Non-traditional REIT transactions An emerging trend
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www.pwc.com/us/realestate
Non-traditional
REIT transactions
An emerging trend
October 2014
Dear Friends,
Since the legislation that first created REITs over 50 years ago, there is no question that much has
changed in the world of real estate and real estate finance. REITs continue to expand and flourish in ways
which were clearly not contemplated 50 years ago or even a decade ago.
We encourage you to obtain Real Estate 2020: building the future, a flagship piece for our sector, which
further builds on the global megatrends research previously released, and complements our own
Emerging Trends research. We can clearly see the impact of the global megatrends at work in many
of these transactions. The real estate market continues to expand to cover new asset classes driven
by changing economics/demographics (e.g., single family housing rental platforms or the expansion
of offerings to address the changing needs of an aging population). Further, the understanding of the
definition of what is “real estate” continues to deepen to cover an ever-broader range of physical assets
currently owned by companies who use those assets directly in their businesses. Accordingly, we believe
this transaction activity will continue as the financial markets strive to satisfy the voracious need for “real
estate” growth capital in the US and globally.
This is evident in the rise of the so called “non-traditional” REIT formations or conversions which are
being used to bring a wide variety of new asset types into the REIT universe, including timber, farmland,
cell towers, billboard, and infrastructure assets of all types in the telecom, energy, storage and many
other real estate-heavy sectors.
Going public as a REIT or converting to a REIT is a monumental decision. It can forever change how a
company does business. Moreover, from a practical standpoint, completing a public offering or a REIT
conversion can be time consuming and expensive. It can take substantial management focus away from
the day-to-day operations of the company. This is why adequate preparation is critical – and can be the
key to your success.
This is where we can help. Through our specialists’ global presence and extensive knowledge of
capital markets, PricewaterhouseCoopers can provide you with the insight you need along the way.
PricewaterhouseCoopers’ Real Estate Services practice is a top choice for assurance and tax consulting
services among businesses in the REIT industry. We have deep experience in helping real estate
companies enter the public market and preparing them to operate as a public company after an IPO or
conversion.
We believe PwC offers a powerful combination of personal service, specialized experience, and global
reach that sets us apart. Especially now, in these difficult times, you can look to our people, knowledge,
organization, and experience to reach beyond your expectations.
Byron Carlock, Jr.
US Real Estate Leader
byron.carlock.jr@us.pwc.com
(214) 754 7580Table of contents Non-traditional REIT transactions 1 What types of companies are considering a REIT conversion? 3 Special tax issues 8 Special operational issues 9 Special accounting and financial reporting issues 10 Special SEC regulatory issues 11 Special investor reporting 11 Types of transactions 12 The conversion process 17 PwC’s strengths to serve you 20 Appendix A – Overview of certain REIT tax compliance tests 22 pwc.com contacts back cover Non-traditional REIT transactions | An emerging trend
Non-traditional REIT transactions
Generally, most property REITs today own “traditional” flexibility as well as drive governance changes that may
rental property, such as apartments, office buildings or themselves cause conflicts with the REIT rules. As a result, a
malls. However, in an effort to unlock shareholder value, REIT conversion/spin-off is not necessarily the best strategy
many companies that are heavy users of real estate are for every company, even if it is legally possible.
increasingly looking for methods to monetize their real
estate in order to free up capital to be used in core operations Expanding the possible
and expansion plans. These methods traditionally have
included non-recourse financing, sale-leaseback transactions Key considerations in a REIT conversion are the operational,
and, more recently, REIT conversions. strategic, regulatory, and tax restrictions on creating a
structure that generates rents from real property. In addition
REIT conversions may be “transactional” or “transformative” to determining whether the property to be held by the REIT
depending on the facts and circumstances of the particular constitutes real property, the parties to the transaction
company. The term “REIT conversion” is used broadly to must observe and comply with restrictions contained within
describe a very wide range of transactions in which the end the tax provisions governing REITs on related-party rents,
result is all or some portion of the original entity becomes rents based on net profits or income, provision of services to
a REIT, including a spin-off transaction. Today, many tenants, rental of personal property, ownership limitations,
companies are evaluating the feasibility, benefits, costs and dividend requirements.
and other issues associated with a potential conversion to
REIT status or a REIT spin-off of their real estate. In some For an entity to be a REIT, a substantial portion of its
cases, these strategic evaluations have been initiated by revenue must be “rents from real property.” What does
the management of the companies themselves. In other this mean? Who decides? Basically, absent a revision of the
situations, the decision was spurred by pressure from activist legislation by Congress, the IRS decides.
shareholder groups or investment bankers.
The IRS has authority
It is not yet clear whether this is a long trend. Arguably, the
existing REIT structures have been available for a long time, The IRS has recently considered several PLR requests related
yet now many of these industries are taking advantage of to non-traditional REIT assets. Favorable rulings in this
them. However, this is not a process one should undertake area are grounded on principles that have been established
lightly. The conversion/spin-off process is highly complex and applied by the IRS in the past to distinguish real estate
from a tax, legal, regulatory, operational and financial from other property. However, the current market activity
reporting perspective. It can be a long, daunting task, regarding REIT conversions has led to additional scrutiny
fraught with potential pitfalls, and it may be extremely concerning the application of the law in this area. The IRS
costly and difficult to reverse. recently issued proposed regulations that “clarify” the
definition of real property for REIT purposes.
