Frequently Asked Questions About Real Estate Investment Trusts In this issue Section 1. — REIT Basics page 1 Section 2. — Structuring a REIT page 2 Section 3. — Operating a REIT page 8 Section 4. — Public REITs page 9 Section 5. — Non-Traded REITs page 16 Section 6. — Mortgage REITs page 17 Section 7. — Private REITs page 18 Section 8. — TAX Matters page 19 Section 9. — About MoFo page 25 Exhibit A-Enhanced Disclosure Obligations under form S-11 page 26 REIT Basics What is a REIT? A REIT refers to a “real estate investment trust,” which is an entity entitled to beneficial federal income tax treatment if it satisfies various requirements relating to its organization, its ownership, its distributions and the nature of its assets and income. What types of REITs are there? Most broadly, there are equity REITs and mortgage REITs. Equity REITs primarily own interests in income-producing real property that is leased to tenants. Equity REITs typically concentrate on one or more asset classes (for instance, industrial, office, healthcare, lodging, residential, retail or self-storage properties). In contrast, mortgage REITs primarily own loans and other real estate-related debt instruments secured by interests in real property. Mortgage REITs typically focus on originating or acquiring loans made to certain types of real estate borrowers (for instance, loans made to developers or distressed borrowers) or on particular loan types (for instance, first mortgages, distressed debt or mezzanine financings). Although it is not unusual for equity REITs to invest in multiple property types, there are relatively few hybrid REITs that, in the ordinary course of executing their investment strategy, focus on owning and acquiring both operating real property and debt instruments secured by interests in real property. However, many equity REITs maintain a small portfolio of acquired or originated debt instruments, primarily secured by the same type of real property held in their operating property portfolio.
FAQ Real Estate Investment Trust Morrison Foerster | 2 REITs are also often characterized by whether they are public or private and whether they trade on a national securities exchange. Listed REITs are public companies that trade on a national securities exchange such as the NYSE or Nasdaq and are required to make filings with the Securities and Exchange Commission (the “SEC”). REITs that are required to make filings with the SEC, but that do not trade on a national securities exchange, are referred to as non-traded or non-listed REITs. See “Non-Traded REITs” below. Finally, private REITs are REITs that neither make filings with the SEC nor have securities that trade on a national securities exchange. When and why were REITs created? Congress passed the original REIT legislation in 1960 in order to provide a tax-preferred method by which all types of investors could invest in a professionally managed portfolio of real estate assets. Many of the limitations imposed upon the operation of REITs and the taxes to which they are potentially subject are perhaps best understood in terms of the original notion that the activities of REITs were to consist predominantly of passive investments in real estate. Do other countries have REITs? A number of countries, including Australia, Brazil, Bulgaria, Canada, Finland, France, Germany, Ghana, Hong Kong, India, Japan, Malaysia, Mexico, Nigeria, Pakistan, Philippines, Saudi Arabia, Singapore and the United Kingdom, have REIT-type legislation. The details of the rules may vary from the U.S. rules and from country to country. Structuring A REIT What types of entities can be REITs? Virtually any type of entity can qualify as a REIT, including corporations, trusts, partnerships and limited liability companies, as long as the entity would be taxed as a domestic corporation if it did not qualify to be treated as a REIT. The relevant regulations provide that an entity eligible to elect to be taxed as a corporation will be deemed to have so elected as a result of electing REIT status. How is a REIT formed? A REIT is formed by organizing an entity under the laws of one of the 50 states or the District of Columbia as an entity eligible to be taxed as a corporation for federal income tax purposes, and by electing to be treated as a REIT. An entity may elect to be treated as a REIT for any taxable year by filing with its tax return for that year an election to be a REIT. Where are REITs typically formed? Most public REITs are formed in Maryland as corporations under the Maryland General Corporation Law (the “MGCL”) or as real estate investment trusts under the Maryland REIT law. The popularity of Maryland as the preferred jurisdiction of formation for most REITs can be attributed primarily to statutory provisions that are REIT-friendly and a state judiciary that has developed expertise in REIT matters. There also are other benefits to forming in Maryland. For instance, while some jurisdictions impose franchise taxes and other costs of being incorporated (which can be as high $200,000 annually), Maryland has no franchise tax. The MGCL also permits a Maryland corporation to eliminate the potential liability of directors and officers to stockholders with only two very narrow exceptions—actual receipt of an improper personal benefit and active and deliberate dishonesty. Furthermore, Maryland has an explicit statutory standard of conduct that governs the duties of directors rather than relying primarily on everdeveloping case law. The MGCL also permits the board of directors of a Maryland corporation to increase the aggregate number of authorized Source: Nareit Public REITs by Sector (as of 1/31/24) Data Center 2 Industrial 33 Residential 28 11 Morgage 19 Self-Storage Diversified 12 Lodging 19 Retail 7 12 Office 4 Specialty 1The substantial majority of listed REITs are listed and traded on the NYSE.
