In the last write-up, I touched upon some of the questions surrounding HASI's ability to maintain REIT status. After delving further into the subject, I have higher conviction now that the HASI efficiency investments are ineligible from a REIT perspective. This conclusion was reached by dissecting the final Treasury Regulations, the Private Letter Ruling (PLR) #201323016 issued July 20, 2012 and the company's recent risk disclosures in the third quarter 2016 10-Q. Thought process follows, beginning with an excerpt from the final Treasury regulations below:
For these reasons, these final regulations provide that a distinct asset qualifies as a structural component only if the REIT holds its interest in the distinct asset together with a real property interest with respect to the space in the IPS that the distinct asset serves. In addition, as illustrated by Rev. Rul. 73-425, for a mortgage that is secured by a structural component to qualify as a real estate asset under these final regulations, the mortgage also must be secured by the IPS served by the structural component.
To paraphrase, in order for HASI efficiency loan investments to qualify as a REIT asset, it needs to be a mortgage that is secured by the structural component (e.g. HVAC system) and the property to which it is affixed. Our primary concern lies in the company holding a mortgage against the property, described in more detail below.
On the third quarter conference call, CFO J. Brendan Herron states the following:
"Let me be clear. The IRS issues new rules. We have an existing private letter ruling. We don't think that the new rule - regulations that they issued impact our existing private letter ruling. We think that, that was - that we qualify under that and continue to qualify under that. And so, there is no plan right now to go and enter into a dialogue with the IRS."
The company has never elaborated on what is contained in their PLR. In fact, they have made it clear they intend to keep the content of their PLR private. In a Forbes article written around the time of the IPO, Tom Konrad wrote:
Eckel has not been forthcoming about its contents: He told me, "We're keeping the 'private' in 'private letter ruling.'"
As I have said before, I believe the redacted PLR obtained online was issued to HASI. The description of the business, the particular transactions in question, and the time line all match up with the HASI IPO. At the bare minimum, it elaborates on the thought process of what is REIT eligible and what is not for transactions in the efficiency space and from my perspective, provides explicit criteria for what constitutes interests in mortgages for the investments in question. Here is the concluding paragraph from the PLR.
The Taxpayer has represented that the Company will in each case have a valid security interest that, in the case of default, provides the holder with the rights of a secured party, including the right to bring a foreclosure action with respect to the Structural Improvements and the real property into which the Structural Improvements have been installed. The security interest in the Structural Improvements (and the building or facility in which they are installed as structural components) are conveyed at the time of financing to secure payments under the financing. Therefore, the Company's interests in the Structural Improvements constitute interests in mortgages on the Structural Improvements and the real property into which the Structural Improvements have been installed.
My rationale for why HASI does not qualify as a REIT:
HASI does not own mortgage interests. The regulations requires that the investment be in the form of a mortgage, and the PLR is clear that security interests in both the Structural Improvement and the real property need to be conveyed at the time of the financing to be construed as a mortgage interest.
Based on discussions with industry participants, my understanding is that no such security interest in the building or facility itself is conveyed at the time of financing. Think about it in practical terms: these are on average very small transactions in relation to the property value. Why would customers provide a mortgage interest on the entire building for financing an energy efficiency project? And if it were indeed a mortgage, why wouldn't the company just describe them as such, rather than going through such extensive effort to describe the local fixture law and how it may or may not apply?
Further, HASI openly acknowledges it may not be able to foreclose on the underlying real property, even though the PLR was issued on the premise that they can foreclose. Their recent risk disclosure in the 10-Q indicates that financing receivables are secured by the Structural Improvement, and by extension through fixture law and UCC, the company surmises they can foreclose on the underlying real property. But they cite various reasons why they can never be sure.
The final Treasury regulations and PLR are pretty clear about the requirements. While the company states they are operating in a manner consistent with the PLR, the fine print of the company disclosures would suggest HASI efficiency investments falls well short of being considered a mortgage interest. This is not just a matter of complying with the new regulations that take effect in 2017 - if I am correct, HASI has been inappropriately electing REIT status since the IPO.
I have laid out why I think HASI never qualified as a REIT from the start. The redacted PLR is available publicly and investors can speak with management to make their own determination. At the moment, the back taxes, penalties, and valuation impact is left to only to our imaginations….but it cannot be good.
Some have commented that the underlying tax characteristics of the dividend as a reason not to worry about the potential need to convert to a Yield Co or MLP. A couple thoughts:
If the IRS challenges their REIT status, per the company's risk disclosure, there could be very substantial penalties. Page 39 of the Third Quarter 10-Q states:
If the IRS were to assert that a significant portion of our financing receivables do not qualify as real estate assets and do not generate income treated as interest income from mortgages on real property, we would fail to satisfy both the gross income requirements and asset requirements applicable to REITs. As a result, we could be required to pay one or more penalty taxes, which could be significant in amount, alter our mix of assets or adjust our business strategy, or we could fail to qualify as a REIT.
Many have pointed out that the dividend is largely a return of capital today. But the complex flip partnership structures utilized to generate these advantageous tax characteristics in their taxable REIT subsidiary do "flip" and the income becomes taxable. You cannot avoid the tax man forever, and the valuation of HASI as a Yield Co would take this into account. While the company can "grow" themselves into smoothing these payments, this cannot persist forever. For a better understanding of this highly complex tax-driven transaction, see the link below. But again, use some common sense: can anything you would ever deem to be a profit be tax free in perpetuity?
Additional food for thought
The inability to qualify as a REIT could result in substantial shareholder turnover in a conversion to a Yield Co or MLP. I have never seen a situation like this. I do not know how the market would price a company that inappropriately elected a tax-advantage status for several years, nor can we appropriately size the potential penalties with certainty.
Based on the information available, I do not believe HASI ever qualified to be a REIT and are taking too much comfort in their ability to convert to a Yield Co. It seems to me that investors are overlooking very significant risks to the company.
To the extent HASI is found to have inappropriately elected REIT status from the beginning, I do not think shareholders will price HASI as a going concern. Confidence in the company and management would be shattered, liabilities would be difficult to quantify, lenders would have a seat at the table (breach of covenant), borrowing costs would go up, and it is difficult to know what the company would have to look like to emerge the other side as a Yield Co or MLP.
My $9 target price applies a 30% discount the current $12 BV per share to account for potential back-taxes and penalties plus a warranted discount to the reduced BV per share to compensate speculative buyers of the stock.
Disclosure: I am/we are short HASI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.