For nearly a decade, umbrella partnership real estate investment trusts ("UPREITs") have been the primary vehicle for an owner of real property to convert his or her ownership of one or more specific properties into an interest which is, immediately, or can ultimately be converted into, a publicly-traded security. In the standard UPREIT structure, all acquired properties are owned directly by the operating partnership, and a real estate investment trust ("REIT"), generally itself a public company, owns a substantial interest in the operating partnership as a limited partner and as the sole general partner of the operating partnership.
The UPREIT structure provides several benefits that are not available in traditional real estate transactions. This article will briefly review those benefits and also provide a basic outline of the essential features and documentation that should be considered in transactions with UPREITs.
Benefits Of An UPREIT Transaction
Primary Incentive
The primary incentive for undertaking a transaction with an UPREIT results from the fact that the transaction can be completed on a tax-deferred basis. The owner does not recognize immediate gain on the transaction because the owner does not acquire publicly-traded stock in the REIT, but rather receives units in the operating partnership. While there are instances where the selling owner, particularly if it is an exempt entity that will not recognize taxable gain on the transaction, will be willing to undertake the real estate transaction directly with the publicly traded REIT, more often than not the transaction is undertaken with the operating partnership. If the operating partnership units received from the operating partnership end up in the owner's estate, the ultimate recipients of the units will receive a stepped up basis equal to the value at death or the alternate valuation date and the inherent gain resulting from the UPREIT transaction will not be subject to capital gains or income tax. The tax deferral or avoidance, as the case may be, gives UPREITs a large advantage over cash purchasers. This is particularly true for individuals or entities which have a low tax basis and therefore the potential gain is substantial.
Secondary Incentive
The second incentive for a property owner to participate in a UPREIT transaction is that, given the number and variety of publicly-traded UPREITs, a transaction can usually be structured which enables the property owner to convert an interest in one or more specific properties into an interest in a larger and more balanced portfolio of properties held by the UPREIT. The portfolio is often diversified as to property type and geography and usually benefits from the economies of scale and management that a larger entity can offer.
Third Incentive
The third, and perhaps ultimately most important benefit that the UPREIT structure permits, is that it allows an interest in illiquid individual properties to become more easily saleable. In the standard UPREIT transaction, a property owner can convert his or her units in the operating partnership into publicly-traded stock of the REIT, which is usually listed on a national exchange. While the conversion to stock may trigger a recognition of taxable gain, the flexibility permits the owner to unlock value and access capital as needed. The ability to convert an interest in the operating partnership into an interest in the REIT is not in itself valuable, however, unless the REIT interest can be more easily sold. Accordingly, property owners, as a part of the transaction, will negotiate a registration rights agreement, wherein the owner will have the ability to have the stock it would receive upon conversion of its operating partnership units registered with the Securities and Exchange Commission ("SEC") for resale so as to enable the property owner to sell its stock in the public markets.
UPREIT Transaction Features
As transactions with UPREITs become more standardized, the essential features of an UPREIT transaction have become more clear. Typically, an UPREIT transaction involves a registration rights agreement, and may well involve several ancillary agreements such as an employment agreement, earn out agreement, real estate services agreement, development and property management and leasing agreement, and development rights agreement. The essential features and types of agreements are discussed below.
Registration Rights Agreements
As discussed above, one of the key incentives for an owner to undertake an UPREIT transaction is the ability of the owner as a holder of operating partnership units, to redeem the units for relatively liquid REIT shares. However, although there is an immediate recognition of taxable gain upon redemption, the REIT shares cannot be sold unless they are registered or sold subject to an exemption from registration. Therefore, it is important to the holder of the operating partnership units that registration rights are in place so that there is not a long delay between the taxable event and the ultimate sale. In the case of an entity not subject to taxation but needing to make an early sale of the REIT shares, the need for a registration rights agreement may well be even more important.
A registration rights agreement may provide several methods pursuant to which the holders of operating partnership units will ultimately acquire tradable REIT shares upon redemption of the operating partnership units. The first option will be to permit the resale of the shares in reliance on Rule 144 promulgated by SEC. This method poses considerable risk for the holder of the operating partnership units since Rule 144 requires that there be a one year holding period which starts with the actual redemption of the operating partnership units. Under this method, the tax liabilities which are incurred as a result of the redemption must be paid long before the shares become freely transferable. Rule 144 also imposes limits on the volume and manner of sale of the shares. As a result, most owners of operating partnership units will insist that they not be requested to rely exclusively on Rule 144 in reselling the shares.
