The Tax Reform Act of 1986 radically changed the real estate investment landscape in two important ways. First, the Act drastically reduced the potential for real estate investment to generate tax shelter opportunities. It did so by limiting the deductibility of interest, lengthening depreciation periods and restricting the use of “passive losses.” This meant that real estate investment had to be economic and income-oriented.
Second, as part of the Act, Congress empowered REITs. The Act permitted REITs not only to own, but also to operate and manage, most types of income-producing commercial properties. They could do so by providing “customary” services associated with real estate ownership. Finally, for most types of real estate (other than hotels, health care facilities and some other activities that require a higher degree of personal services relative to rent), the economic interests of the REIT’s owners could be merged with those of the REIT’s operators and managers.
Even with these changes, REITs did not flourish right away. During the late 1980s, banks, insurance companies and pension funds kept up a fast pace of real estate financing. Foreign investment, particularly from Japan, also helped buoy the marketplace. But by 1990, the combined impact of the savings and loan crisis, the Tax Reform Act of 1986, overbuilding during the 1980s and regulatory pressures on bank and insurance leaders, led to a depression in the real estate industry. During the early 1990s, commercial property values dropped between 30 and 50 percent. Credit and capital for commercial real estate became largely unavailable.
Against this backdrop, many private real estate companies decided that the best and most efficient way to access capital was through the public marketplace using REITs. At the same time, many investors decided that it was a good time to invest in commercial real estate on terms favorable to them. After all, they believed recovering real estate markets were just over the horizon. They were right.