Fall 2000
	Cover Story Doing the REIT Thing Western Properties’ Brad Blake and Bradley’s Tom D’Arcy put their shareholders first. Now they’re looking for work. Company Spotlight Failure to Communicate The "REIT Story" is a good one. Unfortunately, many companies haven’t done as good a job as they should have in telling it. Sector Spotlight Critical Conditions Opportunities among the healthcare REITs, but be careful out there. The New Economy Plugged In Making Money in the Internet Age Tracking The Market Bye, Bye Bear Market Blues After two of the worst years in their 40-year history, REITs have staged a strong comeback. By The Numbers Much Better, Thank You Real estate fund managers may never live down the 1998-99 bear market, but at least these days they can go out in public. Washington Wire Legislative Relief No legislation in the roughly 40-year history of REITs had the potential to alter the landscape more dramatically than the recently enacted REIT Modernization Act. Investment Basics Just How Safe Are REIT Dividends, REALLY? Yield-conscious investors drawn to REITs by their "rich" yields need to look beyond what’s printed in the stock tables of their daily newspapers. Investment Insight Opposites Attract It didn’t come as a surprise to portfolio managers at LaSalle Investment Management that REITs soared when tech stocks hit the wall this past spring. Investment Fundamentals NAV Growth: A Meaningful Performance Yardstick Growing FFO and enhancing shareholder value are not always one and the same. Focusing on NAV growth is a better, though not perfect, alternative suggests Green Street’s Mike Kirby and Jon Fosheim. Editor's Note The Journey Continues ... Parting Shot Wrestling With Net Asset Value The Penobscot Group’s Frederick S. Carr Jr. questions whether the market is telling investors that NAV is irrelevant. Newsline Urban To Be Acquired By Rodamco For $3.4 Billion Investor's Guide Questions Back Issues Feedback

by Barry Vinocur
Illustration by Vasiliy Kafanova

Last year, two-thirds of the House Ways and Means Committee and three-quarters of the Senate Finance Committee introduced the REIT Modernization Act or RMA. A number of industry veterans have characterized the legislation as the equivalent of an "emancipation proclamation" for REITs. Of the various provisions included in the legislation, the one that has received the most attention relates to the creation of so-called Taxable REIT Subsidiaries or TRSs.

At a panel discussion on The Future of REITs earlier this year, sponsored by Lehman Brothers, Sam Zell, the chairman of three REITs (Manufactured Home Communities, Equity Residential, and Equity Office) and the current chairman of the National Association of Real Estate Investment Trusts, the industry’s Washington-based trade group remarked, "This is a brave new world and an exciting world, and I think TRS was truly the linchpin to creating that new world."

The REIT Modernization Act (part of H.R. 1180, the Work Incentives Improvement Act of 1999) was signed into law on December 17, 1999, and its provisions take effect on January 1, 2001. In a report early this year, Wallace Johnson and his colleagues at Moody’s Investors Service (Johnson has since left Moody’s) concluded that the RMA is a credit plus for REITs.

As noted, it’s generally agreed that the most important provision in the RMA allows the creation of TRSs. The Moody’s analysts explained that taxable REIT subsidiaries enhance companies’ strategic flexibility by making it possible for REITs not only to generate revenue, but also, and perhaps most important, to diversify revenue "beyond the current de minimus amounts allowed."

Allowing REITs to provide a wide array of increasingly critical services to tenants and third parties, the Moody’s analysts continued, strengthens property franchises. Moody’s anticipates that REITs will use TRSs to offer concierge, telecommunications, and bulk purchasing services, among others, to tenants and third parties.

Johnson and his former colleagues cited Equity Residential’s purchase of Globe Business Resources, which will ultimately be treated as a TRS, as an example of the utility of these rules. "Globe’s businesses of providing short-term corporate housing and renting and selling residential and office furniture complement Equity Residential’s substantial multifamily property portfolio," the Moody’s analysts wrote.

Rules of the Road

All TRSs must not comprise more than 20% of the value of a REIT’s assets. TRSs must not directly or indirectly manage or operate a lodging or healthcare facility. A TRS must not pay interest to the REIT that would exceed half of the TRS’s adjusted gross income (subject to a 100% tax on excessive portions). All interest, rents and other amounts paid to the REIT by the TRS must be comparable to “arm’s length” transactions (subject to a 100% tax on excessive portions).

Taxable REIT Subsidiaries, the Moody’s report underscored, not only will have to pay normal corporate income tax, but they also will have to meet the following requirements: Prior to the passage of the RMA, REITs were markedly limited in providing such services themselves, the Moody’s analysts pointed out, because related revenues were deemed to be "bad income" (at least 75 percent of a REIT’s revenue must be "passive" income from rents or from interest on mortgages; only 5 percent of revenues could be attributable to noncustomary services) and would similarly exclude rents received from tenants using such services.

