C-Corp to REIT

What’s behind today’s conversion trend?

Real estate investment trusts have existed for more than 50 years and represent a large and growing sector in the commercial real estate industry. During the last two years, an unusually large number of C corporations have converted either themselves or one of their constituent businesses into REITs, or have announced an intention to do so. The financial press has widely reported on this trend. Less discussed are the merits of the conversion trend, particularly in light of the policy objectives that the REIT Act of 1960 sought to attain. Are today’s conversions consistent with these policy objectives?

Traditional and Nontraditional REITs

A REIT is an entity that holds real estate and potentially pays no federal income tax due to a deduction for dividends paid. An entity wishing to claim this significant tax benefit must primarily hold real estate assets and derive a large majority of its gross income from passive real estate-related activities. In addition, a REIT generally cannot retain earnings, but must distribute the majority of its taxable income.

REITs are well known for investing in the traditional four food groups of commercial real estate: retail, industrial, office, and multifamily. What has recently turned heads in the financial community is the mix of nontraditional asset classes now taking REIT clothing. There are timber and railroad REITs, but recent converts and candidates have included companies representing industries as diverse as data centers, billboards, document storage, prisons, cell phone towers, energy infrastructure and infrastructure finance, and waste management.

Two factors have combined to drive the recent REIT conversion trend. The most visible factor, and the one most frequently seized on by the media, has been permissive Internal Revenue Service rulings regarding what qualifies as a real estate asset for REIT purposes. But in reality, the IRS is strictly applying the letter of the REIT Act, whose definition of “real estate asset” (which includes, among other items, “land or improvements thereon”) is already quite broad.

The more important driver behind the trend is REITs’ access to the capital markets, particularly in the current low-interest-rate environment. Simply put, investor demand is driving the conversion trend, as REIT fund-raising figures can attest. In the first six months of 2013, publicly traded U.S. REITs raised $31.8 billion in equity, according to NAREIT, and in the first seven months of 2013, according to Stanger, non-exchange-traded REITs raised more than $10.6 billion in public equity. Because REITs must distribute most of their taxable income, their common equities typically pay a higher dividend than do other common equities. According to NAREIT, the aggregate dividend yield of the FTSE NAREIT U.S. All REITs Index as of July 31, 2013, was 4.26 percent, as compared to 2.08 percent for the S&P 500. Such REIT yields have proven tempting to investors facing a 10-year Treasury yield of 2.60 percent as of the same date.

Companies’ stock performance following the announcement of an intention to convert either themselves or a constituent business into a REIT demonstrates investors’ demand for yield. Companies have seen their stock appreciate significantly immediately following such an announcement. Conversely, when three REIT hopefuls disclosed a delay in the conversion process in June 2013, their shares on the next trading day fell 16 percent, 5.5 percent, and 4.2 percent, respectively, despite a broad market rally that day, according to the Wall Street Journal.

The cause of the delay was that the IRS had informed the conversion candidates that the IRS had formed a “working group” to study the definition of “real estate” for REIT purposes and whether any changes or refinements should be made to the definition. While undoubtedly a regulatory headwind, the IRS working group does not mean the end of holding nontraditional asset classes in REIT form, although it is possible that the issuance of the specific private letter rulings sought will be delayed.

REITs’ Public Policy Aims

Critics point out that because REITs pay no corporate-level federal income tax, the REIT conversion trend depletes the U.S. Treasury. In a narrow sense, this criticism is correct, because in the short term, REITs do cost the federal government a certain amount of money. This remains true even considering that under current law, REIT dividends are taxed at a higher rate than the dividends of a C corporation. However, this criticism ignores that the promoters of the REIT Act expressly anticipated that REITs would impact Treasury revenues. A revenue loss, in other words, is baked into the Act. In passing the Act, Congress was not narrowly focused on deficit reduction, but meant to expend government funds in order to promote broader policies — one economic and the other social.

The more economics-focused of the two policies that Congress expressed when it passed the REIT Act was to facilitate the raising of capital for urban renewal. Congress hoped the act would promote the financing of skyscrapers, shopping centers, and other real estate assets. Against the backdrop of the Cold War and the construction of the Eisenhower Interstate System, Congress wanted to ensure a modern physical environment for an affluent postwar society.

The U.S. federal government has often proved reluctant to fund public programs directly, preferring instead to enact tax incentives to urge the private sector to work toward the stated policy goal. With that in mind, the REIT Act, then as now, operates as a calculated subsidy to critical fixed assets. That the critical fixed assets now include data centers, cell phone towers, and renewable energy infrastructure does not attest to IRS laxity, but rather to technological innovation and the IRS’ strict adherence to the flexible legal standard that Congress adopted. In a way, the REIT industry can be seen as an agglomeration of private capital that builds out (or provides a secondary market for) the assets that Congress wants to see built, but has proven unwilling to fund directly.

The more socially oriented of the two policies that Congress expressed when it passed the REIT Act was to provide “reasonable machinery” whereby a “large number of small investors” could invest in real estate without incurring double taxation. Prior to the passage of the REIT Act, generally only the wealthy could invest in real estate using flow-through entities. The small investor had two choices: invest through an entity at a prohibitive cumulative tax rate, or forego the opportunity. This difference in tax treatment between large and small investors was not palatable to the 86th Congress, who had to answer to their middle-class constituents. (This was 1960, after all.)

If the first policy behind the REIT Act was pro-development, the second was essentially populist, and thematically consistent with the mutual fund statutes that Congress had already passed. It is worth noting that the REIT Act was designed to contain statutory safeguards against exploitation by personal holding companies. First, REITs must be held by at least 100 persons, and second, they must not be subject to greater than 50 percent ownership by any five or fewer individuals during the last half of their taxable year.

Despite the cost to the Treasury, it is a reasonable argument that shepherding private capital towards cell phone towers, data centers, and renewable energy infrastructure is a worthwhile policy goal, particularly if small (read: middle-class) investors are afforded a tax-efficient means of participating. Under this view, the REIT conversion trend appears consistent with what the drafters intended: private enterprise responding to incentives that Congress put in place to further legitimate economic and social policy goals.

Evan Hudson is an associate in the Corporate Department at Proskauer, with a focus on real estate securities. He advises sponsors on the formation and structuring of traded, nontraded, and private mortgage and equity REITs. Contact him at ehudson@proskauer.com.

Evan Hudson

The REIT Conversion Process Before making a REIT election, a company must determine whether its assets constitute real estate assets for REIT purposes, and whether its income constitutes good REIT income. Extensive restructuring, including the outsourcing of impermissible services to “taxable REIT subsidiaries,” may be necessary. If it holds nontraditional real estate assets, a company will likely need to apply for an Internal Revenue Service private-letter ruling. By the end of its first taxable year as a REIT, the company must distribute its non-REIT earnings and profits to stockholders. Following conversion, the company must monitor its compliance with strict REIT qualification tests. Obtaining and maintaining REIT qualification is a serious undertaking whose benefits and drawbacks are usually carefully evaluated by management. In fact, the sheer time and energy required to undertake a REIT conversion make the recent REIT conversion trend all the more noteworthy.