Expanding the REIT Horizon

By Steve Bergsman

In the annals of REIT history it would be hard to find a piece of legislation that has met with such unanimous and unbridled enthusiasm as the Ticket to Work and Work Incentives Improvement Act of 1999.

The legislation, which was signed into law by President Clinton and took effect Jan. 1, 2001, included the REIT Modernization Act that modified some of the rules governing REITs, most importantly allowing the creation of taxable REIT subsidiaries, or TRS.

"It is one of the major milestones in the modernization of the REIT vehicle since the adoption of REIT legislation in 1960," says Gilbert Menna, chairman of the real estate capital markets practice for Goodwin Procter LLP.

Just under five years after it took effect, REITs continue to sing the tax act's praises.

"It has been absolutely great for us," adds Charles Mueller, chief financial officer for residential REIT Archstone-Smith (NYSE: ASN). "There are a lot of requirements that have to be met in order to qualify as a REIT and therefore avoid taxation at the entity level. We understand the reasons for that, such as staying out of businesses at the REIT level that REITs don't qualify for tax purposes to be in. However, what TRS allow us to do is be in some of those businesses in a fully legal, acceptable and appropriate way."

Archstone-Smith uses TRS in a number of ways, including projects where it acts as a merchant builder (develops and sells assets) or in, for example, a joint venture that does condo-conversions.

"In general, TRS legislation has turned out to be a good thing, because lots of REITs have elected to use them to conduct businesses that are related to their core operations but were not originally intended under the initial REIT legislation," says Richard Jeanneret, area industry leader for Ernst & Young's Mid-Atlantic real estate practice. "The original REIT legislation was very narrowly focused, but as the real estate economy has evolved the law was changed to keep REITs competitive in the real estate marketplace."

A Sampling of Subsidiaries American Investment & Management Co. (NYSE: AIV) Purpose: On average, AIMCO has used 155 entities a year from 2001 to present in order to provide asset management or financial management of properties as well as non-customary services to properties and tenants, such as food service, recording studios, health clubs and convenience stores. Additionally, AIMCO owns a company through a TRS entity that provides properties with customary property/hazard insurance as well as additional flood insurance for hurricane and tropical storms. Archstone-Smith (NYSE: ASN) Purpose: Archstone-Smith has used subsidiaries to leverage its core expertise in buying, developing and operating apartments, as well as to invest in commodity markets and create attractive return with shorter-term ownership. AvalonBay Communities, Inc. (NYSE: AVB) Purpose: Used on a limited basis to receive a commission from a "preferred provider" vendor used by residents. Colonial Properties Trust (NYSE: CLP) Purpose: Colonial Properties Services, Inc. (CPSI), has been used from 2001 to 2004 to accommodate sales from land out-parcels and management fee income, and this year CPSI has produced revenue from condo-conversions, build-to-suit contracts, and for-sale projects. Developers Diversified Realty Corporation (NYSE: DDR) Purpose: DDR uses TRS for redevelopments, specifically the CityPlace development in Long Beach, Calif., or with its Retail Value Investment Program LP III (RVIP), a joint venture with Prudential Real Estate Investors and Coventry Real Estate Partners for development. Equity Inns (NYSE: ENN) Purpose: Equity leases all of its hotels to its taxable REIT subsidiaries. Gramercy Capital Corp (NYSE: GKK) Purpose: TRS were used for the company's $1 billion pricing of commercial real estate collateralized debt obligation (CDO) in 2005. CDO Securities were issued by two Gramercy subsidiaries and consist of $810.5 million of investment grade notes, $84.5 million of non-investment grade notes and $105 million of preferred shares. Hospitality Properties Trust (NYSE: HPT) Purpose: As of June 30, 2005, HPT used TRS to lease and manage 189 of its hotels.

A New Approach

Prior to the 1999 Act, REITs could form subsidiaries that were involved in non-customary services and practices. However, the formation of the subsidiaries was quite complicated and unduly restrictive. Efforts to operate within these roles led to ownership structures that created potential conflicts between the shareholder and REIT management.

However, under the TRS regime, a REIT can now own 100 percent of the TRS stock, ensuring that no conflicts arise. What's more, the value of a REIT's TRS cannot exceed more than 20 percent of the gross asset value of the REIT, making sure that the REIT's principal focus is on core real estate operations.

