THE REIT TRANSACTION: STRATEGIES AND HINTS Richard R. Goldberg Ballard Spahr Andrews & Ingersoll, LLP Philadelphia, PA.

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1 THE REIT TRANSACTION: STRATEGIES AND HINTS Richard R. Goldberg Ballard Spahr Andrews & Ingersoll, LLP Philadelphia, PA. American College of Real Estate Lawyers Copyright 1999 All Rights Reserved PHL_A v 1

2 THE REIT TRANSACTION: STRATEGIES AND HINTS Richard R. Goldberg Ballard Spahr Andrews & Ingersoll, LLP Philadelphia, PA. All rights reserved. I. INTRODUCTION The Real Estate Investment Trust ( REIT ) has become a favored investment device of the 1990's. This form of business organization has recovered in popularity after a checkered history in the late 1970's and early 1980's. The REIT, first authorized as an approved form of business organization approximately forty years ago, became a popular device in the 1970's, particularly as a lender of mortgage funds. However, when interest rates began to spiral, the REIT s of that period lacked liquidity and most of them were dissolved or failed. Most notable was the billion dollar liquidation of the Chase Manhattan REIT in the late 1970's. "Wall Street" reinvented the REIT as a securitized form of holding real estate insulating the holder from liabilities without the double taxation of the corporate form. At this writing, the REIT is most commonly found in the equity format as an owner of real estate. Most importantly, utilizing certain partnership structures in combination with the REIT, property can be acquired from third parties affording those parties the opportunity to sell in a tax deferred manner. The mortgage REIT has once again become unpopular. This time around the cause was the dislocation of the capital markets, the fall of interest rates, and the desire for investors to receive a higher return on investment than the mortgage REIT can provide. II. ORGANIZATION OF THE REIT A. TAXATION REQUIREMENTS - ORGANIZATION In order to qualify as a pass- through entity and not have income taxed at the REIT level, the REIT must satisfy certain organizational requirements. A REIT must be organized as a business trust, association or corporation. It is highly unusual for a REIT to form itself as a limited partnership, although check the box which permits a partnership to be treated as a corporation for tax purposes makes it a theoretic possibility. A REIT must have ownership evidence by transferrable shares or certificates of ownership. PHL_A v 1 2

3 In order to assure that a REIT will be a diversely owned organization, it must have at formation and maintain thereafter at least one hundred owners, although voting classes of stock are not prohibited for the purposes of maintaining control of the REIT in a smaller group. However, no five or fewer owners may own 50% or more of the value of all of the outstanding shares of the REIT directly or indirectly. The trust declaration or other organizational documents can adopt certain protective restrictions in order to make sure that these rules are not violated. The classic restriction is one which prohibits the founders from obtaining shares which would convert the REIT into a closely held corporation disqualifying it from REIT status. B. QUALIFICATION OF REITS - ASSET HOLDING TEST In order for a REIT to maintain its status, it must meet certain tests with respect to the nature of its assets at the closing of each quarter of the taxable year. The most important requirement specifies that seventy-five percent (75%) of the value of the assets of the REIT must consist of real estate assets, cash and cash items (which include accounts receivable and government securities). Not more than twenty-five percent (25%) of the value of the REIT s total assets may be invested in securities other than government securities. Not more than five percent (5%) of the value of the REIT s assets may be invested in any one entity (other than an item that is qualified as a real estate asset, a cash item or a government security) and, except with respect to one of its own subsidiaries known as a qualified REIT subsidiary, the REIT may not own more than ten percent (10%) of the outstanding voting securities of any particular entity. By meeting the seventy-five percent test, the REIT will, of course, meet the twenty-five percent test. The fluctuation of the value of the assets during the taxable quarter or the failure to meet the test at the end of a later quarter after initially meeting the test at the close of any one quarter, will not serve to disqualify the REIT. If the REIT fails to meet the seventy-five percent test because it acquires security or other properties, it has thirty (30) days to remedy this discrepancy. Continued qualification will require reevaluation following in any quarter in which there is a significant acquisition of assets which do not qualify as seventy-five percent assets. This requires the REIT to focus the acquisition strategy on real estate securities or cash and the most liquid of governmental securities. An exception to the ten percent and the five percent rule will permit a REIT to acquire non-voting securities so long as the dividends from the non-voting security do not exceed twenty-five percent of their gross income. A note about a qualified REIT subsidiary. This exception to the rule permits a REIT to own entities which, in fact, own its projects. There are also complex rules during formation which will permit REITs to acquire stock of an existing corporation which, when consolidated with the REIT, do not cause the REIT to fail any of the asset tests. For these purposes, real estate assets include interests in real estate, interests in mortgages and shares of other REITs. It may also include short-term instruments as a result of PHL_A v 1 3

