Real Estate Alert
April 7, 2010
Authors:
Gregory R. Andre
greg.andre@klgates.com
+1.312.807.4254
Phillip John Kardis II
phillip.kardis@klgates.com
+1.202.778.9401
Thomas J. Lyden
tom.lyden@klgates.com
+1.202.778.9449
K&L Gates includes lawyers practicing out
of 36 offices located in North America,
Europe, Asia and the Middle East, and
represents numerous GLOBAL 500,
FORTUNE 100, and FTSE 100
corporations, in addition to growth and
middle market companies, entrepreneurs,
capital market participants and public
sector entities. For more information,
visit www.klgates.com.
Mining the Corporate Balance Sheet
for Real Estate Equity
Virtually all corporations own or lease real estate. Some corporations have a real
estate portfolio that is owned or leased in accordance with a well-crafted plan that
made perfect sense years ago, but today would benefit from changes to comport with
new corporate objectives and economic realities. Other corporations have
accumulated real estate portfolios over many years, oftentimes through mergers or
acquisitions, where the manner of ownership was secondary to more important
considerations at the time, but now represent a mix of owned and leased real estate
that is underserving corporate goals.
Corporate objectives with respect to real estate might be simple and straightforward,
such as monetizing illiquid holdings or raising cash immediately. Other objectives
are more complex, such as maximizing flexibility in accessing real estate equity,
improving overall returns on assets, centralizing ownership and management,
streamlining administration or tax planning at the federal or state level.
Many corporations approach the analysis of their real estate portfolios by asking only
the simple question of whether they should be owning or leasing it and, if they own
it, whether they should sell it and lease it back. While these obvious and basic
alternatives must be considered, there are additional alternatives to consider. A few
alternative approaches are set forth below, and other structures may suggest
themselves in the unique circumstances of each corporation.
Restructure Owned Real Estate with Public Capital
Many corporations seek a strategy that will tap equity in their real estate. Given the
current difficulty securing real estate financing from banks, the public capital
markets should be considered as a means for accessing equity in real estate.
Corporations considering these strategies, however, generally need to have a
substantial real estate portfolio to make such transactions worthwhile.
Contribution to an Existing REIT
If a corporation currently holds real estate assets, such as office buildings or hotels,
and it is not as interested in currently monetizing its investment in real estate as it is
in diversifying that investment, it may seek to contribute the real property it owns to
an existing publicly traded REIT.
There are two courses of action open here. First, if the corporation is indifferent to
recognizing tax gain or loss on the transfer of real property, it could simply transfer
the real property to an existing REIT in exchange for shares of its publicly traded
stock. This would be a taxable transaction. Indeed, this strategy might appeal to
corporations seeking to take advantage of tax loss opportunities afforded by low
valuations in the current recession.
Real Estate Alert
The corporation would, through its acquisition of REIT stock, acquire an interest in a diverse portfolio of
real estate. Furthermore, it could sell shares into the market far more readily than it could sell unique parcels
of real property. As a result, the REIT shares would represent an increase in liquidity.
If, however, the real estate owned by the corporation has a large built-in-gain that the corporation does not
want to recognize for tax purposes, then an alternative approach could be employed. Under the alternative,
the corporation could contribute the real estate assets to either a newly formed partnership or an existing
partnership in which a REIT would be the other partner. Careful attention must be paid to the drafting of the
partnership agreement to ensure that sufficient liabilities are allocated to the corporation such that the
contribution to the partnership will not result in gain recognition. In addition, the REIT partner would have
to covenant that it would not undertake actions that would result in gain recognition to the corporation for a
fixed period of years. The interest in the partnership held by the corporation would be convertible into REIT
shares in most circumstances, which would give the corporation the advantage of liquidity represented by
publicly traded REIT shares without the immediate gain recognition.
Advantages
These approaches allow a corporation to diversify its investment in real estate and achieve a degree of
liquidity without significant costs. In addition, if the partnership structure is employed, the corporation can
accomplish these results without the immediate recognition of taxable gain inherent in its investment in real
estate.
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Disadvantages
Under these approaches, the corporation would transfer its entire ownership interest in real estate to a third
party that would manage the real estate and set lease terms. In effect, once the initial negotiations are
concluded, the corporation will have given up control of its real estate. State and local transfer taxes would
also have to be considered in these scenarios.
Contribution to a New Captive REIT
If a corporation has a significant investment in real property, such as numerous big-box stores or warehouse
facilities, it may be able to raise capital while controlling the management of its real property by contributing
the real property to a newly formed subsidiary that would elect to be a real estate investment trust (a
“REIT”) for federal income tax purposes.
For instance, assume a corporation owns several big-box retail facilities that it contributes to a newly formed
subsidiary. Assume further that the corporation enters into leases with the newly formed subsidiary in which
the corporation pays a base rental amount for each store and, in addition, pays contingent rent, the amount of
which depends on gross revenues of the particular stores. The corporation would own substantially all of the
stock of the newly formed corporation (the “REIT Sub”), which would elect to be a REIT for federal income
tax purposes.