FAQ Real Estate Investment Trust Morrison Foerster | 3 shares of stock the corporation without stockholder approval. The Maryland REIT Law, applicable to trust REITs, offers even more flexibility than the MGCL, although the statute does provide less structure. What are the requirements for qualification as a REIT? In order to qualify as a REIT, an entity must: ▪ Have a valid REIT election in effect; ▪ Use a calendar tax year; ▪ Be managed by one or more trustees or directors (or pursuant to comparable constructs, in the case of LLCs or partnerships); ▪ Have transferable shares or interests; ▪ Be taxable as a domestic corporation but for its qualification as a REIT; ▪ Not be a “financial institution” or “insurance company”; ▪ Have at least 100 shareholders for 335/365 days of every year (other than its first REIT year); ▪ Not be owned, actually or constructively, more than 50%, by value, by five or fewer “individuals” during the last half of any taxable year (other than its first REIT year); ▪ Satisfy annual income and quarterly asset tests (described below); ▪ Annually distribute, or be deemed to have distributed, at least 90% of its ordinary taxable income; and ▪ Not have any undistributed non-REIT earnings and profits (either from years prior to electing REIT status, or from an acquisition of a C corporation or its assets in a tax-free transaction) at the end of any taxable year. See “Tax Matters” below. Do REITs limit share ownership? Yes, almost always. To qualify as a REIT, an entity must not be “closely held,” meaning, at any time during the last half of the taxable year, more than 50% in value of its outstanding stock cannot be owned, directly or indirectly, by five or fewer individuals (referred to as the “5/50 test”). Although not legally required, all REITs, including listed public REITs, typically adopt ownership and transfer restrictions in their articles of incorporation or other organizational documents that provide that no person shall beneficially or constructively own more than 9.8% or 9.9% in value of the outstanding shares of the entity, and any attempted transfer of shares that may result in a violation of this ownership limit will be null and void. Depending on the circumstances, the REIT’s board of directors or board of trustees, as applicable, may determine that it is in the best interests of the REIT and its stockholders to grant a waiver of the ownership limitations for a particular stockholder. The board’s decision to grant or deny a waiver is often based on a variety of considerations, including the identity of the stockholder (i.e., is it a REIT-dedicated fund, a hedge fund or an investor that is likely to be a long-term holder?), the existence of outstanding waivers for other stockholders and the impact on the REIT’s ability to satisfy the 5/50 test, the amount of securities in excess of the ownership limit the stockholder is seeking to acquire and other factors bearing on whether or not the grant of an ownership limit waiver is in the best interests of the stockholders. In addition, larger holders, typically sponsors or founders of a REIT, who own more than 9.9% are usually “grandfathered,” potentially requiring a related decrease in the ownership limit to ensure continued compliance with the 5/50 test. For instance, if the founder of a REIT and his or her affiliates are grandfathered and permitted by the board of directors to collectively own up to 20% of the REIT’s outstanding shares, the ownership limit in the REIT’s charter would be lowered to 7.4% or less to ensure continued compliance with the 5/50 test. Investors may view REIT ownership limit provisions as an anti-takeover device for publicly traded REITs because the board of directors may grant or deny a waiver at its discretion. To alleviate stockholder concerns that a REIT will use its ownership limits as an anti-takeover device, some REITs have affirmatively stated in their articles of incorporation/ declaration of trust or public disclosures that the ownership limits will not be used for that purpose.
FAQ Real Estate Investment Trust Morrison Foerster | 4 What is an UPREIT? A common operating structure for publicly traded equity REITs is the umbrella partnership real estate investment trust (“UPREIT”) structure. In a typical UPREIT structure, the REIT holds substantially all of its assets, and conducts substantially all of its operations, through a single operating partnership subsidiary (the “Operating Partnership”). In most cases, the REIT or a wholly owned subsidiary of the REIT serves as the sole general partner of the Operating Partnership and, as a result, the REIT has the exclusive power and authority to manage the Operating Partnership’s business, subject to certain limited rights maintained by holders of units of limited partnership interest (“OP Units”) in the Operating Partnership pursuant to the partnership agreement of the Operating Partnership (the “Partnership Agreement”). In addition to controlling the Operating Partnership, the REIT typically owns a majority, and in some cases all, of the outstanding OP Units. These OP Units were obtained by the REIT in exchange for the contribution by the REIT of the net cash proceeds from the REIT’s IPO or other equity capital raise. The remaining OP Units, if any, are ordinarily held by outside limited partners (“OP Unitholders”) who received their OP Units in exchange for contributing real estate assets that were previously owned by them (or their interests in the entities that previously owned such real estate assets) to the Operating Partnership. Determining the value of the contributed assets and the allocation of the OP Units being issued as consideration to the property contributors often involves significant analysis and negotiation and, in certain instances, may involve third-party valuation firms. In the typical UPREIT structure, after an initial holding period, OP Unitholders may tender their OP Units for redemption by the Operating Partnership for cash or, at the option of the REIT, for shares of the REIT, typically on a 1:1 basis. The customary justification for such exchange ratio is that the OP Units and the REIT shares represent interests in essentially the same pool of assets and, therefore, should have the same pro rata interest in such assets. A typical UPREIT structure is depicted in the diagram below: What are the primary benefits of the UPREIT structure and OP Unit transactions? The UPREIT structure can provide a number of advantages over a typical all-cash real estate transaction, including the following:
