Call it a comeback

The availability of favorable debt financing and the low public valuation of REITs relative to the net asset value of their underlying assets were two principal drivers in the unprecedented wave of REIT M&A deals through the third quarter of 2007. This wave of deals abruptly crashed when the availability of debt financing dried up in late 2007. The availability of debt capital became a crisis in the fall of 2008 and REITs were forced to re-examine their liquidity positions.

Meanwhile, REIT stock prices plummeted nearly 75% from their peak in February 2007 to historic lows as a result of the lack of available financing coupled with more than $1 trillion worth of commercial real estate debt maturing over the next three years. While REIT stock prices have rebounded nearly 52% in the first half of 2009, prices are still relatively low and the recovery has not been evenly spread among all industry participants. Recently, REITs that are perceived as able to survive the economic downturn were able to raise debt and equity capital. In fact, through April 24 this year, REITs raised more than $10 billion of debt and equity capital from the public.

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But what will become of the industry players that are not able to access capital? Some may end up bankrupt like General Growth Properties Inc. Another possibility is that REITs unable to access capital may turn to their better capitalized brethren for relief from pending debt maturities or the inability to fund their operations. These market conditions may make it an opportune time for well-financed buyers to pursue strategic acquisitions of REITs.

While REIT acquisitions raise many of the same issues as purchases of any other business entity, REIT deals involve many issues unique to the industry.

If the target is an UPREIT (a REIT that owns all of its assets through a subsidiary operating partnership in which the REIT is a general partner), buyers will need to carefully analyze the UPREIT's partnership agreement because of the varying rights of the limited partners. The partnership agreement generally will include provisions relating to the vote of limited partners needed to complete the transaction as well as other rights in favor of limited partners. Limited partners in an operating partnership have different rights than those afforded to REIT shareholders and may be able to negotiate a different transaction than that offered to shareholders. The limited partners may have as their primary goal the continued deferral of their built-in tax gains (discussed further below) and, therefore, may be less likely to take cash as part of the transaction and may want to remain as limited partners. Leaving limited partners "in place" may not be appealing to the buyer given the possible fiduciary issues and continued reporting obligations under the Securities Exchange Act for operating partnerships that are reporting companies. In addition, as with any corporate acquisition, buyers approaching the target's board with an acquisition proposal must be conscious of the fiduciary duties owed by board members to the target and its shareholders. However, special considerations may arise in the case of UPREITs. For example, while directors of a corporate general partner of a partnership generally owe fiduciary duties to the limited partners, the partnership agreements for many UPREITs were drafted with specific provisions negating these fiduciary duties and providing that a board's actions consistent with its fiduciary duties to the REIT's shareholders will satisfy any obligation of the directors to the limited partners.

Other unique aspects of REIT acquisitions require the buyer to have clear post-acquisition plans for the acquired assets as well as a clear understanding of the tax impact of the transaction on the buyer and the target.

The REIT's compliance with the requirements of the Internal Revenue Code is critical to the transaction no matter its structure. Regardless of whether the target will continue to qualify as a REIT after completion of the transaction, the target's historical compliance with the REIT requirements of the Code will have an impact on the buyer. If the REIT failed to qualify as a REIT prior to the transaction, it may be subject to an entity level tax or penalties, which, of course, will be borne by the buyer. Similarly, if the buyer is a REIT, the failure of the target REIT to qualify may affect the ability of the buyer to maintain its REIT status. Because of the importance of REIT qualification, buyers customarily require the target REIT's counsel to deliver an opinion at closing that the target qualifies as a REIT under the Code.

Another issue unique to REIT acquisitions arises out of the manner in which REITs were formed and grew. Historically, many of the assets acquired by UPREITs were contributed by the former owner on a tax-deferred basis. As part of the contribution transaction, the REIT may have granted the contributor "tax protection" in the form of an agreement not to sell in a taxable transaction the contributed property for a period of time or to pay the taxes (including a gross-up amount) owed by the contributor on any taxable sale of the property. These agreements need to be examined against the buyer's plans for the related properties and the structure of the transaction. For example, if the transaction results in taxable disposition of the property, then the buyer may be liable for paying the contributor's taxes (including a gross-up amount) on any built-in gain on any tax protected properties.

Because the merger consideration that a buyer will be paying will exceed the depreciated value of the target's property, most buyers will seek a step-up in the tax basis of the underlying assets of the target. However, obtaining this result may come with some unexpected costs depending upon the structure of the transaction. For example, a forward merger of the target into an acquisition vehicle for cash generally results in an immediate step-up in the basis of the underlying assets. However, because the separate existence of the REIT ceases upon completion of this form of transaction, this structure will generally trigger third-party consent requirements, including the consent of lenders, and require the payment of a transfer tax or trigger a reassessment of the REIT's property. Another disadvantage of this structure is that any C-corporation built-in gain (that is, gain from the sale of certain property the target held before electing REIT status or which it obtained in a carry-over basis transaction from a C-corporation) in the target REIT is triggered. These disadvantages could add materially to the cost of the transaction. On the other hand, if the transaction is structured as a reverse merger of an acquisition vehicle into the target for cash, while there may exist fewer third-party consent requirements, and there may be no requirement for the payment of transfer taxes or reassessment of the REIT's property, the buyer will not receive any step-up in the basis of the assets, which will lead to lower depreciation expense and larger gains on dispositions.

The structure of the transaction may also be affected by the buyer's post-acquisition plans with respect to the assets and operations. For example, in the event the buyer wants to immediately dispose of unwanted assets, the buyer will need to be sure those properties will not constitute "dealer property" that could result in a 100% tax to the buyer or force the buyer to dispose of the unwanted properties through tax-deferred like-kind exchanges. Further, as noted above, the REIT may be subject to entity level tax on any C-corporation built-in gain.

One final unique issue in REIT acquisition transactions revolves around the payment of a breakup fee. If the buyer is a REIT or if a reverse breakup fee is payable to the target REIT, the party entitled to receive the breakup fee may need to place limitations on its ability to take the fee in a lump sum. Receipt of such a fee by a REIT would constitute non-qualifying REIT income for purposes of the REIT income tests and thus, if the fee is significant enough, may cause the REIT to fail to qualify as a REIT. To address this issue, most merger agreements involving REITs provide for the payment of the breakup fee into an escrow to be paid out to the REIT over time as permissible in order to maintain the REIT's status under the Code.

While REIT M&A activity has significantly slowed following the record activity through the third quarter of 2007, conditions may be ripe for buyers with access to capital to acquire a REIT on favorable terms. In structuring an acquisition, it is important for both bidders and targets to have a complete understanding of the legal and tax framework involved. Both bidders and targets should consult legal and financial advisers as early in the process as possible.

Michael T. Blair is a corporate partner in Mayer Brown LLP's Chicago office.

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