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CT Expert Insight: Understanding REIT Due Diligence

Real Estate Investment Trusts (REITs) are a specific legal tax formation that gives breaks to those who manage large real estate portfolios such as shopping malls, office buildings and even cell phone towers when certain criteria are met.

Learn the IRS rules governing REITs and why S&P recently reclassified them into a new asset class. Also discussed are best practices for managing a REIT, due diligence issues, current trends, and the impact of politics and tax reform on the future of REITs.

CT Corporation Strategy and Innovation Manager Ian Bone defines REITs and gives tips and trends for managing one. 

 

TRANSCRIPT

Greg: Hi. I’m Greg Corombos. Our guest this week is Ian Bone, Senior Manager of Strategy and Innovation at CT Corporation. Our topic today—real estate investment trusts—how they can be beneficial to your business, and how best to manage them. Ian, it’s great to have you back again. Thanks for being with us.

Ian: Thanks for having me here.

Greg: Real estate investment trusts, the shorthand is REITs, so we’ll probably be referring to them by that name throughout our conversation today. But to begin, what exactly is a real estate investment trust?

Ian: A real estate investment trust is a specific, legal tax formation that you can take advantage of, certain IRS rulings, as a form of investing in real estate. The IRS allows certain tax breaks for the sale and purchase of real estate within certain turnaround times as long as you meet certain criteria. In order to be a REIT, you obviously need to file with the IRS to let them know that’s what you’re doing. You also have to have a minimum of 100 investors, and 80% of all of your income needs to go back to those investors in the form of dividends. It allows you, in a lot of cases, to access the public markets to raise large amounts of cash for buying these larger real estate investments. So you can think of malls, data centers, office buildings, even sometimes cell phone towers and billboards, and things like that fit under these very expensive, very large real estate portfolios of investment type. That doesn’t necessarily mean that any large real estate portfolio has to be a REIT, but for those that are turning over properties or are taking advantage of certain tax incentives will follow this code of operation.

Greg: So some significant parameters to keep in mind. When it comes to figuring out whether this is working for your business or not, what is the best way to do a performance review?

Ian: So obviously you should be looking at if you are in real estate investment itself, you should be looking at whether or not—or if you are in a large, property-heavy business—for you to be owning those within your business, talking to your tax advisors to understand whether or not separating that out. Sometimes we’ve seen a lot of spin-offs, where people will spin off all of their real estate into a REIT and continue to own that as a stock asset and be taking back the cash on rents that they’re paying themselves, and looking at that kind of financial structuring. It also allows you to potentially expand your footprint in a way that’s more aggressive than you would have had for borrowing using the public markets as an alternative source of borrowing, and things like that. It’s really about how to best operationalize the real estate assets that you have, whether or not it’s beneficial to your taxes. And also, from an investment point of view, having this separate from your core business, and potentially getting additional income off of it might be beneficial for you.

Greg: It wasn’t too long ago, Ian, that Standard & Poor’s reclassified REITs, so what exactly did they do, and what’s the impact of that?

Ian: So basically REITs now have their own codes, you can get a lot more information on them. They’re easier to follow. Financial advisors and other finance professionals now have an easier way to track them, to understand them, and to explain them to their clients. Retail investors as well are now getting additional information on them. So what it really does is, is that it takes an asset class that’s had very good returns over the past 20 years or so, and gives people a better understanding of what it is, and how it operates, and who else is in that segment of asset classes. It gives a lot more clarity and a lot more understanding to a lot more people. So again if you’re looking at using a REIT structure in order to go out and raise capital and spin it off (or anything like that) it’s really made it something that the broader [group of investors] can understand in a better way, not just tax policy wonks.

Greg: Well, we’ve talked a little about performance reviews, looking back at how it’s done. What’s the best way to manage a REIT as time goes on and to avoid risk while doing so?

Ian: There’s obviously a lot of tax compliance issues that you [have] to face. Making sure that you have the right talent to be dealing with that, to be tracking all of the really interesting things that the IRS comes out with every year, especially around REITs, and how things can be classified is very important. Tracking all of your documents, your ownership, your structure is very crucial for REITs and linking that back to the property themselves. There’s a lot of financing that happens in this world, very large, deal-size financing, so having the right independent directors and other compliance management partners out there is very important. With these large unwieldy structures, making sure you have the right entity management tools, that you’re filing all of your annual reports property in all the jurisdictions that you need to, the formations and organization that’s involved with that. Also, ongoing due diligence and things like that as you’re looking at investing in new properties and what may be happening within your existing portfolio and understanding any liabilities, judgments, liens, and things like that that might be out there.

