The Un-real World of Troubled REITs
Consider this situation: A highly leveraged company with virtually no current assets files for protection from creditors under the Bankruptcy Code. That's not unusual. But this debtor claims that it is in the best interests of creditors for the debtor to continue dividend payments to shareholders during the bankruptcy. Furthermore, it files a plan of reorganization that proposes to continue dividend payments to shareholders after its plan is confirmed, but provides for minimal (if any) amortization of the creditors' restructured debt. Is this sheer lunacy or merely chutzpah? Actually, it is neither. Rather, it is the un-real world of Real Estate Investment Trusts (REITs) examined through the "looking glass" of the Bankruptcy Code and Internal Revenue Code.
Several peculiarities are created by REIT status when such an entity is also subject to the Bankruptcy Code. Potential restructuring alternatives must accommodate the legitimate expectations of creditors, yet it benefits both the debtor and creditor to work together in unusual ways to preserve the tax benefits accorded a REIT, thereby preventing the Internal Revenue Service (IRS) from gobbling up a large share of the estate's value.
What is a REIT?
Congress enacted the REIT structure in 1960 to provide small investors with the opportunity to participate in large-scale, institutional-type real estate investments. With this legislation, Congress created a potential source of new capital for the real estate markets. Naturally, REIT popularity with investors over the ensuing years has been closely tied to the real estate cycle.
A REIT is a corporation that has elected to be treated as a "pass-through" entity for federal income tax purposes under the provisions of Internal Revenue Code §856. Instead of paying federal income taxes on its corporate income, a REIT passes its earnings through to its shareholders without federal income taxation at the corporate level. In order to enjoy this unique treatment, there are several stringent requirements:
- At least 75 percent of a REIT's annual gross income must be derived from passive investment in real estate equity or real estate secured debt;1
- No more than 50 percent of the stock can be held by five or fewer individuals and there must be a minimum of 100 shareholders;2 and
- The REIT must pay shareholder dividends equal to at least 90 percent of taxable income.
This last requirement created an inherent limitation for REITs: Earnings accumulation is constrained by the REIT's obligation to distribute virtually all its income to shareholders. Without significant retained earnings to re-invest in new properties, REITs must continually rely on new sources of debt and equity capital to provide the requisite financing to achieve meaningful earnings growth. Consequently, REITs are highly dependent upon the whims of the capital markets, which have had an ambivalent relationship with the REIT vehicle over the years.
REIT Bankruptcies Reappear on the Scene
REIT bankruptcies have indeed been a rarity since the REIT debacle of the mid-1970s, when high leverage and highly speculative real estate investments resulted in numerous REIT failures. Thereafter, REIT managers became far more conservative in their investment and financing practices. However, REIT failures, though still rare events, have occurred more frequently in recent years, especially for those with large exposure to industries suffering from economic distress. Criimi Mae, a REIT specializing in non-investment grade commercial mortgage investments, failed in 1998 and is perhaps the most high-profile REIT to declare bankruptcy. Several others may also need to seek the protection of bankruptcy courts, as the core businesses associated with the REIT-owned (or mortgaged) properties are unable to pay their contract rent or mortgage payments, and lenders become ever more reluctant to refinance maturing REIT debts. Most vulnerable are those REITs associated with sub-prime lending, movie exhibition, health care facilities, private prisons, and even some owners of outlet and regional shopping malls.
REITs seeking restructuring through the bankruptcy courts is a relatively new phenomenon that is raising several provocative issues. One of these is conflict between the REIT-enabling legislation and IRS regulations and the application of Bankruptcy Code §1129(b), often known as the absolute priority rule. This section prohibits any distribution to equity-holders unless all creditors will be paid in full with interest—unless a class of creditors votes to accept lesser terms. With the normal application of this rule to a corporate debtor, it would follow that (i) there will be a cessation of dividends to shareholders during the pendency of bankruptcy proceedings, and (ii) future dividends to equity will be allowed under a plan of reorganization only if the court finds a high likelihood that all allowed creditor claims will be satisfied in full.
