November/December  2009 VOL. 2

Infrastructure REITs:
An effective tool to fund America’s infrastructure needs?

Just a few weeks ago, residents in Northern California experienced one of America’s biggest challenges: decaying infrastructure. Pieces of the 73-year-old Bay Bridge, which carries an average of 280,000 vehicles daily between San Francisco-Oakland, fell from the span onto the roadway.

The bridge, which was closed for several days for repairs, is scheduled to be completely replaced in 2013 at a cost of $6.3 billion. It is just one of thousands of infrastructure projects that need to be addressed, according to the American Society of Civil Engineers, which recently estimated that approximately $2.2 trillion is needed to fund infrastructure over the next five years.

The American Recovery and Reinvestment Act of 2009 acknowledged this reality by earmarking more than $100 billion of government funds for infrastructure-related spending—an amount unseen since the days of Franklin Delano Roosevelt’s presidency. But stimulus money funds only a small portion of the work that needs to be done.

In fact, a great deal more capital is needed, and both the private and public sectors are struggling to find a solution. A recent survey of political officials and business executives, conducted by global law firm Goodwin Proctor, found that nearly 25 percent believe additional private sector investment is the most viable source to finance infrastructure projects and more than half expect private sector investment in infrastructure to climb in 2010.

Many experts contend that real estate investment trusts (REITs) may be an effective tool to fund America’s infrastructure needs. “It’s pretty clear we need a lot of new infrastructure and infrastructure repairs,” says Larry Varellas, leader of Deloitte’s U.S. real estate tax group and a member of its infrastructure team. “The issue is how to finance it, and as we increase the avenues for routing capital into infrastructure, I would hope that REITs would emerge as an investment vehicle.”

Proponents contend that REITs would solve many of the impediments that prevent the private sector from investing in infrastructure—namely, opposition to privatization and unfavorable tax regulation. However, many hurdles must be overcome to make infrastructure REITs a reality—not the least of which is overturning or expanding current REIT law. Moreover, many critics contend that infrastructure would not be an effective asset class for REIT investment even if the Internal Revenue Service (IRS) allows it.

Politics of privatization

An increasing number of banks and investment opportunity firms have launched infrastructure funds, raising more than $180 billion for global infrastructure projects. Research suggests that available equity capital for infrastructure from both U.S. and international institutions skyrocketed from $10 billion in 2004 to $180 billion in 2008.

Previous infrastructure investments, such as the Chicago Skyway and Indiana Toll Road, prove that privatization deals can be successful. Yet, there are many examples that illustrate the challenges of privatization.

For example, the Pennsylvania Turnpike proposed a 75-year lease of a 537-mile, state-owned highway to a private consortium composed of Citi Infrastructure Investors, Abertis Infrastructure and Criteria CaixaCorp. The deal met with heavy opposition from Pennsylvania legislators and the Pennsylvania Turnpike Commission; it collapsed in October 2008 after the legislature failed to grant necessary authorizations.

Indeed, privatizing infrastructure can be politically sensitive. Many Americans are suspicious of turning over public assets to profit-making entities.

Goodwin Proctor’s survey found that six out of 10 respondents believe mixed priorities (due to political agendas) provide the greatest impediment to private sector infrastructure investment. In many instances, state and federal governments can sometimes assume a protectionist role and fail to view themselves as partners with the private sector.

Varellas believes that a REIT structure would address some of the concerns and opposition related to privatization. “Let’s assume that the road you’re driving on is owned by a publicly traded REIT—theoretically you could own shares in the REIT, thereby owning part of the road,” he explains, adding that a REIT could be considered a semi-private owner because of its shareholders and governmental oversight through the SEC.

However, the political overtones of privatization would leave an infrastructure REIT in a particularly vulnerable position when it comes to public opinion and its impact on stock valuations. “Investors are not going to be interested in the politics associated with infrastructure, but they will be interested in the fact that REIT provides consistent returns,” points out Lewis Feldman, a partner in Goodwin Procter’s business law department and a member of the real estate, REITs and real estate capital markets group.

