Real estate investment trusts

NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided.

At the recent NADA annual convention in New Orleans one couldn’t go anywhere without hearing comments regarding the impact of Real Estate Investment Trusts (REITs). Already for many dealers the use of a REIT has provided tremendous benefits. Any dealer who owns real estate as part of his dealership operations should explore this opportunity.

These are many questions and issues that must be explored to determine if a REIT is the proper approach for a dealership. The bottom line is that each of these concepts is right for some dealers and wrong for others.

HOW DO I DETERMINE WHETHER I AM A CANDIDATE?

Let’s start with your goals and objectives. If you are looking for an exit strategy, or want a method of generating cash for expansion or acquisitions, then a REIT is a possible solution. If you are concerned that you have too much of your net worth tied up in real estate or you want diversification for estate or retirement planning, then you may be a candidate.

WHAT IS A REIT – REAL ESTATE INVESTMENT TRUST?

Essentially a REIT functions much like a mutual fund for real estate. To qualify, the REIT must have at least 100 shareholders at all times. Of course, most REITs have many more shareholders. Generally, investors purchase shares in the REIT for cash. The REIT pools the capital contributed for the REIT shares and primarily purchases real estate or real estate type assets such as mortgages. A REIT can also invest in securities. However, at least 75% of the value of a REIT’s total assets must consist of real estate, cash and cash items such as receivables and government securities.

In addition, at least 75% of the gross income must come from rents, mortgage interest, gain on the sale of the real property and mortgage interests, and real estate related income. For tax purposes, a REIT generally must distribute at least 95% of its ordinary taxable income to its shareholders, also called beneficiaries. Any amount retained by the REIT over the amount distributed is taxable at regular corporate rates. The REIT is allowed a dividends-paid deduction for the distribution to the beneficiaries and the distributed earnings are taxable to the beneficiaries.

Distributions to the beneficiaries are generally treated as ordinary income. Any capital gains realized by the REIT are taxed to the beneficiaries as long-term capital gains if they are distributed by the REIT.

HOW DOES A REIT ACQUIRE REAL PROPERTY?

A REIT can purchase real property directly from a seller for cash or for cash and a note. In this case, after the sale, the seller has no ownership interest in the REIT. As an alternative, the seller of property such as dealer, can transfer his property to the REIT in return for REIT shares.

From a dealer’s perspective, instead of having his real estate portfolio concentrated in an illiquid asset, the dealer now has, through his REIT shares, a fractional interest in a diversified portfolio of real estate.

Whether the dealer sells his property to the REIT or exchanges the property for REIT shares, the transfer is a taxable event which will generate gain or loss to the dealer. For tax purposes, this transfer will be primarily capital gain or loss.

HOW CAN I USE A REIT IN MY ESTATE PLANNING?

Using a REIT to diversify a dealer’s real estate portfolio can be useful for estate planning purposes. In many cases, the dealership and the dealership real estate comprise the majority of the dealer’s net worth. If the dealer has children, some of whom are active and some of whom are inactive in the dealership, the inactive children will eventually own some or all of the dealership real estate. This situation may not be the most advantageous to the children. One alternative is for the dealership to enter into a long-term lease with the owners of the real estate including the inactive children. While this may provide attractive cash flow to the inactive children, they would probably be unable to liquidate their interest in the real estate unless all parties could agree. In addition, the only available purchasers of their interest would likely be their siblings. However, if the real estate were owned by a REIT, the inactive children could keep or sell their REIT shares, thus creating independence from the dealership and their siblings. In addition, because the REIT shares are liquid, cash could be available through the share of REIT shares to pay estate taxes or estate administrative expenses.

WHAT IS AN UPREIT – UMBRELLA PARTNERSHIP REAL ESTATE INVESTMENT TRUST?

An UPREIT involves a partnership, which functions much like a REIT. However when a dealer contributes real estate to the partnership in exchange for partnership shares there is no immediate tax. The tax is triggered when the partnership shares are exchanged for REIT shares. In effect this allows the dealer to receive dividends on a larger block of shares since none are needed to be sold to pay income tax. If the REIT appreciates so will the UPREIT shares giving the dealer greater upside potential. Of course the value can also decrease. An UPREIT’s main advantage is the deferral of taxes before conversion to a regular REIT at the time most beneficial to the dealer.

WHAT ARE REASONS NOT TO SELL TO A REIT?

One common aspect of a sale of dealership real property to a REIT is the lease-back of the real estate to the dealership usually on a long-term basis. From a dealer’s perspective, this often amounts to a loss of control, as the dealer no longer owns the real estate and no longer has the ability to change the lease to meet his needs. Often the sale to a REIT will result in a significant increase in the dealership lease payments. We all know the auto dealership business is cyclical. What happens when there is a recession and the dealership is committed to paying a high rent factor?

Another negative is that the dealer is giving up future appreciation on the real estate. Many dealers have made more money on their real estate holdings than from their dealerships. If the dealer holds onto his REIT shares as opposed to liquidating for cash, there is the potential upside or downside based on the value of the REIT. The dealer is sharing in a publicly traded company with many properties all subject to market conditions. The dealer probably know his own properties’ upside potential; he must be able to weigh the pros and cons of private ownership versus diversifying through a REIT, and of course, there is always the tax cost of selling or transferring dealership real estate to the REIT.

ARE THERE ANY REITS WORKING WITH AUTO DEALERS?

There are several REITS that have been formed or are in formation that specialize in dealership real estate. Capital Automotive REIT (CARS) is a Washington D.C. REIT that has been acquiring dealership real estate primarily on the East Coast. In the past twelve months, CARS has acquired well over $100 million in real estate from automotive dealers. More information about the CARS REIT can be obtained at (877) 4 CAP-AUTO.

WHAT OTHER QUESTIONS SHOULD I BE ASKING?

There are many issues to explore before making a decision to transfer or sell real estate to a REIT the input of tax, financial and legal professionals is crucial to guide you in your particular situation.

A REIT can be an attractive source of funding for an auto dealership with dealership real estate. All options must be explored to determine if the REIT will meet the dealer’s needs and objectives.

This article was written in 1998.