The REIT Sub could undertake an offering, most likely a private offering, of convertible preferred stock or
convertible notes. The idea here is that the conversion would be tied to the increase in gross revenues of the
REIT Sub, which, in turn, would be tied to the increase in contingent rent paid by the corporation to the
REIT Sub under the gross revenue contingent rent feature of the leases. Thus, an investor could enjoy a base
level return in the amount of the fixed dividend or interest amount, plus the opportunity for additional return
through the conversion feature if the corporation does well. Although this model works better if the REIT is
a publicly traded entity because publicly traded shares afford a degree of liquidity for investors, it can work
in the case of privately offered securities if the conversion feature offers a ”cash in lieu of stock” feature
upon conversion. In any event, the corporation would continue to have indirect ownership of the assets
while leveraging that ownership through the REIT Sub’s issuance of convertible securities.
Of course, the REIT Sub could always undertake an offering, private or public, of its common shares of
stock. We believe, however, that such an offering would be difficult to execute because the REIT would
have only one tenant. In our view, it is more likely that an offering of convertible preferred stock or
convertible notes would be more appealing to investors seeking a fixed income return with upside exposure
to the corporation’s revenue growth.
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Real Estate Alert
Advantages
The REIT Sub structure described above in which the REIT Sub issues convertible preferred stock or
convertible notes accomplishes two objectives. First, the corporation is able to monetize its investment in
real property to the extent of the proceeds of the offering. Second, the corporation centralizes the
management of its real estate holdings under the REIT Sub, an entity that it controls through its ownership
of substantially all of its outstanding common stock. Moreover, through the issuance of convertible
securities, the corporation may be able to lower its financing costs in that the fixed return required for
convertible securities would most likely be less than the return demanded by an investor that purchases a
security without an equity kicker.
Disadvantages
There are, of course, downsides to this approach. Undertaking an offering of securities, especially a public
offering, can be an expensive proposition. Moreover, there are ongoing expenses associated with operating
a public REIT Sub. It may be advisable, therefore, to take the private placement approach. Even in this
case, however, significant costs may be incurred to ensure compliance with REIT tax rules and securities
law requirements. Furthermore, state and local transfer taxes may apply to the transfer of title to real
property to the REIT Sub.
Restructuring Owned Real Estate with Private Capital
Restructuring a real estate portfolio with private capital may appeal to corporations with portfolios that lack
the size needed to tap the public capital markets or that prefer the advantages that private capital transactions
offer. These strategies are summarized below.
Sale-Leaseback
A corporation can sell all or part of its real estate portfolio to an investor and lease the properties back on
any terms to which they may mutually agree, including, for example, options to repurchase, terminate or
renew.
Advantages
The advantages of a sale-leaseback are that it affords 100% financing of the real estate assets (as opposed to,
perhaps, 75% financing from a bank, assuming such financing could be secured), removes real estate from
the balance sheet and allows management of the real estate to remain centralized.
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Real Estate Alert
The owning corporation often has flexibility to structure its sale-leaseback as a taxable or tax-deferred
transaction for federal and state income tax purposes, which could be useful depending on whether there are
unrealized gains or losses in the real estate.
Counterparties may see advantages through (1) the depreciation of real estate, (2) the use of a sale-leaseback
as alternative financing for cash-strapped governmental units, or (3) a reinvestment possibility coming out of
a “Section 1031” or “like-kind” exchange.
Disadvantages
Federal, state, or local taxes, including transfer taxes, may be owed upon the sale.
Joint Venture Leaseback
In a joint venture leaseback, a corporation contributes for no consideration its real estate to a new passthrough legal entity, such as a limited liability company, which leases the properties as the landlord back to
the corporation as the tenant, and then a minority or non-controlling interest in the new entity is sold to an
investor. The investor’s interest may be structured many ways, such as with a priority return. The new
entity also may borrow money on a secured basis, if it wishes. The original corporation, now the tenant and
majority owner of the new entity, can manage the new entity and the real estate.
Advantages
This strategy allows for flexibility with respect to the amount of cash to be raised (based on how much of the
interest in the new entity is sold), which can be designed to fluctuate as needed, removes real estate from the
balance sheet, centralizes the ownership and management of the real estate and allows the new entity to
obtain secured financing, if desired.
Disadvantages
A joint venture leaseback necessarily dilutes the corporation’s ownership interest in the real estate, but may
allow it to retain control and management (depending on the operating agreement), and gives rise to investor
scrutiny of the terms of the leases. Also, the investor might view it as a doubly illiquid investment
(ownership of an illiquid joint venture that owns illiquid real estate), and demand a premium for making the
investment. This strategy will likely appeal to corporations that wish to tap part of the equity in their real
estate, while retaining modified control, and are able to secure an investor or user interested in such a
holding.
