Talk the Talk

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 the CEO of a self-storage real-estate investment trust (REIT) that would like to purchase the discussed facilities. The price alluded to was compelling but, wait a minute, just who are these people? The owner built this storage portfolio into what it is today. If the offer is going to be explored further, he thinks, one is certainly going to look beyond the offering numbers.

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

Created by Congress in 1960, a REIT can be defined as a type of investment vehicle that enables the general public to invest by owning shares in a securitized pool of real-estate assets. REITs are mandated to distribute 95 percent of their taxable income to shareholders in the form of dividend income if they wish to keep their REIT status. In essence, both parties benefit as the REIT shareholder receives dividend income that is not taxed at the corporate level, and the REIT augments a corporate tax deduction for the dividends paid to shareholders.

REITs prefer to grow in order to thrive while hopefully fueling stock appreciation, all under the watchful eye of Wall Street and its willingness to provide further capital. The largest advantage that REITs have over a private owner/developer is their lower cost of capital brought forth by a REIT's sheer volume of properties and more diverse (sometimes by sector, often by geography) portfolios. Operating efficiencies should also be realized due 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 is contributed to a REIT for stock or cash, the transaction is generally taxable. But, if properties are contributed to an operating partnership (OP) associated with a REIT for operating partnership units (OP units), the transfer of ownership generally defers capital gains 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 no directional implication; contributing property owners exchange their portfolios for partnership 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 umbrella partnership, each generally retaining the same rights and privileges. Property owners that swap into the UPREIT can receive OP units, common stock of the UPREIT or cash. Since its genesis in 1992, this type of REIT has proven popular in its ability, if OP units are utilized, to defer the taxable gain on the contributed portfolio of property. UPREITs will have built-in restrictions for OP-unit holders that are negotiated at the letter-of-intent stage.

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

Receiving huge media attention and recent Capitol Hill scrutiny is the Paired Share REIT. Best utilized by any operating, intensive real-estate business, this REIT is structured 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 grandfathered those already with this structure. Both the owner of the real estate and the operating company trade as one publicly traded REIT share. The primary advantage of this structure is the elimination of the conflict of interest among shareholders that could arise from leasing properties to a lessee owned by the management team. An additional concept applied here is the shutting down of "leakage," or the layer of profit that would normally be realized by a separate company.

There are only a few active REITs with the Paired Share structure--such as Starwood Hotels & Resorts, Meditrust Corp., Patriot American Hospitality, Corporate Property Investors (just acquired by retail REIT Simon DeBartolo), and First Union Real Estate--yet, Congress may soon intervene. Proposed legislation now before Congress would not squash the special tax condition held by Paired Share REITs for existing holdings or assets tied up with a binding letter of intent (dated by March 26, 1998), but would limit future acquisitions utilizing this special tax design.

Paper-clip REITs are also beginning to creep into the picture. These are different from a Paired Share structure in that the REIT will lease a group of properties to a separately managed and traded entity that the REIT management ultimately controls. This distinct management 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 dividend income, the REIT lessens its overall corporate tax obligation. As a side note, you may soon see the Paired Share REITs examine whether to re-structure into a Paper-clip REIT if both houses of Congress pass the current bill that would limit the cherished tax status afforded to the Paired Share REITs.

Lastly, publicly traded limited-liability companies (LLCs) have just come onto the radar screen and, according to attorneys Jim Wright and Bob Geis of Venable, Baetjer and Howard, are very similar to the REIT structure in scope and function. As this structure is still evolving (there are currently only two publicly traded LLCs), many kinks have yet to be worked out. However, Geis says that under the right circumstances, the publicly traded LLC 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 tenure and experience characteristics, most solid management teams have been together for some time. If a contributing property owner/developer still has the proverbial fire in his belly, hopefully there is room within the REIT management team or on the board of directors. Insider ownership by management is a must, and an aggregate position of 5 percent to 10 percent is palatable. Only time will ferret out whether the interests of management are aligned with its shareholders.

