Paired-share REITs: flourish or perish?

If the Clinton Administration has its way, the most efficient form of Real Estate Investment Trust (REIT) will be barred from expansion in the future. In his 1999 fiscal budget, President Clinton proposed curbing the growth of the so-called "paired-share" REIT, which in recent years has been very successful in providing shareholders with high returns.

A paired-share REIT is a combination of a REIT and a C Corporation that trades as a single investment unit and has the same shareholders. The REIT owns real estate that is leased to the C Corporation, a fully taxable entity that operates the property. The REIT is subject to all tax rules governing REITs (including limitations on the types of income it may earn without jeopardizing its tax status) and must distribute 95 percent of its taxable income to its shareholders.

One might rightfully question the Administration's motives in making such a proposal. Treasury Department Secretary Rubin describes it as a "loophole closer," and Treasury documents claim that paired-share REITs have a tax advantage over other REITs and real estate entities. The Joint Committee o f Taxation, however, reportedly found that there was little evidence of any tax advantages. In fact, the Joint Committee concluded that the proposal would raise only $34 million over the next five years.

Even by Treasury's own estimates, the proposal would raise relatively little revenue over the next five years - $100 million.) Such an insignificant amount clearly does not warrant tampering with a system that is not only operating efficiently, but is yielding strong returns that accrue to the benefit of public shareholders.

While the proposal would make no changes to treatment of investments currently owned by "grandfathered" paired-share REITs, it would treat the two parts of the paired-share REIT as one entity for purposes of meeting the REIT income test for new acquisitions made after the effective date for the proposal. (The Administration's proposed effective date is the date of first action by a Congressional Committee.) Freezing the growth of paired-share REITs in this manner is unfair to investors who have invested millions in paired REITs in reliance on Congress' promise of continued grandfathered status. It is unfair to deny these investors the potential for growth that surely motivated them to invest in paired REITs.

However, the proposal is subject to a long legislative process, and its final outcome is uncertain. In fact, when the Administration testified before the Ways and Means Committee hearing on its proposal late in February, there was barely a mention of the REIT proposals, and Chairman Archer opened with a denouncement of many of the Administration's proposals, calling them "tax hikes."

Nonetheless, there has been widespread concern among journalists and investors alike about how the REIT legislation might curtail the activities of paired-share REITs. The Wall Street Journal devoted significant coverage to the REIT provision, and the prices of the paired-share REITs have been negatively affected following the budget discussions.

Independent of the current speculation over the proposal, there is a strong case to be made for the fact that the Administration proposal is unnecessary. Not only will it fail to produce significant revenue, it will also penalize a structure that has committed no offense and has instead provided shareholders with strong operational efficiencies and returns on investment. Furthermore, the proposal contradicts Congress' initial intent when it created the REIT.

Business Purpose, Structure and Strategy

The Administration's proposal implies that paired-share REITs employ tax avoidance techniques and enjoy a competitive advantage. This is a complete misperception for the following reasons:

First, paired-share REITs do not enjoy a tax advantage over other real estate companies. Despite the misperception by some that paired-share REITs do not pay taxes, in fact the REIT rules ensure that the REIT's income will be taxed. REITs must distribute 95 percent of their income and REIT shareholders pay regular income tax on these dividend distributions. Shareholders also pay capital gains tax on the sale of their shares.

More importantly, the REIT rules are themselves very restrictive. A REIT is limited in the amount of bad or operational income it can earn and the paired REIT is subject to these restriction just like any REIT, Finally, the paired operating entity pays tax on all its profits, which include all profits attributable to operations rather than to ownership of the property.

The paired-share REIT does not involve a tax advantage. Rather, the primary advantages of this kind of REIT are:

* The elimination of the conflict of interest - or operational conflict - between the owner and entities which lease property for the owner. Shareholders and management are fully aligned in paired-share REITs because they own and operate the real estate in the paired-share structure. In non-paired REITS, the real estate is often operated by a tenant that is privately owned by management, causing the potential for conflict of interest. In addition, property managers (such as management-owned tenants) generally have an incentive to maximize short-term profits, regardless of the effect on the property. Management of the paired-share structure is more focused on long-term profitability, which is healthier for real estate property.

* The elimination of "leakage," which is the amount earned by an unrelated third party to lease and operate the REIT's properties. By owning paired-shares, shareholders of paired-share REITs attain the full value of the enterprise through ownership of the income earned by both the owner and the operating company.

* The effective use of the skills and expertise of management which have played an important role in the success of this kind of REIT. Members of the management teams have developed a clear, cohesive business strategy that combines identification o f well-timed acquisition opportunities and a focus on internal expansion.

