The Institutional Side of Real Estate Transactions:Integrating Business Strategy and Legal Structure

Professor Lynne SagalynB8158 Real Estate TransactionsColumbia Business School

Transaction Structure

Legal Structure& Execution

RegulatoryFrameworks

Market Drivers:Space & Asset

Tax Factors

Transaction Strategy and Structure

Investment StrategyFinancial Strategy

Legal Structure& Execution

• Interests in property• Forms of ownership• Terms and conditions of contracts• Governance • Distress and default

• Local land-use regulations (police powers)• Programmatic incentives linked to zoning

and tax codes• State and federal securities laws

Other Constraints on Property Interests

• Eminent domain (constitutional right, statutory law procedures)

• Taxation of real estate (constitutional right, statutory laws and procedures)

• Escheat (reversionary right)

RegulatoryFrameworks

Course Structure

• Asset Transactions

• Financing Transactions

• Development Transactions

• Complex Transactions

Four Sections:

Asset and Financing Transactions

• Acquisitions and Dispositions

• Space Leases

Asset and Financing Transactions

• Land-Use Controls: Zoning and Value Creation

Asset and Financing Transactions

• Mortgages and Securitization

Property Owner

Equity Interests Borrower SPE(nonrecourse)

Mezzanine DebtPreferred Equity

Senior Loan

Asset and Financing Transactions

• Ground Leases

Landgray AssociatesFee Owner

Landgray AssociatesFee Owner

Metropolitan Life Insurance CompanyMetropolitan Life

Insurance Company

SL Green Graybar Mesne Lease LLC

SL Green Graybar Mesne Lease LLC

New York Graybar Lease LP

New York Graybar Lease LP

SLG Graybar Sublease LLC

SLG Graybar Sublease LLC

Title

Exhibit 1: Graybar Leasehold Structure

Ground Lease

Sublease

Sub-Sublease(Operating Lease)

Sub-Sub-Sublease(Operating Sublease)

Fixed plus revaluation

Fixed

Fixed

Fixed plus 33 1/1% participation

Operating

Exhibit 2: Process for Early Revaluaton and Renegotiation of Graybar Ground Lease

Landgray

Met Life

SLGSLG

Mortgagee

LandgrayMortgagee

New Existing Lease(early renewal &

extension to 2020)

Option to Extend (option to enter into

new ground lease, w/ renewals, maturity 2080)

1b

1

2

3

4Source: Case Author

Development and Other Complex Transactions

• Development Financing

• Mixed-Use Redevelopment

• Private Equity and the JV Transaction

• M&A Transactions

• Surprise!

Forms of Ownership

Real Estate Ownership Structures

Corporations (typically publicly held)

– Non-Taxable REITs

• Real estate asset-based companies qualifying for tax-free status

– Taxable C-Corps

• Typically used for operation-intensive businesses (e.g., hotels)

Partnerships and LLCs (typically privately held)

– General and Limited Partnerships/Limited Liability Companies

• Tax pass-through entities

• Most widely used form of real estate ownership

– Open-end and Closed-end Commingled Funds / Separate Accounts

• Collection of partnerships most typically used with institutional investors

There are four primary ownership structures

What is a Partnership?

• A legal entity that qualifies for tax pass-through status under the tax code

• Created and governed by contractual partnership (or LLC) agreement

• In General Partnerships all partners in the venture share management and liability

• Limited Partnerships create different classes of partners in the venture

– General Partners who manage the venture and have unlimited liability

– Limited Partners who are passive partners with liability limited to their subscribed capital

• Can be organized to engage in any activity

Partnerships

• An organization is classified as a partnership for federal tax purposes if it has two or more members and it is none of the following:

– A corporation or joint-stock company / association

– An insurance company or bank

– A tax-exempt organization

– An organization that elects to be classified as a corporation

– A Real Estate Investment Trust (REIT)

– A trust under Internal Revenue Code

There are few requirements for forming partnerships

Partnership

• Established and governed by partnership agreement

• Managed by General Partner, typically non-exclusive activity

• Super-majority vote to remove general partner

• No employees

• Compensation determined by partnership agreement, often includes share of profits

• Typically privately held

Governance

Washington Partners(Borrower)

1800 L Street(Collateral)

PMP(Lender)

S. HendersonC. HendersonSkyline L.P.

(Partners)

Master Lease(Additional Collateral)

MLHCL

(Participants)

The Single-Asset Partnership: 1800 L Street

What is a REIT?

