A Theory of the REIT

Jason Oh is a Professor of Law and the Lowell Milken Chair in Law, and Andrew Verstein is a Professor of Law at UCLA School of Law. This post is based on their article recently published in The Yale Law Journal.

Real Estate Investment Trusts (REITs) are companies that raise money from the public to invest in real estate. Distinct from almost all other companies, REITs exhibit two unusual governance characteristics. REITs are essentially immune to hostile takeovers and prohibited from reinvesting their profits. These REIT features defy the scholarly consensus on good corporate governance. Corporate law permits takeovers because they serve an important role in keeping managers accountable. Likewise, corporate law grants management discretion over whether to reinvest profits, because reinvestment is often the most economical way for businesses to grow.

With accountability and growth potential diminished, one might expect investors to shun REITs. Yet investors clamor to buy REITs. Thirty years ago, they barely existed. In the intervening decades, America’s public REITs have doubled in size essentially every four years. Almost half of American households own REIT stock. REITs hold more than $4.5 trillion in assets, approximately 3% of all of America’s wealth, and make up 5% of the S&P 500. REITs span a large variety of industries: there are REITs that own a quarter-billion square feet of shopping centers, communication towers that span the globe, and over $100 billion of mortgages.

How can REITs exhibit such “bad” governance characteristics and yet remain an investor favorite?

The answer cannot be that investors want exposure to real estate because there are plenty of alternatives. The question is why the REIT has prevailed.

Nor can the answer be that REITs are subject to a special tax regime that basically eliminates their corporate-level taxes. Other vehicles enjoy similar or even superior tax advantages but have failed to attract the attention of real estate investors.

In an article just published in the Yale Law Journal, we provide a theory of the rise and function of the REIT.  We explain how real estate investing poses profound challenges for collective investment, with costly divisions inevitable among heterogenous investors. REITs are uniquely suited to respond, because of their peculiar governance limitations.

Although governance is the heart of the story, the beginning is indeed a matter of taxation. Tax law incentivizes owners to avoid cash sales of their real estate. Yet the social costs of chilling property transfers are also huge. Accordingly, the tax code overcomes this impediment by letting owners transfer their real estate tax-free to partnerships, so long as the partnership avoids certain sale, refinancing, and merger activities. If the partnership takes any of those actions, the former real estate owner immediately owes the taxes she thought she had avoided.

The problem with this solution is that growing partnerships snowball with many different partners with strikingly different interests. Suppose that a partnership gets an attractive offer to sell a plot of land. Most of the partners will favor this sale, but the property contributor will be starkly opposed. That partner faces a huge tax liability if the partnership sells the plot. Similar conflicts arise if the partnership gets an attractive offer to repay the debt linked to the plot or to undertake a merger that would divest the partner of her partnership status. Conflicts arise in both everyday and momentous decisions. The key issue is that a property contributor bears 100% of the tax downside of these actions but shares pro rata the economic upside.

There is no simple solution to this conflict. Give each partner a veto right on transactions that incur taxes for her, and the partnership will be hamstrung: it will be unable to undertake deals that even the affected partner would have approved were she still the direct owner of the plot. And a contrary norm, allowing some form of majority rule, may devolve into a tyranny of the majority. Owners would be reluctant to join a collective real-estate enterprise if they faced the risk of prompt expropriation by an existing clique.

REITs solve this problem by establishing a durable management team, which develops a reputation for mediating inter-investor conflicts. These managers generally protect the tax interests of individual contributors—if they didn’t, they would never convince new property owners to contribute to the REIT. But they do not always bow to the wishes of particular partners—they would likewise fail to entice new contributors if the enterprise could not take any profitable actions. REIT law makes this balancing possible by entrenching managers against takeover. Managers do not have to capitulate to any investor faction’s demands.

Of course, this entrenchment puts all investors at the mercy of the managers, who might overdo their compensation or otherwise abuse their privilege. REITs address this risk by forcing the REIT to pay large dividends every year. With large distributions, managers know that they cannot coast on internal growth. If they wish to grow their empire, they must go back to property contributors or the capital markets with their hats out. Having shut the door on takeovers, REITs have opened the window to institutionalized exit to maintain managerial accountability.

Mandatory dividends can discipline managers, but they expose REITs to surprisingly harsh tax consequences. Ordinary corporations lower their tax burdens by strategically timing (usually deferring) their dividend payments, something REITs cannot do. Passthrough taxation is necessary to put REITs on level footing again. Our theory shows that focusing on the tax benefits of REITs gets things precisely backwards. Investors don’t come for the passthrough taxation and tolerate the governance restrictions; they come for the governance restrictions and stay for the passthrough taxation. This observation explains why REITs have outperformed other passthrough structures in real estate.

A viable theory of REITs gives us a toehold on the various governance debates that REITs implicate. First, corporate theorists have long understood the power of interest payments and the value of prohibited shareholder distributions, but little attention has been paid to the disciplining power of mandatory shareholder distributions. REITs highlight that distribution regulation can be, and often is, a nuanced tool for agency cost control. Second, REITs offer a vision of governance that disrupts familiar assumptions in the debate about whether boards should cater to stakeholders (such as workers) or focus exclusively on shareholders. REIT law plainly anticipates that boards will protect nonshareholder interests, but it staunchly refuses to vindicate those interests with legal claims on the board. REITs chart a way forward by backstopping a right with an economic (rather than legal) remedy. Third, REITs give new perspective to the much-debated value of takeover defenses. REITs require powerful entrenchment to succeed, but REIT law does not confer this boon without a price: REIT boards are subject to sharp expansion and reinvestment constraints. REITs offer a model of takeover defenses in which courts’ validation of takeover defenses depends in part on managers’ offer of mandatory self-limitation. Entrenchment is more acceptable when the entrenched board relinquishes the powers most easily abused while entrenched.

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