Commercial Investment Real Estate is the magazine of the CCIM Institute, the leading provider of commercial real estate education. CIRE covers market trends, current developments, and business strategies within the commercial real estate field.
Issue link: http://cire.epubxp.com/i/206598
R 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. Te fnancial 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? Sung-Il Kim/Corbis 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 signifcant tax beneft 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, ofce, and multifamily. What has recently turned heads in the fnancial community is the mix of nontraditional asset classes now taking REIT clothing. Tere 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 fnance, and waste management. Two factors have combined to drive the recent REIT conversion trend. Te most visible factor, and the one most frequently seized on by the media, has been permissive Internal Revenue Service rulings regarding what qualifes as a real estate asset for REIT purposes. But in reality, the IRS is strictly applying the letter of the REIT Act, whose defnition of "real estate asset" (which includes, among other items, "land or improvements thereon") is already quite broad. Te 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 fundraising fgures can attest. In the frst six months of 2013, publicly traded U.S. REITs raised $31.8 billion in equity, according to NAREIT, and in the frst seven months of CCIM.com 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 signifcantly 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. Te cause of the delay was that the IRS had informed the conversion candidates that the IRS had formed a "working group" to study the defnition of "real estate" for REIT purposes and whether any changes or refnements should be made to the defnition. 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 specifc private letter rulings sought will be delayed. REITs' Public Policy Aims Critics point out that because REITs pay no corporatelevel 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. Tis 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 defcit reduction, but meant to expend government funds in order to promote broader policies — one economic and the other social. Te more economics-focused of the two policies that November | December | 2013 35