4 the temporary investment of new capital in the REIT. New capital is defined as capital raised from the sale of REIT stock in a private placement or a public offering or from a public offering of debt. Interests in real property embrace fee simple ownership, leasehold ownership, options, but do not include such things as oil or gas royalties and may not include those things which, under state law, might otherwise be defined as fixtures. The tax regulations are specific as to the list of items which are considered to be real property. Most notable, office equipment and hotel/motel or office building furnishings are not considered fixtures even though they may be so under some quirk of state law. C. TAXATION REQUIREMENTS - GROSS INCOME SOURCES AND THE GROSS INCOME TEST There are two fundamental tests that apply to the composition of the gross income of REITs in order for REITs to qualify as a REIT under tax laws. Initially, at least seventy-five percent of the REIT s gross income must be derived from rents on real property; gain from the sale of real property interests not including dealer property; dividends or distributions in gains from the sale of REIT shares; interest on mortgages; property tax refunds; commitment fees from mortgages or key money from the leasing of real property; gains from qualified temporary investments; and income from foreclosure property. There is also a ninety-five gross income test which includes all of the income items previously described, together with non-qualified interest under the previous test and certain kinds of income received from swap or cap agreement dispositions which result in a profit. The ninety-five percent test obviously may be met if the items in the seventy-five percent test constitute ninety-five percent of the REITs gross income. These leave room for five percent of the REIT s gross income to result from sources other than those described above, including so called disqualified income. Since we are dealing with taxable gross income, there is certain significant exceptions otherwise includable in gross income for tax purposes which can be excluded by REITs, the most important of which is income from the discharge of indebtedness. If the REIT fails to meet the test, it is not necessarily disqualified. If the failure results from inadvertence and is not intentional or fraudulent, the REIT is not disqualified. However, it must pay a tax of 100% of the profit from the shortfall of income. The most important use of the 5% basket in the case of REITs is for the receipt of income that otherwise could be classified as service income. For example, property management fees, brokerage commissions, or in the case of a mortgage REIT fees or points derived from items other than commitment fees can be received so long as they do not exceed 5% of the gross income. Prior to the enactment of certain provisions of the Taxpayer Relief Act of 1997, there was an additional limitation on REITs. They could not receive more than 30% of their gross income from the sale of stock or securities or the sale or exchange of property in the nature of a prohibited transaction (property held for less than four years other than foreclosure property). PHL_A v 1 4

