Doug Cornelius .com

In a Bloomberg story By Hui-yong Yu, REITs in U.S. Consider Paying Dividends in Stock to Save Cash, many publicly traded REITs may take advantage of a IRS ruling allowing them to pay dividends instead of cash.

On December 10, 2008 the Internal Revenue Service issued Revenue Procedure 2008-68 announcing that the IRS will treat a cash option stock dividend as satisfying a public REIT’s distribution requirements for 2008 and 2009 so long as shareholders can elect to take at least 10% of the dividend in cash.

According to a REIT Alert from Goodwin Procter, IRS Issues Guidance on Taxable Stock Dividends:

The Revenue Procedure provides that the IRS will treat a capped cash option stock dividend by a REIT as a taxable dividend, and will consider the amount of stock distributed to be equal to the amount of cash which could have been received instead, if:

• the dividend is made by the REIT to its shareholders with respect to its stock;
• the terms of the dividend allow each shareholder the right to elect to receive its entire distribution in either cash or stock of the REIT of equivalent value, provided that the REIT may impose a limitation on the amount of cash to be distributed in the aggregate to all shareholders of not less than 10% of the aggregate distribution; and
• the number of shares to be distributed is determined as close as practicable to the payment date based upon a formula utilizing market prices.

Disclaimers

Standard & Poor’s announced that Health Care REIT Inc. (NYSE:HCN) will replace Sovereign Bancorp Inc.(NYSE:SOV) in the S&P 500. Standard & Poor’s Announces Changes to U.S. Indices [.pdf] Sovereign is being acquired by Banco Santander SA, leaving a vacancy in the index.

Health Care REIT, Inc. is an equity real estate investment trust that invests across the full spectrum of senior housing and health care real estate, including independent living/continuing care retirement communities, assisted living facilities, skilled nursing facilities, hospitals, long-term acute care hospitals and medical office buildings.

Disclaimers

Last week, President Bush signed the Housing and Economic Recovery Act of 2008 [html] [pdf] into law. You have heard about all of the programs designed to stimulate the housing market and to deal with Fannie Mae and Freddie Mac. Summary of the “Housing and Economic Recovery Act of 2008″ [.pdf] from the Senate Banking Committee.

The Act also contained some changes to the REIT limitations. From Goodwin Procter’s Client Alert, New Law Liberalizes REIT Provisions [.pdf]:

The Act shortens the prohibited transactions safe harbor holding period from four years to two. Unless the safe harbor applies, a REIT is potentially subject to a tax equal to 100% of the net income derived from a prohibited transaction (i.e., a sale of property held primarily for sale to customers in the ordinary course of business, or “dealer property”). The prohibited transaction safe harbor used to apply to a sale of real property if, among other requirements, (i) the REIT held the property for at least four years for the production of rental income, and (ii) the aggregate expenditures made by the REIT during the four-year period preceding the date of sale that were includible in the basis of the property (i.e., capital expenditures) did not exceed 30% of the net selling price of the property. The Act shortens both the minimum holding period under the safe harbor and the period during which the limit on capital expenditures applies from four years to two. This provides REITs with significantly more flexibility to dispose of properties without risk of the 100% tax being imposed, provided the other requirements of the safe harbor are met.

An additional requirement for a sale to qualify for the prohibited transactions safe harbor was that the REIT must not have made more than seven sales of property during the applicable tax year, or, that the aggregate tax bases of the properties sold during the taxable year must not have exceeded 10% of the aggregate tax bases of all of the assets of the REIT as of the beginning of the taxable year. The Act changes the 10% limitation so that a REIT can measure its sales based on either tax basis or fair market value, at the REIT’s annual election. This change also applies to sales made on or after July 31, 2008, although IRS guidance will be required to implement this change for 2008.

The Act increases the REIT asset test limitation with respect to securities of taxable REIT subsidiaries from 20% to 25% of the REIT’s assets.

The Act extends the “related party rent” exception that permits leases between REITs and their TRSs for lodging facilities to qualify as “rents from real property” to cover healthcare facilities. Now, a TRS can rent a healthcare facility from its parent REIT without disqualifying the rents paid to the parent REIT for purposes of the 75% and 95% income tests, provided that the healthcare facility is managed and operated by an independent contractor and not the TRS itself.

The Act broadens the REIT income tests with respect to foreign currency exchange gain. Under existing IRS guidance, certain foreign currency gain was treated as qualified income in certain circumstances. Effective July 31, 2008, certain foreign currency gain attributable to real estate income, real estate assets or to certain indebtedness attributable to the REIT’s real estate assets is excluded from the 75% and 95% income tests, and other passive foreign currency gain is excluded from the 95% income test.