• A trust or corporation that combines capital of many investors to acquire or provide financing for real estate properties

• Legislative creation: Real Estate Investment Trust Act of 1960

• Types of REITs:

– Equity REITs own and operate income-producing real estate

– Mortgage REITS lend money directly to real estate owners and their operators, or indirectly through acquisition of loans or mortgage backed securities

– Hybrid REITs own properties and make loans to owners and operators

• REIT mutual funds

Requirements for REIT Status

If a REIT satisfies the following tax code requirements, it pays no corporate tax:

– 90% Payout Rule: Must distribute at least 90% of taxable net income to shareholders

– 75% Earnings Test: Must earn at least 75% of gross income from rents, mortgage interest or capital gains from the sale of real estate

– 75% Assets Test: Must hold at least 75% of assets in real estate, claims against real estate, cash or government securities

– 20% Assets Test: No more than 20% of assets may consist of stocks in taxable REIT subsidiaries

– Five or Fifty Rule: Must have at least 100 shareholders with no five or fewer individuals owning more than 50% of the shares

– Anti-churning Rule: Must refrain from short-term speculative buying or selling of real estate; no more than 30% of gross income from certain types of short-term holdings

– May own stock in a taxable REIT subsidiary (TRS) up to 20% of REIT assets– Trustee Rule: Must be managed by a board of directors (trustees)

REIT Governance

• Entity established and governed by charter and bylaws

• Managed by real estate professionals employed by the company

• Board of Directors (or Trustees) elected by the shareholders

• Management compensation determined by Board, often tied to stock or asset performance

• Typically publicly held

• Board and management can contract day-to-day operations to an Advisor, creating an “Advised REIT”

Why is real estate owned in a publicly traded format, if the historical advantages of being private are so great?

Advantages of Being Public

• Ongoing access to capital

• Enhanced balance-sheet flexibility

• Diversification of funding sources

• Potentially lower cost of capital

• Access to new investors, especially small investors

• Securities as acquisition currency

• Potential economies of scale

• Easier to build a long-term franchise

Advantages of Being Private

• Limited pubic disclosure requirements (less transparency)

• Insulation from volatility of public markets and valuation

• Operational and structural simplicity

• Large investors experience control

• Speed to market

• Flexibility in absence of regulation

• Pass-through of losses

Public vs. Private

REIT Regimes

• Historical regime: C&D REITs of the 1970s

• Tax-oriented investment strategies of the 1980s

• Modern REIT, post 1991

Relative attractiveness as an ownership vehicle:

The UPREIT Structure

The DownREIT Structure

Corporation(publicly traded

or privately held)

REIT(publicly traded

or privately held)

Limited Liability

Corporation

Partnership__________________

General Limited

Avoid Double Taxation No Yes Yes Yes Yes

Avoid management responsibility Yes Yes Yes No Yes

Flexibility in allocation gains/losses

No No Yes Yes Yes

Limited liability Yes Yes Yes No Yes

Ability to pass through tax losses No No Yes Yes Yes

Easy transfer of interests Yes Yes No No No

Typical Ownership Formats for Real Estate Assets

Real Estate Investor Types

Developer Individual Family Investment Fund

Return Requirements

18-20% (Total return driven)

12-18% (total return and IRR )

12-18% (total return)

9-15% + (Total return and IRR)

Cash Flow versus Appreciation

Appreciation Varies Cash Flow dominates

Varies

Holding period Varies with product and equity source

7-10 years Generational

Indefinite

3-10 years

Business plan flexibility needs

High Moderate Low Low to moderate