5 This limitation was repealed for tax years subsequent to the effective date of the Act making it more difficult for REITs to comply. In order to understand these tests, it is important to understand some of the terms contained within them with respect to the items that are included and excluded therefrom. Rents from real property, of course, include those things paid by a lessee under a lease for the right to use real estate. Distinguished from that and not permitted as qualified income is any rental income attributable to the right to use tangible personal property. Rents from real property also include charges for services which are customarily furnished in connection with the rental of real estate and certain rents for personal property if the rent does not exceed 15% of the total rent. The term customary services for real property is a difficult one to pin down. It is normally defined as those services which are provided to tenants and in buildings of similar use in the geographic market where the building is located. In the case of shopping centers, this can include electricity, common area maintenance, trash removal. In the case of office buildings, this can include elevator services and other kinds of normal services. In the case of apartment units, it may include swimming pool income and telephone answering services. In order for this income to be received by the REIT as qualified income, the facilities must be operated by an independent contractor. An independent contractor is a contractor which is not owned or controlled by the REIT to the extent of 35% of the shares of the REIT or the shares of the independent contractor, and the REIT may not receive any income from the work of the independent contractor. The provision of other services which typical landlords have provided such as repair, office cleaning, and interior premises cleaning, are not qualified and fall into the category of impermissible service income. Rents from real property may not include income that is dependent on net profits derived by tenants or subtenants. However, percentage rent income based on gross receipts so long as the gross receipts are defined in a normal and customary manner, which may include certain exclusions such as those commonly found in shopping center leases, is permissible. Receipt of income which is both qualified and nonqualified under a lease will, in normal circumstances, disqualify all the income from the lease. The determination of permissible interest income likewise has its own rules. The receipt of sums in return for permitting someone to use your money is clearly interest. Contingent interest and kicker interest are more complex in consideration. Contingent interest is qualified income to the extent it is based on a tenant s gross receipts or on income or profits if substantially all of the income consists of the rental of real property. Contingent income based on a gross sales price is permissible. Contingent interest based on a fixed fee on sale is permissible. However, contingent interest based on seller s net sales price is not permissible income for a REIT. PHL_A v 1 5

6 Interest based on cash flow is unclear at this time. The IRS has not taken a position with respect to cash flow in determining whether such is gross or net for the purposes of a REIT statute. Shared appreciation mortgages are not treated as the receipt of interest income, but rather gain recognized on the sale of secured property for both gross income and prohibitive transaction purposes. REITs should be careful not to include shared appreciation property which constitutes dealer property since this will result in a prohibitive transaction. REITs may also in lieu of cash kickers receive interest in real estate and in partnership interests, stocks or warrants. However, the REIT must assure themselves that they are receiving real estate interest which meet the 75% test. Commitment fees are recognized as permissible income since they are customarily received as a part of a real estate loan transaction. However, points received for other services is not permissible income. However, it should be noted that REITs are also permitted to receive income on investment capital which is newly raised for one year after such funds are raised through a public placement, private offering of either stock or debt which has maturity for less than five years. This is important since it gives the REITs a safe harbor to prudently invest funds from the result of successful offerings in a security, one of the driving forces with respect to REIT capitalization. D. PROHIBITED TRANSACTIONS As previously mentioned, REITs can receive poisoned income from prohibited transactions for the sale of property held primarily as dealer property under the Internal Revenue Code. Aside from foreclosure property, certain real estate assets will meet a safe harbor test if they otherwise might be found to be dealer property. The safe harbor test requires that the property be held for at least four years and have been used for the production of rental income during that period of time; total expenditures during the four-year preceding the date of the sale does not exceed 30% of the selling price; and, not counting foreclosure property, the REIT did not make more than seven sales or any aggregation of sales exceeding 10% of the basis of all the assets of the Trust. E. FORECLOSURE PROPERTY AND FORECLOSURE INCOME Since a REIT is prohibited from engaging in certain kinds of transactions such as the sale of dealer property and, thus, is required to hold property for a four-year period, Congress, in order to protect mortgage REITs, permitted the receipt of unqualified income from the sale of foreclosed property or property acquired by a deed in lieu after default of a debt obligation or after termination of a defaulted lease. Personal property held and used in connection with the trader business conducted on the foreclosed property will be considered incidental and, thus, constitute real estate assets. Hotel FF&E, apartment refrigerators and appliances and other similar personal property is treated in this manner. Workouts of mortgages and leases in and of PHL_A v 1 6