"REITs have had to fit these increasingly critical and lucrative services into preferred stock subsidiaries, which are awkward to structure, or seek contract fees from independent service providers. Such service providers paid very little to REITs to access their tenants-a real loss for REITs. This will change with the advent of TRSs, which will pay corporate income taxes like a typical corporation," Johnson and his former colleagues noted.

Moody’s believes TRSs are a significant improvement over preferred stock subsidiaries. Further, it expects many REITs to convert their preferred stock subsidiaries to TRSs. Preferred stock subsidiaries, which cannot comprise more than 5 percent of REIT assets individually or 25 percent in aggregate, have cumbersome ownership and control rules.

"Because REITs are currently prohibited from owning more than 10 percent of the voting stock of a corporation, they typically designate a REIT corporate officer as the owner of the preferred stock subsidiary by giving him/her 90 percent or more of the voting power despite this person’s minimal capital contribution. The REIT then contributes the vast bulk of the capital in the form of nonvoting preferred stock. Although the owner is an employee of the REIT, the REIT cannot rest assured that the preferred stock subsidiary will always act in the REIT’s best interest. In addition, preferred stock subsidiaries are usually not consolidated on a REIT’s financial statements, since they are not controlled by the REIT," the Moody’s research team explained. "By addressing these issues, conversion to the TRS structure will enhance transparency."

Though existing preferred stock subsidiaries will be grandfathered under the RMA, no more may be formed once the RMA takes effect. Furthermore, Johnson and his former colleagues wrote, preferred stock subsidiaries will not be able to enter new lines of business or significantly expand their existing operations.

"Although we expect service revenues from TRSs to be modest compared to the rental payments REITs receive, they will enhance and diversify cash flow. Perhaps more importantly, they will help REITs strengthen their tenant relationships and property-based franchises. Additionally, they will put REITs on a more equal footing with non-REIT property owners, who are not similarly encumbered from providing these services to their tenants," the Moody’s analysts added.

The RMA’s TRS provision, Johnson and his former colleagues noted, will allow hotel REITs to reduce so-called leakage (see p. 53), as well as conflicts of interest. Under the old rules, they pointed out, a hotel REIT was required to lease its assets to an independent third party, which in turn managed, or contracted with others to manage, the hotels. These independent entities, in many cases, have been controlled by senior management of the REIT, which gives rise to potential conflicts of interest.

Furthermore, leakage arises from the difference between the net income earned from the assets and the rent paid to the REIT. "While a TRS cannot manage a hotel, under the new rules it can now lease a hotel from and pay rent to its affiliated REIT, as long as an independent contractor manages the hotel and no gaming revenues are derived at it," the Moody’s report stated. "This arrangement will reduce leakage and possible conflicts of interest." However, the buyout of existing lease agreements, which tend to be long term, is an issue. Moody’s believes that those hotel REITs committed to eliminating potential conflicts of interest will diligently pursue this course.

No Biggie
The RMA also reduces REITs’ minimum dividend payout to 90 percent, from 95 percent, of taxable income. While this new rule can help REITs retain capital, Moody’s does not believe this payout adjustment will affect REITs’ actual capital retention much, if at all.

"First, most REITs currently pay out much more than the existing 95 percent minimum requirement. We do not believe REITs will reduce their dividends immediately or more slowly over time to reach the 90 percent level. Second, while a company may keep its REIT status by only paying out 95 percent (soon 90 percent) of its taxable income, U.S. tax law requires that it pay taxes on any taxable income it retains. This encourages REITs to pay out 100 percent of their taxable income."

Helping Hand for Healthcare REITs
According to the Moody’s analysts, two changes applicable to healthcare REITs should help them better meet the growing challenges in the healthcare industry. These changes will provide REITs with more flexibility in cases of lease expiration and relax the rules for independent contractors.

When a lease expires under current rules, the REIT must re-lease it to another operator immediately. The RMA will allow the REIT to operate the facility for 90 days, and then to hire an independent contractor for a two-year grace period. This grace period may be extended to six years, if necessary. This treatment, the Moody’s analysts pointed out, is similar to the treatment of properties affected by a default under a lease or mortgage. "This new rule relieves patient welfare concerns, and it should allow REITs to strike better deals with lessees because they will not be under regulatory pressure to re-lease promptly," Johnson and his former colleagues added.

The RMA also alters independent contractor rules for the healthcare sector. "In recognition of the limited number of suitable providers of healthcare services, the new rule will allow healthcare operators that lease properties from a REIT to serve as independent contractors on other properties (such as properties affected by foreclosures and lease expirations) held by the REIT," the Moody’s analysts explained. Other REIT sectors are not, and will not be, allowed to do this. This rule will broaden the pool of permissible independent contractors.

Print Friendly Version