FAQ Real Estate Investment Trust Morrison Foerster | 5 ▪ Tax-Advantaged Consideration – The most significant benefit of operating through an UPREIT structure is the ability to issue securities (i.e., OP Units) on a tax-deferred basis to sellers of real property in connection with property acquisitions by the REIT. When contemplating the disposition of real property, sellers who have a low tax basis in the property may be reluctant to sell for cash or REIT shares because the sale would trigger significant tax liability. By accepting OP Units as consideration for the contribution of their properties, sellers can defer the tax on their built-in gains, generally until they elect to tender their OP Units for redemption or until there is a taxable disposition of their contributed properties. Under certain circumstances, sellers may even be able to extract some cash in the transaction on a tax-deferred basis as well. Furthermore, OP Unitholders may also tender their OP Units over time, thereby spreading out their tax liability. OP Units also provide favorable tax benefits for estate planning purposes, as discussed below. ▪ Enhanced Liquidity – Unlike real property, for which there is limited liquidity, an OP Unitholder has the ability to obtain liquidity “on demand” by exercising its redemption rights. Pursuant to the Partnership Agreement, OP Unitholders typically have the right to tender their OP Units to the Operating Partnership for redemption. OP Unitholders generally must wait a certain period of time before they can exercise their redemption rights (typically, one year from the date of the issuance), but once the holding period has been satisfied, OP Unitholders generally can tender OP Units at times, and in amounts, of their choosing, subject to applicable limitations set forth in Partnership Agreement. Although the redemption of OP Units will trigger the recognition of the taxable gain that was deferred at the time of the property contribution, OP Unitholders have the flexibility to decide when to monetize their holdings and, accordingly, when the tax liability will be triggered. ▪ Current Income Through Distributions – Holders of common OP Units generally receive the same quarterly distribution payments in respect of their OP Units as stockholders receive in respect of their REIT shares, and the payment dates usually coincide. As a result, the ownership of OP Units generally provides holders with current income in the form of regular (typically quarterly) cash distributions. ▪ Liability Allocations – As a partner in the Operating Partnership, an OP Unitholder will receive an allocation, for income tax purposes, of the liabilities of the Operating Partnership. An OP Unitholder’s adjusted tax basis in his or her OP Units will be increased by the amount of such allocation. Among other things, an increased tax basis from an allocation of liabilities may enhance an OP Unitholder’s ability to (i) receive cash distributions in excess of earnings on a taxdeferred basis and (ii) absorb and use net losses, if any, generated by the Operating Partnership. ▪ Investment Diversification – The UPREIT structure offers property contributors the ability to diversify their holdings. Indeed, by contributing interests in a single property or a small group of properties that are concentrated in terms of geography, asset type or tenants in exchange for OP Units, a seller/contributor receives an interest in an entity (i.e., the Operating Partnership) that owns multiple properties, often in multiple real estate markets, which can diversify the contributor’s investment holdings and, as a result, mitigate the impact of a decline in the value or performance of any particular property. ▪ Depreciation Deductions – In the case of a newly acquired or developed real estate property, OP Unitholders will receive a share of the depreciation deductions from the depreciable asset in accordance with their respective interests in the Operating Partnership. These depreciation deductions will reduce the taxable income allocated to the OP Unitholders by the Operating Partnership with respect to their OP Units. However, OP Unitholders may be subject to limitations in their ability to use depreciation deductions and to subsequent adverse tax consequences in the future, such as depreciation recapture upon a later disposition of either the depreciated property or their OP Units, including pursuant to a redemption as described above.
FAQ Real Estate Investment Trust Morrison Foerster | 6 ▪ Estate Planning – OP Units are helpful for estate planning purposes. For example, an OP Unitholder can transfer OP Units to multiple beneficiaries as part of estate planning, and each beneficiary can choose either to hold his or her OP Units and receive quarterly distributions or tender the OP Units for redemption for cash or, at the REIT’s election, for REIT shares. In addition, when an individual partner holds the OP Units until death, the tax rules generally allow for a “step up” in tax basis of the OP Units, effectively permitting the beneficiaries to subsequently tender the OP Units for cash or REIT shares without incurring tax on the built-in gain in the OP Units at the time of death. For more information regarding public UPREITs and OP Unit transactions, including securities law, tax law and other considerations, see our publication entitled “Frequently Asked Questions about UPREITs and OP Unit Transactions forPublic REITs.” Are there any drawbacks to the UPREIT structure or engaging in an OP Unit transaction? Yes, despite the benefits described above, UPREIT structures can have some drawbacks that should be considered by sponsors and property sellers. UPREIT structures introduce a level of complexity that would not otherwise exist within a REIT structure that does not include an Operating Partnership subsidiary. Additionally, the disposition of property by an UPREIT may result in a conflict of interest with the contributing partner because any disposition of that property could result in gain recognition for that partner. As a result, contributing partners often negotiate mandatory holding periods and other provisions to protect the tax deferral benefits they expect to receive through contribution of appreciated property to an UPREIT. What is a DownREIT? DownREITs are similar to UPREITs in that both structures enable holders of real property to contribute that property to a partnership controlled by the REIT on a tax-deferred basis. The primary difference between the two structures is that DownREITs typically hold their assets directly and/ or through multiple operating partnerships or other subsidiaries (each of which may hold only one property or a small subset of properties), whereas UPREITs typically hold all of their assets through a single operating partnership subsidiary. The DownREIT structure enables existing REITs to compete with UPREITs by allowing them to offer potential sellers a way to dispose of real estate properties on a tax-deferred basis. As with an UPREIT structure, in a DownREIT, limited partnership interests in an operating company are redeemable for cash based upon the fair market value of the REIT shares or, at the REIT’s election, for REIT shares. As distinguished from an UPREIT, however, for a DownREIT, the value of each DownREIT partnership unit is not necessarily directly related to the value of the REIT shares, because, unlike UPREITs, where the value of REIT shares is determined by reference to all of the REIT’s assets, for a DownREIT, the value of each DownREIT unit is determined by reference to the specific assets held in only one of the DownREIT’s partnerships. As a result, there is not necessarily a correlation between the value of each DownREIT partnership’s assets and the value of the REIT shares. However, as a practical matter, almost all DownREIT agreements tie the redemption to a 1:1 ratio. Such a structure raises additional issues regarding the tax-free nature of a contribution by a property seller to a DownREIT partnership.