Disclaimers

Stephane Fitch of Forbes.com put together a sensationalist piece on real estate opportunity funds: The Other Real Estate Disaster.

Fitch puts together some interesting numbers on the extent of holdings by private real estate funds:

They account for one-sixth of $2 trillion in total net assets in private equity, says the London firm Private Equity Intelligence, which tracks the industry. A year ago the most closely studied funds in the U.S. were holding $213 billion in commercial real estate equity, leveraged 70% on average.

Fitch also touches upon some interesting thoughts comparing the performance of private real estate funds against public REIT stocks.

Instead of focusing on these interesting thoughts, Fitch focuses on how the real estate fund performance is a black box revealing little about their current returns.

OF COURSE.

Fitch evidently does not understand the real estate market.

Real estate is a very illiquid asset. The equity value of the commercial real estate may have decreased. (If you compare your real estate to the sales of comparable real estate.) Few funds take on the expense of an annual valuation. But that valuation makes no difference until you sell the real estate. As long as the real estate is throwing off enough income to pay debt and expenses, you can just sit back and own the property.

That is exactly what is happening right now. There are very few commercial properties for sale and even fewer are actually selling. The exception is a property owner with liquidity concerns. Harry Macklowe being the most public case: Harry Macklowe Doesn’t Own Those Seven Buildings Anymore.

The investors in private real estate funds are smart and know what they are getting into. They know they will have to pay fees to the sponsor/manager of the fund. They know their investment is illiquid and that it is investing in illiquid assets. They know some funds will perform well and some funds will perform poorly. They also know that the performance of the fund will not be known for years after they make their first investment in the fund.

That does not mean that private real estate funds are the next real estate disaster.

Thanks to the Deal Junkie for pointing out this story: The Other Real Estate Disaster

Disclaimers

NAREIT has collected a bunch of information and sites under one umbrella site: REIT.com. (Watch out for the music on the opening page!)

According to SmartBrief:

“REIT.com replaces the existing NAREIT Web site, as well as the current Real Estate Portfolio and InvestInREITs.com sites. REIT.com is designed to be your central source for investment news, industry data, event information, Policy and Politics updates, as well as all exclusive NAREIT member services. REIT.com is designed with easy-to-use navigation that will let you find relevant content faster and easier than before.”

I don’t remember the old NAREIT site, but it is good that they folded more information into one place. I think they should kill the music on the home page and make the news available by RSS. If you jump to SmartBrief from the REIT.com site you can find RSS feeds for news.

Disclaimers

While commercial property owners are worried about property market, much of the commercial property market remains stable or strong. In contrast, the residential market is still spiraling down and take lots of people and companies with it.

First up, the summary of REIT earning reports show that most of the public real estate companies are still hitting their earnings targets: REITs Cautious Despite Strong Quarter.

Given fears that a sagging economy and a crippled credit market might wreak havoc on the commercial property market, real-estate investment trusts delivered surprisingly strong earnings for the first quarter, with many companies beating analysts’ estimates.

The implosion of the residential markets is taking down builders: Falling Prices Hit Builder Horton – Home Cancellations, Write-Downs Spur $1.31 Billion Loss.

The implosion is also showing the weakness in the underwriting and origination processes for mortgage lender. It was apparently bad enough at Countrywide that it is giving Bank of America second thoughts about its takeover: Acquisition of Lender Is Possibly in Jeopardy. According to an older WSJ.com story, Loan Data Focus of Probe:

The investigators are finding that Countrywide’s loan documents often were marked by dubious or erroneous information about its mortgage clients, according to people involved in the matter. The company packaged many of those mortgages into securities and sold them to investors, raising the additional question of whether Countrywide understated the risks such investments carried.

Many of these companies mentioned are clients of The Firm. I have no knowledge of the background except what was in these stories.

In another sign that the commercial real estate sector is not in the same trouble as the residential sector, many REITs still have good ratings from S&P.

According to Business week in the first quarter of 2008, the group posted a 0.8% total return, at a time when the S&P 500 index fell 9.4%. (REITs Show Strength)

Business Week put together a list of 17 REITs that have a 4- (buy) or 5-STARS (strong buy) rankings from S&P Equity Research:

(Disclaimer: Some of these REITs are clients of my employer.)

The latest issue of Goodwin Procter’s REsource magazine has been released. Here are the articles in this issue:

Green Building: Now on Firm Footing
by Rachael Simonoff Wexler and Shahrzad Mostofi

Green building is no longer the passion of a few; it is the new standard for commercial and residential developments alike. Green design is an undisputed selling point, remarkably enhancing commercial and residential project value. Green building practices reduce the tremendous impact that building design, construction, and maintenance have on both people and nature. The concept of environmentally friendly real estate is so ubiquitous today that green can be used to describe building without concern that readers will think it refers to the color of a structure.

