Views

Surveying the REITs Landscape: A Conversation With V&E Partner Daniel LeBey

Daniel LeBey feels more than at home talking about REITs.

In fact, the V&E partner has devoted much of his nearly three-decade-long legal career advising real estate companies, private equity sponsors and underwriters on matters involving Real Estate Investment Trusts (REITs), including REIT and pre-REIT formation transactions, initial public offerings, secondary offerings, other public and private securities offerings, debt financings, mergers and acquisitions, and other transactions, as well as on SEC compliance and corporate governance matters.

“Assuming we don’t have any big disruptions in the economy, or a massive stock market correction, I think we will see an uptick in REIT IPO activity in 2019.”

LeBey is one of a five-member team of partners that joined V&E in 2016 to establish a dedicated REITs practice. He recently sat down to share his thoughts on the outlook for REIT IPOs, the impact of the new tax law on REITs, and the legal and market considerations real estate owners should keep in mind before setting out to form a REIT. Here’s what he had to say.

The REIT IPO market has faced a dry spell in recent years. Only 5 REITs went public in 2018, a far cry from 2013 when there were 19 REIT IPOs, according to REIT industry group Nareit. Do you expect REIT IPO activity to pick up in 2019?

I expect to see REIT IPOs rebound this year for a number of reasons.

First, we’re seeing an upswing in secondary public offerings of equity by REITs. In the first quarter of 2019, V&E alone advised on 13 secondary public offerings in the REIT space. In the first quarter of 2018, we advised on only two. That’s a significant increase in volume, and it’s not just us. I don’t know for sure, but I think that’s a hopeful signal that we may see more IPO activity in 2019.

A combination of other factors including the Fed’s recently confirmed freeze on further interest rate hikes, continued strength in the commercial real estate sector and the broader economy, the fact that REITs have managed their balance sheets prudently, and a dynamic shift in the way real estate is being constructed and utilized also bode well for REIT IPOs.

There are already several REIT initial public offerings in process this year. Assuming we don’t have any big disruptions in the economy, or a massive stock market correction, I think we will see an uptick in REIT IPO activity in 2019.

What about the Tax Cuts and Jobs Act of 2017 — does it include legislation that is beneficial to REITs?

The new tax law offers positive news for the REIT industry, starting with a tax break for REIT investors.

REITs don’t pay corporate federal income tax, rather they distribute their earnings to investors in the form of dividends, which are taxed as ordinary income.

Under the new tax law, REIT investors can take a 20% deduction on REIT dividends. That means if you’re in the highest tax bracket of 37%, you don’t pay a 37% income tax rate on REIT dividends, rather you pay an effective rate of just 29.6%.  While this is higher than the capital gains rate investors pay on taxable C corporation dividends, C corporations and their stockholders are subject to double tax due to the corporate level income tax that corporations must pay, so the relative tax benefit for REITs and their investors is approximately where it was pre-tax reform.

In addition, the new tax law created the Opportunity Zone program, where REITs can play an important role.

The program offers investors with realized capital gains an opportunity to defer and partially eliminate those gains by investing them into economically distressed areas. At V&E, we’ve been spending a lot of time advising clients around the possibility of structuring funds and vehicles, some of which would be structured as REITs, that can capitalize on the Opportunity Zone program.

Because this part of the tax legislation was drafted hastily, there are still many unanswered questions. New regulations have been proposed to address these questions, but not all of the issues have been addressed.  In addition, there are significant restrictions on Opportunity Zone fund investments including in particular on the ability to transfer the investments, so we don’t see the Opportunity Zone program having a big impact on the broader REIT sector.

If you’re a real estate owner who is considering forming a REIT, what are some marketplace considerations to keep in mind?

The REIT industry has become highly diversified. While REITs have historically owned traditional asset classes like office buildings, apartment buildings and shopping centers, today REIT assets include everything from healthcare facilities, senior housing assets, and single-family homes operated as rental properties to infrastructure assets like pipelines, cell towers, and data centers. Industrial properties are one of the hottest asset classes in the REIT space today.

There have been even been some marijuana REIT deals done, where the REIT owns the property where the marijuana is grown, and then leases it to a grower/producer.

The REIT IPOs that have been getting done lately have tended to be IPOs by companies that are doing something different from what’s already well represented in the public markets. I think that’s becoming one of the prerequisites to getting a REIT IPO done today.

What legal considerations should would-be REIT issuers keep in mind?

While REITs have an obvious advantage in not having to pay corporate-level income tax, the tax law imposes complex rules on such factors as the type of income REITs can generate and the kind of assets they can hold, as well as various ownership tests.

Among other things, REITs must invest at least 75% of their assets in real estate. They must receive at least 75% of their gross income from real property, mortgage interest, or the sale of real estate. They’re also required to distribute at least 90% of their taxable income to their shareholders, and REITs must be widely held due to rules against too much concentration of ownership.

If you own a hotel, you might think of that hotel as real estate, but a hotel is really a business that’s operated in a building. The revenue earned at a hotel is business income, not rental income, for REIT purposes. So a REIT can own a hotel, but it must lease that hotel to a third-party operator or to a taxable subsidiary that engages a third-party operator.

I would advise would-be sponsors or REITs to make sure they have good advisors and good lawyers, like the lawyers in V&E’s REITs practice. Sponsors and other real estate owner/operators will want to make sure that a REIT structure is consistent with their business strategy and that they are following all of the rules.