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

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

Deal Structure

In exchange for a real-estate portfolio, a REIT can offer any one or combination of the following: cash, common stock or OP units. Since most owners of real estate hope to control 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 into stock (usually at a ratio of 1:1, except for dilution) or cash. OP units carry the same weight as stock by usually throwing off the same amount of income, and are potentially giftable within the holding period, but ordinarily do not carry voting rights. The holder of OP units is normally frozen from selling for a negotiable 13 to 24 months. So, a holder of OP units can actually begin with the best of both worlds by being able to control the tax impact and garner cash flow off of the OP units during the interim. This scenario is hard to beat because, in essence, you are buying yourself time and flexibility while in most cases receiving a more stable cash flow. The contributing property owner also will be exchanging a fixed set of assets, usually within a constrained geographic area for a more geographically diverse portfolio.

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

It should be noted that OP-unit values, not withstanding any prohibitive covenants, can be protected by collaring and hedging techniques. Diversification may be accomplished in some 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 a case-by-case basis along with OP-unit restrictions and the OP-unit holders personal tax situation. The degree of possibility of these goals being accomplished is dependent on the size of the REIT, the daily trading volume of a REIT's shares and the length of time that a 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 handed equity shares. In addition to paying, in most cases, a nice dividend, voting rights are usually assigned to shares. While everyone hopes for additional price appreciation, common shares are giftable whether they rise or drop in value. This plays in well to those owners of private real-estate portfolios who desire to pass on a securitized legacy to their heirs or don't have someone in the family interested in taking over the reins of the company.

If liquidity is a future goal, you may be restricted from selling the common shares for an 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 same caveats.

Cash is cash and plays a role in many REIT acquisitions in whole or part of the deal structure. Either way, accepting cash for properties gives immediate realization of taxable gain, but also circumvents exposure to REIT management miscues and to the market risk of the stock. With the net cash proceeds, almost any stock or property of interest becomes a possibility. Maybe you could even build that house on the water you've always dreamed 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 may be scrutinized. Leverage will be as strong or weak as the degree of demand for a portfolio by the REIT world and the eagerness/passivity to sell. The price offered may be high enough and the deal structure flexible enough to concede on many other areas. Size and management culture of the REIT may be an influence on the owner/developers negotiating prowess. Regardless, here are a few to think about.

As an OP-unit holder, there will be many provisions in the partnership agreement. OP units 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 is important to negotiate certain protections in the partnership agreement with the REIT in order to not have an acceleration of your taxable gain with respect to your OP units. This can 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 normally cooperate 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 or registered shares to give. According to Jerry Chalmers, partner and certified public accountant with Wolpoff & Company, to buffer this occurrence the owner/developer may be able to negotiate a "protection of registration" mandating that the REIT file for a secondary registration within a defined time period. A similar time constraint can be applied mandating the REIT to tap a line of credit if cash is the goal of the OP unit holder. His partner at Wolpfoff, Jim Matheny, also suggests that if a closely held private real-estate company finds itself the aspiration of a REIT, it may be worth the time to explore setting up a Family Limited Partnership before an engagement for the benefit of future family generations.

Market and real-estate sector risk must also be mentioned as we all know that assets classes evolve through cycles. The good news about cycles is that, hey, they cycle. The tough 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 of insolvency. Although modern REITs share little resemblance of their 1960 to 1970s brethren, it is always prudent to review the REIT management, balance sheet and income statement for financial acumen.

Panacea or Pain

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

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

Editor's Note: The views and opinions expressed above are those of the author only, and do not necessarily reflect those of BT Alex. Brown. Nor did BT Alex. Brown participate in the drafting or preparing of this material and is not responsible for its content. Nothing herein is intended as an offer, solicitation or recommendation to purchase, sell or hold a security and should not be considered an endorsement or recommendation by or on behalf of BT Alex. Brown.
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