A Theory of the REIT

abstract. Real Estate Investment Trusts (REITs) are companies that raise money from the public to invest in real estate. Despite REITs being a vast and growing part of the economy, legal scholars have paid them almost no attention. Accordingly, no one has noticed that REITs possess several unique and puzzling legal characteristics. REITs are the only American business form that are forbidden from reinvesting their profits. They are also uniquely immune to hostile takeovers. Since reinvestment and takeovers are thought to be good for investors (at least on average), REIT law would seem to be an obstacle to REIT growth. Yet, REITs have grown feverishly for decades.

We offer a theory to account for the growth of REITs. We suggest that REITs succeed because of—not despite—their mysterious legal attributes. We argue that their superficially inefficient rules that bar reinvestment and takeovers interlock as part of an efficient solution to tax-induced lock-ins and investor conflicts inherent in real estate markets.

Our theory is important because it clarifies the underlying logic of REIT law, which is highly technical and may appear arbitrary. Clarity allows us to evaluate reforms to the real estate sector. Our theory also links the REIT back to mainstream corporate-governance and tax scholarship, illustrating how an overlooked business form sheds light on some of the fields’ central debates.

authors. Jason S. Oh is Professor of Law, Lowell Milken Chair in Law, UCLA School of Law. Andrew Verstein is Professor of Law, UCLA School of Law. Many thanks to Stephen M. Bainbridge, Steven A. Bank, Margaret Mendenhall Blair, Zohar Goshen, Daniel I. Halperin, Henry B. Hansmann, Daniel Hemel, Michael Klausner, John D. Morley, Mariana Pargendler, Gabriel V. Rauterberg, Roberta Romano, Kathleen Smalley, Richard Squire, Kirk J. Stark, Eric Talley, the staff of the Yale Law Journal, and participants of the UCLA Colloquium on Tax Policy and Public Finance for their helpful comments. Andrew Bronstein, J. Hayden Frye, and Emma Pettinga assisted with research.

Introduction

Real Estate Investment Trusts (REITs) are companies that raise money from the public to invest in real estate.1 Unlike all other companies, REITs exhibit two unusual governance characteristics: REITs are immune to hostile takeovers2 and prohibited from reinvesting their profits.3 These REIT features defy the scholarly consensus on good corporate governance. Corporate law permits takeovers because they serve an important role in holding managers accountable.4 Likewise, corporate law affords management vast discretion over whether or not to reinvest profits5 because reinvestment is often the cheapest way to grow viable businesses.6

With accountability and growth potential diminished, one might expect investors to shun REITs. Yet, investors clamor to buy REITs. Every year, REITs grow.7 Thirty years ago, they barely existed. In the intervening decades, America’s public REITs have doubled in size nearly every four years.8 Almost half of American households own REIT stock.9 REITs hold more than $4.5 trillion in assets,10 approximately 3% of all of America’s wealth,11 and make up 5% of the S&P 500.12 Further, 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.13

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

No one has ever seriously tried to offer an answer. Legal scholars have had little to say about REITs.14 Most REIT scholarship comes from tax scholars, who (understandably) focus on the arcane REIT tax rules.15 Thanks to a unique dividends-paid deduction, REITs are effectively exempt from corporate-level taxes.16 That gives them an edge over some other investment structures. Call this the “pass-through theory” of REIT success: REITs enjoy tax benefits attractive enough for investors to tolerate suboptimal corporate governance.

Yet, upon closer scrutiny, the pass-through theory fails to account for investor enthusiasm for REITs. Any tax advantage is small,17 and may even be negative.18 Moreover, other pass-through entities, such as the Master Limited Partnership structure, confer better pass-through tax treatment without REIT-like restrictions.19 Yet, real estate investors have largely ignored those other vehicles.20 More generally, the pass-through theory fails to link federal tax policy to the other curious features of REITs: prohibited reinvestment and resistance to takeover.