FAQ Real Estate Investment Trust Morrison Foerster | 7 Are there Investment Company Act considerations in structuring and operating a REIT? In addition to a REIT’s beneficial federal income tax treatment, a REIT has other regulatory advantages. Most REITs can qualify for one or more exemptions or exceptions to avoid regulation as an “investment company” under the Investment Company Act of 1940, as amended and the rules and regulations promulgated thereunder (the “Investment Company Act”). Most equity REITs qualify for an exemption under Section 3(c)(5)(c) of the Investment Company Act, which is available for entities that are primarily engaged in … [the business of] purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. The exemption generally applies if at least 55% of the REIT’s assets are comprised of qualifying assets (generally fee and ground lease interests in real estate and the structures thereon) and at least 80% of its assets are comprised of qualifying assets and real estate-related assets. Alternatively, equity REITs can definitionally not be an “investment company” under Section 3(a)(1)(A) of the Investment Company Act because it does not engage primarily, or hold itself out as being engaged primarily, in the business of investing, reinvesting or trading in securities as such REITs are primarily engaged in non-investment company businesses related to real estate. It meets this definitional exception so long as the total value of the REIT’s total assets (exclusive of U.S. government securities and cash items) are less than 40%. Excluded from the definition of “investment securities” are securities issued by majority-owned subsidiaries that are themselves not “investment companies” and that are not relying on the exemptions from the definition of investment company set forth in Section 3(c) Down REIT PARTNERSHIP Down REIT PARTNERSHIP COMMON STOCK COMMON STOCK Down REIT Units Down REIT Units Down REIT Units Down REIT Units 100% 100% 100% PROPERTY OWNING SUBSIDIARY PROPERTY OWNING SUBSIDIARY PROPERTY OWNING SUBSIDIARY PROPERTY OWNING SUBSIDIARY REIT (GENERAL PARTNER) PROPERTY OWNING SUBSIDIARY LIMITED PARTNER LIMITED PARTNER MANAGEMENT/ INSIDERS STOCKHOLDERS The following diagram shows a typical DownREIT structure:
FAQ Real Estate Investment Trust Morrison Foerster | 8 (1) (less than 100 holder exemption) or Section 3(c)(7) (qualified purchaser2 exemption) under the Investment Company Act. Most equity REITs hold assets primarily through direct or indirect whollyowned or majority-owned subsidiaries that generally meet the Section 3(c)(5)(c) exemption and therefore do not constitute “investment securities” allowing the equity REIT to hold less than 40% of its total assets in “investment securities”. Most mortgage REITs avail themselves of the same exemptions and exceptions; provided that the analysis can be more complex based on the composition of its mortgage assets. Qualifying assets for purposes of the Section 3(c)(5)(c) exemption include senior whole mortgage loans and certain B-notes and mezzanine loans that satisfy various conditions set forth in SEC no-action letters and other guidance that the SEC staff has determined are the functional equivalent of senior loans for the purpose of the Investment Company Act. Generally, B-notes and mezzanine loans that do not satisfy such conditions as well as preferred equity investments and CMBS are generally treated as real estate-related assets for this exemption. In addition, certain securitization subsidiaries of mortgage REITs that hold specified assets, issue fixed-income securities and meet certain other conditions rely on an exemption under Rule 3a-7 of the Investment Company and therefore are not considered an “investment security” held by the REIT. Private REITS can rely on the exceptions and exemptions described above or on Section 3(c) (1) or Section 3(c)(7). If a REIT does not meet the exemptions or exceptions described above, unless the REIT qualifies for another exemption or exception under Section 3(b) or the other provisions of Section 3(c) of the Investment Company Act, the REIT will be viewed as an investment company and required to comply with the operating restrictions of the Investment Company Act. These restrictions are generally inconsistent with the operations of a typical REIT. Therefore, most REITs monitor their Investment Company Act compliance with the same level of diligence thy apply to monitoring REIT tax compliance, as a violation of either set of rules can lead to material adverse consequences. Operating A REIT What types of assets do REITs own and manage? Broadly speaking, REITs generally own real property or interests in real property and/or loans secured by real property or interests in real property. What are the limitations on the types of assets REITs may own and manage? Entities must satisfy various income and assets tests in order to qualify for treatment as a REIT. These tests effectively limit the types of assets that REITs can own and manage to real estate or real estate related assets. How does a REIT maintain compliance with REIT tax requirements? The types of assets that a REIT can hold and the types of income it can earn are limited by the REIT rules. Therefore, a REIT must establish procedures, typically in coordination with its outside auditors, tax preparers and legal counsel, to ensure that it is investing in the correct types and proportions of assets and earning the right types and amounts of income. See “Tax Matters” below. How does a REIT finance its activities? Because a REIT must annually distribute at least 90% of its ordinary taxable income in order to maintain its REIT status, a REIT may not retain earnings like other companies (although cash generated by REITs often is in excess of their ordinary taxable income and therefore REITs often do have cash they can retain). As a result, REITs often require capital from outside sources to buy 2 Section 2(a)(51) defines “qualified purchaser” as: “(i) any natural person (including any person who holds a joint, community property, or other similar shared ownership interest in an issuer that is excepted under section 3(c)(7) [15 USCS § 80a-3(c)(7)] with that person’s qualified purchaser spouse) who owns not less than $5,000,000 in investments, as defined by the Commission; (ii) any company that owns not less than $5,000,000 in investments and that is owned directly or indirectly by or for 2 or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendants by birth or adoption, spouses of such persons, the estates of such persons, or foundations, charitable organizations, or trusts established by or for the benefit of such persons; (iii) any trust that is not covered by clause (ii) and that was not formed for the specific purpose of acquiring the securities offered, as to which the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a person described in clause (i), (ii), or (iv); or (v) any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments.”