Additional Services and Businesses

Jim Brock, the Southeast real estate tax leader for Deloitte Tax LLP, says the principal effect of the legislation is that it allows the REITs to grow TRS, not to mention that it provides REITs much more flexibility. In 2001, the year the TRS law took effect, there were more than 400 filings for TRS and approximately 40 percent of those were newly established entities, according to corporate filings.

"TRS are a nice vehicle for us when we do creative acquisitions, as we're working through different portfolios," says Michelle Dawson, vice president of investor relations at Developers Diversified Realty Corporation (NYSE: DDR). "We use it to house anything that we don't plan to sell, so that we don't have a dealer tax penalty."

Most of the REITs that use TRS have fairly traditional intentions, such as third-party management, development and providing non-customary services. If, for example, a residential REIT wanted to offer non-customary services such as pizza delivery to the apartment developments in its portfolio, that could be done through a TRS. They are also used, as noted, where the company runs a development outfit and in cases where REITs have entered into the condominium market.

As an example, Colonial Properties Trust (NYSE: CLP) in July announced it was expanding its TRS activities by entering into the for-sale real estate market. One of the TRS' first ventures was a partnership with an independent company to convert apartments into condominiums. In a company statement, Tom Lowder, Colonial Properties' chairman and chief executive officer, said, "these projects are a natural extension of our diversified business model ... it makes sense in today's environment for us to leverage our expertise by including for-sale products in our strategy."

Another area REITs use TRS for is to help manage the foreign currency gains and losses generated from repatriating money from foreign countries, Brock adds. "Some REITs have elected TRS status for foreign corporations to assist in the management of these gains or losses."

Summing up the strategic benefits, Larry Portal, a partner with the Schonbraun McCann Group says, "REITs use the TRS to own an investment that normally might not qualify as a REIT asset. It's often used by development REITs to build and sell residential condos and by mortgage REITs to hold business units that may trade mortgages."

Dawson says subsidiaries have facilitated DDR's joint ventures in development and redevelopment. DDR used TRS to help with the selling of the CityPlace Shopping Center in Long Beach, Calif. CityPlace was developed in stages from 2002 to 2004 by DDR's Retail Value Investment Program LP III (RVIP), a joint venture between DDR and Prudential Real Estate Investors. "We tend to be one of the more active consolidators out there, so it's a nice vehicle for us to use as we do these creative acquisitions," Dawson says.

One of the fastest companies out of the box with a TRS was SL Green Realty Corp. (NYSE: SLG), which formed eEmerge even before the legislation went into effect. This was in the days prior to the collapse of the dot.coms, and SL Green's new company was going to provide flexible, short-term work space solutions for tech companies. The market quickly changed, however, and then came the terrorist attacks on the World Trade Center.

eEmerge persevered and the space that was to be filled by tech companies ended up being used by a number of entertainment companies, specifically film and TV production. eEmerge currently holds 60,000 square feet of space in Manhattan and is adding another 22,000 square feet, all in buildings owned by SL Green.

Melissa Libner, senior managing director of eEmerge, says the subsidiary, "is not SL Green's primary business, in fact, it is a drop in the bucket comparatively speaking, but we fill space otherwise vacant for the landlord at market or above-market rents. The REIT also gets to derive income from any profits that eEmerge is making."

SL Green is a pure-play equity office REIT, Libner adds. "With eEmerge, it saw an opportunity that was synergistic but not a pure-play in its primary business. eEmerge is very complementary to the core business, and that it fills vacant office space."

The advantages of being a TRS are, says Libner, "I get 100 percent exposure to the REIT, its resources and its relationships. Being backed by a publicly traded entity with a real backbone makes it easier to leverage our space and services at any point in the cyclical real estate market."

In 2004, SL Green took the subsidiary concept once step beyond when it formed Gramercy Capital Corp., a specialty finance company focused on originating and acquiring loans and other fixed-income investments secured by commercial and multifamily real estate. SL Green spun off Gramercy Capital (NYSE: GKK) into a separate publicly traded REIT, retaining a 25 percent ownership stake in the new public firm.

According to Michelle LeRoy, vice president at SL Green and Gramercy, the company has used its subsidiaries since the beginning of 2005 for loan trading and net leases. In June 2005, Gramercy used the proceeds from a collateralized debt obligation (CDO) issuance to refinance its warehouse facilities and fund additional investment activities. The CDO securities were issued by two newly formed Gramercy TRS.