Depending on the circumstances, these transactions
can take considerable time to execute – especially if it Real property: Treas. Reg. Section 1.856-3(d) provides
is considered necessary to obtain an IRS private letter that the term “real property” means land or improvements
ruling (“PLR”), re-engineer business processes, or if sales thereon, such as buildings or other inherently permanent
or divestures of aspects of the business are necessary. structures thereon (including items which are structural
Additional complexity arises as the company must components of such buildings or structures). In addition,
subsequently put in processes and controls to maintain the term “real property” includes interests in real property.
its compliance with the sometimes-complicated REIT Local law definitions are not authoritative for purposes of
rules. These rules may also restrict a company’s operating determining the meaning of the term “real property.”
Non-traditional REIT transactions | An emerging trend 1The term “real property” includes, for example, the wiring Congressional action ahead?
in a building, plumbing systems, central heating, or central
air-conditioning machinery, pipes or ducts, elevators or One must remember that REIT vehicles were authorized
escalators installed in the building, or other items which in the 1960s to serve as a real estate counterpart to mutual
are structural components of a building or other permanent funds. Similar to mutual funds, which offer a way for small
structure. investors to invest in a diversified portfolio of securities,
a REIT allows small investors to invest in a diversified
The term “real property” does not include assets accessory portfolio of real estate. Both were designed to give the small
to the operation of a business, such as machinery, printing investor the same advantages otherwise only available
presses, transportation equipment which is not a structural to those with larger resources. Over the years, various
component of the building, office equipment, refrigerators, legislation and regulations have significantly expanded the
individual air-conditioning units, grocery counters, ability of real estate companies to operate as REITs. Some
furnishings of a motel, hotel, or office building, etc., even have raised questions such as: “Do non-traditional REITs still
though such items may be termed “fixtures” under local law. meet the original intent of the REIT set out by Congress?”
or “Does a non-traditional REIT provide a way for a small
Rents: Section 856(d)(1) provides that the term “rents from
investor to invest in a diversified portfolio of real estate
real property” includes (subject to exclusions provided in
assets?”
Section 856(d)(2)): (a) rents from interests in real property;
(b) charges for services customarily furnished or rendered Recent press reports about the use of REITs to hold
in connection with the rental of real property, and (c) rent non-traditional asset classes have raised issues concerning
attributable to personal property which is leased under, or in whether such transactions may erode the corporate tax
connection with, a lease of real property, but only if the rent base. Although these reports have, in several cases, offered
attributable to such personal property does not exceed 15% incomplete and sometimes inaccurate accounts of the
of the total rent for the taxable year attributable to both the tax rules, the reports could prompt Congress to consider
real and personal property leased under, or in connection whether additional restrictions need to be placed on the
with, such lease. assets that may be held by a REIT, or on the circumstances
under which an existing business may convert and conduct
The term “rents from real property” does not include rents
some of its operations in a REIT.
based on net profits or income. However, the term does
include rents based on gross revenues. The term also does For example, in the spring of 2014, Republican Congressman
not include rents paid by related parties. Dave Camp released a far-reaching tax reform proposal
containing REIT provisions that would effectively shut down
If services are provided to tenants in connection with the
REIT conversions. While that proposal has not advanced,
rental of real property, consideration must be given both
other future proposals could adopt similar measures that
to whether the services are customary and to whether
could limit or reduce REIT conversions.
the services may be provided by the REIT, a taxable REIT
subsidiary (“TRS”), or an independent contractor.
2 Non-traditional REIT transactions | An emerging trendWhat types of companies are considering
a REIT conversion?
Many of the companies that have converted, or are contemplating REIT conversions
or spin-offs, have property types which are considered “non-traditional” real estate
by the REIT community. These may include:
Non-traditional REIT activity
Existing In process Potential future candidates
•• Timber •• Record warehousing •• Railroads
•• Agriculture/farmland •• Cold storage •• Docks/marinas
•• Cell towers •• Schools and higher education facilities •• Landfills
•• Hotels •• Telecom infrastructure •• Toll roads/bridges
•• Casinos/gaming •• Energy infrastructure
•• Hospitals/nursing homes – Pipelines
•• Golf courses – Transmission/distribution lines
•• Data centers
•• Billboards
•• Prisons
This is by no means a complete list – any real estate-heavy Real estate-heavy companies might spin off and lease back
entity with property that can meet the REIT requirements their properties, or a larger company may spin off a portion
could be considered for a REIT conversion transaction of its business that might qualify for REIT status on its own.
through the so called “OpCo/PropCo” structure. This might Candidates for these types of transactions include those in
include retailers or franchisers. Furthermore, many real which the real estate element consists of capital-intensive
estate-heavy entities, which traditionally have utilized leases that can be structured to provide investors with a
syndicated master limited partnerships, or PTPs, might find stable yield and a tax-efficient return as a REIT (appealing
benefits now using a REIT structure (e.g., pipelines). to income investors), while other aspects of the business
may not qualify for REIT status or may have more growth
While the potential for tax savings is clearly a major factor, potential (appealing to growth investors). When a company
the decision to do a REIT conversion or a REIT spin-off has elements of both real estate and non-real estate some
is frequently not solely for tax reasons. There are other investors may not be interested. However, by separating the
potential significant benefits from a financial perspective entity into two components and allowing each to operate
where there is a perceived impact on financing costs, separately, the two companies may attract more investor
monetization of non-core assets, and on the company’s interest and thereby more total shareholder value.
share price. Investors today are currently searching for
yield, and they have generally been willing to pay more for
Key challenges
higher dividend stocks including REITs. Furthermore, many
common REIT structures, such as the Umbrella Partnership Depending on the nature of the company’s operations, an
REIT (UPREIT), provide a company with a tax-advantaged entity may qualify for conversion to a REIT if it can meet the
currency to acquire properties in fragmented industries. REIT qualification criteria on its own or after a restructuring
Finally, some candidates are taking advantage of the that puts some of its operations in a taxable REIT subsidiary.
transaction to reorganize themselves and recapitalize their In some cases, a company may need to substantially change
balance sheets (e.g., new financing, stock buybacks, stock- the way it does business with its customers to bring its
for-stock exchanges, etc.). business in line with the REIT requirements. In other cases, a
company may need to sell or spin off portions of its business
so that the remainder of the business can elect REIT status.