FAQ Real Estate Investment Trust Morrison Foerster | 9 additional assets and to fund operations. A REIT generally finances its activities through equity offerings of preferred and/or common stock and debt offerings, including subordinated and senior debt, as well as through financing agreements (credit agreements, term loans, revolving lines of credit, etc.) with banks and other lenders. Mortgage REITs may also securitize their assets. An equity REIT may also incur ordinary course mortgage debt on its real property assets. What is the difference between internally and externally managed REITs? In a REIT with an internal management structure, the REIT’s own officers and employees manage the portfolio of assets. A REIT with an external management structure usually resembles a private equity style arrangement, in which the REIT does not have its own employees and the external manager or advisor receives fees and certain expense reimbursements for managing the REIT’s portfolio of assets. Many non-traded REITs and listed mortgage REITs are externally managed or advised. What fees does a manager of an externally managed REIT receive? The types of fees that an externally managed REIT pays to its manager vary, depending upon the type of assets the REIT is focused on acquiring, as well as whether it is structured as a “finite life” or “perpetual life” REIT. With respect to asset management, an external manager typically will receive a base management fee and an incentive fee. The base management fee and sometimes an incentive fee is based on a percentage of stockholders’ equity or the value of assets under management, while the incentive fee often is based on the achievement of targeted levels of earnings (calculated based on GAAP or non-GAAP measures) and is subordinated to a minimum investor return threshold. In addition, an external manager may receive fees such as property management, acquisition, disposition, development, loan coordination and leasing fees and may be reimbursed for certain operating expenses. Public REITS How can REITs go public? REITs become public companies in the same way as non-REITs, although REITs have additional disclosure obligations and may need to comply with specific rules with respect to roll-ups, which are discussed below. Like other companies, REITs may also take advantage of the more lenient requirements available to “emerging growth companies” (“EGCs”) under the Jumpstart our Business Startups (JOBS) Act of 2012. On June 29, 2017, the SEC announced that the Division of Corporation Finance will permit all companies (no longer limited to EGCs) to submit draft registration statements relating to initial public offerings and certain follow-on registration statements for review on a nonpublic basis. For more information regarding REIT IPOs, see our publication entitled “REIT IPOs and Listing Transactions - A Quick Guide.” Are there special disclosure requirements for public REIT offerings? Yes. In addition to the statutes and regulations applicable to all public companies, REITs that are not eligible to use a short-form registration statement on Form S-3, including REITs conducting an initial public offering, must comply with the disclosure requirements of Form S-11. In addition, REITs conducting a blind pool offering, including non-traded REITs, must comply with the SEC’s Industry Guide 5. What is Form S-11? SEC rules set forth specific disclosures to be made in a prospectus for a public offering of securities as well as for ongoing disclosures once the issuer is public. The registration form for an initial public offering by a U.S. domestic entity is Form S-1. Real estate companies, including REITs, are instead required to register the initial public offering of their shares on Form S-11. In addition to the same kinds of disclosures required by Form S-1, Form S-11 sets forth several additional disclosure requirements, which are summarized on Exhibit A to
FAQ Real Estate Investment Trust Morrison Foerster | 10 these FAQs. REITs conducting a blind pool offering, including non-traded REITs, are also subject to the SEC’s Industry Guide 5, as discussed below. What is a blind pool REIT Offering? A blind pool REIT offering is a public offering by a REIT that does not identify specific real properties or real-estate related debt instruments to be acquired with the net proceeds from its public capital raise; rather, after capital has been raised, the REIT’s sponsor or external manager or advisor will recommend investments in assets for the REIT based on a predetermined investment strategy disclosed in the prospectus. Therefore, the reputation and past experience of the sponsor is critical when establishing a blind pool REIT because an investor may make investment decisions based on the sponsor’s reputation and its track record. Accordingly, the prospectus for a blind pool REIT offering may be required to include information regarding the prior performance of similar investments by the sponsor in order for the investor to make an informed investment decision. Most non-traded REIT public offerings and offerings by private REITs are blind pool offerings. In addition, a public REIT offering may still be deemed a blind pool offering if more than 25% of the proceeds of the offering (as disclosed in the “Use of Proceeds” section of the prospectus) are not allocated to specified uses, such as acquisitions or debt repayment. What is Industry Guide 5? In addition to the enhanced disclosure obligations applicable to real estate companies, including REITs, under Form S-11, REITs conducting blind pool offerings are subject to the SEC’s Industry