August 01, 2022
Institute for New Economic Thinking
Real Estate Investment Trusts (REITs) are important financial actors that control over $3.5 trillion in gross assets and over 500,000 properties in the U.S. Yet they have been largely ignored because tax rules define them as “passive investors.” They exist as tax “pass through” entities and pay no corporate taxes if they invest at least 75 percent of their assets in real estate, derive 75 percent of their gross income from real property, and pay out at least 90 percent of taxable income (excluding capital gains) as shareholder dividends each year.
In our new report, “The Role of Public REITs in Financialization and Industry Restructuring” (Institute for New Economic Thinking Working Paper 189), we question this conventional view of REITs as passive investors. Our evidence shows that they are financial actors that aggressively buy up property assets and manage them to extract wealth at taxpayers’ expense. They do not simply wait patiently to buy real estate through market transactions, sit back passively, and collect the rent. The case studies in this report suggest that their tax-exempt status should be revisited.
We identify three important ways in which REITs have had a powerful impact on the US economy in general and on productive enterprises more specifically – whether intended or not. We draw on cases from markets where REITs have a major presence – nursing homes, hospitals, and hotels.
First, because REITs were designed to facilitate retail investing in the real estate market, they have become an important mechanism for expanding the financialization of the US economy. That is, they increase the power of finance capital by expanding its reach into larger swaths of the productive economy. They have expanded the pool of capital available for transactions that monetize real property and turn it into tradable assets – financial widgets with little or no connection to the real purpose of the productive enterprises that occupy the properties they own.
Second, REITs have played a major role in industry restructuring and consolidation. They have done so by promoting REITs as a separate asset class – one that should be legally separate from the commercial enterprises that produce goods and services on real estate property. By separating ownership of real property (property company or PropCo) from the enterprises operating on that property (operating company or OpCo), investors may more precisely calculate the returns to capital based on the risk-reward features of the asset class – in this OpCo/PropCo model, real estate assets versus the goods or services produced on the property. And the stock market values these assets differently.
Thus, REITs have grown and expanded their reach by separating real estate assets from productive assets. They have dominated M&A activity in real estate markets due to their tax-exempt status, which allows them to pay higher premiums for properties than non-REIT property owners. As REITs buy up local property and consolidate it into national or global property corporations, they also facilitate the consolidation of the operating companies that become their tenants. That is, they facilitate industry consolidation both at the property level and at the commercial enterprise level.
This is evident in the three sectors analyzed in this study. In healthcare, healthcare REITs have partnered with private equity firms to separate assets into property and operating entities — with REITs financing the expansion and consolidation of PE-owned nursing homes and hospitals into mega-chains with enhanced local, regional, or national market power. The anti-competitive implications of these developments in healthcare have become a major focus of scholarly research and a major concern for political leaders and anti-trust regulators. A similar pattern of concentrated ownership is evident in the hotel sector, where REITs have dominated M&A activity and fostered industry consolidation – both at the level of the hotel real estate and also at the level of the brands and operating companies that manage the property assets.
A third effect of REITs occurs at the level of operating companies and the outcomes for the companies, employees, and consumers. By law, REITs must act as passive investors to retain their tax-exempt status, which means that they cannot interfere with the management or operating decisions of their tenants. This has led to the OpCo/PropCo model described above, which separates property and operations ownership into separate legal entities – entities that by law must maintain arms-length relations. But this separation poses major problems from the standpoint of effective business management and service delivery. That is because productive operations depend importantly on the quality and maintenance of the underlying property. The quality of patient care depends on how well facilities are maintained; hotel revenues depend on customer satisfaction with both services and facilities.
In other words, the separation of property ownership from operations is driven entirely by the financial logic of maximizing returns for investors – NOT the business logic of providing high quality integrated services. The legal requirement for an arms-length relationship between property and operating companies is in conflict with the needs of the business, and ironically, also the ability of real estate owners to make sure that operations on their properties are managed effectively.
To overcome this dilemma, REITs have developed work arounds to allow them to influence or partner with the companies that manage their properties – strategies that are at odds with the original conditions for their tax-exempt status. They have successfully lobbied for legal changes that have freed up REITs to behave more and more like publicly traded corporations, but without paying the corporate taxes that their counterparts pay. These work arounds vary based on different risk-reward assumptions across industries.
Moreover, the cases in this report show how REITs achieve their financial goals through work arounds that directly or indirectly shape the decisions or business strategies of their tenants — and in turn, outcomes for consumers, patients, and employees. However, they bear no legal liability for what happens to the operating company or any of these stakeholders. While these REIT strategies may be technically legal, they undercut the original intent of the laws.
In healthcare, REITs use sale-lease back agreements with healthcare operating companies in which the companies are tenants and the REITs are landlords. These agreements assume that government reimbursement systems provide long term predictable funding mechanisms. The tenants bear all of the profit-loss risks, as well as the costs and risks of property maintenance. Thus, healthcare REITs are viewed as safe investments that yield reliable dividends, almost as safe as bonds. They bear little risk if an operating company fails; and in that event, their properties may be repurposed for a new tenant. Healthcare operating companies in nursing homes and hospitals, however, bear substantial risk of financial failure due to ongoing cost increases and uncertain and unpredictable funding.
Healthcare REITs have teamed up with private equity firms to strip property assets from healthcare providers. Our case studies show how private equity firms have bought out nursing homes and hospitals using extensive debt, and then have sold the underlying property to a REIT, in what is known as a ‘sale-leaseback.’ The PE firms have taken the proceeds from these sales to pay dividends to themselves and their investors, rather than using them to improve healthcare services for patients. The REITs have received inflated rents from healthcare providers, while the healthcare providers have become tenants of the property they formerly owned. Now they are burdened with ‘triple net’ leases in which they pay rent subject to annual escalator clauses (and continue to pay the costs of property maintenance and improvements, taxes, and insurance).
While REITs appear to be passive investors in these cases, a deeper analysis shows how they have made it possible for private equity firms to extract wealth through excessive debt financing; and how they have undermined healthcare providers’ financial stability through charging excessive rents with unsustainable escalator clauses in long-term renewable leases. Our case analyses illustrate how this happens. They include examples in skilled nursing: Healthcare Properties (HCP) (a healthcare REIT) and HCR ManorCare (owned by PE firm Carlyle Partners); and Health Care REIT and Genesis (owned by Formation Capital). In hospitals, they include Medical Properties Trust (a healthcare REIT) and its involvement with Cerberus-owned Steward Health, Leonard Green-owned Prospect Medical Holdings, and LifePoint Healthcare, owned by PE firm Apollo.
In hotels, by contrast, REITs bear most of the risk of profit and loss, as they lease their properties to taxable REIT subsidiaries, which in turn contract with hotel operators — paying them a fee for managing the REIT’s properties and reimbursing them for labor and other expenses. Hotel REITs hide behind the complexity of contracting relationships to argue that they maintain arms-length relations with operators. But their financial concerns over risk management lead them to promote strategies to ‘actively manage’ their assets and drive down hotel operating costs, which became particularly evident during the COVID pandemic.
Notably, if operating companies or their stakeholders suffer negative consequences due to REIT ownership strategies, the REITs bear no liability or responsibility for these outcomes.
In sum, this working paper suggests that scholars and policy makers need to take a much closer look at REIT activities. Their profits and executive compensation have been extraordinary in recent years, with little discomfort caused by the COVID pandemic. Their financial transactions offer little or no transparency, and taxpayers deserve a clear assessment of how much they are subsidizing yet another asset class that may be contributing to greater inequality in the US economy.