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REIT Sector Crackdown Is Simply Foolish

Brad Thomas

NEW YORK ( TheStreet) -- More and more companies have been looking at the REIT structure as a way to unlock value in traditional shares. In what was previously more of a trickle of REIT conversions and spinoffs, the more recent activity has been viewed as more of a wave.

Signed into law by President Eisenhower in 1960, Congress intentionally formed a broad definition of real estate when it originally created REIT legislation. Later, in 1964, the IRS adopted the same broadness by recognizing that telecommunication towers and railroad-related assets would apply (the IRS applied railroads in 1969.)

Some of the most recent news has created a stir of sorts as certain fear that the fate of recent conversions and spinoffs could threaten the industry's tax-exempt status. Remember that in exchange for not paying federal income taxes, REITs, whose primary income streams are from real estate, are required by the IRS to distribute at least 90% of their taxable earnings to shareholders in the form of dividends.

But wait. It's clear that the increased demand is not driven by the corporate tax exemption -- because the IRS is going to get their money regardless -- either at the corporately taxed level or at the individual level (taxes paid by investors.) Instead, it seems that the strong demand is being driven by Mr. Market. REITs today are trading at very high multiples and that has created an environment fueled by low cost debt and equity.

Some fear that the increased demand -- including new subsectors like prisons, gaming, and billboards -- could spur an "IRS crackdown" and potentially cause the IRS to change or get rid of the rules that allow REITs to discontinue corporate-level tax as long as they distribute the bulk of their earnings as dividends. One vocal activist, Bill Ackman, founder of Pershing Square Capital Management recently suggested that REITs could spur changes harmful to the REIT industry.

In a recent conference at New York University's Schack Institute of Real Estate in Manhattan, Ackman said, "If you push the envelope too much, there will be a crackdown on the REIT industry." He went on to argue, "I am not a big fan of these really kind of specialty, non-real estate-type industries getting some kind of exemption to stick their assets in a REIT and then not pay corporate-level tax."

I agree with Ackman in that certain specialty categories do lack experienced management teams and most of them have little if any diversification. Take for example casino owner Penn National Gaming . The gaming operator announced plans in November to split into two public companies, one a REIT. It is likely that the original REIT legislation was not designed for casino owners to convert to REITs; however, I don't think it is realistic to argue that such a move will jeopardize REIT status.

The markets, not the IRS, should determine whether there is value in a gaming REIT and it will then produce either a royal flush or bust (I think it's a bust.) Based on my knowledge of the REIT industry, I think the market will find many of the specialty REITs to be fads -- just like they were in the past. I don't see the utilization of the REIT vehicle as way to redefine tax codes. I see the more recent noise as a cyclical strategy driven by the tremendous capital chasing income-oriented investments.

REITS have always been an extraordinarily attractive investment class and one of the few sectors in which companies are forced to payout dividends. Accordingly, unlike a traditional dividend stock, which can utilize a portion of ongoing cash flow to fund expansion, REITs have no such luxury.

The notion that REITs must pay out dividends is a critical component to consider and that is why there needs to be a careful balance of attention to current operations, expansion, leverage, and shareholder value. REITs benefit in the current rate environment as they are able to borrow and refinance at low cost, reinvest, and achieve juicy operating results for investors.

Last week, Steve Wechsler, NAREIT president and CEO, was quoted as saying:

"The main point is that, contrary to the Times piece as well as other articles we've seen, the IRS is not and has not redefined real estate. It is merely interpreting long-established principles embedded in law when asked to do so by private taxpayers or for public guidance. In fact, the IRS has been exceedingly careful to tie all recent rulings to long-standing precedents."

He noted that REITs' tax status has been examined and reaffirmed upon tax reform in the past, and he said there is no reason it should not be again.

Answering a follow-up question about Congress' perception of REITs, Wechsler concluded, "I am unaware of misperceptions by members of Congress about the REIT industry. I am aware of misperceptions about the REIT industry by certain journalists. ... Part of this misperception is a media sensation, and I do not believe there is a misperception on Capitol Hill."

Let's Not Forget Why REITs Are So Important

A few weeks back I caught up with Brad Case, Ph.D., CFA, and CAIA, senior vice president of research and industry information with NAREIT, and he provided me with a value proposition for a REIT dividend vs. a non-REIT dividend:

"There's a big difference between cash that a company has because it raised it externally to finance a planned acquisition, and cash that it has simply because it refused to pay dividends to shareholders. Academic researchers have found time and time again that executives have a tendency to make poor use of free cash on hand, whereas when they have to undergo "capital market scrutiny," they tend to make decisions that are better for shareholders. That may be part of the reason why listed REIT returns have been systematically better than non-REIT stock returns, not just recently but over more than four decades of available history."

The market capitalization for U.S. equity and mortgage REITs total more than $790 billion and it's not hard to see why investors are attracted to the notion of owning a high-dividend-paying stock. Remember, REITs offer the best of both worlds: the potential for long-term capital appreciation and a steady income stream. It's the attraction to dividend repeatability that makes REITs one of the most attractive investment alternatives today. That's why intelligent investors should consider REITs as a core asset class and one that will help them sleep well at night.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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