Thornburg Mortgage Home Loans, a wholly owned subsidiary of Thornburg Mortgage, Inc. (NYSE: TMA), elected to become a TRS in 2004. As a TRS, Thornburg Mortgage Home Loans handles all the loan origination, acquisition and securitizations for the REIT.

"One of the major advantages to the TRS structure is that it allows us to further diversify our funding sources by allowing us to permanently finance adjustable-rate mortgage (ARM) loans through the issuance of CDOs," says Leanne Gallagher, vice president of investor relations for Thornburg.

Through a CDO transaction, Gallagher says Thornburg is able to securitize a pool of ARM loans into multiple classes of securities, and typically the AAA-rated class is sold to investors.

"Since CDOs represent permanent financing and have no margin call risk, they reduce our financing capital requirements and provide an additional source of balance sheet and earnings growth," Gallagher says.

CDO issuance through Thornburg Mortgage Home Loans has given the REIT a more efficient use of capital, which has allowed it to invest in additional assets without having to tap the equity markets.

"As of June 2005, the eight CDOs we completed over the past two years had freed up approximately $514 million of capital, enabling us to hold approximately $3.6 billion in additional ARM assets," Gallagher says.

A Sampling of Subsidiaries IMPAC Mortgage Holdings (NYSE: IMH) Purpose: IMPAC's subsidiaries, IMPAC Funding Corporation, IMPAC Warehouse Lending Group, IMPAC Multifamily Capital Corporation, and Novelle Financial Services, have been used since 1995 for nonconforming Alt-A mortgage loans, to originate small balance multifamily loans through brokers on a wholesale basis, to originate first and second mortgage programs and to assist in the development of creative subprime loan products. Innkeepers USA Trust (NYSE: KPA) Purpose: Innkeepers' TRS manage six extended-stay property hotels previously leased to Wyndham International. Kimco Realty Corporation (NYSE: KIM) Purpose: Since 2001, Kimco has used the TRS Kimco Realty Services Inc., for real estate brokerage, lending to retailers and property owners, debtor in possession financing, recapitalization of bankrupt retailers, designation rights agreements, common stock investments, non-qualified service activities and merchant building. Kimco Developers Inc, also developed in 2001, is used to provide partnership capital development expertise on leasing, construction and the approval process to developers and landowners to be built or redeveloped retail centers. Kimco provides advisory and support services to its properties through Kimsouth Realty Inc, a joint venture between Kimco and Prometheus Southeast Retail Trust, acquired in 2002. Simon Property Group (NYSE: SPG) Purpose: M.S. Management Associates, Inc. became a TRS of SPG in 2001. It provides management, leasing and other services. SL Green Realty Corp. (NYSE: SLG) Purpose: Established in 2000, eEmerge offers short-term work space solutions for companies needing ready-to-use office space. Thornburg Mortgage (NYSE: TMA) Purpose: Thornburg Mortgage formed Thornburg Mortgage Home Loans in May 2004. The TRS is used for loan origi- nation, loan acquisition and loan securitizations. The subsidiary also presents the ability to diversify funding sources and permanently finance ARM loans through CDO issuance. Winston Hotels Inc. (NYSE: WXH) Purpose: Having formed Barclay Hospitality Services in 2002, Winston Hotels Inc. uses the subsidiary to lease hotels from the parent company.

Lodging REITs Score Big

The group that has probably benefited most from the Ticket to Work and Work Incentives Improvement Act has been the lodging REITs, as they had particular sets of restrictions created under the original REIT legislation. The key problem for lodging REITs was that they had to lease their hotels to an independent company, which then chose an operator for the facility.

"Hotels owned by REITs had to be leased to and then operated by third parties. A hospitality REIT could not own and operate its own property as all other REITs could do after 1986," says Joseph Green, president, chief financial officer and secretary of Winston Hotels Inc. (NYSE: WXH).

With the legislation in place, hotel REITs were able to form TRS, which can lease the property from the REIT. However, through the TRS, lodging REITs still must engage an independent management company not owned by the REIT or TRS to actively operate the hotels.

"We now can control our lessee that in turn oversees the independent management company," Green says. "Being able to have the TRS between the REIT and the day-to-day operator has made all the difference in the world because through the TRS the hotel REIT can oversee the operations. The Ticket to Work Act allowed hospitality REITs to have much more visibility over how the properties actually operate the using chosen independent management company."

For the most part, being able to create TRS has worked "fairly well" for the hospitality industry, adds Donald Olinger, executive vice president and chief financial officer for MeriStar Hospitality Corporation (NYSE: MHX).

