The Future of Disruption

By Alan M. Blecher |  Dean Boyer  |  November 22, 2019

Companies today are operating in an increasingly complex environment that is more dynamic and a lot less predictable due to several business disruptors. According to Clayton Christensen, a professor at Harvard Business School, disruptors displace an existing market, industry or technology and produce something new, more efficient and worthwhile.

These disruptors have escalated in recent years – from the recent landmark Supreme Court case South Dakota v. Wayfair, Inc., which upended established precedent and subjected businesses with interstate sales to greatly increased exposure to sales and use tax, to President Trump’s Tax Cuts and Jobs Act (TCJA), his 2017 “holiday present” to the country which was passed quickly and without much deliberation.

In this article, we focus on disruptors in three broad categories affecting the real estate industry:

1. demographic disruptors with the rise of Millennials and Generation Z;
2. technological disruptors such as geospatial analysis, the Internet of Things (IoT), mobile apps and blockchain; and
3. legislative and regulatory disruptors, specifically Internal Revenue Code (IRC) Section 163(j), and 2019 Federal Form 1065 and Schedule K-1.

Each of them, to varying degrees, has had a profound effect on investors, landlords and practitioners alike and has significantly shaped the market.

GENERATION Z AND MILLENNIALS – DEMOGRAPHIC DISRUPTORS

The Generation Z and Millennial age groups are having a significant impact on the current urban real estate market, as they enter the market as new tenants and seek more modest and “green” living arrangements. As this trend continues and grows, investors, developers, landlords, and real estate agents and marketers must understand the motivations of these young people to accommodate their needs.

So who are these demographic groups and what are they interested in? Generation Z consists of young people born between 1996-2010. With numbers in excess of 90 million, they make up more than a quarter of the U.S. population. Millennials, born between 1981-1996, number about 71 million people and comprise approximately 21% of the U.S. population. These young adults are graduating college, building their careers, getting married and starting families. Because of their numbers, they have an outsized influence on business and market trends.

The demands of Generation Z and Millennials regarding rental properties and amenities are different from those in older generations. They are first and foremost tech-savvy and rely heavily on the internet and social media, so powerful Wi-Fi networks included in rental properties will have an immense appeal to them. Landlords should market their rental properties online and have a website and social media accounts for their rental properties. They should also be mindful that many young people prefer emailing or texting to phone calls and expect quick responses to their questions or concerns. Generation Z and Millennials are frugal and environmentally conscious, and thus more amenable to living in micro-apartments (i.e., “tiny living”) as a more economical and eco-friendly option. These new tenants also value community, and communal spaces – such as recreation rooms, fitness centers, an outside barbecue or a swimming pool – will appeal to them as well. Because they are interested in minimizing environmental impact, they are attracted to green features of rental properties such as energy-efficient appliances and window panes, water-saving showerheads and solar panels.

Commercial landlords, too, need to keep Generation Z and Millennials in mind, as they are changing the way commercial real estate is marketed, leased and sold. An increasing number of landlords are including features in their commercial properties to attract companies with a youth-dominated workforce. Retail developers, for example, are looking to draw Generation Z and Millennials into urban mixed-use projects. Young urban professionals prefer to live near shops, restaurants, entertainment, public transportation, and their workplaces, and want to minimize their commuting time.

They prefer a smaller space near their job and social outlets rather than a larger apartment but with a longer commute. E-commerce has changed the way they shop, and retailers will need to rethink how they use their physical space to appeal to customers by offering a unique retail experience.

A good example of this is Hudson Yards, the newly opened large-scale real estate development in Manhattan that was designed to satisfy the needs of the Millennial demographic. This $20 billion project, developed by Related Hudson Yards, will include condos, apartments, offices, a school, a park, a hotel, a shopping center and a cultural event space when fully completed in 2024. This is an ideal arrangement for Millennials who want to live on one floor and work on another!

Generation Z and Millennials have unique wants and needs about where they live and have significantly impacted the real estate market and changed the way business is done. Their impact on the market is likely to continue for years to come, and landlords who can fulfill their needs will have an easier time attracting this significant and burgeoning group as tenants.

TECHNOLOGICAL DISRUPTORS

Rapid technological developments are disrupting traditional business models across many industries, including real estate. These disruptive technologies replace established technologies and have the potential to dramatically alter the face of an industry. In addition to creating inconvenience and frustration, a disruptive technology may also provide opportunities for those who use it effectively.

Four technologies are having a disruptive impact on the real estate rental market today:

1. geospatial analysis;

2. the Internet of Things (IoT);

3. mobile apps; and

4. blockchain.

Each of these may substantially influence the relationship between the lessor and the lessee.

• Geospatial analysis is an approach to applying statistical analysis and other informational techniques to data with a geographical or geospatial aspect; it organizes data in a manner that enables lessors to understand the performance of each rental unit based on location.

• IoT devices are embedded with sensors, software, network connectivity and electronics that enable them to collect and exchange data; they assist in controlling the operational cost of managing buildings based on occupancy.

• Mobile apps can target specific demographics, ensuring that you are reaching optimum markets.

• Blockchain (digital information, or the “block,” stored in a public database, or the “chain”) automates the rental process and lowers operational costs by eliminating the need for a middle man (e.g., a real estate agent). It allows users to send and receive cryptocurrency for rental transactions with minimal to no fees, expedites the rental and saves on commissions and fees charged by intermediaries.