Guide 5, which sets forth the following additional disclosure requirements, among others: ▪ Risks relating to: (i) management’s lack of experience or lack of success in real estate investments; (ii) uncertainty if a material portion of the offering proceeds is not committed to specified properties; and (iii) REIT offerings in general; ▪ General partner’s or sponsor’s prior experience in real estate; and ▪ Risks associated with specified properties, such as competitive factors, environmental regulation, rent control regulation, and fuel or energy requirements and regulations. In addition, REITs conducting a blind pool offering also must make certain undertakings in their registration statements pursuant to the SEC’s Industry Guide 5, including, but not limited to, an undertaking to file a sticker supplement for reasonably probable acquisitions of properties, and consolidate such stickers into a post-effective amendment (a “20D Amendment”) at least once every three months that must include audited financial statements meeting the requirements of Rule 3-14 of Regulation S-X. Non-traded REITs are permitted to continue offering shares after a 20D Amendment is filed with the SEC and before it is declared effective. Depending on the nature of the specific REIT—UPREIT, DownREIT, listed, non-traded, equity, mortgage, externally managed, internally managed, etc.—there are additional necessary disclosures under the SEC’s Industry Guide 5. In July 2013, the SEC issued guidance regarding disclosure by non-traded REITs, particularly the applicability of certain provisions of Industry Guide 53. The SEC’s Industry Guide 5 also includes requirements regarding sales literature. In particular, Item 19.D of Industry Guide 5 provides that “any sales material that is intended to be furnished to investors orally or in writing . . . should be submitted to the staff supplementally, prior to its use.” Pursuant to SEC Staff guidance, if the Staff does not comment on submitted sales literature within 10 calendar days, it may be used by the non-traded REIT. Further, many states have codified the requirement for non-traded REITs to submit sales literature to the states prior to use. Finally, it is best practice for broker-dealers selling non-listed REIT securities to submit sales literature to FINRA and receive a “no objections” notice for use of such sales literature. 3 CF Disclosure Guidance: Topic no. 6, “Staff Observations Regarding Disclosures of Non-Traded Real estate Investment Trusts” (July 16, 2013), available at http:// www.sec.gov/divisions/corpfin/guidance/cfguidance-topic6.htm.
FAQ Real Estate Investment Trust Morrison Foerster | 11 What is a limited partnership roll-up transaction? In the late 1980s, the management of a number of finite life entities, whether public or private, decided to convert their entities into, or to cause interests in such entities to be exchanged for securities of, publicly traded perpetual life REITs. Typically, these transactions involved a number of these entities being “rolled up” into one publicly traded REIT. The SEC saw a number of conflicts and abuses arising from this process. In response, the SEC issued rules on “roll-up transactions,” and, in 1993, Congress enacted Section 14(h) and related provisions of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and the Financial Industry Regulatory Authority (“FINRA”) also issued rules governing the responsibilities of broker-dealers in roll-up transactions. In addition, the Statement of Policy Regarding Real Estate Investment Trusts (the “NASAA REIT SOP”) adopted by the North American State Securities Administrators Association (“NASAA”) included restrictions regarding roll-up transactions in the NASAA REIT SOP when it was initially adopted in 1993. Federal Roll-Up Rules Section 14(h)(4) of the Exchange Act defines a limited partnership roll-up transaction as a transaction involving the combination or reorganization of one or more limited partnerships, directly or indirectly, in which, among other things, investors in any of the limited partnerships involved in the transaction are subject to a significant adverse change with respect to voting rights, the term of existence of the entity, management compensation, or investment objectives; and any of such investors are not provided an option to receive or retain a security under substantially the same terms and conditions as the original issue. Section 14(h)(5) of the Exchange Act provides that the following transactions are not “limited partnership roll-up transactions”: ▪ The transaction only involves a limited partnership that retains cash available for distribution and reinvestment in accordance with the SEC requirements; ▪ In such transaction, the interests of the limited partners are redeemed in accordance with a preexisting agreement for securities in a company identified at the time of the formation of the original limited partnership; ▪ The securities to be issued or exchanged in the transaction are not required to be, and are not, registered under the Securities Act of 1933, as amended (the “Securities Act”); ▪ The issuers are not required to register or report under the Exchange Act before or after the transaction; ▪ Unless otherwise provided in the Exchange Act, the transaction is approved by not less than two thirds of the outstanding shares of each of the participating limited partnerships and the existing general partners will receive only compensation set forth in the preexisting limited partnership agreements; and ▪ Unless otherwise provided in the Exchange Act, the securities were reported and regularly traded not less