REITS’ potential to electrify Midwest real estate

Guest post by Tim Laycock and Tom Smallwood, Stinson Morrison Hecker LLP

Tim Laycock

America’s struggle for energy independence shows no signs of relenting, and recent IRS private letter rulings have greased the wheels for real estate investment trusts (REITs) to invest in alternative energy projects. The appropriated public funds and the federal, state and local government financial incentives created to meet the task of developing and maintaining U.S. alternative energy generation infrastructure have not met demand. Conventional lenders, investment banks and equity investors in alternative energy projects have been unable to provide sufficient capital to sustain these massive – and expensive – projects. The capital investment void has resulted in a need for fresh sources of private capital in alternative energy projects. Some pundits in the industry (the authors of this article included), believe that one potential source that will eventually fill this void will be REIT capital. And pro-alternative energy policy decisions in Washington, D.C., have brought REIT investment one step closer to reality.

Tom Smallwood

Since their inception in the 1960s, REITs have grown to be a primary source of capital for real estate development financing. REITs were created by Congress to make large-scale, income-producing real estate assets accessible to individual and institutional investors without massive amounts of capital to invest. Due to their special status, REITs are given a tax deduction for dividends paid, essentially creating one level of income taxation, because REITs are required by law to distribute 90 percent of their taxable income. Accordingly, REITs are magnets for earnings-oriented investors, such as pension funds, insurance companies, mutual fund companies, banks and other institutional investors. In addition, REITs are often an attractive vehicle for foreign U.S. real estate investors because the sale of REIT shares is not subject to tax under the Foreign Investment in Real Property Tax Act of 1980 if the REIT is domestically controlled or publicly traded and the foreign investor holds 5 percent or less of the REIT stock. REITs can raise equity capital at low costs because of their favored tax status.

A REIT must satisfy a variety of complex requirements, including rules regarding the REIT’s beneficial owners, asset composition, sources of income and required distributions. A REIT must derive at least 75 percent of its gross income on an annual basis from real estate sources (such as rents from real property, mortgage interest and real property gains) and must derive at least 95 percent of its gross income from a combination of real estate sources, dividends, interest and certain other specified sources. In addition, at least 75 percent of the value of a REIT’s assets must be represented by real estate assets, cash and cash items, and government securities. These restrictions act to prohibit REITs from financing certain portions of any real estate investment – for example, moveable snow guns at a ski resort, digital projection equipment in a movie theater, a printing press in an industrial building and tree harvesting equipment for timber operations.

Historically, REITs also have been restricted from investing in en¬ergy assets. However, the winds of change are blowing in Washington, D.C., and policy changes that will benefit the alternative energy development community are being implemented. A 2007 IRS private letter ruling addressed key issues for a REIT that will assist in allowing REITs to invest in alternative energy projects. The ruling confirmed the real property status of a broad range of energy and other tangible non-building, non-machinery infrastructure assets for REIT purposes. The ruling concluded that qualifying power transmission assets are qualified real estate assets under the 75 percent asset test. The ruling also held that rental payments received by the REIT for a lease of the system qualifies as “rents from real property” under the 75 percent income test.

Earlier this year, the IRS issued another relevant private letter ruling, determining that so-called “power purchase agreements” (PPAs) that are specific to energy production facilities are part of the actual related energy production facility and are eligible for favorable five-year depreciation. In this ruling, the taxpayer acquired both a wind facility and the related PPA, and posed the question whether the favorable five-year depreciation life for wind equipment also applied to the value attributable to the PPAs. The favorable ruling will further cement the benefits of alternative energy investment by REITs.

New alternative energy projects of all shapes and sizes have recently sprung-up around the Midwest, including solar plants in Michigan and Ohio, wind farms in Illinois and Kansas, and biomass plants in Wisconsin. Federal and state funds are helping drive these projects, but developers and REITs alike may be missing a strong financing and investment opportunity. Placing wind, solar and other alternative energy as¬sets in a REIT could create signifi¬cant financial benefits for a developer. The primary challenge REITs and developers seeking REIT financing will face is that even with recent private letter rulings, power-generation equipment (as opposed to the transmission system) does not qualify for REIT investment. While this would appear to be a fatal flaw for the REIT model as it pertains to wind and solar assets, there are mechanisms to structure around the issue by including only the real property assets in a REIT, and excluding power-generation technology and equipment.

As we write this, participants in the equity markets and their legal teams are working on structures through which REITs will be used as an alternative source of financing for wind, solar and other alternative energy projects. The role that REITs will play in the financing of wind or solar energy projects remains to be seen. It is unlikely that REITs represent a universal solution for all future wind or solar projects, but they could certainly provide an additional tool in the developer’s arsenal.

For more information about the REIT business cycle and the issues facing REITs, contact attorneys Tim Laycock and Tom Smallwood of Kansas City, Mo.-based Stinson Morrison Hecker LLP at 816-842-8600 or visit www.stinson.com.

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