REIT Investors Overlook Stock Dilution From UpReit Structure

by: Joseph Ori, CFA

Many REITs are formed in an UpReit structure in which the public REIT is the general partner in an UpReit Operating Partnership. In this ownership structure, the public REIT investors do not own 100% of the real estate assets owned by the REIT. Public investors must take into account the ownership dilution of these partnership units that are convertible into REIT shares and held by the affiliated UpReit Operating Partnership when valuing publicly traded REIT stocks. UpReit Operating Partnerships are limited partnerships that own some or a majority of the assets of many public REITs. The public REIT is typically the general partner (although it may also own a limited partnership interest) with a majority interest and the founders of the REIT, special investors in the REIT or sellers of property to the REIT, are the limited partners in the UpReit Operating Partnership.

UpReits are formed for two reasons. First is when the REIT is formed so that the founders can transfer the commercial real estate that they own in various partnerships and limited liability companies to the UpReit in a nontaxable transaction by exchanging their interests in these entities for interests in the UpReit Operating Partnership. Secondly, REIT management can use the partnership interests in the UpReit Operating Partnership to acquire property from sellers who want to delay the taxable gain on the sale transaction. Since a REIT does not pay tax if it pays at least 90% of its taxable income as dividends to its shareholders, any exchange of partnership interests for REIT shares is a taxable transaction for the seller/transferor. However, a seller can transfer property to the UpReit partnership in exchange for partnership units in the UpReit Operating Partnership and this would not be a taxable transaction. The units in the UpReit Operating Partnership are usually convertible into shares of the REIT on a one for one basis at the option of the seller/transferor. The UpReit units also receive the same divided as the common shareholders. This structure not only aids the seller of the real estate, but gives the UpReit an acquisition advantage by being able to offer a nontaxable transaction to sellers, when competing for acquisition opportunities. Below is a diagram showing the typical UpReit structure.

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(Click to enlarge)

Approximately half of all public REITs have an UpReit structure with various ownership interests in their affiliated UpReit Operating Partnerships ranging from 80% to 99%. This means that the public shareholders only own 80%-99% of the REIT and its assets and this valuation discount and related dilution provided by this noncontrolling interest must be taken into account when valuing the net asset value of the REIT. Most REITs show the UpReit interests not owned by the REIT in the stockholders equity section of the balance sheet as a "noncontrolling interest". If the current stock price of a REIT is $30 per share but the REIT only owns a 93% interest in the UpReit Operating Partnership, then the share price should be adjusted for this dilution by 7% or a real price of $27.90 ($30/sh. times 97%). Although the primary owners of REIT stocks are very sophisticated mutual funds and investment managers, I'm not sure they are adjusting their valuation models for this dilution in shares and value.

In the table below are ten REITs with UpReit structures and their current market value and stock price per share, UpReit ownership percentage, common shares outstanding, UpReit partnership units and adjusted market price for the noncontrolling interest.

REIT Market Value (billions) Current Market Price Per Share (7/22/13) REIT Ownership Percentage in UpReit Common Shares Outstanding (millions) UpReit Partnership Units (millions) Adjusted Market Price Per Share
Douglas Emmett, Inc. (NYSE:DEI) $3.77 $26.46 83% 142.57 28.4 (1) $21.96
CBL & Associates Properties, Inc. (NYSE:CBL) $3.93 $23.84 84.7% 164.56 29.5 $20.19
Macerich Company (NYSE:MAC) $9.01 $65.54 93% 137.5 10.2 $60.95
Essex Property Trust, Inc. (NYSE:ESS) $6.43 $169.26 94.5% 38 2.1 $159.95
Apartment Investment and Management Co. (NYSE:AIV) $4.52 $30.96 94.8% 145.91 7.99 $29.35
Hudson Pacific Properties, Inc. (NYSE:HPP) $1.26 $22.41 95.2% 56.07 2.38 $21.33
Equity Residential (NYSE:EQR) $21.15 $58.74 96.2% 360.1 14.2 $56.50
Liberty Property Trust (LRY) $4.78 $39.74 97% 120.25 3.71 $38.54
SL Green Realty Corp. (NYSE:SLG) $8.7 $95 97.25% 91.6 2.58 $92.38
Digital Realty Trust, Inc. (NYSE:DLR) $8.28 $64.51 97.7% 128.41 2.4 $63.02
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(1) Includes long term incentive plan units

As shown in the table above, the common shareholder interests for these ten REITs range from a low of 83% in Douglas Emmett, Inc. to a high of 97.7% in Digital Realty Trust, Inc. The adjusted market price per share is shown in the last column and is the current market price of the stock times the REIT ownership percentage in the UpReit Operating Partnership. Theoretical finance says that this discount should already be reflected in the market prices of the common shares, however, I'm not sure that this unique REIT structure is understood fully by the marketplace.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.