Defining real property

Because of their tax advantages, REITs have successfully attracted a wide variety of investors, ranging from pension funds to life insurance companies to retail investors. In contrast, infrastructure investments have not provided the same tax benefits, according to Donald Zief, managing director at The Schonbraun McCann Group, a New York City-based real estate consulting firm.

Private sector investors evaluate infrastructure assets by the same metric as all other investments: after-tax cash returns. The key to the tax analysis is whether infrastructure constitutes “real estate” or “real property” for various sections of the U.S. Internal Revenue Code (IRC).

To be owned by a REIT, infrastructure assets must be characterized as real estate or real property under the IRC. Under current law, interpretation as real property can be both a benefit and a burden to investors. For example, when infrastructure assets are characterized as real estate, investors may enjoy the substantial tax benefit that REITs provide. On the other hand, such a characterization may subject non-U.S. investors to the burden of the Foreign Investment in Real Property Tax Act (FIRPTA).

The IRS has concluded that certain infrastructure assets—from railroad tracks to broadcasting and cell phone towers—may constitute real property, thereby constituting good REIT assets. Good REIT income will also be created if the revenue streams from such assets are allocated and structured properly.

Recently, the IRS concluded that both an electricity transmission and distribution system and the rental payments from the lease of such a system were “REIT-able,” according to a recent report from Goodwin Proctor. The IRS concluded that the underlying asset is real estate that is producing rental income (not operating income) from a trade or business.

When applied to infrastructure, the distinction between rental income and operating income can be compared to structuring operating leases to facilitate REIT investments in hotels. To avoid characterization as ordinary income from an operating business, the real estate was leased by the REIT to a taxable REIT subsidiary (TRS) so as to separate the revenue stream and value of the real estate from the revenues derived from the operation of the hotel and its other revenue- generating enterprises.

As it relates to infrastructure assets, if the IRS finds that they constitute “good” real property, but generate “bad” REIT income, the REIT could create a TRS. To date, the IRS has taken an expansive view as to what constitutes an interest in real property for these purposes, at least through private letter rulings.

However, there are no official rules or regulations that expressly allow or disallow infrastructure as assets appropriate for REIT investment. As such, many experts and groups, including the National Association of Real Estate Investment Trusts, have lobbied Congress to broaden existing REIT regulation or even establish a new vehicle, an Infrastructure Investment Trust or IIT.

Requires existing cash flow

If legislation were enacted to allow for infrastructure REITs, many industry players contend that these REITs would only be appropriate for certain types of infrastructure assets—the “best” assets and those that already provide steady cash flow.

For example, the privatization deals that have closed in the U.S. to date have not included development projects or any assets that required significant improvements or maintenance. “Investors want to cherry pick the best projects because they’re very serious about low-risk investments,” says Richard Little, director of the Keston Institute for Public Finance and Infrastructure Policy at the University of Southern California. “That’s why they like to buy brownfield toll roads with a track record so they can make revenue projections.”

Indeed, infrastructure REITs would likely not address America’s need for new infrastructure or be able to acquire assets that need significant capital expenditures. Considering the fact that existing REITs with significant development pipelines and redevelopment plans have not been viewed positively in the public markets, it’s highly unlikely an infrastructure REIT would be viewed any differently.
 
“REIT investors demand a significant cash flow from day one,” says Richard Chess, managing partner with Richmond, Va.-based Chess Law Firm. “New infrastructure projects are like any development where there may be no cash flow for the initial years of the investment.”
 
However, REIT infrastructure ownership would allow cities and states to monetize their existing assets to invest in new projects, Varellas says. Moreover, he points out that existing infrastructure investments resemble many real estate investments in that they provide bond-like returns and steady income.

“REITs could emerge as a key lender to an infrastructure owner or operator; they could own the assets, or they could be joint venture partners,” Varellas contends. “But right now, this is all at the embryonic stage and decisions have to be made on the legislative level.”