April 7, 2010 Authors: Gregory R. Andre greg.andre@klgates.com +1.312.807.4254 Phillip John Kardis II phillip.kardis@klgates.com +1.202.778.9401 Thomas J. Lyden tom.lyden@klgates.com +1.202.778.9449 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. Mining the Corporate Balance Sheet for Real Estate Equity Virtually all corporations own or lease real estate. Some corporations have a real estate portfolio that is owned or leased in accordance with a well-crafted plan that made perfect sense years ago, but today would benefit from changes to comport with new corporate objectives and economic realities. Other corporations have accumulated real estate portfolios over many years, oftentimes through mergers or acquisitions, where the manner of ownership was secondary to more important considerations at the time, but now represent a mix of owned and leased real estate that is underserving corporate goals. Corporate objectives with respect to real estate might be simple and straightforward, such as monetizing illiquid holdings or raising cash immediately. Other objectives are more complex, such as maximizing flexibility in accessing real estate equity, improving overall returns on assets, centralizing ownership and management, streamlining administration or tax planning at the federal or state level. Many corporations approach the analysis of their real estate portfolios by asking only the simple question of whether they should be owning or leasing it and, if they own it, whether they should sell it and lease it back. While these obvious and basic alternatives must be considered, there are additional alternatives to consider. A few alternative approaches are set forth below, and other structures may suggest themselves in the unique circumstances of each corporation. Restructure Owned Real Estate with Public Capital Many corporations seek a strategy that will tap equity in their real estate. Given the current difficulty securing real estate financing from banks, the public capital markets should be considered as a means for accessing equity in real estate. Corporations considering these strategies, however, generally need to have a substantial real estate portfolio to make such transactions worthwhile. Contribution to an Existing REIT If a corporation currently holds real estate assets, such as office buildings or hotels, and it is not as interested in currently monetizing its investment in real estate as it is in diversifying that investment, it may seek to contribute the real property it owns to an existing publicly traded REIT. There are two courses of action open here. First, if the corporation is indifferent to recognizing tax gain or loss on the transfer of real property, it could simply transfer the real property to an existing REIT in exchange for shares of its publicly traded stock. This would be a taxable transaction. Indeed, this strategy might appeal to corporations seeking to take advantage of tax loss opportunities afforded by low valuations in the current recession.
The corporation would, through its acquisition of REIT stock, acquire an interest in a diverse portfolio of real estate. Furthermore, it could sell shares into the market far more readily than it could sell unique parcels of real property. As a result, the REIT shares would represent an increase in liquidity. If, however, the real estate owned by the corporation has a large built-in-gain that the corporation does not want to recognize for tax purposes, then an alternative approach could be employed. Under the alternative, the corporation could contribute the real estate assets to either a newly formed partnership or an existing partnership in which a REIT would be the other partner. Careful attention must be paid to the drafting of the partnership agreement to ensure that sufficient liabilities are allocated to the corporation such that the contribution to the partnership will not result in gain recognition. In addition, the REIT partner would have to covenant that it would not undertake actions that would result in gain recognition to the corporation for a fixed period of years. The interest in the partnership held by the corporation would be convertible into REIT shares in most circumstances, which would give the corporation the advantage of liquidity represented by publicly traded REIT shares without the immediate gain recognition. These approaches allow a corporation to diversify its investment in real estate and achieve a degree of liquidity without significant costs. In addition, if the partnership structure is employed, the corporation can accomplish these results without the immediate recognition of taxable gain inherent in its investment in real estate. April 7, 2010 2
Under these approaches, the corporation would transfer its entire ownership interest in real estate to a third party that would manage the real estate and set lease terms. In effect, once the initial negotiations are concluded, the corporation will have given up control of its real estate. State and local transfer taxes would also have to be considered in these scenarios. Contribution to a New Captive REIT If a corporation has a significant investment in real property, such as numerous big-box stores or warehouse facilities, it may be able to raise capital while controlling the management of its real property by contributing the real property to a newly formed subsidiary that would elect to be a real estate investment trust (a REIT ) for federal income tax purposes. For instance, assume a corporation owns several big-box retail facilities that it contributes to a newly formed subsidiary. Assume further that the corporation enters into leases with the newly formed subsidiary in which the corporation pays a base rental amount for each store and, in addition, pays contingent rent, the amount of which depends on gross revenues of the particular stores. The corporation would own substantially all of the stock of the newly formed corporation (the REIT Sub ), which would elect to be a REIT for federal income tax purposes. The