Because all these benefits accrue to shareholders, especially small investors, it is they who will suffer if paired-share REITs are frozen, an irony in light of the fact that REITs were created to advance the plight of small investors. In a recent letter to Treasury Secretary Robert Rubin urging the Administration to rethink its position, a group of lawmakers on Capitol Hill articulated the value of paired-share REITS to shareholders:

"Paired-Shared REITs have been particularly beneficial to their shareholders because they align the interests of property owners and managers while taking advantage of the tax efficiencies, access to capital markets and public accountability available to all REITs." they wrote.

Without the ability to align ownership and management made possible by paired-share REITS, small investors would be placed at a significant disadvantage compared to large private and corporate real estate owners. In addition, many shareholders rely on this type of investment for an income stream now and in the future.

If the grandfather clause is removed, paired-share REITs will be forced to consider adopting a different structure, which will allow them to continue to compete and to grow, and likely would be more highly leveraged and have a greater debt-to-equity ratio in order to reduce taxable income. For example, in C Corporations, real estate assets are more highly leveraged than their REIT counterparts and yield smaller tax revenues to the Treasury. The C Corporation has an incentive to hold a higher debt-to-equity ratio because of the deductibility of the interest on the debt, thereby reducing the corporation's overall tax liability and possibly shareholder returns. The REIT has far less incentive to over-leverage its assets.

Congressional Intent

REITs, like mutual funds, were created by Congress to open up real estate investment to small investors, as well as to support urban renewal and real estate in general. The provisions of the basic legislation, originally proposed during the Eisenhower Administration but not enacted until 1960, have changed significantly since its original enactment. However, the central theme endures: encourage passive investment by a large group of small investors in real estate that may not otherwise be available to them.

In 1984, Congress made changes to the tax laws that prevented the formation of new paired-share REITs that have more than 50 percent common ownership. However, it grandfathered five existing paired-share REITs that were in existence at the time.

More than any other kind of REIT, the paired-share REIT approximates what Congress intended. Because the ownership and operation functions are bundled under the paired structure through the pairing of the REIT and the non-REIT corporation, shareholders come as close as possible to actually owning real estate.

In comparison to other REITs, paired-share REITs, by virtue of their structural link with the operating arm, allow stockholders to benefit to a greater degree from property-level performance. Therefore, it makes no sense that Congress should undo what it conceived almost 40 years ago by preventing these REITs from expanding. They are functioning just as Congress intended.

Furthermore, since 1986, both Congress and the Internal Revenue Service have carefully expanded the ability of REITs to own and operate real estate. In 1997, Congress enacted provisions that improved and expanded the operations of all REITs, including paired-share REITS, allowing them to return a higher level of dividends to shareholders. These legislative changes helped REITs support a rebounding real estate market. In fact, data shows that from 1990 through February 1998, publicly-owned REITs were an increasingly popular vehicle for acquiring and owning real estate in a rebounding market. By the end of 1997, total equity capital (shares x price) for publicly traded REITs had risen from $8.74 billion to $155.7 billion.

The Administration should not suddenly and arbitrarily halt this trend by putting a freeze on the very kind of REIT that represents the purest form of investor involvement in the complete aspects of real estate.

In light of the fact that there are two additional changes to REITs in the Administration's revenue proposals, it seems likely that this could be a first step in reversing some of the gains the REIT industry has achieved through recent legislation.

Conclusion

After careful examination of the history, legislative environment, current structure and many benefits of paired-share REITs, one would question the rationale for the Administration's proposal. According to Alex Brown Research, "The primary benefit to the paired and stapled REIT structure [is] the elimination of potential conflicts of interests, with ancillary benefits, including the elimination of "leakage," [and] the ability of the management team to be actively involved in property-level operations..."

False perception that paired-share REITs use their structure to avoid taxation and enjoy an unfair competitive advantage, as well as widespread media coverage of the Administration's proposal, has resulted in a sharp decline in the stock prices of the paired-share REITS. Careless consideration of grandfather issues and transition rules, in my opinion, were the catalyst that precipitated the collapse of the real estate market after the Tax Reform Act of 1986."

With that in mind, Congress should conduct a thorough examination of the current paired-share structure, as well as wide-spectrum alternatives ranging from more selectively addressing any real problems in the existing structure to extending grandfather status to all REITs.

However, it seems the most logical option would be to simply do nothing, leaving intact a proven and efficient method for shareholders to own real estate.

(Leonard Boxer is chairman of the National Real Estate Practice of Stroock & Stroock & Lavan. Boxer also is an independent director of Wyndam International, Inc., the operating company paired with Patriot American Hospitality, Inc.)