7 themselves do not disqualify a property from being held as foreclosed property if the workout was done in good faith. A REIT may also include income from foreclosed property within the 95% and 75% gross income tests if such income so qualifies. Property can lose its status as foreclosed property if the REIT actually uses the property for more than ninety days, executes a new lease for the property which produces income that fails to qualify for the 75% test or commences new construction on the property which had not already been commenced before default became probable. Multiple tenant property can cause REITs serious problems since the entry of the lease which otherwise does not qualify as noted above or which will result of termination of foreclosed property status can poison the entire asset. F. TAXATION OF REITS It is not the intent of this article to be an exhaustive discussion of REIT income taxation. Suffice it to say that a REIT must distribute to its shareholders not less than 95% of its ordinary net taxable income and 95% of its foreclosure property income to its shareholders. Distribution of less than that sum will eliminate the pass-through status and force the REIT to pay ordinary corporate shareholder rates on the income that does not qualify. REITs generally do not have to distribute excess non-cash income. These items are those under the Internal Revenue Code which produce taxable income as a result of inclusion of the accrual method of accounting and taxable income of income items which are either not received in the future or do not create a comparable cash availability. REITs generally will have cash flow in excess of their taxable income which is one of the significant methods of fueling capital investment and growth. This differential may be used by the REIT for its normal business purposes such as capital investment, provided that investment income derived for this excess cash does not constitute impermissible income. III. TYPES OF REIT STRUCTURES The typical REIT operates as any other business entity with corporate characteristics. It acquires and sells real estate subject to the rules previously enunciated and will pay cash for its acquisitions and receive cash for its dispositions. Its shareholders have the advantage of avoiding double taxation, but nonetheless, pay taxes on the REIT dividends and, except to the extent that the REIT grows in value by sheltering taxes within its own structure, the shareholders do not receive any of the typical benefits of real estate depreciation or other items which shelter income tax. In particular, disposition of property to a REIT afforded no particular tax break to the seller. A. ROLLUPS PHL_A v 1 7

8 After the imposition of tax reform in 1986, in order to promote liquidity of real estate, a number of holders of real estate partnerships engaged in mergers or consolidations of those partnerships avoiding the effect of taxation and forming either REITs or master limited partnerships. These transactions were called Rollups. The groups of properties that were rolled up into the master limited partnership or REIT were then traded in public exchanges such as the New York Stock Exchange or NASDAQ. REITs were not favored as a rollup vehicle since the conversion of limited partnership interest into corporate shares of REITs were treated as taxable events. In addition, Rollups caused significant abuses in many limited partnerships which lead to the adoption of state and ultimately federal regulation. The profusion of Rollups has since diminished. B. UPREITS The development of the UPREIT is the factor that is singularly responsible for the popularity of the REIT as an investment structure because the UPREIT permits the real estate investment trust with an UPREIT structure to acquire properties and provide tax free exchanges for the sellers of many valuable pieces of real estate. UPREIT stands for Umbrella Partnership Real Estate Investment Trust and takes advantage of a transaction type that has been in use by owners of real estate for many years; that is, the contribution of interests to a partnership to avoid taxable gain. A REIT forms a limited partnership in which it owns a controlling interest. It will either issue securities or debt and contribute the cash to the partnership. The partnership will acquire real property and, in lieu of cash, issues partnership interest to pay for the acquisition of real estate. The partnership interests are known as operating partnership units or OP units. At that point in time, the exchange of the property for operating partnership units is a tax free transaction. After a suitable holding period, the owner of the partnership units may convert the units into shares of the real estate investment trust, which is the parent of the operating partnership. At the time of conversion of those units into shares of the REIT, the transaction is taxable. Many of the sellers of property attempt to avoid conversion until their death so that their estates may take advantage of the liberal step up in basis rules apply cash to decedent s estates. The advantages to the seller of property is that they now own partnership units that may be liquified by conversion and, more importantly, their portfolio becomes more diverse since they are receiving income no only from the property that they contributed to the UPREIT, but from all other properties which may have been contributed previously or will be contributed in the future. This provides significant diversity of opportunity to the holder of the units. Additionally, the transaction will provide, subject to certain tax rules, dividends that replicate the REIT dividend to the operating partnership holder so that the income derived has strong elements of predictability. PHL_A v 1 8