Greg: Talk a bit more about due diligence, if you can, Ian. That’s a topic that we like to love to stress here because it takes away so many headaches when it’s done well. When it comes to REITs, what does due diligence involve if you’re doing it right?

Ian: There’s a lot of different kinds of real estate due diligence that you can be doing that is very industry specific. Obviously, you want to do judgment searches and lien searches, and understand that at the different levels that you need to [perform] litigation searches because people slip and fall, and they love to sue everybody, even though they shouldn’t be suing the building itself. Those are some aspects. But there are also a lot of things around EPA searches, around environmental remediation for certain properties and understanding what that is. You don’t want to buy a gas station thinking that you can make it into a new mall, and be told that there are millions of dollars in clean-up that needs to be done before somebody can buy something at the food court. So, really understand all the different elements of what goes into the property. There’s also a lot of things [with] REITs involved with casinos and things like that, especially with some of the Native American ones that are out there. There are tribal searches because they have separate court systems. Although you may have thought you had done all of your lien searches in the different municipalities that you need to if you haven’t done these very esoteric, specific, separate legal systems through the rights of sovereignty that they have, that’s something jumps out sometimes. So it’s a lot of different things based on the jurisdiction that your property is in and the kind of issues your property might be facing based on what it used to be, that you need to understand before you buy anything.

Greg: Let’s talk a little about politics now, and specifically, one of the early focal points of the Trump administration has been to roll back regulations in different sectors of the economy. What’s been done so far when it comes to REITs, and how does that impact the entire concept?

Ian: There’s been a lot of talk. And there hasn’t been anything pushed through specifically yet that has actively hurt or benefited REITs in any major way. But the one thing that has been happening has to do with interest rates rising. So obviously, anyone who has ever thought about getting a mortgage pays attention to the interest rates. And these REITs are getting giant mortgages when they go out and get lending to buy new properties. Interest rates will always be something that affects the attractiveness of being a REIT and buying property and financing these properties, and whether or not you want to go to the public market—and use that as a way of financing it—or going to the banks for using more traditional lending to buy properties. But as far as tax reform goes, the IRS is constantly working and clarifying rules, and there are some very interesting stories of whether or not fruit trees are real property or not and things like that I can go into. But as far as large-scale tax reform and what that means for the real estate sector, it’s something to watch. There’s definitely a lot of talk that I’ve heard about if different things around carried interest are taken away for real estate investors that there may be more esoteric issues around foreign ownership and fees and taxes that are paid for them that may also be repealed as kind of a give-and-take. But it’s all speculation at this point, and it’s really a matter of understanding where the big changes are going to be coming from if anything gets done. So, I think there’s a lot more of monitoring, perhaps, of what our congressmen and senators are saying than what’s coming from the very tippy top, on a rhetoric side.

Greg: Real quick before we let you go, Ian, everybody likes a good tip. So what are some trends and bright spots you’re seeing right now when it comes to REITs?

Ian: One of the trends and bright spots is definitely around data centers. Totally stealing this from the cover of REIT magazine this past month! But as we get more technologically based, the more that we’re relying on data and technology to do everything in our lives, these data centers are going to keep on being a strong industry play. I think there are a lot of interesting things being done by the mall REITs out there that may be undervalued as people think less about going to the mall, but they’ve been doing some interesting things in customer experience and understanding what the mall of the future might be like, so I think it’s something that’s maybe hit a bit of a pothole that could have an interesting left turn in its future. There’s a lot of things around the [cell] tower REITs, and timber REITs are very interesting. There are a lot of different sectors that are doing a lot of great things. It also comes down to the REIT management, how they handle the kind of hurdles or competition that’s out there. Even in a not-great industry, there are great owners and operators that you can look to say who’s the best of the best, and who should you be investing in or partnering with if you’re looking at this sector.

Greg: Ian, this can certainly be an intimidating topic for a lot of people, but you’ve helped us a lot to make it far less complicated. Thank you very much for your time today.

Ian: Thank you.

Greg: Ian Bone, Senior Manager of Strategy and Innovation at CT Corporation. I’m Greg Corombos.

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