Real Estate Against the Ropes: Sector Braces for Barrage of Taxes
Out of all the economic sectors going through tough times as a result of Puerto Rico’s ongoing, 10-year economic recession, the real-estate industry, and especially the residential segment, has been among the most battered. A perfect storm of stagnant economic activity, plummeting property prices, population decline and the onset of seemingly never-ending taxes by the commonwealth government have taken a once-thriving segment to the ground and is barely scraping by.
In addition, the global financial meltdown prompted by the housing-market bubble in 2008 exacerbated matters on the island. Before the housing bubble on the island—during which developers built a glut of medium-high to high-end properties and took advantage of several taxpayer-funded incentives—median home prices on the island skyrocketed to $220,000, beyond the reach of most potential buyers. In turn, this created a mismatch in the local market, as it now stands, in terms of supply and demand for accessibly priced residences.
And while the oft-repeated refrain that the current environment is “perfect” for buyers holds true for the most part, the dynamic is altogether different for those on the other side of the equation: the sellers and people who already own homes.
Case in point: A for-sale sign has stood in front of a house in Caparra Heights, a community in San Juan, for more than a year. The seller, who asked that her name be withheld, has tried to sell the home ever since her mother-in-law passed away in April 2015, eventually giving the house a thorough paint job and listing the property on various online platforms, but to no avail.
On paper, the property looks like a no-brainer: almost 2,000 square feet in total, with three bedrooms, two bathrooms and a big patio. Location-wise, it sits in a centralized area of San Juan with easy access to main thoroughfares such as Roosevelt Avenue and De Diego Expressway. An independent appraiser recently estimated the property to be worth $148,000. Although many potential buyers visited the house and liked it, the process never went further.
That is, until last week, when a married couple appeared with a pre-approved mortgage of $110,000. The pre-approval constituted almost a minor miracle in the current economic landscape, in which banks, stung for years by high levels of delinquency and bulging portfolios of repossessed properties, have significantly tightened their requirements for prospective borrowers.
Despite the pre-approval being an amount significantly below appraisal, the seller jumped at the chance; preliminary paperwork on the purchase is ongoing as of this writing.
As it turns out, the aforementioned case is among the lucky few. For one thing, the Caparra homeowner had already paid off the mortgage, a fact that unfortunately does not apply to thousands of other residences currently for sale. With the ongoing island recession, which first reared its ugly head in 2006, many homeowners have found themselves unable to pay their monthly mortgage payments on time, and some have resorted to selling their homes.
Unfortunately, selling a property under current market conditions is easier said than done, with the average time it takes to sell a residence exceeding 12 months, Vanessa Rivera, president of the Puerto Rico Association of Realtors (PRAR), told Caribbean Business.
Drop in housing sales; increase in repossessions
A statistical snapshot from the Financial Institutions Commissioner’s Office (OCIF by its Spanish acronym) tells the story. During the first two months of 2016, total housing sales dropped by 5.8%, swept away by a downright plunge in new-housing sales (-16.4%), while sales of existing homes went down by 3.9% during the same period.
Meanwhile, the average price of a new home in Puerto Rico was $153,442, which was 10.3% less than February of the previous year. On the other hand, the average price for an existing home fell by 3.7% to settle at $144,218.
Moreover, due to the massive outmigration to the U.S. mainland that Puerto Rico has experienced in recent years, about 22% of the housing units on the island remain vacant.
When it comes to homeowners who are eager to sell their properties and are in arrears with their mortgage payments, the possibilities of selling before the bank forecloses are becoming increasingly unlikely.
Among the indications are OCIF numbers regarding foreclosed residences, as well as those in the process of execution (for eviction, foreclosure or repossession), which are staggering. In 2015, a record-breaking total of 4,459 residential properties were repossessed by banks, according to the data. This total, which represents more than $648.4 million in overall value, is the highest ever registered in Puerto Rico in terms of foreclosures, and represents a 21.2% increase compared with 2014. By comparison, repossessed properties in 2008 were about half of 2015’s, totaling 2,357 residences.
An important factor driving up foreclosures is the increasing number of young professionals leaving the island, plus households wherein one or both income earners have been laid off or seen their salaries reduced.
