The Riseand Complicationsof “the REIT Conversion”
A trend that began slowly several years ago has started to gain momentum. Increasingly, businesses with a substantial amount of real estate have been approaching the IRS for a private letter ruling, granting them permission to realign their businesses under a REIT structure.
The primary driver behind this is simple: demand is high in today’s economy for income-producing assets and, as a result, the market has shown REITs considerable preferential treatment because of their reliable income stream. Looking at the S&P 500, for example, REITs have outperformed the index for the last five years. Also consider that pension funds and endowments, which have historically contributed 5% to 7% of their capital to non-traditional assets, are now allotting closer to 7% to 10% to these investments.
In today’s business climate, where companies are considering all options for increasing value to their shareholders, many of those that own a significant amount of property are exploring the process of REIT conversion. And in almost every case where companies have converted their real estate holdings to REITs, the market has rewarded them for it. Indeed, where companies have looked to restructure as REITs, their stock prices have gotten a 20% to 35% bump merely on the announcement.
That said, converting to and operating a REIT is not just a matter of moving boxes on a piece of paper, it is a long process with significant tax and operational considerations. The process of getting a private letter ruling alone is highly involved, and recent cases of companies that have made the commitment to restructure have taken up to 18 months from start to finish. Those that do go down this road should view it as a long-term change, because the short-term benefits to company value will dissipate quickly if companies do not sufficiently plan for how to use this platform as a long-term growth vehicle.
The first challenge is determining whether or not the business owns a sufficient amount of real property that can generate rental income, since 75% of a REIT’s income must come from rent or interest. If this sounds straightforward enough, how the IRS defines “real property” is not always intuitive, which underscores the importance of private letter rulings, particularly in sectors where there are no or few examples of REIT conversion.
Also, the level of involvement required to operate the assets is another key factor, since the IRS is unlikely to approve a REIT structure in cases where asset operation is too much of an active business. Take, for example, cell tower operation versus toll road operation. Both structures are examples of real property, yet the level of involvement required to run them varies significantly.
This question has been a major hurdle for companies exploring REIT realignment in the energy sector. Transmission pipelines generally have a reasonable case, because their property, the pipeline, is used as a tool for another company or companies to transport a commodity. For solar farms, wind turbines and hydro plants, on the other hand, it is more difficult to prove whether or not these assets are rentable and how much operational involvement is required of the owner.
Among this class of non-traditional REITs, timber companies have been most successful in getting IRS approval, although cases of health care, cell tower operators and data storage companies pursuing REIT structures are also becoming increasingly common. Even utility companies are coming into the REIT space, although these have had varying degrees of success. But many asset types have not been ruled on and there will be limits to the IRS’ appetite for this trend.
Even with IRS approval, the list of considerations for REIT conversion is long and complex. Because of the rental income requirement, all other forms of company revenue are considered bad income under the REIT structure. If these other streams comprise more than 25% of total income, they have to be separated from the taxable REIT structure. This is why many companies with significant real estate assets will often consider a REIT structure as part of their overall business versus doing a complete conversion.
Also, operating as a REIT requires relinquishing certain controls, because REITs cannot control or own the tenants leasing from them. Businesses, therefore, have to weigh how they plan to use their real estate assets going forward and whether they are willing and able to and willing to part with these controls.
From the financial standpoint, NOLs are a critical issue in REIT realignment. Because REITs have to distribute 90% of their taxable income, a business with high NOLs would most likely have to hold off on a conversion until it had burned through them. How intangibles are treated must also be weighed, since they add value to a company but not necessarily to the real estate.
If the considerations and hurdles for REIT conversion appear daunting, the number of firms that are charging ahead with the process suggests that many feel the benefits outweigh them. In addition to a share-price bump, realigning under a REIT structure can offer a significant advantage over non-REIT competitors, because REITs’ cost of capital is generally lower.
For these reasons, and because there are other asset types that have not even come into the fold, the prevalence of non-traditional REITs will likely accelerate further.
Howard Roth is the global real estate leader for Ernst & Young and a partner in E&Y’s real estate practice. Views expressed here are those of the author and not necessarily that of E&Y or ALM.
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