Let’s talk about what REITs are, how they work, and the circumstances where they make sense.
First, a real estate investment trust buys real estate placing those assets in a trust, with the trust leasing the assets back to the original owner. The trust then sells shares to investors. In theory, if all goes well, the investors make a better-than-stock-market return on their investment.
The advantage to the business owner is that a REIT transaction, essentially a sale leaseback of real estate assets, frees up a tremendous amount of previously illiquid cash tied up in hard assets. The disadvantage to a REIT is that the owner gets saddled with a lease in perpetuity plus gives up any potential appreciation in those assets.
There are a few critical issues to consider before saying “yes” to REIT financing. First, what will be the cash flow impact to your company? In order for a REIT to make economic sense, a company must be able to invest the cash received from the REIT asset sale at a greater return than the implied or imputed interest on the new lease payment. To determine the imputed interest on a lease, use a financial calculator entering in the cash you will receive from the REIT as your present cash, zero as the future amount, the lease term (usually 20 years) as the number of payments, and the lease amount as the payment amount. Solve for the interest rate. You will need to be very sure you can invest at a greater return than this rate for the transaction to make economic sense.
Next, consider the long term consequences of selling your hard assets. What is your beyond-20-years plan for your company? If your goal is to transition your company to your children, you may not want to strip the company of its valuable real estate. If you plan to sell your company to an outside buyer, a REIT may force exclusion of buyers who want real estate.
So when do these vehicles make sense? They are most viable for high growth, corporate companies with extremely strong cash flows and the ability to profitably leverage the immediate influx of cash received from the REIT transaction. REITs have long been used in rent driven assets such as retail strip centers, apartment houses, office buildings, etc. where the cash from one project funds the next project.
Finally, if and when you decide to use REIT funding in your business, be sure to read the fine print and have your attorney review any documentation. Because these are market documents, you will have to live by the rules on the document you sign. Remember the big print giveth (the marketing brochure) and the fine print taketh away (the contract).