Our 2022 Real Estate and Hospitality event, featuring a panel with Douglas Dreher, CEO of The Hotel Group – Hotel Equities and Kevin Wallace, President of Wallace Properties, was held on November 8. This event featured a discussion with panelists on finance considerations during times of change and top challenges and opportunities facing the industry, along with an update from the Clark Nuber team on topics including the new lease accounting standard, cybersecurity, and several tax updates. Clark Nuber Shareholder Amber Busch and Principals Christie Streit, Katy Al-Khalidi, and Steve Vasconcellos provided valuable insight and facilitation for this year’s event. Here are the key takeaways from the event:
Challenges & Opportunities in Times of Change
Currently, multiples and values are based on lower interest rates, fundamentals have not adjusted, and there is a greater need for equity. Should we expect this to be the new normal? There are many factors to consider when evaluating the current challenges of the hospitality and real estate sectors, especially in obtaining new hotel loans. Financing cost for new hotels has nearly doubled compared to last year, and trends show the hotel industry often attempts to build at unsuitable times.
While these increasing financing costs may cause slowdowns in new builds, this could still be a positive change for current supply. Overall, there are signs of significant ADR growth. In the future, it is estimated that core office markets will shift to have spaces filled by in-person heavy companies, like biotech and life science organizations, that require more advanced, technology-focused buildings. However, this may cause old office space concepts to struggle in keeping up with new feature demands.
This evolving model highlights the pros and cons of new builds versus acquisitions. With new builds, the latest and greatest in technology and infrastructure can be applied, and there is often less competition from out-of-town developers who want a quick deal. However, building costs can be higher and take longer due to government-regulated permitting and navigating coding restrictions. With acquisition, there is less financial risk to consider, but not as much flexibility in building customization.
Lenders are sitting on significant funds, and for the developers that require these funds to complete deals and keep projects moving, the market needs to come to an equilibrium on rates.
Current Challenges & Opportunities
Additional pain points impacting the real estate and hospitality industry are labor and government regulation. Some organizations believe immigration reform is needed, as current demographics are making hiring and retention extremely challenging. Sufficient labor supply was becoming increasingly challenging before COVID-19 but has since become a top concern coming out of the pandemic for all industries. These organizations are now needing to find creative ways to bridge gaps in workforce demands.
Further, government regulation surrounding environmental sustainability poses more challenges in operating and developing within the real estate and hospitality industries. While there is a push for aggressive carbon footprint reduction in Washington state that requires moving away from coal and natural gas use, there is not a supporting increase in available and reasonably priced clean energy replacements. Demand for electricity is only going to increase with the move away from natural gases.
With the need to address these current challenges, there is opportunity for greater engagement and collaboration between cities and major companies in creatively resolving key issues impacting communities. Companies have the agency to proactively create resolutions for any negative impacts they expect to have on a community. For example, Amazon is working to help plan and develop infrastructure for transportation and human services in response to the Company’s impact on population density.
ASC 842 Lease Accounting
ASC 842 is replacing the previous ASC 840 as the new standard for generally accepted accounting principles (GAAP) leasing. Lessees will see the biggest changes with this advancement, as nearly all leases lasting longer than 12 months (with few exceptions) will now be capitalized onto the balance sheet as Right of Use (ROU) assets and lease liabilities. There will also be many additional disclosures required. Lessors will see fewer changes, with the largest being the additional required disclosures.
Lessees should review debt covenants to ensure they still comply after adding the lease assets and liabilities. A few recommended next steps include:
- Inventory all leases, including contracts that have embedded leases
- Create lease abstracts of key terms for each contract to facilitate data input into an accounting system
- Select an accounting system (Excel or off-the-shelf, such as LeaseCrunch)
- Define a bookkeeping method (monthly entries versus year-end closing entry)
- Coordinate a plan with your audit firm
With the growth of hybrid and remote workspaces, there has been an increase in need for closer security in online platforms.
