The REIT Rat Race
Strategies in selling to a self-storage REIT

By Peter Jenkins

The developer hangs up the phone having just been in an exploratory dialogue with theCEO of a self-storage real-estate investment trust (REIT) that would like to purchase thediscussed facilities. The price alluded to was compelling but, wait a minute, just who arethese people? The owner built this storage portfolio into what it is today. If the offeris going to be explored further, he thinks, one is certainly going to look beyond theoffering numbers.

The scenario depicted above is now being replicated across America in all sectors ofreal estate as REITs, now a $160 billion equity industry according to the NationalAssociation of Real Estate Investment Trusts (NAREIT), scour the landscape for additionsto their portfolios. The reason for this persistent demand lies in the structure of aREIT.

Created by Congress in 1960, a REIT can be defined as a type of investment vehicle thatenables the general public to invest by owning shares in a securitized pool of real-estateassets. REITs are mandated to distribute 95 percent of their taxable income toshareholders in the form of dividend income if they wish to keep their REIT status. Inessence, both parties benefit as the REIT shareholder receives dividend income that is nottaxed at the corporate level, and the REIT augments a corporate tax deduction for thedividends paid to shareholders.

REITs prefer to grow in order to thrive while hopefully fueling stock appreciation, allunder the watchful eye of Wall Street and its willingness to provide further capital. Thelargest advantage that REITs have over a private owner/developer is their lower cost ofcapital brought forth by a REIT's sheer volume of properties and more diverse (sometimesby sector, often by geography) portfolios. Operating efficiencies should also be realizeddue to the number of properties held. Familiar self-storage REITs include Public Storage,Storage USA, Shurgard Storage Centers, Sovran Self Storage and Storage Trust Realty.

Why do REITs currently dominate the real-estate-acquisition landscape? If a property iscontributed to a REIT for stock or cash, the transaction is generally taxable. But, ifproperties are contributed to an operating partnership (OP) associated with a REIT foroperating partnership units (OP units), the transfer of ownership generally defers capitalgains taxation.

Talk the Talk

To better understand REITs, it's probably a good idea to learn "REIT lingo."An UPREIT, for example, is an acronym for an umbrella partnership REIT having nodirectional implication; contributing property owners exchange their portfolios forpartnership interests in an existing OP that owns the entire portfolio of real estate.Now, as limited partners, all contributing property owners fall under the same umbrellapartnership, each generally retaining the same rights and privileges. Property owners thatswap into the UPREIT can receive OP units, common stock of the UPREIT or cash. Since itsgenesis in 1992, this type of REIT has proven popular in its ability, if OP units areutilized, to defer the taxable gain on the contributed portfolio of property. UPREITs willhave built-in restrictions for OP-unit holders that are negotiated at the letter-of-intentstage.

Another mutation, DownREITs, exist to accomplish approximately the same thing asUPREITs. A traditional REIT does not have the ability to give OP units to a contributingproperty owner. Instead, the DownREIT structure allows for the creation of a newpartnership, formed for the selling property owner, and issues OP units in exchange forthe contributed properties.

Receiving huge media attention and recent Capitol Hill scrutiny is the Paired ShareREIT. Best utilized by any operating, intensive real-estate business, this REIT isstructured to both own the properties and operate the business within the properties.Congress shut down any further creation of this type of REIT in 1984, but grandfatheredthose already with this structure. Both the owner of the real estate and the operatingcompany trade as one publicly traded REIT share. The primary advantage of this structureis the elimination of the conflict of interest among shareholders that could arise fromleasing properties to a lessee owned by the management team. An additional concept appliedhere is the shutting down of "leakage," or the layer of profit that wouldnormally be realized by a separate company.

There are only a few active REITs with the Paired Share structure--such as StarwoodHotels & Resorts, Meditrust Corp., Patriot American Hospitality, Corporate PropertyInvestors (just acquired by retail REIT Simon DeBartolo), and First Union RealEstate--yet, Congress may soon intervene. Proposed legislation now before Congress wouldnot squash the special tax condition held by Paired Share REITs for existing holdings orassets tied up with a binding letter of intent (dated by March 26, 1998), but would limitfuture acquisitions utilizing this special tax design.

