Unlocking Value for Real Assets

Transcription

1 Unlocking Value for Real Assets This document is NOT a research report under U.S. law and is NOT a product of a research department. This document is not prepared as or intended to be investment advice and is being provided to you without regard to your particular circumstances, and any decision to purchase or sell a security or other financial instrument is made by you independently without reliance on us.

2 Non-traditional s are increasing in number, can potentially drive value creation, and are being well received by investors. Traditional real estate investment trusts (s) provide public market investors an alternative opportunity to invest in conventional real estate assets such as multifamily residential housing, office buildings, warehouses, shopping centers and hotels. Over the last several years, however, more non-traditional asset classes have emerged. Companies with non-traditional realty assets such as timber, casino buildings, storage facilities, cell towers, billboards, pipelines, storage terminals, transmission lines, certain other infrastructure assets and most recently wireline telecom networks, are seizing opportunities to either convert into a or separate realty assets in the hope of creating significant shareholder value. A common trait among recent adopters of the structure, particularly for non-traditional real estate asset classes, is the desire to drive shareholder value by highlighting real asset value and the potential for embedded revenue streams, steady return of capital and the benefit from tax efficiencies in the structure. Executive Summary 1. What is a? A is a tax-efficient vehicle for investing in real property whereby income is largely derived from rental streams or interest from mortgages. s as an asset class have undergone significant development since they were first introduced by Congress in 1960 as a vehicle to provide greater access to real estate investment opportunities. As of September 2014, there were over 200 publicly traded s included in the FTSE NA All s Index 1 with a total market cap of approximately $800 billion. stocks 2

3 have outperformed the S&P 500 over five-year, 10-year and 15-year periods by 0.3%, 0.6% and 6.8%, respectively 2. Although s suffered through the financial crisis from (the RMZ Index was down 53%, while the S&P 500 Index dropped 36%) the subsequent sharp rebound has helped the sector regain investor interest. 2. Recent proliferation of non-traditional s. The universe of non-traditional s is expanding, as many companies receive private letter rulings (PLRs) from the IRS to confirm their eligibility for election. The U.S. Treasury released proposed regulations in May 2014, which define real property, providing further clarity on asset classes that could qualify as s. The clarification of what constitutes realty under the rules, coupled with a diligent focus on driving shareholder value among corporations, has fueled a new wave of non-traditional s. 3. Unlocking value in real estate assets. Companies considering highlighting the value of their real assets via the structure have utilized multiple structures. In this report, we highlight the most commonly used structures and present examples of corporations that have used these structures to drive value creation. The utilization of structures by these corporations has been very well received by investors. 4. Benefits and considerations for adopting a structure. Companies consider converting to s for a variety of reasons. s have generally traded at a premium valuation compared to traditional corporations, primarily due to a lower cash tax burden, and at times have benefited from investor interest in potentially stable dividend yield stocks. Since s are able to deduct dividends against their taxable income, they effectively have a single layer of tax. Potential considerations for electing a structure include upfront conversion costs, ongoing qualification criteria, governance, dividend requirements and others. Corporates should carefully assess the eligibility of their real estate assets and weigh the benefits of a structure against these considerations. 1 The FTSE NA All s Index is a market capitalization-weighted index that includes all tax-qualified real estate investment trusts (s) that are listed on the NYSE, AMEX or NASDAQ. 2 All total return periods are through 9/15/2014, using the MSCI US (RMZ) Index versus the S&P 500 Index. 3

4 1 What is a? History of s: On September 14, 1960, President Dwight D. Eisenhower signed legislation that created the. Throughout the 1970s and 1980s, the industry enjoyed modest but steady growth. The Tax Reform Act of 1986 allowed for s to integrate property management into their organization, aligning incentives of the manager and the shareholders. The sector gained momentum and achieved tremendous growth and acceptance during the 1990s. In 2001, the Modernization Act allowed for the formation of Taxable Subsidiaries (TRS), which enhanced the services that s can provide to tenants through non-rental, ancillary business activities. s are widely accepted across a broad spectrum of property sectors (Figure 1). The FTSE NA All s Index includes over 200 publicly traded s with a total market cap of approximately $800 billion (as of September 2014) and the number of s included in the S&P indices 3 has increased to 85 since the first addition of s to the index back in October Number of Constituents Market Capitalization 1% 2% 2% 19% 7% 9% 14% 17% 10% 18% 8% 8% 4% 10% 5% 6% 8% 15% 12% 23% Figure 1. s by Property Sector and Investment Sector Industrial/Office Self Storage Retail Health Care Residential Timber Diversified Infrastructure Lodging/Resorts Mortgage s 3 Includes S&P 400, 500 and 600 indices. 4 Source: NA Market Watch, September

