What is the impact of operating as a REIT?

Recently, Forest City Enterprises, Inc. (“Forest City”) announced that their shareholders approved five measures required for the company’s planned conversion to a Real Estate Investment Trust (“REIT”). Shareholder approval sets the stage for Forest City to elect REIT status effective January 1, 2016, and along with it begin compliance with a myriad of new rules and regulations in exchange for its tax favored status.

Modeled after mutual funds, REITs provide investors access to regular income streams, diversification, and long-term capital appreciation opportunities by allowing investment in portfolios of large scale properties similar to how an investor could invest in other industries. As a result of increased investor attraction to commercial real estate, REITs have exhibited strong performance the past few years, which, in part, helped fuel a recent consolidation within the industry. The strong REIT market and realization of tax efficiencies are expected to enhance Forest City’s competitive position within the real estate market as they shift focus from development activity to operation of their existing properties.

In order to initially qualify as a REIT, an entity must satisfy certain requirements set forth in the Internal Revenue Code, but in addition to these organizational requirements, the REIT must also satisfy ongoing requirements which include:

• Investing at least 75 percent of its total assets in real estate
• Deriving at least 75 percent of its gross income from rents from real property, interest on mortgages financing real property, or from sales of real estate
• Paying at least 90 percent of its taxable income in the form of shareholder dividends each year

These requirements are more commonly referred to as the asset and income tests. The asset test is comprised of six interacting tests which must be satisfied at the end of each quarter of the taxable year. The income test is applied on an annual basis and was originally intended to ensure the REIT’s gross income consisted mainly of passive income and not income from the active conduct of a trade or business. While application of the tests places significant operational constraints on a REIT, compliance with the rules relieves the REIT of an entity level tax on its earnings. However, in order to maintain compliance, the REIT must refrain from certain activities and may even need to divest certain assets prior to becoming a REIT. Once an entity reorganizes its operations, it is able to realize the benefits associated with the tax advantaged structure, which enable it to realize tax savings and have a significant economic impact on its earnings.

According to the National Association of Real Estate Investment Trusts (“NAREIT”), the outlook for companies operating as a REIT continues to be positive in the current, low interest rate environment.  The economic impact of REITs also continues to be positive. NAREIT estimate that stock exchange-listed REITs own nearly $2 trillion in gross assets, and publicly listed REITs paid out approximately $42 billion in dividends in 2014. Further, it is estimated that REITs directly employ 1.2 million full-time workers and an additional 7.6 million employees work at REIT-owned properties. A reorganized Forest City appears to be well-positioned as a REIT to continue its contributions to the economies in which it operates.