Non-traditional REIT transactions | An emerging trend 3While going through the REIT conversion/spin-off process, Subsequent challenges
some of the key challenges you may face will include:
• Managing the complex requirements for continuing to
qualify as a REIT.
Transactional challenges
• Managing dividend levels to balance both tax
• Structuring the transactions in a tax-efficient manner.
requirements and financial goals.
• Potential need to reorganize for governance and/or tax
• Avoiding “dealer” issues and other REIT “penalty” taxes.
purposes, which may require shareholder approval.
• Significant changes to controls and processes necessary to
• Potential need to obtain a private-letter ruling for REIT
operate as a REIT (potentially with taxable subsidiaries).
qualification purposes to address REIT conversion issues
or to ensure a tax-free spin-off. • Managing potential taxes on “built-in gains” at time of
conversion.
• Potential need to make substantial distributions of
pre-conversion accumulated earnings and profits • Building the personnel, controls, processes and systems
to shareholders (i.e., the “E&P purge,” which may infrastructure necessary to operate successfully as a
be financed or paid in part through a taxable stock standalone public REIT.
dividend).
• Determining the appropriate placement of company
• Potential need to reoganize operations to segregate employees (i.e., whether they will be employed by the
non-qualified REIT elements into taxable REIT REIT or a TRS).
subsidiaries (TRSs).
• Evaluating financing strategies, including unsecured,
• Potential need to restructure contracts to make some or secured, and revolving credit lines and considering
all of the revenue REIT-qualified and move non-qualified changes resulting from the impact of dividend
revenue contracts or portions of them to taxable REIT requirements and the resultant increased need to finance
subsidiaries. growth capital externally.
• Developing additional reporting metrics and supplimental • Revising treasury functions to align with new business
reporting packages commonly demanded by the REIT model and legal/tax needs.
investor community.
• Considering changes to stock-based compensation
• Meeting the widely held REIT ownership requirements packages, which typically differ for dividend-paying
(must have at least 100 shareholders, and ownership of REITs when compared to those of operating companies in
more than 50% of REIT shares, by value, may not be held growth industries in a C-corp structure (which generally
by five or fewer individuals) (see appendix A). Most REITs retain operating cash flow for growth).
will have special rules in their governance by-laws that
• Containing administrative costs.
limit the ownership level.
• Managing REIT dividend reporting and other regulatory
• Managing the potential tax, accounting and SEC
requirements.
reporting requirements related to the transaction.
• New investor relations reporting might be mandated by
the investor base and analyst community (e.g., metrics
such as funds from operations/adjusted funds from
operations/cash available for distribution, and substantial
“supplemental reporting packages” are common in the
REIT industry).
4 Non-traditional REIT transactions | An emerging trendDo the benefits outweigh the costs? Better access to unsecured debt markets
REITs typically have relatively low leverage, and their stable
All in favor?
cash flow streams allow many of them to earn investment-
grade ratings. As a result, REITs are very active in the public
Significant corporate tax savings
unsecured debt markets. Given recent market conditions,
The most commonly cited reason for a REIT conversion is to these transactions have been consummated at historically
reduce corporate taxes. Traditional REITs themselves would low rates. In many cases, pre-REIT conversion or pre-spin-off
generally not pay taxes on distributed earnings. However, combined companies would not be able to achieve the same
companies undertaking non-traditional REIT conversions ratings. As a result, they may have substantially higher
may have significant portions of their operations in taxable borrowing costs.
REIT subsidiaries that pay corporate taxes. A REIT is
required to distribute at least 90% of its income to retain its Mergers/acquisitions
REIT status, and typically most REITs will in fact distribute
Mergers and acquisitions may be achieved with stock or
at least 100% (or more) to not pay corporate taxes, resulting
operating partnership unit (OPU) transactions (see “Tax
in the REIT itself paying less taxes.
structuring” discussions) on a tax-advantaged basis for
sellers at better pricing while conserving cash. This may be
“Multiple expansion”
especially helpful in industries that are fragmented, such
Although valuations for public versus private markets go as cell towers/billboards, and/or currently held by private
in cycles, in many industries the value of public companies individuals or pass-through entities.
tends to be higher than that of comparable private
companies. This is partly the result of increased liquidity, Reorganization benefits to operating company
available information, and a readily ascertainable value.
Some of the spin-off transactions may utilize the transaction
REITs typically have lower leverage and more stable cash
for other capital purposes that benefit the operating
flows than many other operating companies. As a result,
company. For example, the real estate element could be
separating the “real estate” elements of an operation out of
levered up with new debt at favorable rates and the proceeds
a larger company may appeal to value investors, while the
retained by the operating company. Furthermore, some
operating elements may appeal to growth investors – with
transactions may be arranged where the separation of the
each trading at higher multiples than they would on a pro
REIT from the operating company is effectuated by an
rata basis as combined. In some cases, the market will value
equity-carve out followed by a split-off and/or a spin-off
the two pieces at a greater amount than the combined whole.
transaction. The proceeds of the leverage on the real estate
company and equity carve-out can be used by the operating
Appeal to “yield hungry” investors
company for its capital needs, which may include expansion
Current market conditions, including historical low yields plans, acquisitions or stock buy-backs. Further, a split-off
for fixed-income securities, have driven many investors to transaction may provide the ability to exchange the shares
search for yield outside of traditional CDs, money market, of the new REIT in redemption of existing shares of the prior
government securities and preferred stocks, or similar owner entity – thereby effectuating a partial buyback. While
investments that are not providing desired returns. This these transactions may provide benefits to the company, they
has increased investor demand for REITs in general for both may also add to the complexity and duration of the process.
their equity and debt securities (see below).