5 performance: Real estate assets have traditionally been viewed by investors as a source of potential stable income and an opportunity to benefit from real estate appreciation. s seek to provide healthy dividend income, along with the potential for stock price appreciation, and have outperformed the broader market over the last 15 years. Although stocks experienced meaningful losses during 2008 as a result of the financial crisis, they have experienced a sharp rebound since 2009, demonstrating the resilience of the sector and investor appetite for stable income and real estate exposure/diversification (see Figure 2). Figure 2. Historical Compound Annualized Performance MSCI US Index (RMZ) vs S&P % 16% 14% 12% 10% 8% 6% 4% 2% 0% 16.2% 15.9% 11.5% 8.7% 8.1% 4.7% 5 Year 10 Year 15 Year MSCI US Index (RMZ) S&P Factset data as of 9/15/14. The MSCI US Index is a free float-adjusted market capitalization weighted index that is comprised of equity securities. 5

6 requirements In order to qualify as a, an organization must comply with the following general requirements of the Internal Revenue Code: Asset test Income test Distribution requirement At least 75% of the value of its total assets must constitute qualifying real estate assets No more than 25% of its assets may consist of net investments in taxable subsidiaries At least 75% of gross income must come from real estate-related sources At least 95% of gross income must come from real estate-related sources, dividends, interest and gain from the sale or exchange of non- stocks or securities At least 90% of its ordinary taxable income must be paid annually in the form of dividends Any dividend paid offsets taxable income of the Figure 3. Qualifications to be a Ownership Must have more than 100 shareholders No more than 50% of the value of its shares can be held by five or fewer individuals 2 Recent proliferation of non-traditional s Lately, many companies holding non-traditional real estate assets have obtained PLRs from the IRS confirming their eligibility to convert to a or qualify a substantial portion of their business as a. This allows them to capitalize on the tax efficiencies offered to s, and the successful conversions of these companies have been well received by the market. Asset category Companies with qualified assets Wireless communication systems Manufactured housing Power distribution facilities American Tower Corporation Crown Castle International Corp. UMH Properties Equity LifeStyle Properties, Inc. Hannon Armstrong Sustainable Infrastructure Capital Figure 4. Examples of Companies Utilizing Structures for Non-traditional Asset Classes 6 Timberlands Pipeline systems Billboards Data centers Rayonier Potlatch Corporation Plum Creek Timber Co. CorEnergy CBS Outdoor Americas Lamar Advertising Digital Realty Trust, Inc. CyrusOne Inc.

7 On May 9, 2014, the U.S. Treasury released proposed regulations to define real property by providing a framework to analyze the qualification of assets, consistent with prior PLRs. The assets that would qualify as real property under the proposed regulations include: Microwave, cell broadcast, and electric transmission towers Telephone poles Parking facilities Bridges, tunnels and roadbeds Transmission lines Pipelines Offshore drilling platforms Stationary docks Certain outdoor advertising displays Railroad tracks If an asset does not fall within the list above, its qualification as real estate would depend largely on its lack of movability and passive nature of income generated. With the recent interpretation and expansion of the scope of -qualifying assets, it is worth noting that certain energy infrastructure assets now have an attractive alternative to the master limited partnership (MLP) structure to achieve a single layer tax structure. 3 Unlocking value in real estate assets Corporations who convert to s can deduct dividends paid against taxable income. s are exempted from taxation at the corporate level provided that they distribute at least 90% of net income to investors via dividends. Therefore, as illustrated in Figure 5 below, a can have a higher net profit and lower total tax burden than a dividend-paying corporation. Profit before taxes $100 $100 Corporate taxes (@ 35%) (35) Net profit $65 $100 Figure 5. Tax Saving Illustration Dividends paid 6 $65 $100 6 dividends do not qualify as qualified dividends, as typical dividends do; they are treated as ordinary income for shareholders. 7

