DownREIT and Other Growth Strategies (Spring 1996)

by Gary Sabin

Like many REITs, we have faced the dilemma of how to continually grow without issuing equity at dilutive prices or increasing our leverage. We believe we have resolved this dilemma by creating what is now referred to in the industry as a DownREIT structure.

Excel formed its first DownREIT early in 1994 to facilitate the purchase of six shopping centers from a seller who wished to defer income taxes on the sale of those properties. Because we were not an UPREIT and had no OP units to offer, we formed a partnership wherein the seller contributed the six properties in exchange for equity units and we contributed cash which was used to payoff certain mortgages. The equity units were valued according to the respective contributions of cash and/or real property equity that each party contributed. The REIT became the sole general partner and the seller became the limited partner. The limited partner was required to hold the DownREIT units for a minimum of one year before having the option to exchange for REIT shares. At that time, the price of our common stock was $22.25 which we found to be an acceptable level, so the exchange value for units into shares was set at the market price of $22.25 per share.

Later, however, we agreed to acquire a portfolio of 15 shopping centers from a developer when our common stock price was $16.75 (the company was suffering with a number of retail REITs at the end of 1994). Obviously, we did not want to issue equity at this price but still wished to acquire the portfolio. To facilitate the purchase, we devised a flexible master limited partnership structure with the REIT acting as the sole general partner and the developer as one of potentially several limited partners that could contribute their particular properties to the master partnership in exchange for partnership units.

The partnership units are customized at the time of a particular transaction so that exchange values and other particularities unique to each property contract can be taken into account, thus avoiding the need of forming a separate partnership for each transaction. This structure allowed the exchange value to be set substantially higher than where the company's common stock was currently trading. For example, in the above transaction, the exchange value ultimately agreed upon was approximately $21 which represented a 25 percent premium. The seller agreed to this premium because of the logic that the stock market will ebb and flow but the portfolio is a long-term portfolio and the company valuation should be tied more closely to the underlying asset values. In essence, we compared the cash flows of the existing portfolio and the new properties and determined that the stock was undervalued by 25 percent.

There are several other distinct advantages to this structure. First, an unlimited amount of currency is available for acquisitions. Second, because the DownREIT units often have no immediate tax impact to the seller, better pricing is potentially available. For instance, in the above example, we were able to contract for these 15 shopping centers at a price lower than a competing all-cash bid because of the seller's desire to minimize his tax burden.

Third, the opportunity exists to accretively impact the common shareholders because of the different sharing ratios of the cash flow in the partnership.

This works as follows: The limited partners receive units in exchange for their equity with the partnership assuming mortgages on the properties, if any. The equity is divided by the unit price agreed upon for the future exchange and the unit holders receive distributions from the partnership equal to the then-prevailing common dividend being paid (to the extent the partnership has sufficient cash flow). The REIT, as general partner, contributes capital to the partnership equal to a designated percentage and, therefore, is entitled to that percentage of the initial cash flow with the limited partners receiving the remaining percentage of the cash flow up to their preferred distribution per unit. After the limited partners have received their preferred distribution, then most of the excess cash flow is paid to the REIT, as general partner, with a smaller percentage remaining for the limited partners.

The benefit of this structure is that even though the REIT, as general partner, owns only a small percentage of the partnership, it receives a substantially higher percentage of the total cash flow. This provides a substantial return on the investment that is difficult to achieve elsewhere through a direct fee purchase. It is obviously temporary until the time (if ever) the limited partners convert into shares but, in a master DownREIT when transactions are continually being added, there is an on going stream of cash flow which continues to benefit the common shareholders.

Fourth, the ability to retain quality assets off balance sheet is created until such time as the REIT desires to up-stream these assets. It can, in essence, serve as either a "holding tank" until additional equity is raised so that debt to equity ratios are kept in balance or until properties are sold with the profits being divided by the partners.

The final advantage is the avoidance of conflicts of interest between the contributors of the property and the operators of the REIT because these are "arms length" transactions and the decision to sell a property in the partnership is not affected by the tax basis of the decision maker. There are also no management agreements or other fee arrangements between the parties. However, the general partner does have the responsibility for operating the properties for which it receives a larger percentage of the cash flow.

This strategy provides tremendous flexibility and most importantly, avoids the entire issue of the cost of capital since the company is not at the mercy of the capital markets in deciding to purchase additional properties within the DownREIT structure.

The disadvantage is that it takes a tremendous amount of work on the part of the purchaser to educate sellers as to the benefits of this structure. The sellers must be comfortable with the REIT portfolio because, at the end of the day, that is what they will own once their units are exchanged for shares. We have found, however, that there are many holders of portfolios and individual owners, who are favorably disposed to this structure because of the distinct tax advantages and flexibility it offers.

Property Sales. Another "tool in the arsenal" for growth should be the willingness to sell properties from time to time when such properties have matured or when a higher price can be obtained than one would pay for that property anew. I believe many REITs could benefit from this strategy as long as the various tax issues are adhered to (i.e. 1031 exchanges utilized for investment properties held less than four years and no greater than seven sales or 10 percent of one's portfolio sold in any one year). This provides a tremendous vehicle for growth and likewise avoids the cost of capital issue since capital for new investments is internally generated.

Ground Lease Development. Another strategy we have found extremely helpful is to team up with developers who have identified sites, tenants, construction lenders, etc., but who lack sufficient capital to purchase the ground in order to complete the project(s). We typically purchase the ground and lease it back to the developer with an option to purchase the finished product at capitalization rates substantially higher than what we would be facing if we waited for the developer to finish the project and then stood in line with others to buy. We have been able to achieve capitalization rates between 150 and 200 basis points higher using this strategy without incurring the traditional development risks. Part of this strategy entails the use of a taxable affiliate providing the company with a sell or keep option.

The finished product can either be sold with the after tax profits being up-streamed to the REIT, or the REIT can exercise its purchase option at a favorable price. The REIT's taxable affiliate can also take advantage of fee income on properties which are not pursued but are referred to others.

Joint Ventures. A final strategy which takes advantage of management's expertise is to enter into joint ventures wherein the company is paid for its expertise as opposed to its capital and, as a result, receives management income or a share of profits for such expertise (i.e. acquiring, managing and selling). This presupposes that the company is a true operating real estate company-not merely a holder of assets-and that this income can safely fit within the 5 percent "bad income" basket.

These are some ways we have found helpful in operating in a capital-intensive environment, which is not always friendly, yet demands accretive growth. I believe the combination of these strategies together with quality leasing and management provides a self-sustaining methodology that allows a company to have an impressive growth pattern in spite of the temperature of the capital markets at any given time.

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