Non-traditional REIT transactions | An emerging trend 5All opposed? Transition expenses
Tax benefits may be elusive, diminished or subject Many factors play a role in the ultimate cost of a REIT
to loss/reduction as a result of legislative or conversion or split-off, but in many cases these costs are
regulatory action significant. Most of these costs are likely to be required
to be expensed as incurred, thereby affecting reported
As discussed previously, a REIT is required to distribute profitability while the protracted process is played out.
at least 90% of its income to retain its REIT status, and
typically most REITs will in fact distribute at least 100% Increases in ongoing administrative expenses
(or more) to not pay corporate taxes. While the REIT itself
pays less taxes, taxable investors (individuals) in the REIT As a public REIT, you may have increased reporting costs
are receiving higher dividends and these dividends in large (e.g., REIT compliance costs and costs for increased
part are not “qualified dividends” and, therefore, subject to supplemental reporting common for REITs). Furthermore,
the investor’s highest marginal tax rate (currently at 39.6%) in spin-off/split-off transactions, there may be separate
as well as potential additional taxes of up to 3.8% on such operating costs to running two companies (i.e., more board
dividends resulting from the Affordable Care Act (a.k.a. members, higher D&O insurance, higher compliance costs
“Obamacare”). under SOX 404 internally and for external audit).
In addition, as federal and state governments look for more Ascertaining and financing the “purging” or
revenue, it is certainly possible that legislative or regulatory accumulated earnings of the company
changes may further change the dynamic. Such changes
might include those affecting the taxability of REITs in In order to complete a REIT conversion, in addition to
general, non-traditional REIT transactions in particular, or normal distribution requirements, a company must also
further changes to investor tax consequences on dividends. “purge” all of its accumulated undistributed earnings and
In cases where some or all of the real estate is located in profits (“E&P”) for all periods prior to conversion. This
foreign jurisdictions, a REIT may not be able to shield the taxable distribution is generally completed as a “special
rental income stream from foreign taxes. Similarly, some dividend,” and can be paid in cash or a combination of cash
states are proposing rules which may, in some fashion, tax and stock (subjected to certain limitations on the stock
REIT income. portion). In some cases, merely figuring out the amount of
the required distribution may be a significant undertaking.
Complexity and impact on operations The company may also need to finance the cash portion
of the distribution. The taxability of this dividend also
Many REIT conversions and spin-offs are highly complex, reduces the potential overall tax savings of the transaction
requiring significant reorganizations, divestitures and to investors. For example, in one conversion, the company
financing to complete. Furthermore, they may require had to compute the undistributed E&P (no small feat for
changes in operations (e.g., changes in contract terms) and a company which may have had an operating history
absorb significant amounts of senior management’s time. approaching 100 years) and paid a special dividend of
These impacts may be indirectly detrimental to operations $5.6 billion.
in addition to their direct costs.
6 Non-traditional REIT transactions | An emerging trendLimitations on ability to retain capital from Uncertainty of investor perception of non-
operations or capital gains traditional REITs
REITs are required to pay out 90% of income to their With non-traditional REIT conversions, there is often the
shareholders to retain REIT status. Generally, most REITs likelihood that investors may not understand or favorably
distribute 100% or more to minimize corporate level taxes. value portfolios of non-traditional real estate. Even
While REITs can elect to retain capital gains if they pay a among the investment community and rating agencies,
corporate level tax on them, most do not elect to do so and non-traditional REITs provide significant valuation
pay-out their capital gains as well. challenges. Many will not give assurances of value and
pricing, while others provide exceptionally wide ranges of
While taxable income is generally less than cash flow from value. For example, there has been resistance to including
operations because of depreciation, most REITs distribute in certain non-traditional REITs in REIT indexes.
excess of taxable income (such excess treated as a return-of
capital). As a result, most REITs do not retain significant Tension between REIT investors and strategic
amounts of cash from operations to reinvest in existing or business objectives
new properties.
In many cases, an enterprise is willing to make speculative
Need to access capital markets for growth real estate investments for future expansion. However,
a REIT investor, reliant on dividend streams, may not be
As a result of the limited ability of most REITs to retain willing to make the same investment without adequate
growth capital from operations, most REITs are required returns. The separation of the real estate operations of the
to access the capital markets for growth, development and enterprise may significantly impact the strategic business
capital improvement capital. These capital sources most objective of the combined enterprise.
commonly include public debt/equity, private mortgage
financing and syndicated lines of credit. The syndicated No turning back
lines of credit are generally LIBOR-based with terms of three
to four years. Frequently, the syndicated lines of credit are The REIT conversion or spin-off process is essentially
used to finance the accumulation of acquisition assets and one-way. It may be difficult and costly to reverse the process.
development/capital improvements until sufficient mass is
accumulated to make a more permanent capital transaction
more cost effective.