8 Multiple transaction structures have been utilized by corporations looking to unlock value via a structure. Choosing the appropriate structure takes careful consideration of a corporation s assets and revenues that could qualify as realty. 3A conversion In a straightforward conversion of a to a, a elects tax status for its entire business, while stripping out non-qualifying real estate services/ operations into a Taxable Subsidiary (TRS). A conversion is often pursued by a company that has a majority of its assets qualify as realty and that already generates a majority of its revenue stream from realty or property via rents. Pre- conversion Post- conversion shareholders shareholders 7 Figure 6. Straight Conversion Illustration Qualified subsidiaries Taxable subsidiaries Company Announcement date Conversion year Return relative to S&P Index since announcement EBITDA multiple change since 1-month prior to announcement 1-day 1-week 1-month Current 8 Figure 7. Recent Completed Conversions Crown Castle International COR Energy Infrastructure Trust, Inc. Ryman Hospitality Properties, Inc. The GEO Group, Inc. Corrections Corporation of America 9/9/ % (3.0%) 0.2x 2.8x 12/13/ % 0.3% NA NA 5/31/ % 15.1% 1.8 x 3.4x 5/7/ % 11.2% 0.5x 4.3x 4/5/ % 7.6% 0.3x 5.4x Mean 5.7% 6.3% 0.7x 4.0x Median 6.6% 7.6% 0.4x 3.9x 7 Former shareholders. 8 As of 9/15/

9 3B OpCo/PropCo structure In situations where converting the entire corporation to a is more challenging, due to the corporation s inability to meet both the asset and income tests, companies could still consider an OpCo/PropCo structure to highlight value in owned realty. In an OpCo/PropCo structure, the company (OpCo) spins-off or splits-off its real estate-heavy subsidiary (PropCo) through a distribution of the subsidiary to its current shareholders. Immediately following the distribution, the PropCo converts into a and leases back real estate to the company (OpCo). The spin-off transaction can be accomplished as a taxable or tax-free spin-off (which would require additional conditions to be met to qualify as a tax-free distribution). The OpCo/PropCo structure results in two separate publicly traded companies. Pre- distribution Post- distribution shareholders shareholders shareholders shares Dividends (E&P and ordinary) (OpCo) Rent payments (PropCo) Figure 8. OpCo/PropCo Conversion eligible assets Non-real estate assets and operations Non-real estate assets and operations assets TRS Operating assets Illustration Company Announcement date Separation date Parent return relative to S&P Index since announcement 1-day 1-week Figure 9. Recent OpCo/PropCo Separations 9 Windstream Communications Penn National Gaming, Inc. 7/29/14 Expected Q % 11.1% 11/15/12 November % 21.6% Mean/Median 20.3% 16.4% 9 Source: Company Filings, Factset, Bloomberg. 9

10 Case study Windstream OpCo/ PropCo conversion 10 Transaction overview On July 29, 2014, Windstream, a provider of advanced telecom services to consumer and enterprises, announced plans to spin off certain telecommunications network assets into an independent, publicly traded, real estate investment trust (PropCo ). Following the transaction, Windstream will retain operational control of network assets via a triple net master lease agreement. The separation is expected to close in Q1 2015, subject to regulatory and board approval. Strategic benefits Windstream will be better positioned to focus on growth through attractive expansion projects, while the PropCo s strong and stable cash flow may support an attractive dividend, as well as growth opportunities utilizing its currency. The transaction unlocks meaningful value for shareholders. Additional cash flow generated from the structure will allow Windstream to accelerate debt pay down, increase reinvestment in its business, transition to an IP-centric network faster and deliver enhanced services to customers. The new capital structures provide increased strategic flexibility and will allow each company to optimize its own priorities and opportunities. As the first mover in the space, the PropCo will have meaningful opportunities to grow and diversify via similar arrangement for other distribution systems, additional joint capex initiatives with Windstream, as well as acquisitions in adjacent telecom markets. Management perspectives This transaction will make Windstream a more nimble competitor in today s increasingly dynamic communications marketplace and accelerate our deployment of advanced communications services. Additionally, the will have geographically diverse, high-quality assets and sustainable cash flows with the ability to grow and diversify over time. President and CEO of Windstream, Jeff Gardner The is going to be uniquely positioned to be in a great spot to help unlock value at other companies. We have a good understanding of how the opportunity could work in the telecom landscape. CFO of Windstream, Tony Thomas Stock price reaction Following the announcement, Windstream s stock rose 12.3% in one day, outperforming the S&P 500 by 12.8%. 10 Source: Public company filings and press releases. 10