9 C. DOWNREITS The DOWNREIT is also a partnership formed by the REIT. However, it is most often used where the REIT wants to place a portfolio of properties into a discreet partnership vehicle which does not co-mingle its income with that of other properties or portfolios purchased. The REIT will form a partnership, the seller will contribute their properties and the partnership will contain no other assets except the assets contributed and any other assets which may be developed out of any cash flow or activities of the REIT. DOWNREITs are frequently used by REITs to start new property types. For example, an office REIT may wish to diversify and form an industrial REIT, but keep the property types separate. The DOWNREIT is a useful structure for these purposes. The DOWNREIT is also used where the REIT intends to develop properties which will then be placed in the real estate portfolio. This is often done in lieu of a specific merger transaction with another REIT or the holder of a large portfolio. The specific disadvantage of the DOWNREIT is that it fails to provide the holder of the operating partnership units will diversification that the UPREIT structure can provide. D. PAIRED SHARES; STAPLED STOCK Prior to 1984, a number of REITs developed a structure by which shares in the REITs were sold along with shares in a fully taxable C corporation which acted as the management company of the REIT. The shares were traded together and bought and sold as a unit. The REIT was able to operate its properties through the stapled company, retaining its pass-through characteristics while permitting it to engage in the active management of property. In 1984 the law was changed to prohibit any new paired share REITs from being created. Nonetheless, several of these companies remained and when the REIT proliferation in the early 1990s occurred the value of these companies increased significantly. The paired share concept is particularly appropriate for the development of an operation of the hotel REIT since a hotel REIT, without paired share status, could only own hotel property by leasing the real property of the hotel and having an independent contractor engage in the operations. Congress has recently attempted to restrict paired shares by prohibiting any new ventures from having the benefits of paired shares activities. There an additional technique called the paper clip REIT. The paper clip REIT involves the pairing of shares of a real estate management company with a REIT and having the two shares traded separately. The REIT rents its properties to its operating companies. However, the shares no longer work in tandem. IV. REIT FINANCIAL TERMINOLOGY PHL_A v 1 9

10 A. FUNDS FROM OPERATION For many years real estate companies which were publicly traded were significantly devalued by the investing public as a result of the inability of GAAP measures of income and loss to effectively permit the measurement of the performance of those real estate companies and the inherent value of their portfolio. GAAP income and loss takes into consideration the effect of depreciation, which in a manufacturing company is an important component since plant aging will normally result in productivity loss and the need to then accumulate funds as replacement of the facilities. However, in the case of real estate, it has been proven that book depreciation in no way reflects the value or performance of income producing real estate since real estate appreciates in value over time as the income portfolio appreciates without regard to whether or not the property is new or old and the investment required in income producing real estate to freshen it does not typically equal the depreciation required to be taken under generally accepted accounting principles. In the early 1990s, in order to offset the effect of the investment public s perception, the National Association of Real Estate Investment Trusts ( NAREIT ) adopted a definition to avoid GAAP treatment and more properly reflect correct measurement of real estate. This concept is called Funds From Operation or FFO. FFO means net income or loss (computed in accordance with GAAP) excluding gains or losses from debt restructuring or from the sales of property and then adding back depreciation and amortization, and further adjusting for unconsolidated partnerships and joint ventures of REITs. Those adjustments will utilize FFO as well. The adjustment to unconsolidated entities will be similar to that of the equity method of accounting. NAREIT frequently has pointed out that since GAAP depreciation does not affect the value of real estate assets, income on a GAAP basis which includes GAAP depreciation will frequently produce losses rather than gains and produce unacceptable price earnings ratios for real estate entities. FFO, as you can see, does not necessarily parallel cash flow, nor does it necessarily measure dividend capacity. However, it does measure to a better extent investment availability on the part of a REIT. In adding back depreciation and amortization, NAREIT has recommended to its members that they add back those items of depreciation and amortization only directly related to real estate and to real estate income, including real property depreciation, capitalized leasing expenses, and tenant allowances. They do not include normal corporate depreciation of company offices and typical expenses. NAREIT encourages its members to disclose the basis for computing funds from operations. It encourages the disclosure of the nature of non-recurring items, the basis for inclusion and exclusion of depreciation and separate items for the gain and loss of asset dispositions. PHL_A v 1 10