At least tax scholarship has theories about REITs. By contrast, no corporate-law scholar has ever noticed that REITs possess takeover defenses more potent than the most aggressive poison pill, and so none has ventured an explanation.21 The few corporate-law articles about REITs make at most a passing reference to the tax benefits and reinvestment rules—they leave those for the tax lawyers.22 Despite thousands of articles about mergers and acquisitions and corporate governance, no one has asked what REITs’ success might signify.

Lacking a theory of REITs, we also have no ability to evaluate changes to the REIT regime, of which there have been many. At first, REITs could own real estate, but they had to hire an external company to operate it for them.23 By 1999, REITs were given the choice of internal or external management.24 And over time, the IRS has relaxed what counts as “real estate,” including, among other things, prisons, cell-phone towers, and mortgage-backed securities.25 Most recently, in 2017, REITs were authorized to reinvest more of their profits.26 Are these good changes? Absent a theory, we have no principled basis for evaluation, nor any theoretical basis to generate new reform proposals. We need a theory of what REITs are all about, and how their parts fit together. With such a theory, we could decide whether regulatory changes support or undermine the logic of REITs. We could perceive that some apparently pro-REIT changes actually spell their downfall, while other seemingly burdensome rules could actually save the industry from itself. This is a timely examination. Recent turmoil in the REIT markets—most notably the struggles of Blackstone’s BREIT—have underscored a theoretical gap. Why do REITs exist? When should a real estate venture be organized as a REIT?

This Article provides the first theory of the REIT. While the Article itself explains this theory at length, we sketch it out here.

The taxation of real estate poses distinctive challenges for collective investment. Tax law incentivizes owners to avoid cash sales of their real estate.27 Yet, the social costs of chilling property transfers are also substantial.28 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.29 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 who have strikingly different interests.30 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.

These conflicts do not arise to the same degree in familiar publicly traded corporations.31 There, the investors are shareholders who largely want the corporation to make profitable decisions. Henry Hansmann explains that this is no accident: firms usually end up with a single homogenous body of owners precisely in order to minimize the cost of inter-owner conflicts.32 Yet, heterogeneous ownership of real estate ventures cannot be avoided. Because of the tax code, it can only be mitigated.33

And mitigation is sensitive. 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. On the other hand, allowing some form of majority rule can devolve into a tyranny of the majority.34 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.35 These managers generally protect the tax interests of individual contributors—if they did not, 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.36 No takeovers means managers do not have to capitulate to any investor faction’s demands.37

Of course, this entrenchment places 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.38 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. REITs have disabled the corporate-shareholder vote as a channel for accountability, but they have institutionalized exit.39

Mandatory dividends can discipline managers, but they expose REITs to surprisingly harsh tax consequences. Ordinary corporations lower their tax burdens by strategically timing their dividend payments, something REITs cannot do. Pass-through taxation is necessary to put REITs on level footing again.40 Our theory shows that the pass-through theory gets things precisely backwards. Investors do not come for the pass-through taxation and tolerate the governance restrictions; they come for the governance restrictions and stay for the pass-through taxation. This observation explains why REITs have outperformed other pass-through structures in real estate.41

A viable theory of REITs gives us a toehold in the various governance debates that REITs implicate. First, corporate theorists have long understood the power of interest payments42 and the value of prohibited shareholder distributions,43 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.44 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.45 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.46 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 voluntary self-limitation. Entrenchment is more acceptable when the entrenched board relinquishes the powers most easily abused while entrenched.

With that preview aside, what is to come? Part I of this Article introduces the key legal features of the REIT and their economic significance. Part II describes the tax problem endemic to real estate. Part III presents a clever structural solution developed in the early 1990s. Part IV explains the investor conflicts latent in that structural solution. Most succinctly, this structure created a pattern of heterogenous ownership, which had to be overcome for joint real estate ventures to thrive. Part V explains how REITs solve that problem. Part VI elaborates on the theory to address a number of REIT puzzles, including why no other solution is practical. Part VII considers policy implications to guide courts and policymakers as they ponder the future of the REIT. Changes to REIT law should be held up to the functional structure we have uncovered. If a reform helps investors and managers to balance necessarily heterogenous ownership, it is to be supported. Part VIII widens the lens to consider implications for governance theory more generally. And then we conclude.