In 1964, Supreme Court Justice Potter Stewart famously avoided trying to define certain, ahem, inappropriate films by simply stating, “I know it when I see it.” Since the dawn of the Modern REIT Era in the early 1990s, investors have taken a similar approach when defining real estate. That changed in the last few years, though, as more and more companies seek to convert to REIT status.
The REIT conversion fervor appeared to reach a head in June 2013 when the IRS suspended all private letter rulings (PLRs) for REIT conversion in order to assemble an internal working group to re-evaluate the definition of real estate. It is easy to see why the IRS then decided to call a time-out on issuing PLRs, since they were facing three disparate companies in three very different industries with Equinix (data centers), Lamar (billboards), and Iron Mountain (document storage).
After going radio silent for several months, news broke in November 2013 when the three companies issued press releases stating the IRS was again reviewing their PLRs. There was no public announcement at the time from the IRS, so we had to hear secondhand from the companies themselves that the REIT conversion rush was back on. Just like a 19th-century gold rush, we can call it the great REIT Rush of the 2010s. Only instead of prospectors, we have activist investors.
To better explain how we got here, we should take a brief trip back in time to the early 1990s. Back then, when REITs were going public at a fevered pace in the aftermath of the S&L crisis, defining real estate was easy because we only had the Four Basic Food Groups: Office, Apartments, Industrial, and Retail.
This definition of institutional real estate began to expand in the mid-1990s when Hotels became an accepted asset class. This was followed by an explosion of specialty property sectors during the early 2000s that included Self-Storage, Manufactured Housing, Health Care, Life Science, and Data Centers. While the inclusion of these new property sectors was scary at first, time has shown that they offer risk and return characteristics similar to traditional real estate and should garner inclusion in a properly diversified portfolio.
Composition of Benchmark by Property Type
Today, we are again seeing an explosion of real estate sectors that has, so far, included billboards, cell phone towers, casinos, and prisons (you might want to skip that property tour). While we welcome the expansion of the REIT industry, we note that even more non-traditional REITs could be on their way following the IRS clarification of real property in 2014.
While the definition of a “Building” seems self-explanatory enough for even Justice Stewart, the IRS released a list of “Other Inherently Permanent Structures” that qualify as real property. This safe harbor list includes microwave transmission, cell, broadcast, and electrical transmission towers; telephone poles; parking facilities; bridges; tunnels; roadbeds; railroad tracks; transmission lines; pipelines; fences; in-ground swimming pools; offshore drilling platforms; storage structures such as silos and oil and gas storage tanks; stationary wharves and docks; and outdoor advertising displays.
And just when you thought defining real estate was going to be easy…
With this safe harbor list in hand, it’s easy to speculate that we will see even more new entrants into the REIT space when activists and investment bankers find the list.
A prime example is Windstream, a publically traded telecom service provider in rural communities in the United States. In 2014, the company announced its intention to spin off its in-the-ground copper and fiber assets into a REIT and lease them back. By creating two separate companies, the REIT can own the fiber and copper and receive rent via a long-term lease from Windstream.
While there is nothing inherently wrong with investing in the backbone of a telecommunication network, it does make you wonder if these assets will offer risk and return characteristics similar to traditional real estate or even many of the new specialty assets of the past 20 years.
We recommend that real estate investors take time to make sure the assets that they own offer the characteristics they desire from real estate. The asset itself, dependence on the operator, the lack of location value, or the ownership structure can increase the risk or reduce the residual value.
There are many shades of grey in this discussion, but key questions we believe investors should consider include:
- Does the REIT have fee simple ownership or a long-term leasehold interest in the assets?
- Is there a liquid transaction market for the assets?
- Do the assets have residual value absent the operator?
- Are rents set by an open market of supply and demand?
To be clear, the REIT market today largely comprises traditional real estate assets and proven specialty assets. REITs that own towers, timberlands, billboards, and other less traditional assets have generally not been included in some of the most popular REIT indices.
While investors can expect to see increasing headlines in the coming years regarding relatively esoteric REITs, do not be alarmed. Simply make sure the benchmarks your investment managers are measured against represent the institutional real estate characteristics you desire when allocating to REITs.