changes to domestic and international politics make it a factor shaping the outlook for real estate markets.

US and China decoupling is shaping domestic policies. Regardless of the outcome, the upcoming presidential election is likely to shape US domestic policies (through subsidies or tariffs) to see increased demand for industrial space as it seeks to replace parts of the global supply chain, with foreign investment into US real estate set to remain weak.

Is it a new era for inflation and rates?

A persistently higher inflation regime would have profound impacts on real estate returns as well as other asset classes and the relationships between them. Currently financial markets are pricing in approximately a 30% chance that inflation will still be 3% or above in 5 years’ time but we think those odds are too high because a high proportion of the recent surge in inflation can be explained by excess demand.

But we are more cautious when it comes to the volatility of inflation. The pre-pandemic economy was unusual for its low and stable inflation rate, with the 20 years leading up to the pandemic being the lowest and most stable periods of inflation over the past 700 years. Whilst the simple law of averages would suggest the future is set to be more volatile, geopolitics and the disruptive influence of generative AI also point in that direction. And if we do see more volatility, we expect central banks to react more swiftly to nascent signs of inflation in the future.

The recent collapse of the Baltimore Key Bridge is another reminder of how adverse supply shocks can also become more frequent as narrowing global supply chains place more emphasis on key assets.

The key lesson for real estate markets is that interest rates may be more volatile in the future.

Source: Oxford Economics

Office Workplace Strategy: Taking a Lesson from Retail

As hybrid work now prevails, the office competes for use among employees who have greater choice in determining where they work. An increase in occupier investment in workplace experience and personalization echoes retailer behavior over the past two decades.

Top trends we’re seeing in the workplace, regardless of industry, indicate an increased focus on investing in data to capture employee behavior that informs workplace strategy. This resembles the $200 billion consumer data industry that drives retail strategy.

Three Retail-to-Office Trends:

Creating a memorable experience

Nearly 97% of Gen Z shop at brick-and-mortar stores, with one of the primary drivers being the ability to see, touch and try products, according to ICSC’s Rise of the Gen Z Consumer study. This emphasis on experiencing products and brands in person reflects a redefining of the store’s value. Retail’s shift over the last 10 years from transactional store counters to flagship experiences and concept stores, where brand immersion is the focal point, follows the office evolution from a factory-like production line of the early 1900s to the present-day workplace, a hub of brand and cultural immersion.

With 90% of companies adopting hybrid work, occupiers are striving to define the value of the office. Overwhelmingly, workplace investment has prioritized employee connection, with an over 50% increase of office space allocated to collaboration. The emphasis on collaboration redefines the purpose of the office into a space for companies to reinforce their brand, culture and values with employees.

We expect to see continuing evolution of work, with leading organizations investing in not just collaboration spaces, but true placemaking experiences and the creation of memorable moments.

Tracking foot traffic

With online retail sales forecast to surpass brick-and-mortar by 2033, retail companies are starting to measure the success of their stores by foot traffic and conversion rates as much as revenue dollars. Retail executives are realigning their metrics to reflect omnichannel operations rather than traditional store-only models. Similarly, office space planning has shifted to measuring in-person utilization and, increasingly, vibrancy—the tipping point in the ideal number of employees in an office at any given time—instead of traditional $/sq. ft. occupancy metrics.

As retailers monitor not just foot traffic, but more importantly when and how customers are spending time in store, they are able to convert more traffic into sales. This detailed data is used to define a store’s value, capture customer behavior and, ultimately, influence buying habits.

In parallel, offices in a hybrid work environment measure daily foot traffic, with utilization rate—the rate at which employees enter the office per day—the top metric tracked for office occupancy over the past two years. However, like retail, data on people merely showing up at the office is not where value is driven. Instead, vibrancy is increasingly the most important measure of office value.

Tracking vibrancy allows businesses to take more strategic targeted actions with outsized impact on employee experience. Organizations that can look beyond how often vibrancy occurs and instead prioritize how to establish vibrancy within their workplace will see higher employee engagement, cultural alignment and ultimately greater value in their real estate.

Using data for personalization

The onset of internet ad sales in 1994 revolutionized how retailers understand their customers. Online advertising has transformed the retail industry’s ability to track customer behavior and consequently offer personalized experiences and product selection. Similarly, the recent adoption of hybrid working at a global scale has left occupiers seeking data to capture employee behavior and influence employee decision-making through personalization.

Retail’s investment in ad sales is projected to account for 25% of all digital media spending by 2026. This investment in customer data has allowed global retailers to understand which brands would appeal most to individual consumers and why, creating personalized shopping experiences. The focus on personalization has increased customer satisfaction by 20% and consequently revenue.

