Merger and acquisition activity involving REITs has fallen off sharply from its peak in late 2007 when the availability of debt financing dried up. From the beginning of the liquidity crisis in the fall of 2008 until March of 2009, publicly traded REITs faced a battle for their survival. During that period, REIT stock prices plummeted nearly 75%.
Beginning in March 2009, REITs began to dig out of the liquidity crisis when the capital markets reopened and, since then, equity REIT stock prices have rebounded over 100% through the first quarter of 2010. Between March 2009 and April 2010, REITs have raised almost $50 billion of debt and equity capital and 25 REITs have filed for initial public offerings. REITs are widely viewed as having addressed their liquidity concerns and are now looking for ways to invest their capital. Further, many institutional sources of capital have announced that they intend to increase their investment allocations in U.S. real estate. Will this availability of capital lead to an increase in REIT M&A activity?
While REIT acquisitions raise many of the same issues as purchases of any other business entity, REIT deals involve many issues unique to the industry.
If the target is an UPREIT (a REIT that owns all of its assets through a subsidiary operating partnership in which the REIT is a general partner), buyers will need to carefully analyze the UPREIT's partnership agreement because of the varying rights of the limited partners. The partnership agreement generally will include provisions relating to the vote of limited partners needed to complete the transaction as well as other rights in favor of limited partners.
Limited partners in an operating partnership have different rights than those afforded to REIT shareholders and may be able to negotiate a different transaction than that offered to shareholders. The limited partners may have as their primary goal the continued deferral of their built-in tax gains (discussed further below) and, therefore, may be less likely to take cash as part of the transaction and may want to remain as limited partners. Leaving limited partners "in place" may not be appealing to the buyer given the possible fiduciary issues and continued reporting obligations under the Securities Exchange Act for operating partnerships that are reporting companies.
In addition, as with any corporate acquisition, buyers approaching the target's board with an acquisition proposal must be conscious of the fiduciary duties owed by board members to the target and its shareholders. In both Delaware and Maryland (where most REITs are organized), decisions by directors in determining how to sell control of the REIT are protected by the business judgment rule. This rule offers protection to directors in their deliberations surrounding a change of control transaction and focuses on the process followed by the directors in evaluating the transaction rather than the results obtained. Directors must act with adequate information and be actively involved in the process in order to benefit from the protections of the rule.
However, special considerations may arise in the case of UPREITs. For example, while directors of a corporate general partner of a partnership generally owe fiduciary duties to the limited partners, the partnership agreements for many UPREITs were drafted with specific provisions negating these fiduciary duties and providing that a board's actions consistent with its fiduciary duties to the REIT's shareholders will satisfy any obligation of the directors to the limited partners. The partnership agreement of the operating partnership will also include provisions dealing with matters relating to the vote of limited partners needed to complete the transaction. As a result, these operating partnership agreements must be carefully scrutinized to be certain that there is no conflict between the duties of the board to the shareholders and to the limited partners.
Unless the REIT is actively seeking to sell itself, approaching a REIT with an acquisition proposal will generally start the process and will dictate the pace and scope of the process. Typically, the friendly suitor will seek an exclusive time period during which to negotiate and document a transaction. While the REIT may insist on a full pre-signing auction of the REIT, in exchange for granting exclusivity, the REIT may be agreeable a post-signing market check of the transaction. This market check may take the form of “window shop” provisions, “go shop” provisions or a low break-up fee (or some combination). Deciding which type of market check mechanism is appropriate under the circumstances should be carefully considered with qualified financial and legal advisors.
Other unique aspects of REIT acquisitions require the buyer to have clear post-acquisition plans for the acquired assets as well as a clear understanding of the tax impact of the transaction on the buyer and the target.
The REIT's compliance with the requirements of the Internal Revenue Code is critical to the transaction no matter its structure. Regardless of whether the target will continue to qualify as a REIT after completion of the transaction, the target's historical compliance with the REIT requirements of the Code will have an impact on the buyer. If the REIT failed to qualify as a REIT prior to the transaction, it may be subject to an entity level tax or penalties, which, of course, will be borne by the buyer. Similarly, if the buyer is a REIT, the failure of the target REIT to qualify may affect the ability of the buyer to maintain its REIT status. Because of the importance of REIT qualification, buyers customarily require the target REIT's counsel to deliver an opinion at closing that the target qualifies as a REIT under the Code.
