After the first Real Estate Investment Trust or REIT listing recently, several real estate developers and potential REIT Sponsors are considering converting their portfolio of assets into REITs, and many domestic and foreign investors are eager to participate in future REIT listings. With such significant interest from across the industry, the focus is on larger listings and more successful REIT conversions.
Our REIT law provides an advantageous tax regime to a REIT Company (REITCo) as long as the REITCo complies with the necessary requirements. However, this undertaking is not merely an exercise in applying for and maintaining one tax regime in lieu of another. The REIT journey begins with an assessment of the opportunity with guiding principles grounded on maximizing shareholder value, articulating the value story, preparing the organization for the operational changes as well as the myriad external communications and reporting requirements to the capital markets, all in addition to the tax considerations.
STARTING THE REIT JOURNEY
Considering the complexity of parts, how can an organization embark on such a journey? With the above guiding principles, the organization can start with an evaluation of capital structure and regulatory requirements that will maximize deal value and liquidity.
Tax and capital markets considerations will still drive the overall transaction structure, while the analysis of capital structure will involve an assessment of debt capacity.
A Sponsor can transfer to a REIT real property that is subject to a mortgage by way of a taxable transfer (i.e., an outright sale to a REIT together with the mortgage) or by way of a tax-free transfer under Section 40(C)(2) of the Tax Code. In the case of the latter, however, if the amount of the liabilities assumed by the REITCo plus the amount of the liabilities to which the property is subject exceed the total of the adjusted basis in the property transferred, then the excess shall be recognized as a gain on the part of the transferor, which shall be taxed accordingly.
Apart from such incidental transfers of liabilities to a REITCo, the REITCo itself can issue publicly traded debt, or incur bank debt to finance acquisitions of REITable assets. The total borrowings and deferred payments of a REITCo that has a publicly disclosed investment credit grade rating by a duly accredited or internationally recognized rating agency may exceed 35% (which is the default ceiling) but may not exceed 70% of its deposited property.
CONSIDERATIONS TO MAKE
Leverage is one means to maximize returns to shareholders and introducing debt into the REIT structure should be considered early on, since it may bring with it issues on seniority of debt claims, approval of creditors, and costs of refinancing.
Another area to consider would be the regulatory framework. This includes an assessment of the ease in the actual transfer of title, actual sale or transfer of the assets, alternatives to lease renewal, any restrictions that may limit the assets to be transferred, and most importantly, an assessment of the timeliness of securing rulings from the Bureau of Internal Revenue (BIR) confirming tax-free transfers to a REITCo.
Strategic analysis of the asset portfolio and its potential for sustained growth beyond the initial listing are of equal importance in evaluating the benefits of a REIT conversion. Within the pool of assets in a portfolio, the challenge is to identify which of those are REITable assets, including the current tax incentives the property is enjoying versus the tax incentives the REIT offers, as well as those assets that can provide steady streams of income and cash flow. In case a building is decided to be part of the REITable assets, the question of whether a Sponsor-owned land will be transferred as well or will be leased out to the REIT company is another important consideration given its impact on the future valuation, cash flow and calculated distributable income. These considerations will involve heavy modelling and optimization with various scenario analyses.
Analysis of cost structures is just as important. This is because while a REIT Company can operate within a lean infrastructure, standalone costs should be identified and considered in the overall return analysis. Identifying which are centralized costs previously incurred by the Sponsor and which are standalone costs once a REIT is set-up is critical to a REIT operating model. It would be useful to compare pre-REIT and post-REIT scenarios to benchmark the costs and better analyze the value creation potential of a REIT conversion.
Lease analyses are also cornerstones in the benefit analysis of a REIT conversion. A true analysis of the leases is required to ensure that lease agreements are reflected in the financial statements in accordance with the current reporting standards. A review of the lease terms, rates, renewal provisions and remaining economic life of the REIT assets will be critical to ensure that these satisfy not just the tax and accounting requirements but also the commercial implications. Appropriate valuation of the assets and leases is also necessary to validate the REIT status and transaction structuring.
THE REIT STRATEGY
It also goes without saying that, with all the above considerations, the resulting accounting impact must be carefully evaluated to ensure that the correctness of application of the accounting standards and the anticipated outcome in the financial statements is as it should be. The appropriate accounting method for recognition and measurement of the asset transfers, leases, fair value measurement, and revenues for both the Sponsor and the REITCo must be properly applied.
This may be a daunting task for some organizations contemplating a REIT listing. Setting up a framework in the form of a “gating” mechanism to guide the organization will be useful to aid in the analysis of whether to continue with the listing journey or defer to the future when a more opportune time is best for the organization. A simple framework can start with the evaluation of alternatives and selection of a REIT strategy where the organization can conduct a feasibility and readiness assessment, prior to deciding whether to go ahead or not. After which, it can develop a plan to implement the selected REIT strategy and then execute the REIT conversion.
Embarking on and getting your REIT conversion journey on the right track can be challenging, but ultimately, rewarding. However, as with all things, timing will be different for each organization and it will greatly depend on the readiness of the organization, and ideally, the right market conditions.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the authors and do not necessarily represent the views of SGV & Co.
Marie Stephanie C. Tan-Hamed And Veronica A. Santos are a Strategy and Transactions Partner and a Tax Principal, respectively, of SGV & Co.