Apparently, the IRS is concerned that too many corporations are converting, and that some may not qualify. Iron Mountain's comments that so spooked the market were:
"The Company has recently been informed by the IRS that the IRS formed a new internal working group (the "Working Group") to study the current legal standards the IRS uses to define "real estate" for purposes of the REIT provisions of the Code and what changes or refinements, if any, should be made to those current legal standards."
… and that IRM
"believes one or more of the following are the most likely explanations: (1) the IRS was simply undecided, under current legal standards, on whether the Company's racking structures are properly characterized as "real estate" for REIT purposes, (2) the IRS sought greater clarity of the underlying facts and additional input on technical points of law, and/or (3) the IRS did not want to issue a ruling, either favorable or adverse, on the Company's racking structures until the Working Group completed its study."
The first inkling that Iron Mountain might go down the route towards becoming a REIT came when Elliott Management became an activist investor in the company and, in early 2011, nominated four individuals to IRM's board of directors, including two that had experience in converting other companies into REITs. Shortly thereafter, IRM appointed a new CEO and subsequently announced plans to pursue a REIT conversion.
Iron Mountain is in the business of property protection and storage. The most common type of property IRM protects and/or stores would be an older business document, and the service would be known as records storage. The company also provides data backup services and records management services for industries such as healthcare that require secure management of patient data. Iron Mountain also provides other document related services, such as destruction through shredding.
It appears most probable that IRM's core businesses of storage should qualify for REIT status, but it does offer many services that may not be properly defined as a real estate investment. One of the main issues may be how IRM defines its revenue, and that services are less clearly real estate related than the rental model that traditional document storage uses. In order to qualify as a REIT, a company must invest at least 75 percent of its assets in real estate and obtain at least 75 percent of its gross income from rent on that real estate and/or interest on mortgages.
Despite IRM's uncharacteristic real estate business model, the business of storage is generally accepted for REIT status. For example, most of the larger companies in the businesses of personal storage, such as Public Storage (PSA), and corporate digital datacenter management, such as Digital Realty Trust (DLR), qualify as REITs. This more recent scrutiny indicates the IRS may be re-examining whether datacenters should qualify as rentable real estate.
It appears likely that the core businesses of hard document storage and management should qualify, and that IRM may be better-off if it re-characterized certain data services as in a manner that makes the revenue derived from a form more like a lease. Nonetheless, it may certainly be the case that some business segments should be divested from IRM in order to the transition to be completed and for IRM to be a proper REIT.
If the IRS concludes that IRM's current mix is not suitable for REIT status, but IRM wants to modify itself so it can still convert, the company will still have the ability to either spin-off or sell those units that are most accountable for its inability to qualify. This may be a sensible course of events, especially considering how ideal IRM's core business appears for the REIT model. Other businesses that recently converted to REITs have had to do so. For example, before Weyerhaeuser (WY) converted to a timber REIT, it divested itself of its fine paper business by combining it with Domtar's (UFS), and WY also subsequently sold numerous other smaller non-core segments.
A large portion of IRM's customer base is composed of large corporate clients that have used the company's services for many years. These clients are unlikely to switch, from IRM especially considering the level of trust and reliability that IRM has established, and can therefore be considered long-term tenants. Moreover, IRM already holds these clients' old documents, and it would simply be inconvenient, expensive and downright dangerous move them without being forced to do so. This business is pretty perfect for a REIT, and the cash flow that it generates should support a stable and growing REIT dividend.
Beyond its long-standing business, Iron Mountain also owns warehouses filled with servers that hold and manage digital data, and the company, as well as the market, appears mostly concerned with whether those assets will constitute real estate. Similarly, the IRS is scrutinizing Equinix (EQIX), which is more specifically virtual in its real estate.
Current legal standards indicate that racking structures should be considered real estate for REIT purposes, and the existence of Digital Realty Trust and DuPont Fabros Technology (DFT) as REITs appears to confirm this. These REITs may have just as much to lose, if not more than IRM and EQIX, if the IRS concludes that such businesses are improper for REIT status.
Nonetheless, it appears more probable that EQIX and IRM will qualify as REITs, either in their current forms or after making some minor modifications, and that IRM's core business is certainly suitable for REIT status. As a result, the most likely occurrence is that this IRS scrutiny delays and/or complicates IRM's inevitable REIT conversion. If that is the case, this most recent downturn would represent a short-term fire-sale opportunity.