Non-traditional REIT transactions | An emerging trend 7Special tax issues
Clearly a REIT conversion can have a significant number of Built-in gains – To the extent that property of C-corporation
tax issues to address. Much of these will be figuring out how becomes property of a REIT in a tax-free transaction or in a
to operate as a REIT – which in many cases can necessitate a conversion to REIT status, special rules subject the REIT to
very significant change in the way a company does business, corporate-level taxation on subsequent recognition of the net
including how it contracts with its customers. In addition to built-in gains within a 10-year period (pending legislation
the general REIT requirements listed in Appendix A, some would reduce the period to five years). Alternatively, the
of the more unique tax issues relating to a REIT conversion C-corporation could elect to recognize these gains on its
include the following: final tax return prior to transfer of its assets or conversion
to REIT status. To mitigate the impact of the built-in gains
E&P purge – A REIT must distribute any C-corporation tax, REITs can use carryover C-corporation net operating
earnings and profits in its initial REIT year. This requirement losses, time the recognition of built-in losses with built-in
is often accomplished through a special distribution, and gains, or dispose of properties in tax-free transactions, such
requires an accurate assessment of the earnings and profits as like-kind exchanges. To the extent that a partnership with
of the C corporation as of the date of the REIT conversion. corporate partners transfers property to the REIT, a portion
This distribution takes priority for tax purposes over the of the contributed property could be subject to the built-in
distribution of the REIT’s current-year taxable income. gains taxation regime.
This taxable distribution is generally completed as a “special Dividend reporting – A REIT’s dividend may be some
dividend,” and can be paid in cash or in a combination of combination of ordinary capital gains or a return of capital.
cash and stock (subjected to certain limitations on the stock REITs are required to disclose the character of their
portion). In some cases, merely figuring out the amount of dividends before January 31 of the succeeding year via a
the required distribution may be a significant undertaking. Form 1099. A REIT’s ordinary dividends are not generally
The company may also need to finance the cash portion of “qualified dividends,” and are not subject to the lower rates
the distribution. thereon, but rather are subject to the shareholder’s regular
income tax rates. Generally, most REITs try to provide
this information prior to that date, as investors need this
information to file their tax returns (and brokers want the
information as early as possible so that they do not need to
issue revised composite form 1099s).
8 Non-traditional REIT transactions | An emerging trendSpecial operational issues
Operating as a REIT may represent a nominal change Shared services
operationally or require significant changes in how a
company operates and interacts with its customers. Taxable Services performed to provide benefits to both qualified and
REIT subsidiaries and the operating partnership must non-qualified assets --from the maintenance staff, repairing
be treated as separate legal entities. The results of this both qualified and non-qualified assets to the CEO, providing
separation will have an effect on many areas of the business. business strategy to the qualifying and non-qualifying
activity-- employment and benefits costs must be properly
For example, where the entirety of the company’s revenue charged to the appropriate entity. This is typically done
is qualified, the impact on operations might be relatively through some combination of management contracts, special
modest. On the other hand, if a substantial portion of the accounting allocations, and/or specialized cost-sharing legal
company’s business is not qualified and must be conducted entities. In addition, services such as shared IT support,
through a taxable REIT subsidiary, this may require centralized A/P costs, and costs of accounting systems must
bifurcation or modification of existing or future contracts be tracked and/or allocated. Generally, these types of cost
with customers and significant changes to where costs are of service allocations require time and cost studies and the
incurred or allocated. In short, a company need not only be implementation of sound cost and tax accounting principles.
able to operate as a REIT on day one, it needs to be able to In certain circumstances, transfer pricing studies are
operate as a REIT over the long term. This would include advisable.
consideration of a company’s growth plans and how they
impact REIT status. They may also include regulatory Shared costs
issues unique to the asset class. For example, in the telecom
or utility industries, an entity’s tax elections may impact Like shared services, accounting for shared costs requires
customer rate setting which would require approval by state attention to detail. Examples of enterprise-shared costs are
or federal authorities. umbrella insurance policies, shared offices space rent, and
the shared cost of financing. Shared operational cost must
Business strategy also be allocated. Items like vendor volume discount rebates,
legal and accounting fees and shared utility costs, etc.,
As noted above, a REIT conversion can cause a shift in the become harder to identify but also must be allocated. Failure
profile of the enterprise’s shareholders. In the case of the to adequately identify and properly charge costs and services
separation of the business through spin-offs or split-ups, could result in the 100% related party rents penalty tax.
separated entities may have different shareholder value
propositions. Additionally, due to REIT distribution rules, Accounting processes and systems
internally generated cash flows may no longer be available to
fund future expansion. These and other conversion factors The tax requirements for the TRS to maintain separate
may require the enterprise to rethink its existing business books and records, as well as the complexity of the REIT
strategies and models. In many cases, cash flow to make tests, will require converting companies to reexamine their
dividend payments, as well as the ability to access capital for existing transactional accounting processes, their financial
expansion, will become a higher priority for the converted accounting and sub-ledger systems, and existing accounting
company. This shift must be managed to avoid distraction culture. From the A/P clerk who now must decide to
from the existing strategies that have made the business which entity to code an invoice, to the corporate reporting
enterprise successful. accountant who must decide how to apply a top-level AJE
to the qualifying and non-qualifying activity, accounting
Existing contracts processes must change to accommodate the REIT form.
New companies must be created to accommodate the TRS
In many cases, consents, assignment, or re-negotiation of activity, and sub-ledger systems must be modified to properly
existing contracts are required to maintain the separation allocate costs. General ledgers and charts of accounts must
of costs among the qualifying and non-qualifying activities. be scrubbed to ensure that enough detail is available to
This can be at significant cost to the entity converting to a identify activities to support the various REIT tests and the
REIT. Additionally, certain contracts and leases may need to supplemental reporting required to investors. Beyond a
be made between an enterprise’s qualified and non-qualified systems change, many companies must make the accounting
entities. These contractual relationships often require arm’s cultural change from single-enterprise accounting to legal-
length terms, and support by transfer pricing studies may be entity reporting.
advisable.