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Real Estate Alert
Subsidiary Spin-Off to Shareholders
A corporation may contribute its real estate to a newly formed subsidiary (non-REIT) and lease the real
estate back. The value of the real estate, therefore, is transferred from the parent corporation to the new
subsidiary. Management of the real estate will be centralized in the subsidiary. The stock of the subsidiary
can be distributed to the parent corporation’s shareholders who may retain the stock or sell it in a taxable
transaction.
Advantages
This structure can be used to centralize the management of the real estate and shift its value from the parent
corporation to its subsidiary. It puts the value of the real estate ultimately into the hands of the parent
corporation’s shareholders.
Disadvantages
A disadvantage of this approach is that it does not generate cash for the parent corporation – the parent
corporation’s shareholders are the ones who benefit. Another disadvantage is that it is generally difficult to
spin off the subsidiary to existing shareholders of a parent corporation in a tax-deferred transaction.
This strategy may be worth considering in the unique circumstances where a taxable gain is not a concern, or
there are losses to be utilized, and it is beneficial to transfer the value of the real estate to the shareholders.
Subsidiary Spin-Off to Investors
As another subsidiary strategy, the parent corporation can contribute its real estate to a newly formed
subsidiary (non-REIT), lease the real estate back and issue stock in the new subsidiary to an investing group.
This structure likely will require limiting the offering to no more than 20% of the stock (to preserve federal
tax consolidation) and introduces potentially complicating issues of oversight and fiduciary responsibility
with respect to the new shareholding group. Nonetheless, it might be a viable strategy under special
circumstances.
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Advantages
This strategy shifts some (20% or less) of the real estate value from the parent corporation ultimately to the
investors as the owners of a minority interest in the new subsidiary. The cash generated from the sale of the
subsidiary’s stock to the investors can be disbursed to the parent corporation. Because the parent
corporation will continue to own 80% or more of the subsidiary’s stock, it will continue to control its real
estate, and management of the real estate can be centralized in the new subsidiary.
Disadvantages
A serious drawback to this strategy is the need to limit the offering to no more than 20% of the stock of the
new subsidiary to preserve federal tax consolidation. The cash received from the 20% maximum offering
might not justify the lease scrutiny surely to be imposed by the investor.
Secured Line of Credit
Although obtaining financing for real estate is currently difficult for most corporations, those that are in a
position to obtain it may wish to consider borrowing as a viable option for tapping most, but not all, of their
equity in real estate. Under this alternative, a corporation would retain ownership of its real estate and
obtain a line of credit secured by a mortgage (or comparable instrument) encumbering the real estate.
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Real Estate Alert
Advantages
This transaction will generate cash, as needed, to the extent of the loan-to-value ratio that is mutually agreed
upon between the corporation and the lender, which is likely to be in the range of roughly 75% (or perhaps
less in the current market). Companies currently owning real estate under multiple operating company
subsidiaries may wish to consolidate and centralize ownership first in a separate entity prior to effecting this
transaction.
Disadvantages
The main disadvantages of accessing equity in real estate through a secured line of credit are that it provides
less than 100% financing, which may be exacerbated by current low real estate valuations, and it will add
debt to the balance sheet.
This alternative should be considered by a corporation that wishes to retain ownership and control, tap up to
75% of its equity in real estate and is in a position to borrow the funds and have the debt on its books.
Leased Real Estate Strategies
Strategies involving real estate that is currently leased are limited, of course, to the terms of the existing
leases. However, all leases eventually expire and afford the opportunity for change, and landlords can
always be approached to consider new terms designed to accommodate a real estate portfolio strategy.
Accordingly, corporations may wish to consider the following strategies for leased real estate:
•
Lease Expiration.
A corporation can have a plan to seek lease renewal or ownership of an existing leased facility or to lease or
own another facility upon expiration of the existing lease term in a manner that dovetails with an overall real
estate portfolio strategy, such as one of the alternatives outlined above.
•
Lease Options.
A corporation can always request that its landlord grant various lease options that will allow the leased
property to fit into an overall real estate portfolio strategy. For example, the landlord might agree to grant
the tenant corporation an option to purchase the facility or to terminate the lease altogether so the
corporation will be able to lease or own elsewhere as necessary to meet the requirements of its portfolio
strategy.
•
Lease Management.
Some tenant corporations can benefit from centralizing management and legal services related to leases,
especially where multiple operating companies separately manage their real estate. If the lease portfolio is
large enough, consistency and cost-efficiency can often be achieved through the use of standardized lease
forms or adopting a standardized approach to lease review and negotiation.
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K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous
GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market
participants and public sector entities. For more information, visit www.klgates.com.
April 7, 2010
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Real Estate Alert
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