About the only change Olinger would consider making to the TRS legislation would be to broaden the definition of what is permissible and what is not, as this would give REITs more opportunities to provide a wider range of services. For lodging REITs, that may or may not include gaming.

"In order to buy a hotel that has gambling (such as most properties in the Caribbean), you would have to structure some sort of separate lease arrangement and have somebody else run the casino," Olinger says. "Gaming is one of the more profitable parts of the enterprise so you would lose the advantage of owning that hotel."

Although the hotel sector "as much as anybody" drove the legislation that got TRS approved and has seemingly endless possibilities for TRS, external factors have limited how widely used TRS have been across the sector.

The problem has been nothing more than timing, Olinger says. "September 11 happened right after this came into effect and everybody was in such a downward spiral for the next couple of years there was little venturing out into new initiatives. Now, fortunately, we are in a very strong cycle of recovery, so I suspect we will start to see people lifting their heads out of the foxholes and more and more companies considering new business ventures."

Lingering Issues

Although there has been unanimity in the viewpoint that TRS have been a success, some minor administrative issues have cropped up. Portal lists two irritants: tight filing requirements and restrictive transfer pricing rules.

In regards to filing, what has proved problematic is that when a company elects to create a TRS, a form has to be filed with the IRS within 75 days.

"I'm guessing 15 to 20 REITs have missed the 75-day filing requirements and have had to seek special relief from the IRS," Portal says.

A second issue is that under the preferred stock affiliate rule there was no transfer pricing concept. Now there is, which is appropriate, but it means any transaction between the REIT and the TRS has to be documented as done at arm's length or the REIT can be susceptible to an excise tax.

William Hauser, director and portfolio manager for HVB Asset Management, Inc., says a question of business judgment is whether too much creativity at the subsidiary level is going on hand-in-hand with lack of expertise, which can make investors nervous.

"A potential criticism that is not specific to TRS, but is simply conceptual, is that anytime a management team is doing something astray from their primary line of business, this could draw investor concern," he says. "They start to wonder ‘how much time are you spending on making that business grow, as opposed to what we thought we were paying you for.' If companies start doing cable television services, investors worry that it could be risky business."

The TRS question hovers over analyst coverage as well. The underlying question is, how much emphasis should be placed on these units when a company reports its annual or quarterly financial results? Richard Moore, a managing director and real estate analyst at KeyBanc Capital Markets, calls TRS the "least important parts of the story." It's not that he doesn't like them, but he cautions, "analysts should not overplay what is going on with them. TRS add to the story, but they are icing on the cake and the cake is the most important part."

Moore includes TRS units in his analysis reports, especially in terms of fees being generated. Still, he asserts, "the heart of any REIT's story is the ongoing management of properties."

Jeff Donnelly, senior analyst with Wachovia Securities, adds that it is important for companies to disclose information relating to their TRS in order to evaluate the company as a whole.

"TRS information is included [in most quarterly and annual financial reports] but the companies don't always provide adequate disclosure, and they could do a better job highlighting some of these things. A company might report that the equity investment in a particular venture is ‘x', but it doesn't give much detail about that venture," he says.

Donnelly says that while it is valuable for a company to report the amount of investment in a TRS, it should also disclose the amount of risk involved—something he says doesn't always happen.

Greater Usage

Now that TRS have been in existence for five years and companies have used them for everything from development and merchant banking to international operations and concierge services, how will TRS continue to evolve?

The answer to that could reflect on Moore's distinction between the cake and the icing. Deloitte's Brock puts it this way: if profits relating to the core business of a REIT start to erode, then that same REIT would be more inclined to find a way to generate other types of income.

"A lot of REITs are doing so well today that a focus on developing businesses through TRS is not so great," Brock says. "But if you see FFO (funds from operations) from the core asset holdings start to diminish then you traditionally see REITs looking at using TRS to generate income."

Steven Brown, portfolio manager with Neuberger Berman, agrees. "As we move further into the real estate cycle, we'll continue to see REIT management push the edges of the box in the realm of possible ventures. If fundamentals deteriorate, I would expect the TRS to be a more important source for REITs," he says.

Jeanneret concludes that the flexibility TRS have given REITs will continue to be one of the main benefits going forward. "TRS have allowed REITs to stay fully focused on their core operations but be able to change with the times as the industry evolves. That will continue."