11 NAREIT also has encouraged the use of modified FFO in which capital expenditures are set forth which separately list tenant improvements, capitalized leasing costs, costs of expansions and major renovations. NAREIT also encourages its members to reflect in its financial statements the GAAP reporting of straight-lining of rents, which requires companies who engage in graduated rent transactions to average over the term for GAAP reporting. NAREIT would have its members disclose the positive or negative effects to income of this concept. B. ACCRETION As operating partnership transactions for items other than cash became increasingly popular, financial analysts began to look at those transactions to see if they were beneficial to the REIT beyond the effect that delusion of ownership shares of the REIT caused by the dispensing of equity interests in return for real estate. For the purposes of determining dilution, operating partnership units are treated functionally as if they were shares of the REIT. OP Unit transactions are often able to gain more value than the dilution that results from the granting of interest in the entity. Accretion usually results because the REIT is capable of paying for real estate utilizing capitalization rates that are higher than the market place ascribes to the asset acquired when blended in with the REIT portfolio. Wall Street analysts will utilize cap rates against funds from operation that are lower by anywhere from 50 basis points to 150 basis points than that which the REIT will pay with respect to a single asset or a portfolio of assets. Certain items of cash flow to which the market place ascribes higher than normal cap rates are treated by Wall Street as in the same manner as with the cash component which is derived from the rent of the real estate REITs. The perfect example is the management fee. REITs will frequently use multipliers of one when paying for management fees when, in fact, analysts will treat management fee income in the same fashion as they treat rental income which can achieve multipliers of anywhere from eight to thirteen times their cash value. This is also true for income which in the normal valuation process would be more heavily discounted such as temporary tenant income, percentage rents or certain permission service income. Thus, the REIT derives the benefit of Wall Street s quest for consistency and macro analysis as opposed to the real estate communities driving desire to analyze properties on a micro analytic basis. V. CONSIDERATIONS FOR THE SELLER IN REIT EXCHANGE TRANSACTIONS A. PITFALLS IN THE TAX FREE NATURE OF OPERATING PARTNERSHIP TRANSACTIONS PHL_A v 1 11

12 In order to preserve the tax free nature of the REIT transaction, there are a number of significant issues which must be recognized by the seller of properties in exchange for REIT units. Although sellers of property desire to obtain income on their operating units which are equal to the REIT dividend, care must be taken that the distributions attributable to the OP units bear a reasonable relationship to the taxable income derived from the transferred assets for a period of several years. Failure to provide for this may result in recharacterization of the transaction as a taxable transaction. There exists a safe harbor under the tax laws with respect to a permissible deviation. Since most owners of real estate (other than REITs) like to leverage up as much as possible, REITs will often buy property that is subject to significant mortgage debt. In order to avoid burdening the seller with significant taxes as a result of cancellation of indebtedness income, the operating partnership must agree with its seller to do one of the following things: 1. Maintain the existing debt on the property or place new qualified non-recourse debt on the property in an amount sufficient to avoid income recognition; 2. Allow the transferring party to guarantee partnership debt in amounts sufficient to avoid income recognition; or 3. Provide for the restoration of negative capital accounts upon the termination of the operating partnership. It must be noted that REITs, in today s market, are not fond of secured debt at the property level. Wall Street prefers to see REITs borrow on an unsecured basis so that there can be a significant measurement against the portfolio as a whole. REITs like to avoid the use of property debt until they have to as a result of the failure of the capital markets, in which case secured debt may be their only out. If the option offered to the seller is to guarantee partnership debt, it is vital that there be adequate partnership unsecured debt in order to avoid income recognition. In addition, the transferring party should insist that the debt guaranteed be the bottom portion of the partnership debt so that there is little or perhaps less, likelihood of the guarantee being called for payment. The problem with the restoration of negative capital accounts is that when the operating units are transferred, this will almost assuredly result in a mandatory payment on the part of the limited partner. B. REGISTRATION RIGHTS AGREEMENT The conversion of the operating partnership units to shares of the REIT are problematic unless the transferring party is assured that the corporation or trust has sufficient authorized shares to prevent the full conversion of the units. The Registration Rights Agreement PHL_A v 1 12