Negotiating in a See-Saw Market
by Andrew Kirsh

In today’s market, however, the number of real estate transactions that make economic sense is dwindling. Fewer buyers are able to obtain adequate financing due to the recent credit crunch. Thus, an imbalance between seller supply and buyer demand now exists in the real estate market. The negotiating pendulum long thought to be stuck at the top of the seller’s side is finally returning to an even position. The return of balance due to the changing market should allow buyers to negotiate more favorably certain hot button issues concerning due diligence, deposit, as-is and release provisions, representations and warranties, and seller remedies.

Turn Down Service: Key Aspects of Hotel Real Estate Due Diligence
by Christopher Barker and Benjamin Tschann

Investors know the importance of conducting thorough due diligence in the acquisition of real estate assets. Generally speaking, the due diligence tasks for completed and stabilized projects are the same regardless of the type of assets to be acquired. For those evaluating hotel assets, however, the due diligence tasks are greater, and these expanded investigations are crucial to understanding not only the real estate being acquired, but the business that comes with it. For hotel assets, apart from the due diligence associated with tax structuring issues that arise if tax-exempt entities or REITs are involved, there are four main categories of additional due diligence required to evaluate both the real estate and the business: (i) branding; (ii) hotel management; (iii) employment matters; and (iv) operating licenses and permits. Each area must be evaluated for financial as well as legal consequences.

Issues in Joint Venture Capitalization
by Dean Pappas and Hamilton Tran

As the allocation of global investment capital to real estate has increased in recent years, joint ventures between capital partners and developer partners have become commonplace in real estate transactions, making joint venture agreements familiar real estate documents. Familiar as they may be, however, many joint venture agreements overlook or do not adequately address critical issues that often arise during the joint venture relationship. One basic but significant provision found in joint venture agreements is capitalization – the funding of the venture by its partners. Capitalization will become even more significant in the current volatile real estate and credit markets as traditional debt financing becomes scarcer and the infusion of equity may be the only means to sustain joint ventures.

Real Difficult: Structuring Investments in Real Estate
by Christopher Price and Rishi Sehgal

The existence of publicly traded real estate investment trusts (REITs) and the proliferation of commingled real estate investment funds has made investing in institutional-quality real estate increasingly mainstream and available to a
wider class of investors. Fund sponsors in particular, through the use of creative structuring, have been able to access a diverse array of capital sources and have given real estate a prominent seat at the capital markets table. To attract capital from investors as diverse as governmental and corporate pension plans, U.S. and overseas insurance companies, university endowments, private foundations,
and sovereign wealth funds acting on behalf of foreign governments, fund sponsors typically use a variety of structures including “blocker entities” and private REITs to marry their capital with their investment strategy by accounting for investors’ tax and regulatory requirements. While the goal is to attract the greatest amount of capital into their funds, the tradeoffs sponsors face are less flexibility, greater complexity, and increased costs when actually making investments.

Arleen Jacobius of PIonline.com reports on institutional investors entering into joint ventures with REITs to as an alternative to direct real estate investments: Joint Ventures Emerging as New Vehicle for REITs.

The nice match of pension funds and REITs is that they are both used to dealing with the complexities of the tax code and other regulatory schemes that affect their investments in real estate. The rules for REITs on their income tests and asset tests are similar to the UBIT rules in compliance.

The pension funds get the benefit of a large professional REIT manging and operating the portfolio, but the additional control rights they would expect if they own the real estate outright. In exchange for the convenience of not having day-to-day management of the asset, they trade a piece of the upside on the real estate by giving the REIT a promote on the increase in value of the property.

I see that the article also quotes Steve Lyons of Reed Smith. Steve and I have worked together on a few REIT joint ventures.

On Tuesday, the MSCI US REIT Index (RMZ) dropped 5.61% to 914.85, and the SNL US REIT Equity Index plummeted 5.59% to 235.96 with five winners, 106 losers and four companies closing flat. The losses mark the worst one-day tumble for the SNL US REIT Equity Index since July 25, 1989.

By comparison, the Dow Jones Industrial Average traded down 2.14% to 13,432.77, and the S&P 500 fell 2.53% to 1,477.65. The yield on the 10-year Treasury dropped to 3.97% from Monday’s
4.15% close.

The Federal Open Market Committee voted Dec. 11 to lower its target for the federal funds rate by 25 basis points to 4.25%, noting in its monetary policy statement that “incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending.” In a news release, the FOMC stated that strains in financial markets have increased in recent weeks. The FOMC believes their latest action, combined with previous moves, “should help promote moderate growth over time.” The committee also decided, in a related action, to cut the discount rate by 25 basis points to 4.75%.