Social engineering remains the biggest threat to cybersecurity. Methods include:
Business email compromise:
An attacker sends a malicious email impersonating someone with authority in an organization. These attacks have evolved from simple emails to even remote Zoom meeting invitations. With these advanced forms, attackers may use chat, deep fake audio, or possibly video impersonation to extract information.
IT Help Desk impersonation:
An attacker pretends to be a member of IT helpdesk with the goal of gaining remote access to a laptop. Since employees are familiar with receiving remote assistance from helpdesk members on their computers, attackers will prey on this trust.
Entry points into an organization’s network and systems via cyberattack can result in ransomware and extortion. Ransomware is when an attacker encrypts data in a system, such as a database, making the data unreadable and unusable. The encryption key is exchanged for a ransom payment. Many organizations unfortunately believe that recovering the database from a replica will solve all problems. However, without proper due diligence, it is nearly impossible to know the extent of an attack. When live databases are encrypted, data typically cannot be processed, read, or used in real time, resulting in direct impacts on business performance.
The most effective way to address security risks is to implement a formal security program with proper governance and management. There should be a process to ensure security accountability along with the adoption of an industry framework. This means having someone accountable for security and the adoption of an industry framework. Such security frameworks include:
- AICPA SOC 2
- ISO 27001
Additionally, everyone within an organization should be conscious of the behavior used in managing data. Security training must go beyond helping users identify attack patterns and methods through which data can be compromised. Users should be trained to report any threat or attack based on the organization’s defined incident management and response plan.
Organizations should also actively “hunt” for system vulnerabilities that enable a successful attack. Performing vulnerability scans are good first steps, but the next step should be performing a penetration test. Penetration tests enable ethical hackers to simulate real-world attacks, such as the use of phishing and social engineering to actively gain access to systems. Only testing defense will prove whether defense works.
Finally, it is imperative to share information on security breaches to prevent future events. A one-off attack has the potential to reveal patterns, such as a national security threat. Reporting breaches to the authorities, such as the FBI, will help identify relevant resources and plans to remediate. Most states do have disclosure laws that require organizations to report these breaches.
Business Interest Deduction Limitation
Starting in 2022, depreciation and amortization cannot be added back for purpose of the business interest limitation calculation. This will result in many more companies being impacted by interest limitations. Speaking with a designated CPA regarding pros and cons should be your first course of action if limitations have not yet been elected out for 2022.
After 2022, bonus depreciation will decrease to 80%. Thereafter, an additional 20% decrease will occur each year until eliminated in total. It is recommended that the 100% bonus rules are taken advantage of in 2022 by placing in service qualifying additions.
CPAs should analyze improvements to determine if they would qualify as repairs and maintenance for tax purposes under the tangible property regulations. Further steps include reviewing fixed asset listings to dispose of any assets that are no longer held.
Opportunity Zone Reminders
- Any deferred gain from the initial investment in an Opportunity Zone Fund must be brought into income in 2026.
- Opportunity Zone Fund investments should be made by the person or entity with a gain to defer so that it will be a qualified investment for purposes of the 10-year hold rules.
- Ensure that the proper disclosure forms are filed each year. Working with a knowledgeable CPA will result in best practices.
Amended Partnership Returns
Unless the centralized partnership audit regime (CPAR) is specifically elected out of, an amended partnership return will be unavailable for filing. Instead, an Administrative Adjustment Request (AAR) would need to be filed. It is recommended to elect out of CPAR if eligible. Extending partnership returns is also recommended, even if the filing 3/15 date is expected to be met. In the case there are necessary changes after the 3/15 filing date, there will be the opportunity to make corrections before the extended due date.
Deductibility of Losses
Rules relating to Excess Business Losses have been made permanent and may limit the ability to deduct losses in the year they are incurred. Any excess business losses will be treated as net operating losses (NOL) in the subsequent year and will be subject to the NOL limitation of 80% of taxable income.
Please reach out to Clark Nuber if you have any questions relating to these real estate, lease, security, and/or tax changes.
Shelley Oswald is a senior manager in Clark Nuber’s Audit and Assurance Services Group.
© Clark Nuber PS, 2022. All Rights Reserved.