What’s worse, all signs point to 2016 breaking the record once again. During the first two months of this year, there have been 707 registered foreclosures, establishing a worrying precedent, especially since by comparison the first two months of 2015 saw 637 foreclosures. “We expect total foreclosures during 2016 to increase by about 300 units, at least,” said Eduardo Santos, president-elect of PRAR.
This in turn has prompted another distressing dynamic in the local banking sector. No matter how hard banks are trying to sell off properties on one end—mainly by selling portfolios of toxic assets to investment funds—more repossessed properties are entering their portfolios on the other end. And even though financial institutions are trying to hold off repossessions as long as possible, primarily through loss-mitigation procedures, the foreclosures keep coming with no end in sight. “It’s like a boat with a hole in it; it doesn’t matter how much water you get out,” Santos noted.
Tax increases hurting the industry
Many of the issues affecting the real-estate industry—and other economic sectors, for that matter—can only be effectively addressed in the long-term and would lead to a protracted recovery. Despite this, one of the most salient factors ailing the real-estate segment in particular can be immediately remedied, namely government taxation, various industry players said.
Specifically, the burden of an 11.5% sales & use tax (IVU by its Spanish acronym), which was increased from its previous 7% rate last July, and a 4% business-to-business (B2B) tax that was implemented in October, have delivered yet another knockout blow to the sector, and has made matters more difficult for sellers and buyers alike.
“Anytime you start taxing services, it will always have a negative impact on the housing market, especially when you consider that the market in Puerto Rico is on a steady decline,” said Michael Ford, vice president of the National Association of Realtors (NAR). “Property values are down and foreclosure rates are climbing; that tax will just continue to cause that to happen.”
PRAR’s Rivera said the increased IVU and the new B2B tax have had a noxious effect on the sector. “With the current tax scheme, a home purchase averaging $200,000 is entailing an additional $1,500 in professional services related to the transaction; that’s on top of the closing costs involved in a purchase, which are already substantial,” she said, citing a study that Lawrence Yun, chief economist & senior vice president of research at NAR, recently carried out on the Puerto Rico market.
The B2B tax in particular has increased the cost of several services in the sales chain—such as appraisals, land surveys and credit—in turn adding to the total cost for the customer, Rivera noted. To this, Santos added, “In my experience as a Realtor, a lot of home purchases have broken down because the buyer has to pay an additional $500; imagine what an average increase of $1,500 is having on the market.”
The increase in closing costs is even higher when it comes to the 203(k) Rehab Mortgage Insurance Program, one of the most oft-used programs by the U.S. Department of Housing & Urban Development on the island. “Because the number of repossessed properties in Puerto Rico is so astronomical, a lot of these properties require improvements,” Santos explained. “While the $1,500 increase applies to conventional FHA [Federal Housing Administration] loans, in the case of 203(k), it represents an increase of $1,700.”
To top things off, the government plans to carry out more changes to the tax system, starting with a phase-out of the IVU in favor of a value-added tax (VAT or IVA by its Spanish acronym), also of 11.5%. An even larger concern exists for the planned increase of the 4% B2B tax to 10.5%. While the changes were originally scheduled for April 1, the Puerto Rico Treasury Department has postponed the implementation to June 1.
“As far as the real-estate segment is concerned, the move just prolonged the industry’s life by 60 days,” Rivera said. “If such an increase goes into effect, it will effectively leave the industry completely adrift.” Apart from the effect that an increased B2B tax would have, she warned that the implementation of the VAT alone would represent a loss of about $126 million for the economy and the “imminent stagnation of housing inventory.”
Help on the way?
This precarious dynamic has led the industry to champion recently filed legislation, House Bill 2872, that would provide some much-needed breathing room. In mid-April, Rep. Ángel Matos and Jenniffer González—from the Popular Democratic Party (PDP) and New Progressive Party (NPP), respectively—presented HB 2872 to amend sections 4110.01 and 4120.03 of the Puerto Rico Internal Revenue Code to exclude the IVU, VAT and B2B taxes from all services related to real-estate brokerage, whether residential, commercial or industrial. PDP Reps. Narden Jaime and Luis Vega Ramos also co-authored the bill.
