REIT relief

After suffering through the expensive, time consuming process of implementing the complex financial disclosure reporting changes required by the Sarbanes-Oxley Act of 2002, it is about time for some good news from the regulatory side for REITs.

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The good tidings may come in the form of legislative approval of the REIT Investment Diversification and Empowerment Act (RIDEA) by the 110th U.S. Congress this year.

Longtime REIT supporter Sen. Orrin Hatch (R-Utah), who introduced the bill to the U.S. Senate last fall, told his fellow senators the measure would modify the tax rules governing REITs “to better meet the challenges of evolving market conditions and opportunities.” The opportunities addressed in the bill that directly affect apartment REITs include increasing investment by U.S. REITs overseas, the use of taxable REIT subsidiaries (TRS) to bolster income and the ongoing liquidity of the apartment transaction market.

Tony Edwards, National Association of Real Estate Investment Trusts (NAREIT) executive VP and general counsel, believes the extent to which apartment REITs would benefit from the passage of the bill that was introduced in the U.S. House of Representatives on Feb. 16 will depend on each company’s strategy.

He expects most apartment REITs will welcome the changes to the “safe harbor” provision in the REIT rules that protects them from paying the 100 percent excise tax levied on profits from sales of property in which a REIT is acting as a dealer rather than an investor. RIDEA would change the safe harbor limits that currently require a REIT to hold assets for four years or more before selling them to two years. And it would change the way the 10 percent is measured in the requirement that a REIT make either no more than seven property sales or sell no more than 10 percent of its portfolio during a taxable year.

“Right now, it’s measured according to tax basis, what you paid for it, plus capital improvements minus depreciation. The problem is that REITs really are long-term investors, so they hold properties for a long time and, for apartment buildings, depreciation is over 29.5 years,” Edwards explained. “So, if you hold a property for a period of time, that tax basis goes down. If you do own property for a while and you’re measuring 10 percent of the tax basis, you really are measuring a small amount of what the true value is because of tax depreciation,” he said.

RIDEA changes the measurement from tax basis to actual fair market value, which would enable REITs to sell 10 percent of what their portfolios really are worth — net asset value (NAV) — and still qualify as investors.

“NAV is calculated either by appraisers or by analysts following public REITs, but it’s something that people are comfortable with estimating. Warren Buffet always says that he would rather be generally right rather than precisely wrong. Tax basis is precisely wrong because it doesn’t measure fair value in any way,” Edwards said.

And, although REITs generally hold assets long-term, the real estate market has become ever more liquid over the past five or 10 years and transaction activity has been especially hot in the past few years, thanks to low interest rates and the condo conversion explosion that only recently began to implode. “A number of our REITs have had situations where they could have sold properties at a nice profit, but they were concerned about falling outside the safe harbor, so they just held onto it,” said Edwards.

Another strategy that most apartment REITs have in common nowadays is the generation of income through the TRS vehicle. With apartment occupancies soaring into the mid-90 percent range and rents rising faster than they have since the dot-com bust, generating other income likely will become a more important growth engine for public apartment companies that would welcome relief from some of the pressure the current restrictions impose.

RIDEA would increase the limit for a REIT’s TRS ownership to 25 percent of a REIT’s gross assets from the current 20 percent, freeing them to make greater use of the tool that allows them to pursue income through activities not officially recognized as generated by real estate-related sources. Such activities include brokering renters’ insurance, which AIMCO and other REITs do in TRS, Camden Properties Trust’s recently implemented Perfect Connection cable TV service program, Archstone-Smith’s merchant builder Ameriton and condo conversions and sales for which United Dominion Realty Trust, Equity Residential and Post Properties all created TRS to manage.

Failure to comply with any of the myriad and complex TRS rules, including the percentage of gross income test, could result in loss of REIT status, a calamity no REIT wants to take a chance on, Edwards explained. “No one wants to get close to the 20 percent limit, in case there’s anything they don’t know about or values go up that they can’t predict at the beginning of the year, so it’s really like a 15 percent rule. This would let them go up to a true 20 percent,” he said.

Archstone-Smith, which started investing in Germany in Q4 2005 and purchased German apartment owner and manager Deutsche WohnAnlaghe GmBH (DeWag) last June, obviously will benefit from the change to the tax laws suggested in Title I of the bill that Hatch explained “would clarify existing law by characterizing foreign currency gains generated by a REIT outside the U.S. as ‘good’ REIT income, so long as the REIT focuses on commercial real estate.”

That seemingly minor change would make a major difference in foreign investment for Archstone and apartment REITs that decide to follow its lead overseas. In order not to run afoul of the IRS, most foreign investment by REITs is done through TRS, or through “subsidiary REITs” the IRS has approved in many private letter rulings, but those solutions are, Hatch noted, “cumbersome and unmanageable” and put a REIT in danger of losing REIT status if any of the rules governing TRS inadvertently are violated. Classifying foreign profits as qualifying income under the REIT gross income test would eliminate that quandary.

The bill also addresses the fact that a number of foreign countries have enacted REIT legislation that parallels the U.S. REIT rules and more countries are expected to do the same. RIDEA would amend this country’s REIT rules to provide that income from, and interests in, foreign-qualified REITs would be treated as qualifying REIT income and assets. The bill applies current REIT hedging rules to foreign currency gains for purposes of the REIT gross income test, which requires that 95 percent of a REIT’s annual gross income come from specified sources such as dividends, interests and rents and 75 percent must be from real estate-related sources.

NAREIT worked closely with legislators on RIDEA, Edwards said, adding that apartment REITs were well represented in the organization’s legislative committee and executive committee when the decisions were made. When the bill first was introduced and a lot of the research and development occurred, Archstone-Smith CEO R. Scot Sellers was NAREIT’s chair.

“It was a collaborative process. We talked with a number of policy makers and a lot of tax staff, especially the joint committee on taxation and we try, on all the legislation, to work through the issues with tax professionals and members, so that it’s a bi-partisan measure that’s non-controversial,” said Edwards.

“We don’t have three million members that can march on Washington, so we fall back on the old traditional basis — try to have good policy, instead,” he said.