Dissecting the nuances of transacting with a REIT. Why invest? Why contribute or sell to a REIT? Why transition your real estate company into a REIT ecosystem? How can a REIT enable value creation in real estate ecosystems?
This article delves into the transformative role of Real Estate Investment Trusts (REITs) as seen through the lens of investors, developers, and operators. We will hone in on how REITs can unlock inherent opportunities across the real estate value chain.
Modeled after mutual funds, REITs started as investment vehicles that offer investors fractional ownership of real estate instead of having to commit exorbitant amounts of capital to one-off real estate investments. Over time, REITs have evolved into complex capital markets vehicles that can be difficult to understand and evaluate.
For developers, a Real Estate Investment Trust can become the north star for the evolution of their entire operation as they seek to capture a bigger part of the real estate value chain - from land to stabilized NOI and everything in between - and use the REIT as a takeout investment vehicle for their development properties. Through the asset contributions to the REIT, the developer can become a majority shareholder of such REIT, which allows developers to capture the second half of the value chain (rental cash flows and long-term appreciation in property value) and vertically integrate into real estate operations.
REITs are acquisition artilleries. Not only can operators own and manage real estate through REITs but also unlock M&A opportunities to expand their portfolios by both sectors and locations. REITs do not only provide access to more sophisticated and substantial M&A capital but also to liquid publicly traded stock.
It is common for REITs to use their shares to acquire properties. Property owners also prefer stock as it provides immediate liquidity (i.e. not having to wait months or in some cases, years to make the sale), the option to hold on to part of the shares to participate in long-term growth, and liquidity premium to private market valuations of their properties.
Furthermore, a carefully curated REIT M&A strategy will strike the perfect balance between managing an operator’s control rights (essentially ensuring that the operator maintains post-acquisitions majority holdings of the REIT), and NAV accretion (increasing the operator’s profits through acquisitions driven NAV growth).
Additionally, operators can create additional streams of cash flow by owning their real estate portfolios through a REIT, and by managing the REIT and its assets through an external advisor agreement.
A REIT is an investment vehicle that can operate as part of an ecosystem built to capture the entire real estate value chain: land acquisition, development, construction, sales and leasing, property management, capital markets, and M&A. The REIT is the centerpiece of this ecosystem, the imperative that enables the entire value chain:
REIT shareholders generally realize returns in two primary ways: through dividends and capital appreciation.
1. Dividends: As required by law, REITs distribute at least 90% of their taxable income to shareholders in the form of dividends. These dividends, often distributed quarterly, generate a steady income stream.
For example, Realty Income Corp (O), often called "The Monthly Dividend Company," is a prominent equity REIT that pays dividends every month.
2. Net Asset Value (NAV) Appreciation: The market value of a REIT can grow over time with the increase in the REIT's underlying real estate portfolio's NAV, or if the REIT's earnings grow - this results in share price growth.
For instance, American Tower Corporation (AMT) is an example of an equity REIT that has seen substantial share price appreciation over the years, driven by the growing demand for its telecommunications infrastructure.
Real estate assets can be sold (or contributed) to a REIT through several different structures. Traditionally, as is practiced in the private markets, where the property is sold for cash, you can expect the same from a REIT. However, in this case, sellers should not expect a REIT to offer a premium to the private market valuations of their property.
In a stock-for-property transaction, REITs generally offer a premium to private market valuations, as the public markets give REIT valuations a liquidity premium to the actual private market value of their portfolios, which REITs share with asset sellers (or contributors).
Additionally, a REIT may carve out specific rights in connection with the property, or add on certain performance milestones which vary from asset to asset and offer to offer - development rights, seller carry back, and phase-out acquisitions, to name a few.
IRS code section 721 exchange allows property owners to contribute their property to a REIT in exchange for Operating Partnership (OP) units without recognizing a taxable gain. This is known as an UPREIT (Umbrella Partnership REIT) transaction. In an UPREIT, the REIT is the general partner of the OP, and the remaining OP units are held by limited partners.
When a property owner contributes their asset to the OP, they receive OP units in return. OP Units are economically equivalent to and convertible into REIT shares. OP Units are often converted at a fixed conversion ratio or a valuation-based conversion ratio.
Sellers can also negotiate a hybrid structure, whereby the transaction consideration is payable partially in cash and partially in OP Units.
In some cases, asset contributions in a REIT can be partially or fully paid for in the form of preferred or common stock of the REIT. These transactions are generally more complex and require thorough due diligence of the REIT stock being offered, its features, rights, obligations, and marketability.
For example, in the case of common stock, it is important to evaluate, amongst various other considerations, its trading history (i.e. price and liquidity), trading restrictions, and exposure to possible dilution events in the future. Similarly, assessing the voting, conversion, and liquidation rights of preferred stock is critical.
A DownREIT is a variation of the UPREIT structure. Unlike an UPREIT where all properties are held in a single operating partnership, in a DownREIT, each property, or set of properties, contributed is held in a separate joint venture between the REIT and the contributor.
DownREIT structures are generally valued by property owners who believe their property will outperform the overall REIT portfolio. The performance of the limited partnership interests or DownREIT units that the contributor receives, is tied solely to the performance of the contributed property, rather than the overall REIT portfolio.