Another issue unique to REIT acquisitions arises out of the manner in which REITs were formed and grew. Historically, many of the assets acquired by UPREITs were contributed by the former owner on a tax-deferred basis. As part of the contribution transaction, the REIT may have granted the contributor "tax protection" in the form of an agreement not to sell in a taxable transaction the contributed property for a period of time or to pay the taxes (including a gross-up amount) owed by the contributor on any taxable sale of the property. These agreements need to be examined against the buyer's plans for the related properties and the structure of the transaction. For example, if the transaction results in taxable disposition of the property, then the buyer may be liable for paying the contributor's taxes (including a gross-up amount) on any built-in gain on any tax protected properties.
Because the merger consideration that a buyer will be paying will exceed the depreciated value of the target's property, most buyers will seek a step-up in the tax basis of the underlying assets of the target. However, obtaining this result may come with some unexpected costs depending upon the structure of the transaction. In general, there are three types of acquisition structures in all cash transactions (while there are, of course, a myriad of structures involving a variety of merger consideration that can be dreamed up, they are well beyond the scope of this article):
- Forward merger of REIT into acquisition vehicle. In this type of transaction, the separate existence of the REIT ceases. An advantage of this structure is that it generally results in an immediate step-up in the basis of the assets. However, because the separate existence of the REIT ceases upon completion of the transaction, this structure will generally trigger third-party consent requirements, including the consent of lenders. For the same reason, most jurisdictions will view this structure as requiring the payment of a transfer tax or triggering a reassessment of the REIT’s property. Another disadvantage of this structure is that any C-Corporation built-in gain (i.e., gain from the sale of certain property the REIT held before electing REIT status or which it obtained in a carry-over basis transaction) in the target REIT is triggered. These disadvantages could materially add to the cost of the transaction.
- Reverse merger of acquisition vehicle into REIT.In this type of transaction, the REIT continues as the surviving entity. As a result, there may exist fewer third-party consent requirements. For the same reason, some jurisdictions may not recognize the reverse merger as a transaction requiring the payment of transfer taxes or the reassessment of the REIT’s property. A major disadvantage of this structure is that the buyer will not receive any step-up in the basis of the assets. The lack of basis step-up will lead to lower depreciation expense for tax purposes and larger tax gains from dispositions.
- Reverse merger followed by liquidation of REIT.The effects of this structure are very similar to the first structure described above in that the buyer receives a step-up in the basis of the assets. However, because the REIT is liquidated as part of the transaction, this structure will likely maximize the need for third-party consents and will almost certainly trigger transfer taxes and reassessment and therefore result in relatively higher costs.
The structure of the transaction may also be affected by the buyer's post- acquisition plans with respect to the assets and operations. For example, in the event the buyer wants to immediately dispose of unwanted assets, the buyer will need to be sure those properties will not constitute "dealer property" that could result in a 100% tax to the buyer or force the buyer to dispose of the unwanted properties through tax-deferred like-kind exchanges. Further, as noted above, the REIT may be subject to entity level tax on any C-corporation built-in gain.
One final unique issue in REIT acquisition transactions revolves around the payment of a breakup fee. If the buyer is a REIT or if a reverse breakup fee is payable to the target REIT, the party entitled to receive the breakup fee may need to place limitations on its ability to take the fee in a lump sum. Receipt of such a fee by a REIT would constitute non-qualifying REIT income for purposes of the REIT income tests and thus, if the fee is significant enough, may cause the REIT to fail to qualify as a REIT. To address this issue, most merger agreements involving REITs provide for the payment of the breakup fee into an escrow to be paid out to the REIT over time as permissible in order to maintain the REIT's status under the Code.
While REIT M&A activity has significantly slowed following the record activity through the third quarter of 2007, conditions may be ripe for buyers with access to capital to acquire a REIT on favorable terms. In structuring an acquisition, it is important for both buyers and targets to have a complete understanding of the legal and tax framework involved. Both buyers and targets should consult legal and financial advisers as early in the process as possible.
About the Author:
Michael Blair is a partner in the Corporate & Securities practice in the Chicago office of Mayer Brown LLP. His practice focuses on all aspects of public and private merger, acquisition, divestiture, and financing transactions and on issues of Securities Act and Exchange Act compliance, with a particular emphasis on real estate investment trusts and other real estate companies. Mike can be reached at 312-701-7832 and firstname.lastname@example.org. For more information on Mayer Brown’s Corporate & Securities practice, please visit https://www.mayerbrown.com/experience/Corporate-Securities.