than 12 months before the securities offered to investors and the securities issued to investors do not exceed 20% of the total outstanding securities of the limited partnership. See also Item 901 of Regulation S-K. If the transaction is a limited partnership roll-up not entitled to an exemption from registration, in addition to the requirements of Form S-11 and SEC Industry Guide 5 (see “What is Form S-11?” and “What is Industry Guide 5?” above), Section 14(h) of the Exchange Act and Items 902 through 915 of Regulation S-K will require significant additional disclosure on an overall and per partnership basis, addressing changes in the business plan, voting rights, form of ownership interest, the compensation of the general partner or another entity from the original limited partnership, additional risk factors, conflicts of interest of the general partner and statements as to the fairness of the proposed roll-up transaction to the investors, including whether there are fairness opinions, explanations of the allocation of the roll-up consideration (on a general and per partnership basis), federal income tax consequences and pro forma financial
FAQ Real Estate Investment Trust Morrison Foerster | 12 information. Because of the significant additional disclosure burdens, most sponsors seek to enable any potential roll-up transaction to qualify for an exemption from registration under the Securities Act. State Roll-Up Rules (Non-Traded REITs) The NASAA REIT SOP imposes significant requirements with respect to the entry into a roll-up transaction by a non-traded REIT. The NASAA REIT SOP defines a roll-up transaction as a transaction involving the acquisition, merger, conversion or consolidation, directly or indirectly, of the REIT and the issuance of securities of an entity that would be created or would survive after the successful completion of the transaction (referred to as the “roll-up entity”), but excluding: ▪ A transaction involving securities of the REIT that have been listed on a national securities exchange for at least 12 months; or ▪ A transaction involving the conversion to corporate, trust or association form of only the REIT if, as a consequence of the transaction, there will be no significant adverse change in: ▪ Stockholder voting rights; ▪ The term of the REIT’s existence; ▪ Compensation to the REIT’s external advisor; or ▪ The REIT’s investment objectives. Among other protections, an appraisal of the REIT’s assets as of a date immediately prior to the announcement of the proposed roll-up transaction must be obtained from an independent expert in connection with any roll-up transaction. In addition, stockholders who vote against any proposed roll-up transaction must be given the choice of (i) accepting the securities of the roll-up entity or (ii) either (a) remaining as stockholders of the REIT and preserving their interests therein on the same terms and conditions as existed previously or (b) receiving cash in an amount equal to their pro rata share of the appraised value of the net assets of the REIT. Further, non-traded REITs are prohibited from participating in any roll-up transaction: (i) that would result in the REIT’s stockholders having voting rights in a roll-up entity that are less than those provided in the REIT’s charter, (ii) that includes provisions that would operate to materially impede or frustrate the accumulation of shares by any purchaser of the securities of the roll-up entity, except to the minimum extent necessary to preserve the tax status of the roll-up entity, or which would limit the ability of an investor to exercise the voting rights of its securities of the roll-up entity on the basis of the number of shares held by that investor, (iii) in which an investor’s rights to access of records of the roll-up entity will be less than those provided in the REIT’s charter or (iv) in which any of the costs of the roll-up transaction would be borne by the REIT if the roll-up transaction is not approved by at least a majority of the REIT’s outstanding shares. Are there any specific FINRA rules that affect REITs? FINRA rules regulate the activities of registered broker-dealers. As with any offering of securities of a non-REIT, a public offering by a REIT involving FINRA members requires the FINRA member to comply with FINRA Rule 5110, known as the “Corporate Financing Rule.” In addition to Rule 5110, a public offering by a non-traded REIT must comply with FINRA Rule 23104. Rule 2310 prohibits members and persons associated with members from participating in a public offering of a non-traded REIT unless the specific disclosure requirements and organization and offering expense limitations of Rule 2310 are satisfied. Rule 2310 requires firms, prior to participating in a public offering of a non-traded REIT, to have reasonable grounds to believe that all material facts are adequately and accurately disclosed and provide a basis for evaluating the offering. The rule enumerates specific areas to be reviewed by the member, in particular compensation, descriptions of the physical properties, appraisal reports, tax consequences, financial stability and experience of the sponsor and management, conflicts of interest and risk factors. A member may not submit a subscription 4 FINRA Rule 2310 applies to direct participation programs and non-traded REITs. Under Rule 2310(a)(4), a “direct participation program” is a program that provides for flow-through tax consequences regardless of the structure of the legal entity or vehicle for distribution or industry. REITs are excluded from the definition of a “direct participation program.”
