2013 saw 19 REIT IPOs raising $5.7 billion in capital, including the high-publicity Empire State Building IPO, which raised $930 million.
How did the Empire State Building REIT (Empire State Realty Trust; NYSE Ticker: ESRT) get to market?
It did so through the use of a “roll-up” including the landmark namesake building and a portfolio of New York properties owned by the Malkin family.
A REIT rollup gives real estate owners liquidity, preserves the tax basis of existing investors that do not want to cash out of their current investment and provides the opportunity for the REIT to obtain funds from the capital market.
It will create a perpetual platform, provide diversification, the ability to cross collateralize properties for better access to debt at lower rates and the opportunity to access the capital markets directly in a tax efficient manner.
A REIT rollup ends with a typical UP-REIT structure wherein a public REIT owns the majority interest in an operating partnership (“OP”) which, in turn, owns real estate investments.
The REIT acquires ownership in the partnership through the roll up process.
The starting point for a rollup is one or more partnerships owning real estate. Partnership shares are inherently illiquid. They are hard to buy and sell.
Additionally, partners can have negative tax capital accounts as a result of receiving depreciation deductions and cash distributions over the years. A sale of these negative capital account interests or of the underlying property itself can trigger significant tax gains to the partners.
In a rollup, the partners in each of the property owning partnerships contribute or merger their partnership interests into the OP in exchange for shares in the OP.
Their tax basis is preserved as a partnership contribution is a tax free exchange.
Generally, a tax protection agreement is included in the OP partnership agreement to ensure that the OP does not cause gain to be triggered to the contributing partners because of a sale of the contributed property or a debt paydown. This allows the contributing partners to maintain control of the timing of their tax gain recognition.
Generally, the OP shares are convertible on demand and pegged to the REIT shares on a one-for-one basis at the demand of the OP partners. This allows the partners to cash out by exchanging their illiquid partnership interest for publically traded REIT shares. This exchange is a taxable transaction.
The partners that want to maintain their investment position can do so without any tax gain recognition by remaining OP partners while still having the opportunity to convert to readily tradable REIT shares at any point in the future.
As a result of the pegging of OP units to REIT shares, the OP partners still benefit from an increase in the REIT stock price when they choose to convert at a future point in time. This also allows the OP partners to easily value their investment based on the REIT stock price.
The REIT shares eliminate the lack of control valuation penalty that is often associated with the sale of minority interests in partnerships. Often it is difficult to find an investor willing to buy a partnership interest as they are required to “step into the shoes” of the selling partner’s tax position and are bound by the existing terms of the partnership agreement and any historical legal and tax issues of the partnership. The conversion to REIT shares increases the pool of potential buyers exponentially.
These REIT rollup benefits do not come easily as a host of legal and tax issues must be navigated throughout the rollup process. In addition to the standard IPO and SEC registration considerations, the REIT organization, income, asset and distribution requirements and the book and tax capital account maintenance for the OP require special attention.
Close attention should be paid to the form of all rollup transactions as well as the resulting debt allocations to the OP partners to prevent triggering unintended tax gain recognition.
Finally, once operations commence, OP partner income allocations are complicated by the historical tax carry over basis of contributed property and partner capital accounts compared to newly revalued book capital accounts.
Each time OP interests are converted to REIT shares an additional income allocation layer is created by the revaluation of the REIT assets and capital accounts based on the share price at the time of conversion.
The REIT itself will have the ability to obtain new capital from the market through the IPO or future share offerings.
Properties that were previously owned and managed separately are now pooled resulting in diversification of risk to the shareholders and the ability for the REIT to obtain capital from the debt markets more readily and at more favorable terms due to cross collateralization.
The management, administrative and overhead costs associated with each of the separate properties is centralized resulting in lower costs to the OP and REIT shareholders.