As a long-time watcher of the master limited partnership (MLP) market, Tortoise Capital Advisors co-founder and former managing director David Schulte had learned to make a habit of keeping his eyes on regulatory rulings surrounding the US energy space. And by 2011, he had seen all the evidence he needed to create one of the first real estate investment trust (REIT) vehicles to own infrastructure assets, as the co-founder and managing director of the CorEnergy Infrastructure Trust.
The infrastructure REIT is an emergent concept aimed at extending some of the risk-return profile characteristics offered by MLPs to two particular types of investors that may otherwise find themselves unable to invest through such vehicles – those with a K-1 aversion and non-US companies.
At first glance, MLPs and REITs can seem fairly similar. After all, as Schulte points out, “in both cases you're talking about a large capital expense on a long-lived asset that doesn't add a lot of value to the overall equity of the upstream company.”
Where they begin to differ, however, is that REITs cannot operate the businesses they own, whereas operation is at the heart of an MLP.
“What MLPs have done is gotten very good at running the trade or business around those assets [they own],” Schulte explains. “We're foreclosed from that activity. REITs have to be passive in nature, so our income has to be rent or interest income – but that can't come from an active trade or business. So even though the assets we would own could be the same, we need to lease them to somebody else who's the operator.”
This leads to the next difference between the two vehicles: since MLPs are operators, owners of MLPs have to pay tax on the operating income generated and passed through to the partnership via a K-1 tax form. REITs, however, use the 1099 form – not the K-1 – since their income is based on rents rather than usage fees.
Says Schulte: “It's ordinary income in character, not operating income, and those dividends paid by the REIT can be owned by any investor – be they taxable, tax exempt, foreign or domestic, institutional or individual. And so there's a much broader investor suitability for REITs than for MLPs, even if both had the same revenue and the same assets inside of them.”
While there are funds that purchase MLP shares in order to create vehicles for tax-exempt investors to participate in the space without being subject to the K-1 requirement – Tortoise Capital Advisors being the first to employ such a platform – the infrastructure REIT makes this possible at the individual asset level.
“Now we've taken the REIT structure that's otherwise well-known and put infrastructure inside of it, for the first time providing access to US infrastructure in an investor-friendly vehicle with no K-1,” says Schulte.
There are also other advantages to using a REIT structure in the energy space. As Hunt Consolidate Services, another player in the infrastructure REIT space explains, REITs are required to pay out 90 percent of their taxable income. Another attractive feature is the level of control that is possible in REITs, where “shareholders have a significant role and vote”, as opposed to MLPs, where general partners make the decisions and limited partners “usually have very little say in the company”.
To understand how infrastructure REITs became possible, we have to go back to the mid-2000s, when letters by the Internal Revenue Service (IRS) indicated that REITs were suitable for the ownership of certain energy infrastructure assets.
One of the first companies to receive an IRS letter ruling was InfraREIT, externally managed by Hunt. Hunt founded Sharyland in the late 1990s, forming the first investor-owned utility since the 1960s. In 2007, the company received a letter ruling from the IRS indicating that its transmission and distribution infrastructure could be considered real estate assets under applicable REIT rules.
Approval from the Public Utilities Commission of Texas (PUCT) followed in 2008 and two years later, InfraREIT was formed with its assets coming from Hunt and founding equity investments from Marubeni Corporation, John Hancock Life Insurance Company, OpTrust Infrastructure and Teachers Insurance and Annuity Association of America, according to information shared by a Hunt spokesperson.
In 2014, however, Hunt bagged a landmark decision for InfraREIT that may have broader implications for the nascent infrastructure REIT market.
Having helped lead development of Competitive Renewable Energy Zone (CREZ) transmission infrastructure on federal land and integrated the transmission and distribution assets it acquired from Cap Rock Energy Corporation into its REIT, Hunt received approval for the arrangement from both the PUCT and – crucially – the Federal Energy Regulatory Commission (FERC). The latter is particularly important because it was the first time FERC allowed a regulated transmission asset to be owned by a REIT.
Fast-forward to 2016 and you have CorEnergy trying to clinch a similarly groundbreaking transaction.
CorEnergy's REIT owns four assets valued at about $700 million across the upstream, midstream and downstream environment. But it is the company's third transaction that could perhaps end up setting a precedent for the midstream space analogous to the precedent established by Hunt in the electricity and distribution space.
In November 2014, CorEnergy bought the FERC-regulated MoGas Pipeline System, which transports natural gas across Missouri and Illinois, for $125 million. As part of the deal, CorEnergy also acquired one of the eight regulated offtakers MoGas serves and, as such, finds itself in the unusual position of being an owner and operator. As such, “MoGas' income is not REIT-qualifying [at the moment],” explains MoGas president Rick Kreul. “We pay federal income tax on MoGas, whereas on other REIT-qualifying assets we don't.”
CorEnergy has signaled to the market that it plans to sell the utility, which would then ostensibly lease the pipeline from CorEnergy, but the firm needs FERC approval to do that. “We're looking to implement a sale and leaseback arrangement – to break up the regulated utility, spin the assets out and then lease them back to MoGas. We plan to put the assets into another CorEnergy sub-entity and have a lease arrangement between the two entities. And that requires FERC approval, because you're pulling assets out of a regulated utility,” Kreul explains.
To date, “many assets have been leased to FERC utilities, but not a pipeline, so FERC wants to review the transaction and make a determination,” says Kreul. He believes there is good chance for a favourable ruling: “It's been done on the electric side, but it hasn't been done on the gas side. We're making an argument that, from a practical standpoint, it shouldn't make a difference whether energy is travelling down a wire or a pipe,” he adds.
That is, CorEnergy is hoping FERC will look at MoGas along the same lines as Hunt's 2014 landmark deal. “That was a precedent-setting transaction and very important because it also satisfied the IRS' REIT test and the PUCT. This decision would do the same thing, only at FERC-level for the midstream oil and gas space. So it's a very important transaction that can add capital to the national transmission grid using a REIT structure – which is very familiar to institutional investors – as a fundraising vehicle,” Schulte argues.
With MLPs having seen better days, the prospect of unlocking a cheaper source of institutional capital could prove very attractive to the government. For the emerging infrastructure REIT market, a widening of its asset base could give it the boost it needs to convince investors it is here to stay.