FAQ Real Estate Investment Trust Morrison Foerster | 13 on behalf of a prospective investor unless the prospective investor is informed about the liquidity and marketability of the investment. In addition, if the sponsor has offered prior programs or nontraded REITs with respect to which a date or time period at which the program or REIT might be liquidated was disclosed in the offering materials, then the prospectus for the current non-traded REIT offering must include information about whether the prior program(s) or REIT(s) in fact liquidated on or around that date or during that time period. Under Rule 2310, the total amount of underwriting compensation (as defined and determined under FINRA rules) shall not exceed 10% of the gross proceeds of the offering (not including proceeds from the sale of shares pursuant to a distribution reinvestment plan), and the total organization and offering expenses, including all expenses in connection with the offering, shall not exceed 15% of the gross proceeds of the offering. Rule 2310 also identifies, and imposes limitations and restrictions with respect to, non-cash compensation. Rule 2310 and FINRA Rule 2340 prohibit members from participating in a public offering by a non-traded REIT unless the REIT agrees to disclose a per share estimated value in its periodic reports. FINRA permits a “net investment” value to be used until up to 150 days after the second anniversary of breaking escrow in the initial public offering. The “net investment” value is the offering price less upfront selling commissions and fees as well as issuer organization and offering expenses. FINRA permits an “appraised value” to be used at any time and requires it to be used when the net investment value is no longer permitted. The “appraised value” is a value determined at least annually by or with the material assistance of an independent valuation firm and derived from a methodology that conforms to standard industry practice. Rule 2340 also requires members to include certain disclosure on customer account statements, including disclosure concerning the illiquidity of an investment in a non-traded REIT. As with the SEC and exchange rules, FINRA Rule 2310 also contains detailed rules on compliance in connection with limited partnership roll-up transactions. All REIT offerings are excluded from FINRA Rule 5121, which restricts member firms’ participation in an entity’s public offering when the member has a conflict of interest. What are common examples of non-GAAP financial measures used by REITs? Common examples of non-GAAP financial measures used by REITs include: ▪ Funds from operations (“FFO”) as defined by the National Association of Real Estate Investment Trusts, the leading industry trade group for REITs (“Nareit”), and variations of FFO, such as adjusted FFO (“AFFO”), core FFO and normalized FFO; ▪ Earnings before interest, taxes, depreciation and amortization (“EBITDA”) and variations of EBITDA, such as EBITDAre, adjusted EBITDA and core EBITDA; ▪ Net operating income (“NOI”), cash NOI and same-store NOI; ▪ Core earnings or adjusted earnings (for mortgage REITs); ▪ Cash or funds available for distribution (“CAD” or “FAD,” respectively); and ▪ Net debt or core debt. In addition, many REITs use one or more non-GAAP financial measures in certain ratios, including to show their leverage (e.g., net debt to adjusted EBITDA), ability to cover interest expense (e.g., adjusted EBITDA divided by cash interest expense) and ability to cover fixed charges (e.g., adjusted EBITDA divided by fixed charges). Are there industry standards applicable to non-GAAP financial measures used by REITs? FFO In 1991, Nareit published a white paper on FFO in order to promote a uniform, widely accepted standard measure of REIT operating performance. The FFO white paper was supplemented over the years and, in December 2018, was restated to consolidate Nareit’s prior guidance (see the 2018 restatement of Nareit’s FFO white paper). The primary reason that Nareit developed FFO as a supplemental performance measure was “to address the artificial nature of historical cost
FAQ Real Estate Investment Trust Morrison Foerster | 14 depreciation and amortization of real estate and real estate-related assets mandated by GAAP.” In addition, Nareit-defined FFO excludes gains or losses on the sale of certain real estate assets, as well as impairment write-downs of certain real estate assets, which improves the comparability of companies’ period-over-period results. FFO is defined by Nareit as net income (computed in accordance with GAAP), excluding: ▪ Depreciation and amortization expenses related to real estate; ▪ Gains and losses from the sale of certain real estate assets; ▪ Gains and losses from change in control; and ▪ Impairment write-downs of certain real estate assets and investments in entities when the impairment is directly attributable to decreases in the value of depreciable real estate held by the entity. The reconciling items should include amounts to adjust earnings from consolidated partially-owned entities and equity in earnings of unconsolidated affiliates to FFO, or such adjustments could be presented as a single line item. Nareit’s definition does not specify whether FFO should be presented as FFO attributable to common stockholders or FFO attributable to all common equity holders (i.e., common stockholders and outside limited partners of a REIT’s operating partnership). REITs should be mindful that they accurately and appropriately label FFO and variations of FFO to reflect the securities to which the reported measure is applicable, which has been a subject of SEC comment letters. For example, UPREITs with outside limited partners should specify whether FFO is presented as “FFO attributable to common stockholders and OP unitholders” or “FFO attributable to common stockholders.” Many REITs also present additional variations of FFO, such as AFFO and core FFO, in order to show a more consistent comparison of operating performance over time or to report a metric that better explains their dividend policies. These metrics may adjust for additional items such as straight-line rent, non-cash stock-based compensation expense, gains/losses on early extinguishment of debt, capital expenditures and acquisition and pursuit costs. However, there are not uniform approaches to the labeling of, or the adjustments included in, such variations of FFO. EBITDAre Similar to its white paper on FFO, in September 2017, Nareit published a white paper to create a uniform definition of EBITDA for real estate (“EBITDAre”). Similar to FFO, in order to improve the comparability of REITs’ period-over-period performance, EBITDAre includes adjustments for gains/losses on the disposition of depreciated property and impairment write-downs of depreciated property. Nareit defines EBITDAre as net income (computed in accordance with GAAP), plus: ▪ Interest expense; ▪ Income tax expense; ▪ Depreciation and amortization expense; ▪ Losses (or minus gains) on the disposition of depreciated property, including losses/gains on change of control; ▪ Impairment write-downs of depreciated property and of investments in unconsolidated affiliates caused by a decrease in value of depreciated property in the affiliate; and ▪ Adjustments to reflect the entity’s share of EBITDAre of unconsolidated affiliates. For additional information, see Nareit’s EBITDAre white paper. For more information regarding the most commonly used non-GAAP measures presented by REITs, see our publication entitled “Frequently Asked Questions about Non-GAAP Measures for REITs.” What are the stock exchange rules applicable to listed REITs? REITs seeking to be listed on a securities exchange like the NYSE or Nasdaq are generally subject to the same rules as non-REITs. However, for a REIT that does not have a three-year operating history, the NYSE will generally authorize listing if the REIT has at least $60 million in stockholders’ equity, including the funds raised in any IPO related to the listing. For more information regarding the stock exchange listing requirements fortraded REITs, see our publication entitled “REIT IPOs and Listing Transactions - A Quick Guide”
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