Non-traditional REIT transactions | An emerging trend 9Special accounting and financial reporting issues
As with any corporate reorganization, REIT conversions A company should account for the conversion to a REIT
have unique accounting and financial reporting issues when it:
that must be carefully evaluated based on the nature of
• Has committed itself to this course of action in such a way
the transactions. Some of these issues may include the
that it would be impossible or practically impossible to
following:
not convert to REIT status. Approval by the appropriate
• Release of deferred taxes parties within the company (e.g., board of directors) and
a public announcement of the change might produce this
• Sale-leaseback rules on spinor/lessee
result, provided that this truly constituted a commitment.
• Carve out financial statement requirments for spin-off/
• Has obtained financing for the E&P purge (if necessary
split-off
and considered significant).
• Pro forma financial statement requirements
• Is “REIT-ready” in all material respects such that the only
• Discontinued operations reporting for parent legal and administrative actions necessary to qualify for
REIT status are to file its tax return on Form 1120- REIT
• Implications of spin-off/split off to stock-based
(i.e., any remaining steps are considered perfunctory).
compensation plans
• Impact of intercompany debt arrangements At that time, tax assets or liabilities should be adjusted to
reflect the change to REIT structure. This may not result in
• Allocation of goodwill between spinn or and spinnee a complete release of all deferred tax accounts, since many
(may also impact impairment analysis) non-traditional REITs would have substantial taxable REIT
• Lease classification rules on both parties subsidiary (TRS) operations and deferred taxes would have
to be provided there-on. Further, to the extent any built-
Release of deferred taxes – One of the more unique in-gains are expected to be paid, associated deferred taxes
accounting issues includes the release of deferred income would have to be retained for the related assets.
taxes. Generally, this will be an income event. However, this
may be different for the spinnor/lessee in a spin-off/split off Spin-off/split-off and leaseback – While not a sale, these
transaction if that transaction happens before the election of types of transactions generally must be evaluated under the
REIT status. complex “sale-leaseback” rules of ASC 840-40. Depending
on the terms of the lease it is also possible that the spinnor/
In our view, the conversion of a C corporation to a REIT is lessee could be required to consolidate the spinnee/lessor.
not a “change in tax status” as described in ASC 740-10- Furthermore, even if the transaction were a qualified sale-
25-33. This is because a REIT is still technically a taxable leaseback and the spinnee/lessor were not consolidated,
entity under the Internal Revenue Code. A REIT’s earnings the lease must be evaluated to see if it is a capital lease
are taxable (although the amount subject to income taxes (including consideration of the impact of inclusion of
is reduced by a deduction for the amount of REIT income extension options the spinnor/lessee may have if there is a
distributed to shareholders). penalty on non-renewal – this would include not only direct
penalties but indirect ones such as the impact of losing a
Because we do not view the REIT conversion to be a change “mission-critical” asset may have on the lessee’s operations).
in tax status, we believe it would be appropriate to reflect the
effects of the REIT conversion at the date when the company Depending on the terms of the spin-off/split-off and
(1) completed all significant actions necessary to qualify leaseback, the asset may end up on both the spinnor and the
as a REIT and (2) committed to that course of action. This spinnee’s books.
is consistent with the guidance in ASC 740-10-05-9 which
addresses situations where companies have “control” over
the outcome of whether certain temporary differences will
result in taxable amounts in future years.
10 Non-traditional REIT transactions | An emerging trendSpecial SEC regulatory issues
There are any number of SEC regulatory issues that may relating to the “property” and tenant base (e.g., significant
affect the transaction depending on its form. These may tenant reporting requirements under S-X regulations) and
drive the need for historical carve-out financial statements, more extensive reporting of the anticipated dividend policy
pro formas and other reporting issues. The conversion of the public REIT. In addition, there are additional financial
transaction may be consummated on Form 10, may be in the statement disclosure requirements subject to audit for public
form of an IPO first on Form S-11 or S-1, or may need an S-4 REITs, such as Schedule III, which requires a roll-forward
if a shareholder vote is required or to effectuate a change of each investment in real estate (by property) making up
in the legal form and governance provisions of the entity to at least 95% of the gross amount of all real estate property
ones that are more “REIT-friendly.” Most significantly, this as of the latest balance sheet date. Depending on the
includes adding the ownership restrictions and protective structure of the transaction or the properties included in the
elements such as “excess share provisions.” transactions, preclearance with the SEC may be necessary to
discuss potential relief.
Furthermore, reporting on REIT-specific forms may require
additional disclosures outside the financial statements
Special investor reporting
There are a number of reporting issues that are somewhat Furthermore, many REIT analysts and investors are used
unique to REITs. These include disclosing the key to significant “supplemental reporting packages” which are
performance indicators most commonly used by REITs: usually furnished to investors on the company’s website and
funds from operations, adjusted funds from operations, through a Form 8-k filing. These supplemental packages
and cash available for distribution, which are all non-GAAP may contain a level of granularity that many non-traditional
measures subject to SEC Regulation G (“Reg. G”). While REIT companies are not used to providing (e.g., property-
these are largely defined for the different property sectors in level details for operating revenue, tenant information, lease
the existing traditional REIT universe, they may take some expiration data and detail information on joint venture and
careful thought and discussion when dealing with newer development activity).
classes of property for non-traditional REITs.