A second method that is often provided in a registration rights agreement is to provide for the registration of the issuance of the shares by the REIT. This method will not work by itself, however, for affiliates of the REIT, and may not work for property owners who acquired operating partnership units, as they may be deemed "statutory underwriters". As a result, property owners who will become owners of operating partnership units should ordinarily insist on a registration by the REIT of the resale of the REIT shares utilizing a form S-3 or other appropriate registration statement.
Typical provisions of a registration rights agreement include a lock out provision whereby the holders of partnership units agree not to seek redemption, exchange or dispose of any partnership units for a fixed period of time, sometimes as long as one year. The registration rights provisions usually require the REIT to file a registration statement under Rule 415 of the Securities Act within a fixed period and to use reasonable efforts to cause the registration statement to be declared and maintained effective.
These provisions will also set forth the specifics for issuance, resale or piggyback registrations. Often, registration rights agreements contain provisions for suspension of the registration requirement and other restrictions on sales. For an owner desirous of early conversion of its operating partnership units, the provisions relating to suspension and restriction will need to be negotiated carefully.
Ancillary Agreements
Owners are always eager for ways to derive additional compensation from real estate transactions. In addition to receiving operating partnership units for the sale of his or her properties, other forms of compensation, ranging from traditional employment or property management arrangements to more sophisticated structures designed to afford the developer a more or less certain source of capital to finance new projects (usually also affording the UPREIT exclusive rights to acquire the developer's projects within a given area) have become the norm in UPREIT transactions.
In some of the early UPREIT transactions, traditional employment or consulting agreements were utilized. However, there are no particularly unusual aspects concerning an UPREIT transaction which require special features to be included in these types of agreements. Obviously, if appropriate, these types of arrangements may provide the owner with an opportunity to contract for long-term consulting or employment services, but that is a matter of negotiating leverage and relationship. Typical employment agreements will include carefully crafted provisions regarding the employment period, the terms of employment, termination (including changes of control), confidential information, non-competition and remedies for breach.
Earn Out Agreements
Another type of real estate arrangement that can be utilized in an UPREIT transaction is an earn out agreement. While earn out agreements are also traditional forms of real estate arrangements, the owner in an UPREIT transaction could receive, in lieu of cash consideration, operating units in the UPREIT with associated conversion rights. In such a situation, the registration rights agreement should cover the initial issuance of the operating units as well as the conversion of the operating units into REIT shares. Typical earn out agreements will contain provisions regarding the conditions for earn out, the formula for receiving operating partnership units through leasing or development activities, and further assurance provisions.
Traditional Forms of Agreements
Other types of agreements which can be utilized in an UPREIT transaction also include traditional forms of agreements. These include management, leasing and brokerage service agreements and development agreements. While these forms of agreements are traditional in nature, the agreements are typically tailored to contain specific provisions, including provisions dealing with acquisition and development services, assignment of rights and change of control, and leasing and development guidelines.
Long-Term Exclusive Arrangement
A final possibility of an arrangement resulting from an UPREIT transaction is the potential for a developer to enter into a long-term exclusive arrangement whereby the developer agrees to make available to the UPREIT all product it develops within a given area or region and the UPREIT agrees to take that product. Given the public nature of the UPREIT and the likelihood of changing circumstances or economies, such agreements are somewhat difficult to document in a manner which anticipates the myriad of circumstances which may arise over the life of a development management relationship.
For this reason, such an agreement is often utilized in a down-REIT partnership for a specific property or properties and is based upon mutual rights of first refusal concepts within a given region. In such an agreement, both the developer and the UPREIT will typically agree to grant each other a first right as to investment opportunities. This type of agreement can be utilized to provide a valuable source of capital to a developer and provide an UPREIT with a steady stream of the product type it would like to have for its investment portfolio, while precluding competition from access to the product.
In Closing
While UPREIT transactions are becoming more standardized and therefore have features which fall into predictable agreement types and provisions, there are many creative forms of agreements and features which may be utilized in UPREIT transactions. With the increase in the number and variety of UPREIT transactions, it is incumbent upon clients and their attorneys to carefully analyze and actively negotiate the registration rights and other forms of agreements presented by counsel for the UPREIT. In addition, owners, particularly those with on-going businesses, should examine traditional forms of agreements and, where appropriate, negotiate for ancillary arrangements in connection with the UPREIT transaction.