Since 2018, a common trend for mortgage fund managers has been converting or adding a real estate investment trust (“REIT”) to their capital structure.
The two methods to achieve this for an existing fund manager is to (a) convert the existing fund into a REIT; or (b) install a qualified REIT subsidiary (“SUBREIT”) as a wholly owned subsidiary of the fund. This article will weigh the pros and cons for both options.
What is a REIT?
Real Estate Investment Trusts, or REITs, own real estate or real estate related assetsthat meet certain, specific qualifications set forth in the tax code. Being a REIT allows the company to qualify for pass through taxation by meeting certain key requirements set forth in the tax code. In addition, thanks to tax reform, REIT dividends are eligible for the 20% qualified business income deduction, or “QBID”, regardless of the investor’s tax bracket (provided they are not a tax deferred investor, e.g. Individual Retirement Plans).
Most REITs are designed as pooled funds with real estate assets. The key requirements to qualify as a REIT are as follows:
- Must be an entity taxed as a C-corporation
- 90% of its taxable income must be distributed to shareholders in the form of dividends each year
- 75% of its assets must be in real estate, cash, or U.S. Treasuries
- 75% of its gross income must come from real estate related assets
- It must not be “closely held”, meaning no 5 investors may own more than 50% of the REIT; and
- It must have a minimum of 100 shareholders.
In the non-conventional lending industry, mortgage REITs have made a major comeback, thanks to the 20% QBID.
Should I Convert to a REIT or Add a SUBREIT to My Fund?
This becomes the primary question for mortgage fund managers. There are many pros and cons to both options, which are outlined below:
Pros and Cons to REITs and SubREITs
Conversion to REIT
PROS:
- Easier to understand
- If fund already has 100 investors, it may be simpler
- No need to move assets to subsidiary
- 1 tax return and 1 audit*
- No additional entities to manage*
CONS:
- Requires Fund to convert to C-corp tax election (will probably require vote)
- No disposability – once you go REIT, you can’t go back
- May require additional taxable REIT subsidiary
- Will likely require an amendment to the fund’s current waterfall / terms to achieve REIT status.
Adding a SubREIT
PROS:
- Disposability – because it’s a subsidiary, if laws change or REIT loses status, you can eliminate it with minimal disruption to the fund
- Fund can take place of taxable REIT subsidiary
- Minimal fund disruption: maintain economics & fee structure, most likely no vote required, no change to investors’ position
- Minimizes risk for non-compliance of REIT rules
- Commonly used strategy
CONS:
- Requires an additional subsidiary to be formed
- Requires 2 tax returns & 2 financial statements (consolidated but separate).
- May require an additional license for SUBREIT
- Requires asset transfer to the SUBREIT
Today, the SUBREIT is the most commonly used strategy for many of the pros stated above. The biggest reason has to do with the QBID tax benefit, as the legislation that created the QBID will sunset in 2026. Many funds want to maximize their time while it is available, but do not want to unwind or eliminate their funds if it were to sunset. In addition, many fund managers prefer to avoid any disruption to their fund’s existing structure, but also be able to take a carried interest / profit split. For those reasons, the SUBREIT has become the preferred strategy for mortgage funds in pursuing a REIT strategy.
