The Little Growth Engine That Could
Non-traditional commercial real estate (CRE) REIT structures
Posted by Surabhi Sheth, Real Estate research leader, Deloitte Services LP, on June 18, 2013
What makes real estate investment trusts (REIT) so appealing?
There are likely several factors: for instance, higher valuations, a single level of taxation, and easier access to low-cost capital are some of the benefits that attract retail, office, industrial, multifamily, hotel, and healthcare property owners. More importantly, investors may regard REITs as an additional asset class that provides portfolio diversification opportunities, with returns moderately correlated to the S&P 500. Given these factors, it’s not surprising that other real estate owners have begun to capitalize on the inherent benefits of this structure.
Over the past few years there has been a surge in REITs or intended REITs whose businesses are outside the historical categories: data centers, document storage facilities, cell towers, prisons, and billboard REITs. These REITs, commonly termed as “non-traditional,” can provide diversification options to investors within the real estate sector. In fact, non-traditional REITs have posted better returns than their C-corporation peers and traditional REITs over the past 10 years!
Non-traditional REITs are viewed as attractive ownership structures among some sectors. A REIT conversion, however, is a complex process that requires strategic, financial, and operational restructuring to comply with regulations and one that a company should assess before deciding whether or not to convert.
Recently, several companies that are in the process of REIT conversion publicly announced that the IRS has formed an internal working group to study the current legal standards the IRS uses to define “real estate” for purposes of the REIT and other provisions of the tax code, and what changes or refinements, if any, should be made to the current legal standards.
As of this writing, the IRS has not changed its position on what constitutes real estate for REIT purposes. In fact, the IRS has been very consistent in its application of the law in recent conversion ruling requests. While certain asset classes in recent ruling requests may be considered non-traditional, those assets have met the historical REIT standards. The standards themselves have not changed. IRS officials have expressed concern that the REIT standards may not be the same as have generally been applied for other tax purposes, such as depreciation. A company electing REIT status may find itself having to reclassify as real property various assets it previously depreciated as personal property. It is unlikely that the IRS will provide a definitive response to private letter ruling requests until the working group concludes its study.
That said, a non-traditional CRE owner considering a REIT conversion would likely benefit from having a clear understanding of the entire process. One of the prime questions to consider is: Can an entity be restructured by placing non-real estate operations into subsidiaries or would it be necessary to spin off the real estate from the operations? A conversion requires several strategic and tactical considerations (predominantly revolving around growth and financial and operational re-engineering) given the complexity of REIT regulations. An informed decision is critical to a REIT conversion.
In the same vein, a company should consider the impact of REIT regulations on its ongoing business and long-term strategy. For example, REITs need to comply with asset and income tests: a minimum percentage of assets have to be invested in qualifying assets and a minimum percentage of income has to be generated from qualifying assets.
In light of this, some questions to consider include:
- Does the existing business model and structure conform to REIT qualification guidelines?
- What are potential changes a company will be required to make to its organizational structure?
- Does the conversion align with the long-term strategy of the company?
Moreover, REITs are required to pay a regular minimum dividend and meet dividend distribution requirements to maintain REIT status and derive tax benefits. A potential convert needs to carefully assess the impact of the REIT distribution requirements on its financial structure. The existing capital structure, expected cash flows, future access to capital, and the proportion and form of dividend distribution should be gauged to determine any funding gap.
Given the above considerations, a company should consider the following parameters:
- Does it have sufficient liquidity to pay out the accumulated earnings and profits (E&P) and minimum dividend required to qualify and maintain a REIT status, respectively?
- What are the various forms in which a REIT can pay dividends?
- What alternative finance mechanisms may be used to enhance liquidity so that a REIT can sustain its status?
Also, the regulatory requirements of a REIT structure tend to require operational restructuring. Before proceeding, a company should consider the following:
- Has it done sufficient tax due diligence?
- Does it have appropriate infrastructure in place to monitor ongoing reporting and compliance requirements?
- Does it have a change management plan?
Apart from the above, a company should assess the time required for a conversion, which can take at least 18-24 months following a board approval to restructure and convert to a REIT. If the due diligence implies that benefits will outweigh costs and result in short- and long-term value creation, only then might a REIT conversion make economic sense.
Is your institution investing in REITS? Is it part of your future strategy? Interested in reading more? The full report on the key considerations prior to a REIT conversion decision – Non-traditional CRE: Capitalizing on the REIT Opportunity – can be accessed here.