Non-traditional REIT transactions | An emerging trend 11Types of transactions
The term “REIT conversion” is used broadly today to Determining the type of REIT conversion
describe a very wide range of transactions with the end transaction:
result that all or some portion of the original entity becomes
a REIT. As with any other reorganization transaction, the Identifying qualifying and non-qualifying REIT
complexity of the transaction is driven by the complexity of activities
the existing structure and the amount of legal steps required
to get from the existing structure to the desired structure. One of the core steps in evaluating the form of a REIT
conversion is to identify the qualifying and nonqualifying
Furthermore, additional factors more unique to REIT REIT activities, as well as shared services and costs. By
conversion may tend to increase the complexity (and the identifying these activities of the enterprise, high-level
time required to effectuate the transactions), including the REIT tests can be prepared. The relative income and value
following: of the qualified activities as compared to the nonqualified
• Need to obtain a private-letter ruling from the IRS for activities will significantly impact the structuring decision as
REIT-qualification purposes, to address conversion issues to a REIT conversion, spin-off, or split-off. Additionally, the
or to ensure a tax-free spin-off/split-off identification of these activities will allow the company to
test against the various existing REIT operational models to
• Potential need to make substantial distributions of identify a fitting REIT conversion form, allow the company
pre-conversion accumulated earnings and profits to to estimate tax benefits, and to identify any barriers to a
shareholders (may be financed or paid in part through a REIT conversion.
taxable stock dividend)
This section will discuss a number of different types of
• Potential need to reoganize operations to segregate transactions, including the following:
non-qualified REIT elements into taxable REIT
subsidiaries • “Simple” REIT conversion
• Potential need to restructure contracts to make some or • Spin-offs of unrelated REIT-qualified businesses
all of the revenue REIT-qualified and move non-qualified • Split-off transactions with unrelated businesses
revenue contracts or portions of them to taxable REIT
subsidiaries. • OpCo/PropCo spin-offs with related business
The discussions below are overly simplified for discussion
purposes and actual transactions are usually significantly
more complex.
12 Non-traditional REIT transactions | An emerging trend“Simple” REIT conversion
C-Corp
In a “simple” REIT conversion, the majority of the Before
company’s assets and operations qualify under the REIT tax Sub 1 Sub 2 Sub 3
requirements. Any remaining nonqualified operations (within
certain predefined size limitations discussed in the tax section
of the guide) can reside in a taxable REIT subsidiary (“TRS”).
REIT
In some cases, the company may need to divest itself of
After
nonqualifying operations if they are too large.
QRS1 QRS2 TRS1
Business/transaction considerations:
• May require a private letter ruling (“PLR”) for REIT
qualification (if “good” REIT revenue is not clearly “rents
from real property” or “real property” for REIT purposes)
or for taxability of reorganization
• May require significant reorganization and incurrence of
costs (e.g., legal, realty transfer taxes, reorganization, new
accounting/tax/compliance systems and personnel, and
other costs)
• Foreign property and operations can qualify, but require
special considerations
• Potential need to move assets and/or restructure contracts
to make some or all of the revenue contracts to split
qualified revenue to REIT and nonqualified revenue to TRS
• May require divestiture of some of business if “bad” assets/
operations are too large relative to TRS limitations
• May require merger of C-corporation into Newco REIT in
order to bring governance provisions in line with normal
REIT (may require shareholder votes and/or Form S-4
exchange)
• In order to qualify as a REIT, any C-corporation E&P will
need to be distributed at the end of its first REIT taxable
year
• Potential techniques to “purge” C-corporation E&P:
ºº Distribution of OpCo may reduce PropCo E&P
ºº Cash dividends
ºº Cash/stock dividends
Non-traditional REIT transactions | An emerging trend 13Spin-offs of unrelated REIT qualified business
Before After
In this type of transaction, the non-REIT business is spun off
to its existing shareholders and the remaining entity elects Shareholders
Shareholders
REIT status. Conversely, the spin-off entity is the real estate
entity that becomes the REIT. The decision of which entity to
spin off may be driven by either legal issues or cost issues (e.g., C-Corp
C-Corp REIT
transfer taxes).
In a spin-off, the distribution transaction is conducted on a Business Business
A B Business Business
pro-rata basis such that each existing shareholder receives A B
stock in the new company in the same relative proportion that
they owned of the pre-spin company.
Business/transaction considerations:
All the issues in a “simple REIT” plus the following:
• Need to “rationalize” corporate overhead structure
• May need post closing shared services/employee
agreements for some period
• Will the spin-off qualify as a tax-free spin-off?
• A tax-free spin-off requires, among other things, that both
corporations be engaged in an active trade or business after
the spin-off
14 Non-traditional REIT transactions | An emerging trendSplit-off/equity carve-out transactions participating shareholders receive their exchange shares.
However, this results in an incomplete separation of the
In this type of transaction, the REIT business is also underlying business. As a result, a split-off transaction
distributed to its existing shareholders, and the remaining may be followed by a pro rata spin-off of any remaining
entity elects REIT status. Unlike a spin-off, however, the ownership in the REIT.
distribution transaction is conducted through an exchange
offer with its existing shareholders in exchange for their In this type of transaction, there may be an intervening step:
existing shares. For example, a shareholder might receive an equity carve-out. In an equity carve-out, the subsidiary
two shares of the REIT valued at $30 each in exchange for entity that will ultimately become the REIT completes an
one share of the existing company valued at $60. IPO for less than 20% of the shares of the subsidiary. This
allows for two things: (i) it provides cash which may be
If the exchange offer is oversubscribed, the participating given to the parent or used by the subsidiary (including to
shareholders particpate on a pro-rata basis with other finance the E&P purge required to convert to a REIT); and
participating shareholders and will retain a portion of (ii) it allows for a public price reference to set the exchange
their existing shares. If the exchange is underscribed, all offer for the split-off.
