DownREIT Strategy (Spring 1996)

How does a small-capitalization REIT grow when stock prices of REITs are soft, making it impossible to sell additional stock? The temptation is to sit back and say, "Well, we'll just do a good job of managing our properties and hopefully the stock price will come back up. Then, we'll sell some stock and go buy additional properties."

Alternatively, management can say, "We can't wait for the market to take notice of us. We've got to be innovative and make something happen that will enable us to grow and expand."

At Pacific Gulf Properties, we chose the second approach. In the spring of 1995, the company was little more than a year old and had real estate assets of just $193 million. Our stock price was hovering at $15.50, well below the per-share market value of our assets. We needed a strategy that would make it possible for us to grow our funds from operation base and increase the size of our real estate base.

Our REIT specializes in apartment and industrial properties on the West Coast. We knew that many attractive properties in our area would become available if their owners could sell their properties without triggering significant income taxes. Acting on the counsel of the E & Y Kenneth Leventhal Real Estate Group, we decided to become one of the first REITs to use a DownREIT structure to accomplish this purpose.

A DownREIT enables a REIT to acquire and hold real estate properties in an operating partnership that is separate and apart from other properties in the REIT. The owner/developer contributes assets to the operating partnership and, in return, receives partnership units that can be exchanged at some future date for shares of stock in the REIT.

In most cases, no tax liability is triggered when the owner/developer contributes properties to the operating partnership. Not until the partnership units are converted into stock or the partnership assets are sold will the owner/developer units become taxable. In a DownREIT the REIT will probably have to agree to a standstill agreement for five years or longer. This is generally negotiated at the front end.

The DownREIT is an excellent tax planning tool. Sellers do not have to convert their partnership units all at the same time; they can do the conversion in segments, spreading out their tax liability over several years.

DownRElTs are also valuable for estate planning purposes because the tax laws allow for a step-up in basis upon the death of a spouse. In this case, the surviving spouse will get a step-up in basis which will allow him or her to convert the operating partnership units into REIT shares without incurring taxes. This allows the surviving spouse to obtain cash without waiting for the remaining partners to agree to sell and also lets the remaining partners stay in the DownREIT without incurring a tax liability.

In most instances, holders of partnership units will receive distributions from the operating partnership, effectively giving them the equivalent of dividends.

The flexibility afforded by a DownRElT can make the difference between success and failure when trying to acquire property with numerous owners who may or may not have tax problems. Consider this hypothetical but typical example:

Fifty years ago, Jack Smith established a business that became highly successful. Over the years, it acquired real estate that has greatly appreciated in value. During the same period of time, Mr. Smith has given ownership interests to 25 family members-his children and grand children and other relatives.

The grandchildren and other younger owners would like to sell and get cash for their interests. But Mr. Smith is reluctant to sell because he would incur a substantial tax liability. So, he prefers to hold off until his estate planning program kicks in.

Obviously, it would be difficult to purchase this property for cash. But a DownREIT would enable each owner to sell at a time of his or her choosing, thereby giving all parties liquidity when they want it and setting around the problem that is posed when all owners are tied together in an investment.

Once we had the structure, or vehicle, of the DownRElT ready for use, the next question was how to find properties we could acquire with it. You do not go to a broker or to a real estate company and offer to buy its portfolio; the DownREIT is suitable only for select groups of individuals who are concerned with taxes and tax planning.

To find those groups, we talked to our established business contacts, to contacts of our board members and to accountants and lawyers who might know of opportunities to use a DownREIT.

It was through a long standing relationship with southern California developer John Konwiser that, early in 1995, we found an opportunity for doing a DownREIT. Mr. Konwiser headed a consortium of 11 apartment projects in five southern California cities: Covina, West Covina, Diamond Bar, Ontario and San Dimas. There were a total of 1,368 units in these properties.

We saw that this would be a complex transaction because the 11 properties were owned by approximately 70 partners in 17 different partnerships. The first transaction took a year to put together. We signed an agreement to acquire all of the properties for about $72 million. We then formed a new operating partnership in which Pacific Gulf Properties would own 80 per cent and become the general partner with the members of the consortium all becoming limited partners and holding a 20 percent interest.

In mid-August, we announced that escrow had closed on eight of the 11 projects, with a total value of $63 million. A few days later, we closed escrow on the last three properties, valued at $9 million.

At these closings, Pacific Gulf issued a total of 226,000 limited partnership units. These units are convertible into Pacific Gulf common stock on a one-for-one basis beginning in August 1997.

Our company will invest a total of $14.5 million in the operating partnership. Of that total, $13.5 million will be used to pay down and restructure conventional debt on a portion of the portfolio and costs associated with consummating the transaction.

The remaining $1 million will be used to improve the properties over the next year or two.

After the company has received a stated fixed return on its investment, the limited partners will receive a cash distribution (to the extent that the partnership has cash to distribute) equal to Pacific Gulf's dividend per share for each partnership they hold.

Thus, in a single transaction, Pacific Gulf increased its assets to $280 million, more than double what they were less than two years earlier.

The 11 projects in this DownREIT appealed to us for several reasons. First, we saw great potential for increasing their occupancy and revenues. Second was the fact that they included three projects for active senior citizens.

We view senior housing as a growing market, especially in southern California, and these projects can be quite profitable and fit into our long-term business strategy.

Finally, five of the acquired properties are financed by tax-exempt, low-floating rate bonds. We expect to use tax-exempt financing programs in future acquisitions.

We were extremely pleased with this acquisition because it showed that Pacific Gulf has the expertise to deal with difficult, complicated situations. Owners of other attractive properties can be confident that we will be able to accommodate them through a DownRElT structure when that appears to be the appropriate method for an acquisition.

A couple of cautionary notes: In structuring a DownREIT, great care must be taken to avoid diluting the equity of a REIT's existing shareholders. It is also essential to avoid too much lever age on a transaction. Highly leveraged projects may not provide enough room to do a DownREIT; in some situations it might not be possible to restructure the debt without putting in more money than the property is worth or triggering a tax liability to the owner/developer.

Finally, tax accountants and corporate attorneys should be consulted on each transaction to be sure the structure is correct for the particular acquisition.

We are continuing to explore the use of the DownREIT concept with several sources. The best time to do so is at tax time because owner/developers are more aware of their tax problems then. A REIT that works closely with its accountants and lawyers in the tax season should be able to identify solid candidates for the DownRElT structure.

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