REIT Sub could undertake an offering, most likely a private offering, of convertible preferred stock or convertible notes. The idea here is that the conversion would be tied to the increase in gross revenues of the REIT Sub, which, in turn, would be tied to the increase in contingent rent paid by the corporation to the REIT Sub under the gross revenue contingent rent feature of the leases. Thus, an investor could enjoy a base level return in the amount of the fixed dividend or interest amount, plus the opportunity for additional return through the conversion feature if the corporation does well. Although this model works better if the REIT is a publicly traded entity because publicly traded shares afford a degree of liquidity for investors, it can work in the case of privately offered securities if the conversion feature offers a cash in lieu of stock feature upon conversion. In any event, the corporation would continue to have indirect ownership of the assets while leveraging that ownership through the REIT Sub s issuance of convertible securities. Of course, the REIT Sub could always undertake an offering, private or public, of its common shares of stock. We believe, however, that such an offering would be difficult to execute because the REIT would have only one tenant. In our view, it is more likely that an offering of convertible preferred stock or convertible notes would be more appealing to investors seeking a fixed income return with upside exposure to the corporation s revenue growth. April 7, 2010 3
The REIT Sub structure described above in which the REIT Sub issues convertible preferred stock or convertible notes accomplishes two objectives. First, the corporation is able to monetize its investment in real property to the extent of the proceeds of the offering. Second, the corporation centralizes the management of its real estate holdings under the REIT Sub, an entity that it controls through its ownership of substantially all of its outstanding common stock. Moreover, through the issuance of convertible securities, the corporation may be able to lower its financing costs in that the fixed return required for convertible securities would most likely be less than the return demanded by an investor that purchases a security without an equity kicker. There are, of course, downsides to this approach. Undertaking an offering of securities, especially a public offering, can be an expensive proposition. Moreover, there are ongoing expenses associated with operating a public REIT Sub. It may be advisable, therefore, to take the private placement approach. Even in this case, however, significant costs may be incurred to ensure compliance with REIT tax rules and securities law requirements. Furthermore, state and local transfer taxes may apply to the transfer of title to real property to the REIT Sub. Restructuring Owned Real Estate with Private Capital Restructuring a real estate portfolio with private capital may appeal to corporations with portfolios that lack the size needed to tap the public capital markets or that prefer the advantages that private capital transactions offer. These strategies are summarized below. Sale-Leaseback A corporation can sell all or part of its real estate portfolio to an investor and lease the properties back on any terms to which they may mutually agree, including, for example, options to repurchase, terminate or renew. The advantages of a sale-leaseback are that it affords 100% financing of the real estate assets (as opposed to, perhaps, 75% financing from a bank, assuming such financing could be secured), removes real estate from the balance sheet and allows management of the real estate to remain centralized. April 7, 2010 4
The owning corporation often has flexibility to structure its sale-leaseback as a taxable or tax-deferred transaction for federal and state income tax purposes, which could be useful depending on whether there are unrealized gains or losses in the real estate. Counterparties may see advantages through (1) the depreciation of real estate, (2) the use of a sale-leaseback as alternative financing for cash-strapped governmental units, or (3) a reinvestment possibility coming out of a Section 1031 or like-kind exchange. Federal, state, or local taxes, including transfer taxes, may be owed upon the sale. Joint Venture Leaseback In a joint venture leaseback, a corporation contributes for no consideration its real estate to a new passthrough legal entity, such as a limited liability company, which leases the properties as the landlord back to the corporation as the tenant, and then a minority or non-controlling interest in the new entity is sold to an investor. The investor s interest may be structured many ways, such as with a priority return. The new entity also may borrow money on a secured basis, if it wishes. The original corporation, now the tenant and majority owner of the new entity, can manage the new entity and the real estate. This strategy allows for flexibility with respect to the amount of cash to be raised (based on how much of the interest in the new entity is sold), which can be designed to fluctuate as needed, removes real estate from the balance sheet, centralizes the ownership and management of the real estate and allows the new entity to obtain secured financing, if desired. A joint venture leaseback necessarily dilutes the corporation s ownership interest in the real estate, but may allow it to retain control and management (depending on the operating agreement), and gives rise to investor scrutiny of the terms of the leases. Also, the investor might view it as a doubly illiquid investment (ownership of an illiquid joint venture that owns illiquid real estate), and demand a premium for making the investment. This strategy will likely appeal to corporations that wish to tap part of the equity in their real estate, while retaining modified control, and are able to secure an investor or user interested in such a holding. April 7, 2010 5
