One of real estate's most popular ownership vehicles has found a niche within infrastructure in the past decade. But will the troubles of the last year scare off investors, or will the clarity brought by regulatory rulings bring more into the space? Andrew Vitelli investigates.
For CorEnergy chief executive David Schulte, the past 18 months have been trying. Turmoil in the energy industry led to bankruptcies of the parent companies of CorEnergy's two largest tenants, Energy XXI and Ultra Petroleum.
“I've been asked many times what keeps you up at night,” Schulte told investors on a March conference call. “Twenty-sixteen kept me up at night for a year, and it's good to have had that behind us.”
But with last year finally in the rear-view mirror, Schulte tells Infrastructure Investor the company's ability to navigate the year's rocky waters without capsising proves the viability of the company and its REIT model of owning infrastructure assets.
“What we've demonstrated is that in a period of incredible stress not only were the assets that we own critical, which is one hallmark of an infrastructure investment, but secondly our contracts were durable,” Schulte explains. “We think that's an absolute validation of our strategy.”
CorEnergy, Schulte notes, continued to collect income during the bankruptcies of Energy XXI and Ultra Petroleum, as the company's monthly rents were regarded as senior obligations. Schulte sees this as a big win for the REIT model in a year full of ups and downs.
Rise of the REITs
A popular vehicle for real estate ownership, REITs function much like a mutual fund, allowing investors to pool money to invest in real estate assets. Created by Congress in 1960, REITs were established to ease raising capital for shopping malls, apartment buildings and other similar projects. Now, total REIT market capitalisation tops $1 trillion.
Along with distributing 90 percent of its taxable income as dividends to shareholders, a REIT must invest at least 75 percent of its total income into and generate 75 percent of its revenue from real estate.
But a 2007 IRS letter to Hunt Consolidated Services, a Dallas-based oil and gas company, determined REITs were in some cases suitable for the ownership of energy infrastructure, in this case the investor-owned Sharyland Utilities in Texas. The Public Utilities Commission of Texas, a state regulator, soon followed suit and in 2010 Hunt formed InfraREIT, with assets coming from Hunt and several founding investors.
Schulte, the co-founder of Tortoise Capital Advisors, had been watching these developments closely and in 2011 collaborated with former Aquila Inc. chairman and chief executive Rick Green to launch CorEnergy Infrastructure Trust. The company focused on acquiring midstream and downstream energy assets across the US.
REITs function in many ways like master limited partnerships, with several key distinctions. For one, unlike an MLP, a REIT cannot operate its assets. The REIT structure allows an operator to maintain operational control of the asset while monetising it.
For investors, the REIT offers several advantages over an MLP. While MLP investors are taxed on their incomes using the K-1, REITs use the simpler 1099 form, opening investment up to non-US companies and the tax-averse.
InfraREIT and CorEnergy each nudged the door a bit more open for innovative REIT uses. In 2014, PUTC and the Federal Energy Regulatory Commission signed off on InfraREIT's acquisition and integration of Cap Rock Energy, the first time FERC allowed a regulated transmission asset to be owned by a REIT.
But in 2016, Texas regulators pushed back.
Hurdles for the Hunts
The Hunts hoped to use the Sharyland model on a much larger scale, putting forth a plan to acquire Oncor, the state's largest transmission and distribution utility, from Dallas-based Energy Future Holdings in bankruptcy proceedings. The deal, worth close to $18 billion, would have dwarfed Sharyland and transformed Oncor into a REIT.
In March 2016, PUCT tripped up the Hunts' plans. Unlike Sharyland, which flew somewhat under the radar, the attempt to acquire Oncor drew much attention – even the state's former governor came out against the sale – and raised a number of concerns.
For one, some within PUCT wanted the tax savings inherent in the REIT model to be passed onto Oncor's consumers. REITs are generally exempt from paying federal corporate income tax, which is instead paid by investors. PUCT ultimately ruled ratepayers should receive at least part of this benefit.
“It is a significant blow for their model,” Timothy Toy, a New Jersey-based attorney focused on REITs, explains to Infrastructure Investor. “Their model has been aggressive in that it doesn't share the benefit of the REIT structure with ratepayers.”
But regulators were also worried about the setup's financial stability. Oncor officials had raised red flags over whether the requirement to pay 90 percent of its income to shareholders would leave the utility without the flexibility needed to handle unexpected changes.
Though the PUCT ruling does not directly affect Sharyland, it has brought scrutiny to the arrangement. A rate case filed last year by Sharyland is currently before PUCT. In its annual report to the SEC, InfraREIT said that its ability to continue operating as a REIT hangs on decisions by regulators.
The Hunts declined to comment for this article.
Regardless of what PUCT determines in the rate case, Toy believes the Hunts' difficulties will serve as a cautionary tale for the infrastructure REIT model. “Don't assume you're going to keep all the benefits,” Toy says. “Design your transaction to share with the ratepayers.”
Better opportunities ahead?
Along with the Hunts' complications, 2016 brought some clarity through several regulatory rulings. One key determination, Schulte says, was an IRS decision opening offshore energy production assets to REIT ownership. CorEnergy had planned on assessing these assets for acquisitions regardless, he adds, but the IRS decision removes some uncertainty and obviates the need to ask for a private letter.
The REIT model also got a boost in September when real estate, previously considered a financial sector subset, was given its own GICS classification. This has drawn more investors into the REIT sector, according to Schulte.
Infrastructure investors seeking out REITs have a solid handful of opportunities. In the telecom space, the REIT model has proven attractive for companies such as American Tower and Windstream Holdings. And Hannon Armstrong, which focuses on renewables, adopted the REIT structure in 2013.
But under existing legislation, opportunities to apply the REIT model to infrastructure may be limited and at times, especially in intra-state projects, subject to the whims of regulators. Some investors see greater possibilities.
CenterSquare, an investment management firm, thinks a REIT-like structure focused on infrastructure could bring significant capital into the nation's roads, railways, airports and energy systems. “The models have some promise, but you need legislation to protect them,” Ted Brooks, the firm's portfolio manager for listed infrastructure, tells Infrastructure Investor. “You've got a lot of potential if the regulators and the legislators are willing to sit down and roll their sleeves up.”
Brooks notes President Trump's promise to generate $1 trillion in infrastructure investment and his interest in putting private capital to work rather than relying on government spending. A structure with a mix of REIT and MLP characteristics would be an effective vehicle to bring investors on board, Brooks says.
Under the correct set-up, Brooks believes such a vehicle could rival the REIT opportunity set.
“The size of the potential asset base – roads, bridges, airports, sea ports – is enormous,” he says. “And given the right incentive schemes, private capital would flock to it.”
But while the topic may be on the minds of investors, Brooks said he has been to Capitol Hill twice since the election and does not see Congress rushing to tackle the issue. Lawmakers are focused on healthcare, immigration and tax reform, while infrastructure is “not important to them at the moment.”