What it means
A real estate investment trust (REIT) is a company that owns income-producing property and distributes most of its taxable income to shareholders, usually with favourable tax treatment. Property owners who sell a building for cash typically face tax on any gain.
A DownREIT offers an alternative that allows the tax to be deferred. In a DownREIT, the REIT forms a partnership with the property owner.
The owner contributes a building to the partnership and receives partnership units, while the REIT acts as general partner and usually contributes cash or other properties. The units usually carry the right to receive distributions similar to REIT dividends and can often be exchanged for REIT shares later.
The key difference from an UPREIT is the level at which assets sit. In an UPREIT, the REIT owns nearly everything through one operating partnership, while in a DownREIT the REIT holds some properties directly and the partnership holds others.
The REIT may therefore have several partnerships, each with its own contributors and terms. The main attraction for a seller is tax deferral, because the gain is not realised until the units are exchanged or sold.
For the REIT, it is a way to acquire buildings without using cash and to attract sellers who would otherwise refuse to sell. The trade-offs include added complexity and possible conflicts of interest, since the REIT's duties to its shareholders may differ from its duties to the partners.
A further point is liquidity. Holders of partnership units cannot usually sell them on a stock exchange, so the right to exchange them for REIT shares is an important feature, and it often comes with a minimum holding period.
The REIT must decide whether to settle an exchange in shares or in cash, which affects its balance sheet. Investors reading a REIT's accounts should look at the notes on non-controlling interests, which show how much of the property belongs to outside partners.
They should also check what happens if the units are redeemed, because the REIT may need to issue shares or pay cash. These details can affect earnings per share and future dilution.
In practice
Real-world examples.
Example
An investor owns an office building worth $20,000,000 that he bought decades ago for $5,000,000. Selling for cash would create a large taxable gain. He contributes the building to a DownREIT partnership in exchange for units, deferring the tax.
Example
A listed REIT wants to buy a shopping centre from a family that refuses to sell for cash. The REIT offers partnership units that pay distributions equal to its dividends. The family accepts because it keeps an income stream and avoids an immediate tax bill.
Example
An analyst reviewing a REIT notices that part of its net income is attributed to non-controlling interests. She checks the notes and finds that these are partnership units held by former property owners. She adjusts her per-share estimates to allow for possible conversion.
Case study
Seen in the real world.
Meridian Properties Trust is an illustrative, fictional REIT that wanted to acquire a $30,000,000 apartment complex from a retired developer. The developer had bought it years earlier for much less and did not want to pay tax on a large gain.
Meridian set up a DownREIT partnership. The developer contributed the complex and received units worth $30,000,000, which paid distributions in line with Meridian's dividend, and Meridian contributed a smaller property and acted as general partner.
The deal closed without Meridian using any cash, and the developer deferred his tax. Meridian's finance team noted that the units could later convert into about 1,000,000 shares, which would dilute existing holders. The finance team also agreed that the units could only be exchanged after a holding period of one year, which gave it time to plan. The illustrative lesson is that the structure solves a real problem but adds long-term obligations that shareholders should understand.
Watch out
Common mistakes.
- Confusing a DownREIT with an UPREIT, when in a DownREIT the REIT owns some properties directly and others through partnerships.
- Assuming the tax deferral is permanent, when the gain can be triggered when the units are sold or redeemed.
- Ignoring the dilution risk, when units may convert into REIT shares.
Questions
People also ask.
Why would an owner choose a DownREIT?
The owner can contribute property for units and defer capital gains tax, instead of selling for cash and paying tax immediately.
How is it different from an UPREIT?
An UPREIT holds nearly all property through one operating partnership, while a DownREIT holds some directly and uses separate partnerships for contributed properties.
Are there risks for REIT shareholders?
Yes, potential conflicts of interest and future share issuance can affect shareholders, so the details in the REIT's filings are worth reading.
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