Subsidiary Spin-Off to Shareholders A corporation may contribute its real estate to a newly formed subsidiary (non-reit) and lease the real estate back. The value of the real estate, therefore, is transferred from the parent corporation to the new subsidiary. Management of the real estate will be centralized in the subsidiary. The stock of the subsidiary can be distributed to the parent corporation s shareholders who may retain the stock or sell it in a taxable transaction. This structure can be used to centralize the management of the real estate and shift its value from the parent corporation to its subsidiary. It puts the value of the real estate ultimately into the hands of the parent corporation s shareholders. A disadvantage of this approach is that it does not generate cash for the parent corporation the parent corporation s shareholders are the ones who benefit. Another disadvantage is that it is generally difficult to spin off the subsidiary to existing shareholders of a parent corporation in a tax-deferred transaction. This strategy may be worth considering in the unique circumstances where a taxable gain is not a concern, or there are losses to be utilized, and it is beneficial to transfer the value of the real estate to the shareholders. Subsidiary Spin-Off to Investors As another subsidiary strategy, the parent corporation can contribute its real estate to a newly formed subsidiary (non-reit), lease the real estate back and issue stock in the new subsidiary to an investing group. This structure likely will require limiting the offering to no more than 20% of the stock (to preserve federal tax consolidation) and introduces potentially complicating issues of oversight and fiduciary responsibility with respect to the new shareholding group. Nonetheless, it might be a viable strategy under special circumstances. April 7, 2010 6
This strategy shifts some (20% or less) of the real estate value from the parent corporation ultimately to the investors as the owners of a minority interest in the new subsidiary. The cash generated from the sale of the subsidiary s stock to the investors can be disbursed to the parent corporation. Because the parent corporation will continue to own 80% or more of the subsidiary s stock, it will continue to control its real estate, and management of the real estate can be centralized in the new subsidiary. A serious drawback to this strategy is the need to limit the offering to no more than 20% of the stock of the new subsidiary to preserve federal tax consolidation. The cash received from the 20% maximum offering might not justify the lease scrutiny surely to be imposed by the investor. Secured Line of Credit Although obtaining financing for real estate is currently difficult for most corporations, those that are in a position to obtain it may wish to consider borrowing as a viable option for tapping most, but not all, of their equity in real estate. Under this alternative, a corporation would retain ownership of its real estate and obtain a line of credit secured by a mortgage (or comparable instrument) encumbering the real estate. April 7, 2010 7
This transaction will generate cash, as needed, to the extent of the loan-to-value ratio that is mutually agreed upon between the corporation and the lender, which is likely to be in the range of roughly 75% (or perhaps less in the current market). Companies currently owning real estate under multiple operating company subsidiaries may wish to consolidate and centralize ownership first in a separate entity prior to effecting this transaction. The main disadvantages of accessing equity in real estate through a secured line of credit are that it provides less than 100% financing, which may be exacerbated by current low real estate valuations, and it will add debt to the balance sheet. This alternative should be considered by a corporation that wishes to retain ownership and control, tap up to 75% of its equity in real estate and is in a position to borrow the funds and have the debt on its books. Leased Real Estate Strategies Strategies involving real estate that is currently leased are limited, of course, to the terms of the existing leases. However, all leases eventually expire and afford the opportunity for change, and landlords can always be approached to consider new terms designed to accommodate a real estate portfolio strategy. Accordingly, corporations may wish to consider the following strategies for leased real estate: Lease Expiration. A corporation can have a plan to seek lease renewal or ownership of an existing leased facility or to lease or own another facility upon expiration of the existing lease term in a manner that dovetails with an overall real estate portfolio strategy, such as one of the alternatives outlined above. Lease Options. A corporation can always request that its landlord grant various lease options that will allow the leased property to fit into an overall real estate portfolio strategy. For example, the landlord might agree to grant the tenant corporation an option to purchase the facility or to terminate the lease altogether so the corporation will be able to lease or own elsewhere as necessary to meet the requirements of its portfolio strategy. Lease Management. Some tenant corporations can benefit from centralizing management and legal services related to leases, especially where multiple operating companies separately manage their real estate. If the lease portfolio is large enough, consistency and cost-efficiency can often be achieved through the use of standardized lease forms or adopting a standardized approach to lease review and negotiation. Anchorage Austin Beijing Berlin Boston Charlotte Chicago Dallas Dubai Fort Worth Frankfurt Harrisburg Hong Kong London Los Angeles Miami Moscow Newark New York Orange County Palo Alto Paris Pittsburgh Portland Raleigh Research Triangle Park San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d Alene Taipei Tokyo Warsaw Washington, D.C. K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. April 7, 2010 8
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