13 is the contractual basis for this assurance. The agreement provides for the registration of the shares, how the shares are registered, who pays for the costs, and what restrictions, if any, will be imposed on the shares, including the initial typical two-year standstill which prevents conversion in the early years of contribution. Conversion of units into authorized but unregistered shares of a publicly traded company means that the quest for liquidity, which is one of the primary results of this form of transaction, is virtually a nullity. The Registration Rights Agreement is one of the most significant documents in the UPREIT or DOWNREIT transaction for the seller of the real estate. C. OPERATING PARTNERSHIP CONTROL ISSUES Although sometimes difficult to achieve, the transferring party must impose certain controls in addition to the maintenance of debt covenants and the Registration Rights Agreement. Most importantly, where property debt is maintained to avoid cancellation of indebtedness income, the transferring party must negotiate for a restriction on sale of the asset. Unless there is a restriction on sale, the cancellation of indebtedness income will almost surely be triggered (unless there is a provision for other forms of debt to replace the debt cancelled as a result of the sale). Because the REIT general partner is constantly seeking to acquire new properties in return for OP units, the seller to a REIT should attempt to impose broad limitations on the REIT s ability to make future changes to the REIT organizational documents which diminish the control rights of existing OP unit holders. The terms of these subsequent transactions may, in fact, result in diminishment of control as a result of negotiated document changes which materially alter, change or reduce the manner or character of future cash distributions or alter, change or restrict previously negotiated major transaction control provisions. D. CONSIDERATIONS IN MERGER TRANSACTIONS OR NEW REIT FORMATIONS In addition to the considerations as set forth in the previous section, if a party selling its real estate assets to a REIT intends to remain active in the operational life of the REIT there are certain negotiations which must occur between the buyer and the seller. It is possible for a seller of a portfolio of properties to do an interim transaction which results in the formation of a private REIT. Although the private REIT must comply with diversity rules, it is possible by creation of classes of shares of securities to vest control in an entity in the original buyer and seller. The private REIT is often used to set the stage for growth of a portfolio through acquisition and further nurturing of its original assets. The downside of a private REIT is that if the market for IPOs becomes erratic, the opportunity to do a public offering may be lost. If the parties do such an interim transaction, the minority party (usually the seller) needs to negotiate protections over the governance of the private REIT entity. This typically takes the form of shareholder agreements or major transaction definitions contained in PHL_A v 1 13

14 partnership agreements. When the REIT goes public, these transactions will have to be abrogated since the investing community does not look kindly on these restrictions. When organizing a REIT, the founding parties will frequent negotiate stock option plans that permit the acquisition of additional shares for founders. These rules will be subject to the tax rules which prohibit entities from owning too many shares in the REIT. Nonetheless, these plans will usually provide a significantly beneficial acquisition price of the stock rate for those parties and the existence of the control rules will not normally defeat the party s ability to gain significant profit on the issuance on the successful public issuance of a REIT. When one is acquired by a REIT, existing incentive option plans must be examined and modified to suit the need of the new entrants. The principals of an acquired company if they are to continue as part of the management of the REIT should negotiate employment agreements. Employment agreements take customary form and cover salary, benefits, terminations and non-competition provisions. VI. CONCLUSION The REIT transaction today can be an important surrogate for the financing transaction. It permits the conversion of real property into an equity security on a tax free basis and permits the transferring party to receive liquidity and diversity. The transaction is complex and requires a multi-disciplinary approach by a law firm. Often the corporate lawyer, the real estate lawyer, the tax lawyer, the labor lawyer, the environmental lawyer, and the employee benefits lawyer will comprise the team. However, the typical reward is great for the client with the right portfolio. PHL_A v 1