Paper-clip REITs are also beginning to creep into the picture. These are different froma Paired Share structure in that the REIT will lease a group of properties to a separatelymanaged and traded entity that the REIT management ultimately controls. This distinctmanagement company turns around and pays most of its own cash flow to the REIT as income.As this income flows over to the REIT's obligation to pay out their 95 percent as dividendincome, the REIT lessens its overall corporate tax obligation. As a side note, you maysoon see the Paired Share REITs examine whether to re-structure into a Paper-clip REIT ifboth houses of Congress pass the current bill that would limit the cherished tax statusafforded to the Paired Share REITs.

Lastly, publicly traded limited-liability companies (LLCs) have just come onto theradar screen and, according to attorneys Jim Wright and Bob Geis of Venable, Baetjer andHoward, are very similar to the REIT structure in scope and function. As this structure isstill evolving (there are currently only two publicly traded LLCs), many kinks have yet tobe worked out. However, Geis says that under the right circumstances, the publicly tradedLLC may be a good REIT substitute and could take the place of the Paired Share REIT.

Emperor's New Clothes?

A major facet to peruse is the REIT's management. Beyond the obvious individual tenureand experience characteristics, most solid management teams have been together for sometime. If a contributing property owner/developer still has the proverbial fire in hisbelly, hopefully there is room within the REIT management team or on the board ofdirectors. Insider ownership by management is a must, and an aggregate position of 5percent to 10 percent is palatable. Only time will ferret out whether the interests ofmanagement are aligned with its shareholders.

It would also be prudent to take a peek at the balance sheet of the REIT. An acceptabletarget on debt levels is debt/equity of around 40 percent or below. Please note that thereare great REITs with more than this 40 percent and not-so-great REITs with less. Alsoremember that the higher the dividend payout ratio a REIT is currently paying, the lessdry powder there is around for the ability to increase the dividend or to meet existingdividend obligations, especially in a rising interest-rate environment.

Rather than being surprised in the future, look to see if there has been a change incontrol in the recent past. While you are in the discovery mode, also look at the price ofa REIT to assess both its short- and long-term trend. Wall Street and institutionalinvestors have a swift and succinct way of voting their approval or disappointment withany REIT or non-REIT.

Deal Structure

In exchange for a real-estate portfolio, a REIT can offer any one or combination of thefollowing: cash, common stock or OP units. Since most owners of real estate hope tocontrol taxable gains, let's assume initially that the suitor is an UPREIT or DownREIT.

OP units, with proper tax planning, are generally non-taxable until conversion intostock (usually at a ratio of 1:1, except for dilution) or cash. OP units carry the sameweight as stock by usually throwing off the same amount of income, and are potentiallygiftable within the holding period, but ordinarily do not carry voting rights. The holderof OP units is normally frozen from selling for a negotiable 13 to 24 months. So, a holderof OP units can actually begin with the best of both worlds by being able to control thetax impact and garner cash flow off of the OP units during the interim. This scenario ishard to beat because, in essence, you are buying yourself time and flexibility while inmost cases receiving a more stable cash flow. The contributing property owner also will beexchanging a fixed set of assets, usually within a constrained geographic area for a moregeographically diverse portfolio.

Another benefit, though not to the actual holder of OP units, comes into play in estatesituations. OP units can transfer to your heirs at a stepped-up basis and generallyby-pass the taxable gains obligation normally encountered. Heirs will also have theflexibility to exercise the OP units at their own discretion and timing in whateverincrements desirable.

It should be noted that OP-unit values, not withstanding any prohibitive covenants, canbe protected by collaring and hedging techniques. Diversification may be accomplished insome cases without adverse tax effects by OP units being contributed to an exchange fund.If cash is needed, OP-unit holders may have the ability to borrow against their value.These three areas (protection, diversification, liquidity) should all be examined on acase-by-case basis along with OP-unit restrictions and the OP-unit holders personal taxsituation. The degree of possibility of these goals being accomplished is dependent on thesize of the REIT, the daily trading volume of a REIT's shares and the length of time thata REIT has been in existence.