In offices, however, data is often not captured by tracking employee behavior and instead may be comprised of self-reported data, leading to inaccuracy. Some organizations are giving employees choice and control, offering a variety of space types in the office. However, to truly understand what drives employee behavior, better data will need to be captured to facilitate a personalized employee experience in and out of the office.

We expect to see leading organizations invest in smart occupancy management technology that captures behavioral data—such as when, how and how often an employee books a workstation—and encourages employee behaviors—like reminders to come into the office for important meetings or when colleagues they’d like to connect with are in. The market for Integrated Workplace Management Software is anticipated to reach $1.1 billion in 2022 and will grow at a CAGR of 15% to surpass $2.1 billion by 2027.

What’s next for the future of work?

If retail is a harbinger of workplace trends to come, CBRE expects to see the following three key trends to not just improve office work, but to push the boundaries of how work is performed. The business that learns how to truly capture these trends and transform how work is done is the one that will leapfrog ahead.

Source: CBRE

Is it wise to borrow from a related party?

When operating a company, capitalization and working funds are needed for it to run properly and efficiently. One way of getting this necessary funding is through borrowings. Normally, a company will borrow from banks or any financial institution that is willing to lend, provided certain qualifications or collaterals are offered. This route, however, may take a while to get approved.

As an alternative, a company can opt to borrow from related parties that are willing to lend under more convenient circumstances, that is, without requiring collaterals or qualifications guaranteeing the company's ability to pay. These lenders instead rely on the related party relationship as assurance that the company will pay them back.

The question now is: Can interest expense be claimed as a deduction from gross income, and what are the requirements for the same to be considered deductible?

Based on the recent issuance of Revenue Memorandum Circular (RMC) 19-2024, under Section III. A1, interest paid or incurred within a taxable year on indebtedness in connection with the taxpayer's profession, trade, or business shall be allowed as a deduction from gross income, subject to certain limitations, when the following requisites, provided in Section 34(B)(2) of the National Internal Revenue Code (NIRC) of 1997, as amended, and as implemented by Revenue Regulation (RR) 13-2000 and Section 7(B) of RR 5-2-21, are met:

– the indebtedness must be that of the taxpayer;

– the interest must have been stipulated in writing;

– the interest must be legally due;

– the interest payment arrangement must not be between related taxpayers as mandated in Sec.34(B)(2)(b), in relation to Sec. 36(B), both of the NIRC of 1997, as amended;

– the interest must not be incurred to finance petroleum operations;

– the interest was not treated as "capital expenditure" if such interest was incurred in acquiring property used in trade, business, or exercise of profession; and

– the interest will be reduced by an amount equivalent to 20 percent of interest income subject to final tax; however, if the final withholding tax rate on interest income of 20 percent will be adjusted in the future, the interest reduction will be adjusted accordingly.

In addition, the taxpayer must have withheld the appropriate tax to claim the interest expense as deduction from gross income. Further, the same RMC also provides that interest expense paid on intercompany loans will not be deductible from gross income if both the taxpayer and the person to whom the payment has been made are persons specified under Section 36(B) of the NIRC of 1997, as amended.

Section 36(B) reads as follows: "(B) Losses from Sales or Exchanges of Property. – In computing net income, no deductions shall in any case be allowed in respect of losses from sales or exchanges of property directly or indirectly... (1) Between members of a family. For purposes of this paragraph, the family of an individual shall include only his brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants...."

Based also on RR 19-2020, in determining whether a person or entity is a related party, the following will apply: A person or a close member of that person's family is related to a reporting entity if that person has control or joint control of the reporting entity, has significant influence over the reporting entity or is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.

An entity is related to a reporting entity if any of the following conditions apply:

– The entity and the reporting entity are members of the same group, which means that each parent, subsidiary, and fellow subsidiary is related to the others.

– One entity is an associate or joint venture of the other entity or an associate or joint venture of a member of a group of which the other entity is a member.

– Both entities are joint ventures of the same third party.

– One entity is a joint venture of a third entity, and the other entity is an associate of the third entity.

– The entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity.

– The entity is controlled or jointly controlled by a person identified.

– A person identified has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity).

– The entity, or any member of a group of which it is a part, provides key management personnel services to the reporting entity or to the parent of the reporting entity.

In all cases, the substance of relationships between entities shall be taken into account and not merely the legal form.

With the above clarifications, borrowings from a related party will not be considered deductible for purposes of income tax calculation even if all other requisites are met and even if corresponding withholding taxes are remitted to the tax office.

Although it is easier to borrow from a related party, it comes at a price: not being able to deduct the corresponding interest expense for purposes of income tax calculation. Hence, taxpayers should carefully consider their options when the need to borrow arises. For all its requirements and scrutiny, perhaps borrowing from banks and other financial institutions is the smarter move compared to knocking on the door of a related party.

Source: Manila Times