11 % interest 3C Carve-out/spin-off This version of the separation involves an operating business distributing or selling a minority stake in its real estate intensive segment (PropCo) to public investors. The key difference between this structure and an OpCo/PropCo structure is that instead of PropCo deriving rents solely from OpCo, the PropCo will generate revenue from a variety of external tenants. It is important for this structure that the being separated meets the asset and income tests for s on a stand-alone basis. Pre- conversion Post- conversion shareholders shareholders Public shareholders IPO proceeds shares Public shareholders % interest Figure 10. Carve-out Conversion Non-real estate assets and operations eligible assets Non-real estate assets and operations Rents External tenants Illustration Company Announcement date Separation/IPO date Parent return relative to S&P Index since announcement 1-day 1-week Figure 11. Recent Completed Carve-outs CBS Corporation 1/17/13 April % 9.8% Cincinnati Bell 5/1/12 January % 6.9% Mean/Median 8.8% 8.4% 3D Other structures Other potential structures are available for s that qualify for the structure. Merger: Although rare, merging a into an existing has been utilized by some companies. Recent examples of merger and conversion include investment firm W.P. Carey converting to a by merging with its non-traded affiliate, Corporate Property Associates 15 Inc., in October Dual class stapled : This structure is designed to achieve the benefit of a with minimal disruption to the original corporation s structure and ownership by issuing a combination of parent shares and shares in a stapled form. Recently, Extended Stay America completed a dual class stapled IPO. 11

12 4 Benefits and considerations for adopting a structure Broadly speaking, the success of the structure is a reflection of the benefits it offers both corporations and investors. For corporations, the key conversion drivers are: (i) highlighting value, (ii) creating an independent strategic path for each entity (in an OpCo/PropCo spin or carve-out), (iii) realizing savings afforded by the tax efficient structure and (iv) boosting public valuation by appealing to shareholders looking for stable and growing yield. For investors, s are attractive because of their potential for growth and stable income. In addition, inflation protection, low correlation with the broader market 11 and liquidity of shares, have also contributed to the appeal of s. conversions or spin-offs and their attendant benefits and considerations are very situation specific. We recommend that management teams and boards consider and analyze the key threshold issues before embarking down the path of a conversion. Some potential considerations include (i) the ability to qualify both upfront and on an ongoing basis, (ii) regulatory issues, (iii) debt and capital structure constraints, (iv) one-time conversion costs and upfront tax treatment, (v) governance issues, and others. In addition, the dividend requirements under the structure may necessitate more reliance on external funding for acquisitions and investments going forward. 5 Conclusion Recently, the U.S. Treasury released proposed regulations on eligible nontraditional assets potentially granting assets that were previously subject to private IRS rulings (e.g., telephone poles, transmission lines, outdoor advertising displays, pipelines, etc.) automatic real property qualifications. The proposed list is expected to provide greater regulatory clarity for adoption of structures by corporations with non-traditional real assets. Over the years, the market has been very receptive of structures and has rewarded corporations that have utilized them for real assets. structures may offer significant oppportunities for corporations to unlock shareholder value via financial tax efficiences., stable revenue streams and potentially premium market valuations. This is an opportune time for corporations to look at their underlying assets and evaluate if the structure provides an opportunity to create significant value for their stakeholders. 11 Factset data as of 9/15/2014. YTD Correlation of MSCI US (RMZ) Index and S&P 500 Index at

13 For more information, please contact: Souren Ouzounian Head of Americas Corporate Finance Jay Bliley Amir Mirza Philip Turbin Leonard Chung baml.com/corporatefinance Jeffrey Horowitz Global Head of Real Estate, Gaming & Lodging Corporate & Investment Banking Jack Vissicchio Gregory Wright

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