For the average dealership, two thirds of the value of the business is tied up in real estate. Despite its value, the real estate is not liquid. The property can't be sold without relocating or terminating the dealership operation, and there are very few buyers for these single-tenant, special-use properties. Sometimes the real estate can be refinanced to pull cash out, but banks typically lend only 70 to 80% of value. Another drawback to borrowing is that it increases business risk at a time when many dealers are trying to become debt free. Participation in a real estate investment trust (REIT) gives dealers a third option. By contributing properties to a REIT, dealers have an opportunity to reduce debt and receive 100% of the equity in their property pretax in a form that can easily be converted into highly liquid REIT shares. The transaction can be structured so that any income taxes on the sale of the property are deferred until the REIT shares are sold.
What is a REIT?
Congress passed the Real Estate Investment Trust Act in 1960 and the first REIT was formed in 1963. REITs are required to have 100 or more shareholders and must derive most of their income from the ownership and management of real estate. REITs have a unique tax advantage over other publicly traded companies: income paid to shareholders (dividends) are deductible to the REIT. As a result, REITs pay out large dividends, usually 6 to 8% of the stock value annually. Another tax advantage is that the money distributed is not fully taxable. Typically, only 70 to 75% of the amount received is taxable. The balance is deemed to be a return of capital.
The UPREIT
Early REIT structure had a significant drawback. The transfer of properties into a REIT would have triggered a capital gains tax for many potential investors. The REIT industry really came of age in 1992 when the first UPREIT was formed. The UPREIT structure was designed to allow property owners to defer the tax when contributing their real estate. Look at the diagram in the bottom left corner of this page to see how a typical UPREIT is structured.
As the diagram shows, the UPREIT is one of several limited partners in an operating partnership that owns multiple real estate holdings. The UPREIT is the sole General Partner in the operating partnership, and therefore has a controlling interest. The UPREIT, in turn, is controlled by its managers, who may also own partnership units. Other limited partners include private investors who contributed properties in exchange for units in the limited partnership. Why don't the private investors get REIT shares?
The private investors can exchange their units for REIT shares (after a one-year waiting period), but this triggers the capital gains tax. Units and shares are equivalent, so private investors wait until they are ready to cash out to complete the exchange.
Growth and Specialization in the REIT Industry
Because of their many tax advantages, UPREITS are popular with both property owners and investors. The invention of UPREITs spurred tremendous growth in the REIT industry. As of December 31, 1996, REITs had an equity market capitalization of approximately 89 billion. Typically, REITs are specialized, either by type of property or geography. Although some REITs are diversified, most focus on sectors, such as office buildings, apartments, shopping centers, hotels, hospitals or even self-storage facilities. Investors seem to prefer specialization because it implies management expertise. The compound return on equity REITs has rivaled the Standard & Poor 500 over the last 20 years.
Advantages to REIT Participation
for Car Dealers
The many advantages to participating in a REIT include the following:
· Enhanced liquidity. REIT shares will be traded on the stock exchange. Dealers will have the option of selling all at once, selling a portion at a time, or borrowing against the value of the shares. This cash can be used to acquire dealerships, pay down debt or invest in other opportunities.
· Reduced risk through diversification. A portfolio of 100 properties will have significantly lower risk than any one individual property.
· Financing efficiency. REITs have improved access to capital markets. The REIT's cost of debt financing will be significantly lower than the rate dealers are presently paying. Other conditions, such as loan terms, security interest and personal guarantees may be improved.
· Chance for improved returns. REITs specializing in other sectors have experienced significant appreciation in share value.
· Simplified estate planning. Splitting up the family's most valuable asset is facilitated and control issues are resolved. REIT participation dovetails nicely with other estate planning strategies, such as gifting and family limited partnerships.
· Greater flexibility in banking relationships. No compensating balances, loan covenants, etc. stemming from the real estate loans.
Conclusion
What you get from participating in a REIT is improved access to capital markets, diversification, liquidity, and stock appreciation. What you give up is control and appreciation of the specific properties contributed. In considering the REIT option, try to separate your interest in the real estate from your interest in the dealership operation. Recognize that they could be worth more separately than together. Seize the value of your holdings by maximizing the value of each independently.
Next month we will look at some of the risks associated with REITs and examine some strategies for dealers. We'll discuss the use of sensitivity analysis and discounted cash flows to see if the deal makes sense for you. Finally, we'll show you how to tailor your deal with the REIT to meet your individual needs and those of your dealership operation.