But the elimination of dividends, even if only during the pendency of the bankruptcy filing, can endanger the enterprise's tax status as a REIT.3 Once disqualified, the company has lost this valuable benefit for at least five years and must pay corporate income tax. Loss of the benefit may not only devalue the enterprise, but may create a senior priority tax obligation arising out of pre-petition and post-petition income.
Clearly, a devalued enterprise and the use of estate assets to pay avoidable federal tax obligations are not in the economic interest of either creditors or equity-holders, but few creditors are willing to agree to the payment of a REIT's relatively scarce liquid assets to equity owners.
Restructuring Options That Are Unique to Troubled REITs
What are the potential restructuring alternatives that may create a "win-win" situation for all REIT constituents?4 First, though it has been customary, there appears to be no requirement that a REIT make its required dividend payments in cash. Thus, a REIT could make a payment-in-kind (PIK) dividend of preferred stock. Initially, this would maintain the relative liquidation priorities between debt and equity, thereby satisfying the objectives of the absolute priority rule, because the newly issued preferred stock would receive liquidation preference junior to the creditors. Minimally, for a PIK dividend to have the prospect of satisfying the IRS, the REIT's assets must exceed its liabilities, otherwise the preferred stock dividend would be illusory. Furthermore, the preferred stock would likely need to have a provision for a future cash dividend of sufficient amount and likelihood to create an economically valuable current dividend. Creditors, the court and, potentially, the IRS are likely to endorse this approach only if there is a well-reasoned plan of reorganization supported by credible evidence that equity-holders will ultimately realize the promised value of the PIK dividend.
But what if creditors (or the court) are unwilling to sanction the long-term payment of dividends to "old equity" on PIK preferred stock, or there is insufficient equity to allow PIK dividends to be considered an economic dividend? In such situations, the creditors could be issued senior preferred stock and then paid on a current basis the requisite cash dividends to maintain REIT status. This too would retain the relative priority between creditors and "old" equity (ignoring inter-creditor priorities) and retain the valuable REIT status of the debtor. Moreover, this could be structured as a "springing" remedy, such that if operations deteriorate or plan of reorganization projections are not met in the future, cash dividends to common equity could be suspended and paid instead to the preferred shares held by the former creditors. This alternative also has the advantage that the valuation of the dividend, since it is paid currently in cash, is not subject to subsequent challenge by the IRS.
Sound, Professional Analysis Must Support the Plan
In both of these structures the soundness of the plan and the reasonableness of the economic assumptions that underpin its conclusions cannot be overemphasized. Not only do they have to "pass muster" with the IRS to sustain the REIT's tax treatment, but the ultimate recovery by the creditors is totally dependent upon the realism portrayed by the assumptions and the success of intended business strategies to deal with future events. In some instances, there is a temptation to "reverse engineer" economic projections to produce a plan that supports a desired result. Care should be exercised to ensure that the plan is based on independently produced projections from respected experts who understand the realities of the real estate markets, the structuring options and the capital sources available to the debtor.
The fact that certain REITs focus on a limited segment of the real estate market (e.g., health care facilities) places a unique burden on the cash-flow forecasting techniques. In these instances, the analyst must assess the business viability and cash flow characteristics of the ultimate real estate occupants rather than accept the traditional reliance on contract rents and customary bad debt provisions, as seen in the cash-flow sections of many appraisals. Debtors, having regularly reported estimated net asset values to their shareholders, may be reluctant to recognize that such values may no longer be a reliable predictor of future cash flow if they depend on historical contract rents and delinquency experience.
No expert can guarantee the outcome of future events. Operating projections should be examined from the perspective of alternative sets of assumptions to gauge the sensitivity of the results to changes in economic circumstances and market conditions. Only then can meaningful conclusions be drawn with regard to the degree of risk borne by the respective stakeholders in the plan.