When asked what prompted the legislators to present the bipartisan bill, Matos responded. “We realize the need for government to attract revenues, but citizens’ ability to buy a home must be protected,” he said.
“The real-estate industry in Puerto Rico is at its lowest point in a long time,” noted González, who is the House Minority Leader and a resident commissioner pre-candidate for the NPP. “In the past six years, the number of foreclosed properties has quickly risen to about 21,000 units. Just last year, about 3,600 to 4,000 families had to hand their homes over to the bank.”
“The fact that the VAT will apply to certain real-estate transactions will have the effect of increasing the crisis in this important segment of the Puerto Rican economy,” she added.
“If this tax increase goes into effect, you are just continuing to make it more difficult for sellers to sell their homes if they’re already upside down on their mortgages,” said NAR’s Ford. “You are also going to make it more difficult for buyers to purchase homes because the longer this tax exists, it means housing prices are also going to increase to cover this—because it’s a cost the seller has to incur—so every time you raise the price, you just knock a few more people out of their ability to purchase a home.”
When asked if he had seen anything as onerous as the island’s tax system in the U.S. mainland, Ford responded, “In my close to 40 years in the industry, no, I’ve never seen anything like this. There are precedents in the states in which sales taxes and services have had a very negative impact on the housing market. Nowadays, there are very few states and municipalities in the U.S. that charge a sales tax on professional services. The state of Florida, for example did pass a sales tax on services back in the 1980s, but it was very quickly repealed, and now Florida has one of the fastest-growing job creations in the entire country.”
The Yun study at NAR also found that in Puerto Rico, every property sold at a price of $200,000, generates around $35,000 in additional economic activity, mostly from improvements and maintenance projects on the household and the purchase of furniture and home equipment such as air conditioners and water heaters.
“There’s a lot of economic activity that isn’t captured if the property isn’t sold,” Santos said. “The study also found that the tax hike would leave around 3,600 additional families out of being able to buy homes. If you multiply that amount, you would get $128 million that the [local] economy isn’t receiving and the government can’t tax.”
Commercial real estate also suffering blows
When it comes to commercial real estate, and specifically the government’s push to lure offshore investors through incentives such as Acts 20 and 22 of 2012, the onset of new taxes has given some investors pause, said Agnes Rivera, past president of the Certified Commercial Investment Members (CCIM), Puerto Rico Chapter. “Plenty of investors have come because they were promised they wouldn’t pay taxes, but now they have seen they are being charged through other means, such as the tax on professional services, and as a result, some have pulled back on planned investments,” she noted.
The change was seen immediately after the sales-tax hike and B2B were implemented, she added. “A lot of commercial brokers had clients who had optioned various properties, only for the sale to crash during the closing process. This has happened a lot with retail chains that originally planned to open a certain number of stores throughout the island and had the expansions already budgeted, only to see the rules of the game change overnight,” Rivera said. “This prompted them to basically keep still, and meanwhile, for all the stores that haven’t opened, it means hundreds of jobs that aren’t being created and millions in economic activity that isn’t being generated.”
Time running out
Contrary to what some may think, by and large, the public should be aware of the challenges that the real-estate sector is facing on the island. For instance, evidence of the struggling sector is readily visible in the plethora of “for sale” signs throughout residential neighborhoods and the abundance of abandoned properties.
With this in mind, perhaps it is not surprising that a recent PRAR survey carried out with 800 random people found that a whopping 91% believe it is more difficult to sell a residence nowadays compared with a year ago. By the same token, 90% answered that the real-estate sector is either “important” or “very important” for the island’s economy.
Such opinions underline the urgency with which the sector regards HB 2872 in terms of stemming the tide on an already swamped industry. However, time is running out in this regard, with only weeks left to go before the current legislative session ends on June 25.
“We aren’t asking for a special privilege,” said the CCIM’s Rivera. “We are just asking for things to go back to the status quo, which was already a challenging scenario. The elimination of these taxes wouldn’t mean less revenue for the government; instead, it would stimulate the economy and generate more tax revenues in the long run.”
PRAR’s Rivera added, “The elimination of the VAT and B2B on real estate will create a positive psychological effect among the population that will go a long way toward turning the island’s economy around. In times like these, we need all the good news we can get.”