Closing Range

Past, Present, Future Part 2

The transition of timber companies into Real Estate Investment Trusts

Continuing discussion of Montana’s forestry sector, the transformation of industrial wood products companies into Real Estate Investment Trusts (or REIT’s, rhymes with beets) was a complete game changer.

Congress actually created REITs in 1960, intending to create a “tax-preferred” means for small investors to invest in professionally-managed, big-time real estate – basically allowing similar tax “preferences” for humble stockholders in a new kind of corporation, preferences previously reserved for big shots who could throw down millions for a partnership.

Conventional “C-Corporations” pay a 35 percent federal tax on operating income, and stockholders are then expected to cough up another 15 percent on dividends. REITs pay no income tax (but their “taxable REIT subsidiary” must) on profits, 90 percent of which must go to shareholders, who pay 15 percent on their annual capital gains.

How does that work? If you’ve invested $100 in Corp C, and Corp C makes $10, Uncle Sam rakes off $3.50 to start, leaving $6.50. If Corp C gives it all to shareholders (they usually won’t), you’ll get $5.52 as your best-case net after you pay capital gains.

With REITs, 90 percent of all profits must be “distributed” to shareholders – $9 of our REIT’s $10 profit. Pay 15 percent of that, and our shareholder is left with $7.65 net for a $100 stake. Bottom line is, for identical businesses that differ only in tax treatment, the REIT returns at least 38 percent more than a C-Corporation for each invested dollar.

So – is it any surprise Wall Street and the timber industry went nuts? Nope. The tax break alone enabled Plum Creek to gain millions of acres – as a “tax-preferred” REIT, they could pay more for forest land than any competitor could afford.

Besides the tax factor, another huge but little-known aspect of REITs is restrictions on how they can make money. Seventy-five percent of gross REIT revenue must come from sources such as “rents from real property,” “gain from the sale or other disposition” of property and other “real-estate” activities – with another hitch: These activities are expected to be what REIT advisors call “passive,” which Forbes in turn calls “tax code terminology for ‘fat cat.’”

Critically, only 25 percent of a REIT’s total assets can be used for other revenue-producing activities, manufacturing included, which we’ll call “active.” Such active tasks are normally conducted by a “Taxable REIT Subsidiary” or TRS, with the TRS taxed like a regular corporation on those allowable, not-quite-REIT business activities.

Further, only 25 percent of REIT gross revenue can originate from manufacturing – and Congress just cut that number to 20 percent, starting in 2018. However, the after-tax profits sent to the REIT by the “TRS” manufacturing subsidiary don’t count in calculating whether or not the income is “permissible.”

If you find this accounting kabuki strange, keep in mind that REITs have been around since 1960. Only in 1999 did Plum Creek (first founded as a master limited partnership) transition into a REIT – in large part because the company’s asset mix of land (real estate) and mills (manufacturing) was already near the “passive/active” proportions required of a REIT.

How might all these fiscal gymnastics affect Montana?

Well, it is clear that REITs like Plum Creek, and now Weyerhaeuser, are structured to focus primarily on “real estate investment.” Equally clear, REITs with a manufacturing component must pay a higher tax rate on any production profits.

Almost by necessity, making stuff using people is a very low priority for REITs, which explains why, when Plum Creek bought the Champion and Stimson lands, the associated mills were left behind, except for temporary supply contracts. When those supply contracts expired, so did the mills.

That low priority also explains why Ksanka and Pablo were closed and not either mothballed or sold, but quickly dismantled.

Finally, that low priority explains why, as Plum Creek bought millions of acres of timberland all across America, at merger time it owned just three mills, all here in Flathead County.

Now a REIT, milling wood is no longer Weyerhaeuser’s top priority in the United States. Managing their real estate for maximum return to shareholders is now Job One.

How might REITs maximize returns? That’s next.