Problems Associated with Asset Liquidation and Redeployment
The customary asset redeployment strategies for over-leveraged enterprises are also not available to REITs. Generally, one would expect a sale of assets to generate liquidity that, together with future earnings and profits, would be used to amortize debt principal. This can be especially problematic in real estate enterprises, since the depreciated tax basis may be low compared to market value.5 Even though capital gains are not included in the 90 percent dividend requirement, such gains must either be distributed to shareholders (often requiring the full after-secured-debt-retirement net proceeds to be distributed) or the REIT must pay taxes on the gain. Moreover, it is apparent that little annual cash flow will be left to amortize debt after remitting 90 percent of taxable income to equity. Unlike C corporations seeking to restructure under bankruptcy protection, REITs seldom have tax loss carry-forward balances to shelter future income.
These additional limitations create a predicament for creditors presented with a long-term plan of reorganization that provides for few, if any, asset sales and virtually no principal amortization. Furthermore, a public equity infusion is not likely, given Wall Street's current antipathy toward new capital for REIT stocks. New equity in a bankruptcy restructuring from a privately held "opportunity fund" may also be thwarted due to IRC restrictions on concentrated REIT ownership, which a private equity investor often requires.
Difficult Choices for Creditors
Many creditors of a bankrupt REIT thus face a difficult dilemma. They can bide their time with significant, non-amortizing risk exposure until the REIT's business (or public equity market's appetite) improves. Alternatively, they may try to force an immediate sale of assets—often at distressed prices because of the underlying business difficulties that precipitated the bankruptcy—and then further share the proceeds with the IRS. The latter tends to be especially unfavorable for REIT lenders since they often underwrote their loans assuming permanent REIT status and (mistakenly) assumed that upon sale of the asset, 100 percent of the realized value would be available for REIT cash flow or debt repayment needs.
As noted earlier, structuring techniques involving issuance of PIK dividends or preferred stock to the creditor class may be available. Such techniques hold the promise of ensuring that value is not bled off to "old" equity, leaving creditors with the prospect of ultimate liquidation and recovery of but a fraction of the value of their current interest. When pondering such options, careful consideration must be given to the long-term real estate market risks and the quality of cash flow within the underlying revenue stream of rents or debt service receivables. There must be a thorough understanding of market conditions and the business climate facing tenants and borrowers of the REIT. With this information in hand, examining the sensitivity of the results to a realistic range of possible outcomes will reveal the risk profile associated with each of the available options.
When a bankrupt debtor is a REIT, the restructuring plan should be sensitive to the unique nature of the REIT structure. Debtor and creditor constituencies should strive to find a logical solution that respects the limitations inherent in the REIT structure and still preserves the principles and objectives of the bankruptcy process. However, when you step "through the looking glass" into a new and different kind of place, logic may be hard to recognize and even harder to implement.
1 As initially created, REITs could not engage in any active business. In 1986, following the problems encountered in the 1970s, REIT regulations were relaxed to allow REITs to perform customary real estate management and operating functions without impairing the passive nature of their earnings. Return to article
3 I.R.C. §858 (a) permits, subject to various limitations, a REIT to credit dividends paid during a taxable year and certain dividends paid in the following year that it elects to treat as deductible in the prior year—effectively providing a nine-month grace period. Return to article
4 To the best of the authors' knowledge, none of the ideas set forth in this article has been subject to IRS scrutiny nor final bankruptcy court approval (although several are pending) and we offer no opinion nor assurances regarding their suitability. In no event should this article be considered tax or legal advice, and the reader should consult his or her own tax and legal counsel for issues regarding the application of the IRC and Bankruptcy Code to his/her particular circumstances. Return to article
5 Many REIT assets were contributed by shareholders via tax-free exchanges of shares of previous, non-public REITs. Consequently, the assets' tax basis may be the carry-over basis from the prior owner. This also creates a unique tax problem for some REIT equity-holders, since liquidation of the REIT can create taxable income to the equity holders in excess of any cash recovery. Such income is often labeled "phantom income." Return to article