In each of these examples, the deployment of technology has prompted a change in the business paradigm. Geospatial analytics is improving unit price performance based on location; the success of IoT devices is resulting in more smart buildings; mobile apps enable property managers to optimize marketing spend, and blockchain has the potential to lower costs.

Although these technologies have all delivered positive results, they may not always have a silver lining. Recent hacks impacting personal information are the result of deployed technologies that lack the controls and safeguards required to secure this information. Because of these violations affecting individuals’ rights, organizations are being held accountable for their use and deployment of technologies. New regulations and laws in themselves are disruptors in that they require the deployment of technology that enforces compliance.

Going forward, the biggest disruptor in real estate will be the impending change from process-centric to data-centric operations. This paradigm shift is going to force the industry to change how firms operate their businesses. Firms that embrace these changes and invest in a data strategy early on will be the long-term beneficiaries and will minimize the disruptions caused by new technologies and data.

SECTION 163(J) – WHAT HAVEN’T WE LEARNED?

What have we learned about the IRC Section 163(j) limitation on the deductibility of business interest expense, now that the 2018 filing season is over? That question is best answered with another question – what haven’t we learned?

Early in the year, the Treasury Department issued a voluminous and complex set of proposed regulations which, despite their length, left several key questions unanswered. For example, many real estate partnership structures are “tiered.” The property is held in one partnership, which is owned by another partnership, with perhaps other partnerships in the tier, before we get to the “ultimate” partners. Yet the entire issue of how to apply these byzantine rules in the tiered partnership context was left open. The proposed regulations contemplate only one-tier structures, in which the property is held in a partnership that is not owned by any other partnerships.

Another example: IRC Section 163(j) provides that a real estate business subject to the limitation can elect out (at the cost of a less favorable depreciation regime). The proposed regulations imply that a “small taxpayer” - not subject to the limitation - is not eligible to elect out since it is not subject to these rules, to begin with. But now assume that a partner in this small taxpayer partnership is itself subject to the limitation. Can the small taxpayer elect out? Can the upper-tier partner do so, even if it doesn’t hold the property directly?

Many practitioners believe (read: pray) that the next round of regulations will address these – and many other – open issues. During the winter of 2019, Treasury dropped some hints that such regulations would be issued by late summer. Therefore, the filing of many partnership tax returns – due September 15 – was delayed as long as possible, as well as individual tax returns due October 15. However, not only were these regulations not issued prior to those deadlines, but as we approach the holiday season, they have still not appeared. This lack of clear guidance forced many practitioners to make ad hoc decisions at the buzzer, regarding one of the most complex provisions of the Code.

Perhaps the only clarification that practitioners received in this area has to do with the $25 million gross receipts limitation for claiming small taxpayer status. There is an “aggregation rule” in which the gross receipts of certain “related” (by ownership) entities are combined in determining whether this threshold has been met. And if it is, none of the constituent entities is treated as a small taxpayer, even if one or more would otherwise qualify to stand alone. The aggregation rules under Section 163(j) – which are not to be confused with the aggregation rules for other Code sections – have brought even the most experienced practitioners to their knees. Treasury did tie up some loose ends here, although not until July, by providing clarification as to what rules apply when aggregating a group of entities that does not wholly consist of corporations, but also partnerships and sole proprietorships.

PROPOSED CHANGES IN DRAFT VERSIONS OF THE 2019 FEDERAL FORM 1065 AND SCHEDULE K-1

The IRS recently issued draft versions of the 2019 Federal Form 1065 (U.S. Return of Partnership

Income) and the Schedule K-1 (Partner’s Share of Income Deduction Credit, etc.). There are several significant changes aimed to enhance the quality, transparency and availability of the information reported by partnerships to the IRS and the partners of such business entities.

The intent of the new information being requested and many of the revisions is to assist the IRS in assessing compliance risk and identifying potential noncompliant filings. The changes also reflect updates that are consistent with the new tax provisions set forth in the TCJA. Among the proposed changes are several new questions requesting details for IRC Section 704(c) gain/loss property, guaranteed payments (for services or capital), whether a decrease in a partner’s share of profit, loss or capital was due to a sale or an exchange,  whether partnership liabilities include liabilities from a lower-tier entity and other questions asking if there is more than one activity for at-risk purposes (IRC Section 465) as well as for passive activity purposes (IRC Section 469). In addition, a checkbox is added that allows a taxpayer to indicate if certain groupings or aggregation elections have been made.

One of the more significant proposed changes is the requirement for partnerships to report tax basis capital account roll-forward to its partners (in Section L of Schedule K-1). You may recall for 2018 the tax basis capital account reporting disclosure was only required for those partners having a deficit balance at the beginning or end of the year.

The forms and related schedules are near completion, and we understand updated final versions will be released before the new year. In the meantime, partnerships should review their partnership agreements to ensure a partnership representative’s name is stated (to handle potential entity level audits) and further evaluate additional information and/or time needed to comply with these proposed new tax compliance reporting requirements.

FINAL THOUGHTS

As you can see, demographics, technology, legislation and regulation are causing disruption in the real estate marketplace with profound consequences. Investors, landlords and practitioners will ignore these developments at their peril. Let’s keep the discussion going.

About Alan M. Blecher

About Dean Boyer