I’ve always associated real estate with REITs and pipelines with MLPs. Recently, I heard someone say there are pipeline REITs and real estate MLPs. What am I missing?
Life can get confusing. Let me untangle this one so you have one less thing to worry about.
First, let’s talk hard numbers. There are currently 219 REITs with a market cap of $993 billion. As of June 30th, there were 114 energy MLPs with a market cap of $375 billion. REITs are 56 years old and MLPs are only 35. The chart below compares the investment vehicles over similar periods in their life cycles to show how they have had similar growth trajectories:
REITs and MLPs Have Similar Growth Trajectories
REITs and MLPs are alike in that both have no entity level federal income tax. The two are also typically known for paying above-average yields. The regulations for each, however, differ. REITs must obtain 75% of their income from real property and 75% of the assets a REIT holds must also be real property. For the record, real property is a broader category than real estate. Real property includes real estate plus the legal rights attached to it. Most investors are familiar with both equity and mortgage REITs which earn qualifying income from rent, interest on mortgages, and capital gains from the sales of properties. However, because real property includes more than just land, a REIT can own midstream and even utility assets. For example, take a peek at CorEnergy Infrastructure Trust (CORR). This REIT owns pipelines, storage terminals, and transmission and distribution assets.
For MLPs, 90% of their income must come from qualifying income sources, as defined by Section 7704. For energy MLPs, the most common source is the income or gains from the transportation, processing, storage, refining, marketing, or exploration and production of natural resources. Other qualifying income sources include interest, dividends, real property rents, and gains from the sale of real property. The MLPs that qualify under these lesser-known sources are the minority, but they do exist. An example is Landmark Infrastructure Partners (LMRK), a “real estate MLP” which owns and manages a portfolio of real property interests that they lease to companies in the wireless communication, outdoor advertising, and renewable power generation industries. Or Blackstone Group (BX), a “financial MLP” which collects interest and dividends from its private equity and real estate investments.
So, why would a company that primarily owns pipelines choose a REIT over an MLP and why would a company that primarily owns real property choose an MLP over a REIT? Well, since the CEOs of these companies likely have better things to do than chit-chat with me, I can only speculate, but here are few valid reasons I could see for picking one structure over the other.
- Tax forms – REIT shareholders receive a 1099, MLP unitholders receive a K-1.
- Distribution flexibility – MLPs must follow the distribution guidelines as outlined by their partnership agreements. There are no legal requirements on how much cash must be distributed to investors, however. MLP partnership agreements may allow the general partner to reduce available cash to establish reserves, which reduces the amount of cash available to unitholders. This is why all MLPs don’t have a 1.0x coverage ratio. REITs, on the other hand, are legally required to pay out 90% of their taxable income by law in order to keep their tax-preferred entity status. Therefore, a company’s financial strategy could cause them to choose one vehicle over the other if the option is available.
- Marketplace acceptance – In 2001, REITs became eligible to join S&P indices. In 2015, a new sector under the GICS was created for REITs (previously under Financials), with implementation to occur on August 31, 2016. Through index-linked products, these actions have and could continue to increase the investment opportunity and visibility of REITs as an “alternatives” option in diversified portfolios. MLPs, on the other hand, are currently excluded from major indexes and do not have a separate GICS classification sector.
- Regulation compliance – If you are a company that doesn’t receive 90% of your income from a qualified source per the MLP regulations, it might be that your income does meet the 75% income requirement per the REIT regulations. For this reason, structuring as a REIT could be the best option.
- Control – REITs are a bit more traditional in that they typically have an elected board, whereas MLPs are usually controlled by general partners and rarely owe fiduciary duty to unitholders.
Remember, pipeline REITs and real estate MLPs are still the minorities in each of these investment vehicles, but it’s important to know they exist and the reasons why. Hopefully, I’ve helped untangle this for you a bit, but as always, if you have further questions, please send me an email at [email protected] and I’ll be happy to try my hand at helping you sort out life’s confusions.
2016.07.25 4:30pm CST – Edited to clarify the text explaining distribution flexibility.