Both UPREITs and DownREITs offer benefits such as tax deferral of capital gains from sale of real estate.
REITs offer partial or full purchase of units in a DST against OP Units in a 721 exchange; an alternative tax deference solution to the 1031 exchange. This allows DST shareholders to hold onto their current portfolios in a partnership structure similar to that of a DST, and use the liquidity from the OP Units to expand their portfolios into multiple properties without having to exit a tax-efficient structure.
REITs can be daunting, especially when negotiating with them. Given CIEL has been on both sides of the table, real estate owner/developer and REIT sponsor and manager, we understand and appreciate the nuances.
The success of a transaction can be traced back to the onset of negotiations. Here, we have outlined certain fundamentals that will help guide your initial negotiations with a REIT as a developer or property owner, and your initial assessment of the viability of contributing your property to a REIT.
Generally, REITs offer the UpREIT structure to single-asset and portfolio owners and developers. However, before you give the transaction structure any consideration, you should identify what you want to achieve in transacting with a REIT: liquidity, access to capital, tax deference, price premium, or a captive investor audience, amongst other considerations. This will help you set the right expectations from the get-go.
With your objectives in stone, it will be easier to evaluate and negotiate offers from a REIT. Transacting with a REIT in stock entails becoming its shareholder, hence it is imperative to intimately understand potential REIT suitors before picking the final one.
To fully understand a REIT's proposition, a seller must conduct thorough due diligence on the REIT and its financial prospects. Public REITs’ current events, quarterly reports, and annual audited reports, amongst various other filings, can be accessed through the U.S. Securities and Exchange Commission EDGAR database.
When conducting your analysis, consider whether the REIT's strategy aligns with your investment thesis and risk tolerance. Review the Management's Discussion and Analysis sections of the REIT's annual report to assess its strategy and the depth of its management team’s experience and decision-making process. Study key fundamentals and financial metrics, such as the REIT's fund from operations (FFO), net asset value (NAV) performance, debt levels, occupancy rates, and share pricing and liquidity.
Additionally, conduct a thorough analysis of the REIT's capital stack, stock classes, and the quality of its portfolio assets and capital markets channels.
Finally, prepare a valuation model of the REIT. REIT valuation models can be prepared through three approaches:
Ideally, multiple valuation approaches should be deployed when analyzing the REIT's stock to understand whether the securities you are being offered are at par, overvalued, or undervalued.
Analyzing the nuances above will serve as the starting point for designing and negotiating a structure that meets your objectives, and informatively evaluate the considerations you have to make and the questions you have to answer for yourself and your advisors to chart the best path forward:
Private REITs are a tax and estate planning tool that private real estate sponsors use for deferring capital gain taxes and eliminating capital gains upon transfer of inheritance to family members, whereby the tax basis is stepped up at the time of such transfer to eliminate legacy capital gains. Additionally, private REITs can use certain securities laws exemptions to raise capital from institutional and accredited investors. Hence in the private REIT domain, the tax advantages are a big plus but you will have access to limited REIT capital channels unless you have a sizable portfolio or a preemptive capital raise strategy. Nonetheless, the sizable equity will still remain illiquid in a private REIT.
For smaller portfolios, organizing as a private Real Estate Investment Trust for tax benefits can still make sense, as long as you are willing to rely on traditional and REIT agnostic capital channels, such as asset-level financings.
The transition to a public reporting REIT i.e. a public non-traded REIT or a publicly traded one, entails a more nuanced analysis.
Generally, the going public transition can be viewed by a sponsor as going from operating and managing one company, to two companies: the existing operation, and the public company itself. Why is that?
Private companies are regulated by various state and federal laws and regulations. These laws and regulations only get more rigorous and complex for public companies, which are regulated by various authorities and agencies (such as Stock Exchanges, FINRA, and SEC), ones that generally do not regulate a private company. The additional level of regulation entails more scrutiny and responsibility. The added compliance, investor relations, corporate governance, finance, accounting, and reporting obligations require a team that is skilled in and dedicated to managing the "public layer" of the overall operation. It is costly, and time and resource extensive. You step into this world with both public non-traded, and publicly traded REITs. To understand the implications of going public in detail you can read more here.
Operating and managing public non-traded, and publicly traded REITs, requires an even more sophisticated understanding and practice of rules and regulations that specifically apply to Real Estate Investment Trusts. This article will provide you with a comprehensive understanding of these REIT-specific rules and regulations.
As you can well imagine, this added layer of complexity to the public business requires delicate handling of tactical and strategic decisions within the organization: acquisitions, divestments, reinvestment and distribution of profits, capital raise, the legal and financial structure of the organization, and tax planning - to name a few.
The journey of transitioning a privately held real estate company into a REIT requires meticulous planning, significant reorganization, and an unwavering commitment to navigating the complex regulatory landscape. Before you set out on this path, we can help you fully understand this challenging but substantial opportunity, the options you have, how you can create the best possible outcomes, and how to avoid unexpected surprises.
CIEL's Strategy and Corporate Finance experts help companies navigate the complex landscape of REITs and U.S. capital markets - from drafting and filing a registration statement or filing Form 1120-REIT, to setting up corporate governance practices, to raising capital and implementing M&A strategies.
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