Before Intervening Partial IPO Post Split-off/Spin-off
of Subsidiary
IPO
Original Original A B Shareholders
Shareholders Shareholders
C-Corp REIT
C-Corp C-Corp IPO
Shareholders“OpCo-PropCo” spin-offs
Shareholders Shareholders
This type of transaction is similar in form to the unrelated
REIT-qualified business. However, subsequent to the
transaction, a significant portion of the REIT “PropCo’s” C-Corp
C-Corp
C-Corp
C-Corp REIT
“OpCo” “OpCo”
“OpCo” “PropCo”
business will be a leaseback to the “OpCo” corporation.
Lease
Business/transaction considerations: Operations Operations Property
Rent
All of the issues with the “simple REIT” and with spin-off of
the unrelated REIT-qualified businesses, plus the following:
• Concentration of credit with single tenant may not price
favorably
• Transfer-pricing issues with respect to setting initial rents
• Business concerns around whether OpCo will be
comfortable with an independent PropCo as its landlord
– lease renewal terms, dealing with underperforming
properties and potentially leasing property to OpCo’s
competitors
• Will the spin-off qualify as a tax-free spin-off? A
tax-free spin-off requires, among other things, that both
corporations be engaged in an active trade or business
after the spin-off. A REIT’s rental of property to OpCo will
not satisfy the active trade or business requirement for a
tax-free spin, so an additional business is required to be
transferred to the REIT.
• Restrictions on qualifying “rents from real property” can
put stress on business relationship between REIT and OpCo
• REIT leasing to OpCo will not count as an active trade or
business for this purpose
• In order to qualify as a REIT, PropCo cannot have any
C-corporation E&P at the end of its first REIT-taxable year
• Related party rent issues may arise if common shareholders
are significant (i.e., REIT ownership limitations may
become even more significant)
16 Non-traditional REIT transactions | An emerging trendThe conversion process
The conversion process can be long and costly. Like any complex
transaction, organization is critical to success.
The process and its planning can be broken down into four
phases as follows:
• Strategy development • Private Letter Ruling • Launch projects • REIT election
and alignment with Request • Legal structure in place • Quarterly & annual
company objectives • Investor messaging testing
• People, processes, and
• Preliminary tax • Governance structure systems in place to • Dividends
assessment (incl. • Enterprise wide support REIT • Control/compliance
consideration of operational readiness • Change in corporate environment in place
asset/rent tests) plan charter, shareholder
• Develop roadmap approval
• Investor perception
assessment • Long Lead/Fast Track • “Operate as a REIT”
initiatives (dry run)
• Education of internal
personnel • Assimilate REIT
requirements into
• Barrier identification governance & controls
Readiness Readiness
Feasibility Operational
assessment implementation
Develop REIT Annual Provide REIT
Strategy & E&P study shareholder metric
Vision complete meeting & vote disclosure
Total
time
12-18
months
Private Letter Seek board Announce definitive File first REIT tax
Ruling approval; REIT timing, E&P return, officially
request filed PLR received distribution electing REIT status
Feasibility is to discuss the nature of the conversion, the potential
need for a PLR, and regulatory filing requirements. The
Once a decision is made to consider conversion and a goal of the meeting is to coordinate responsibilities for the
tentative transaction form, the first step in the conversion PLR (if necessary), delegate sections of the registration
process is arranging an “all hands” meeting. This meeting statement, establish a timetable for the anticipated filing
should be attended by all members of the conversion dates, and share information regarding the working group’s
team: company management, independent accountants, availability. Throughout the conversion process, additional
underwriters, and your company’s attorneys. meetings (either in person or via teleconference) will take
place to discuss progress and any problems, review drafts
Depending on the type of transaction, ultimately you may
of the registration statement, and determine whether the
need to also include your underwriter and the underwriter’s
registration process is on schedule.
attorneys. The purpose of this initial organizational meeting
Non-traditional REIT transactions | An emerging trend 17The readiness assessment
Depending on the level of complexity of the conversion, it A list of those functional groups, and some of the key
may be necessary to form a steering committee comprised of tasks for which they may be responsible, may include the
representatives of many functional groups. following:
Readiness & implementation – Operating model
Steering Committee
Tax •• Develop proposed legal structure and transfer pricing methodologies
•• REIT Tests including Asset, Income, and Distribution requirements
•• Public Letter Ruling (PLR)
•• E&P/Goodwill
•• State and Local REIT Compliance
Finance & Accounting •• Update financial systems (Budget, Forecast, Actuals)
– New legal entity structure
– COA
– OH Allocation
•• Ensure separate bookkeeping for REIT and TRSs
•• Identify additional disclosure requirements or supplemental schedules
•• File pre conversion S-4 (if required)
Corporate Planning/ Forecasting •• Model projections of taxable income and distribution requirements
•• Model valuation for asset testing
Investor Relations •• Message REIT conversion and impact to investors
•• Communicate final BOD decision and reasoning to stockholders
•• Determine dividend policy
Treasury •• Evaluate and implement dividend strategy aligned with 90% payout requirement
•• Discuss effects of leveraging decisions on REIT testing
•• Identify hedging activity
•• Identify optimum Capital Structure, new sources of capital, and migration plan
Legal •• Develop proposed legal structure, and transform when appropriate
•• Address REIT ownership limitations
•• Review lease agreements for REIT compliance
•• Review and assess impact of conversion on other relationships (customer contracts,
employment)
Human Resources •• Discuss division of employees between REIT and TRSs
•• Payroll alignment with new legal entity structure
•• Time tracking for labor shared between entities (QRS vs. TRS)
•• Determine equity compensation strategy
Corporate Governance/Internal Audit •• REIT Organization Structure
•• Determine additional REIT controls needed
Information Technology •• Identify technology support requirements across all disciplines
•• Facilitate tracking of fixed assets and separate legal entity books and records
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