Opting for common stock is still another way to go about selling a portfolio to a REIT.Although this will create an immediate taxable event, there are advantages to being handedequity shares. In addition to paying, in most cases, a nice dividend, voting rights areusually assigned to shares. While everyone hopes for additional price appreciation, commonshares are giftable whether they rise or drop in value. This plays in well to those ownersof private real-estate portfolios who desire to pass on a securitized legacy to theirheirs or don't have someone in the family interested in taking over the reins of thecompany.

If liquidity is a future goal, you may be restricted from selling the common shares foran initial time period (one to two years) and thereafter only during certain"windows" of time. The previously mentioned goals of value protection,diversification and liquidity can also be accomplished by stockholders with the samecaveats.

Cash is cash and plays a role in many REIT acquisitions in whole or part of the dealstructure. Either way, accepting cash for properties gives immediate realization oftaxable gain, but also circumvents exposure to REIT management miscues and to the marketrisk of the stock. With the net cash proceeds, almost any stock or property of interestbecomes a possibility. Maybe you could even build that house on the water you've alwaysdreamed about--just don't forget about the looming tax obligation to Uncle Sam.

Potholes and Snags

If one is willing to go into negotiations with a REIT, there are several areas that maybe scrutinized. Leverage will be as strong or weak as the degree of demand for a portfolioby the REIT world and the eagerness/passivity to sell. The price offered may be highenough and the deal structure flexible enough to concede on many other areas. Size andmanagement culture of the REIT may be an influence on the owner/developers negotiatingprowess. Regardless, here are a few to think about.

As an OP-unit holder, there will be many provisions in the partnership agreement. OPunits will have been chosen to delay the taxable gain while buying time flexibility. But,be careful, cautions Larry Katz, tax partner at the law firm of Piper & Marbury. It isimportant to negotiate certain protections in the partnership agreement with the REIT inorder to not have an acceleration of your taxable gain with respect to your OP units. Thiscan take the form of basis leakage, contributed property being sold or debt paid down.Avoidance of these possibilities is never 100 percent, but the REIT will normallycooperate with the OP-unit holder to an acceptable degree.

Again, when converting OP units to cash or stock, the OP may not have the dollars orregistered shares to give. According to Jerry Chalmers, partner and certified publicaccountant with Wolpoff & Company, to buffer this occurrence the owner/developer maybe able to negotiate a "protection of registration" mandating that the REIT filefor a secondary registration within a defined time period. A similar time constraint canbe applied mandating the REIT to tap a line of credit if cash is the goal of the OP unitholder. His partner at Wolpfoff, Jim Matheny, also suggests that if a closely held privatereal-estate company finds itself the aspiration of a REIT, it may be worth the time toexplore setting up a Family Limited Partnership before an engagement for the benefit offuture family generations.

Market and real-estate sector risk must also be mentioned as we all know that assetsclasses evolve through cycles. The good news about cycles is that, hey, they cycle. Thetough part is judging which part of the cycle you are in.

Also, never assume any company, REIT or non-REIT, is immune from the risk ofinsolvency. Although modern REITs share little resemblance of their 1960 to 1970sbrethren, it is always prudent to review the REIT management, balance sheet and incomestatement for financial acumen.

Panacea or Pain

There are many emotional and strategic variables to assess in the scenario ofcontemplating marriage into a REIT. Be prepared by doing your due diligence early in theprocess, not after the execution of the letter of intent. Surrounding yourself withcompetent legal, tax and investment advisory can prove beneficial as both legislative andmarket forces shift daily. REITs are still evolving into a burgeoning asset class anddeliver a viable platform for the investing public to participate in the real-estateindustry. To the self-storage owner/developer, REITs provide an attractive and pliableexit strategy.

Peter P. Jenkins is an investment advisor with BT Alex. Brown, where he providesinvestment solutions to the challenges of high net-worth individuals as well as privateand publicly held companies. Based in Baltimore, BT Alex. Brown combines the experience ofone of America's oldest investment banks with the global resources of Bankers Trust, acommercial banking pioneer in the capital markets. The firm provides single-sourcefinancing for growing and restructuring companies. He can be reached at (800) 521-3012, ore-mail: [email protected].