At its core, a real estate investment trust (REIT) is a company that owns or finances income-producing real estate. While most REITs focus on operating traditional properties like apartment complexes and office buildings, the definition of income-producing real estate has broadened over the years to also include a variety of infrastructure assets, including those in the energy midstream sector like pipelines and storage terminals.
Currently, only one REIT focuses on owning these assets: CorEnergy Infrastructure Trust (NYSE: CORR). However, some energy master limited partnerships (MLPs) are looking into becoming a REIT because it would allow them to tap into real estate investors, who highly value stable cash flow. As such, a REIT conversion could help boost their valuations.
A tool we're trying to figure out how to use
Energy Transfer (NYSE: ET) is one of the largest MLPs by enterprise value. However, the energy midstream behemoth has had trouble raising capital from investors in recent years because they've grown less fond of the MLP structure. While it has some similarities to a REIT -- MLPs need to distribute 90% of their taxable income to keep their tax advantages -- investors can't own them in a retirement account. This issue is one of many that has weighed on the value of most MLPs, leading several to convert into tax-paying corporations.
Some, however, are looking for alternative solutions, including forming a REIT. On Energy Transfer's third-quarter conference call last year, an analyst asked the company's management the following question:
"It seems like in the marketplace there has been a bit of discussion on the REIT structure. … Just wondering if you guys have analyzed that or explored the potential for any of your pipelines to kind of utilize the REIT structure. Is this something that could be of interest to you guys?"
Energy Transfer Executive Vice President and Head of Tax Brad Whitehurst addressed this topic on the call by saying:
"We have looked at it. It is technology that's been around. It doesn't always work as well with operators. But we continue to look at it as possibly being a tool in our toolbox."
As Whitehurst notes, Energy Transfer has kicked around the idea of converting into a REIT. The problem it has encountered is that the structure doesn't work for some customers. That hasn't stopped it from looking at how it might still be a useful tool since, for example, it could form a separate REIT to house assets that wouldn't negatively impact customers.
Not exactly rent
Fellow MLP Magellan Midstream Partners (NYSE: MMP) elaborated on one of the sticking points of becoming a REIT during its fourth-quarter call when asked for its thoughts on the structure by an analyst. CFO Jeffrey Holman answered by saying:
"The restructure is interesting, but our appreciation of it is that the qualifications for rents would not fit with a large proportion of our business model. Tariffs that are not subject to monitor commitments probably are not rents, and that makes it very complicated for us to consider a REIT structure without multiple securities."
CEO Michael Mears followed up those comments by stating:
"And maybe just more clarity on that, the majority of shipments on our refined product pipeline are not done under a contract. They're done only under a posted tariff. And we don't believe that revenue from a posted tariff would qualify under a REIT structure, and if there's no term contract associated with it."
In other words, the primary problem these MLPs have encountered is that the revenue they collect from regulated interstate pipelines isn't rental income but a posted tariff, which is more like a user fee. As such, they don't believe these assets would qualify to be in a REIT because shippers haven't signed a term contract that would be akin to a lease agreement.
However, while these two MLPs can't convert into REITs because many of their assets wouldn't qualify, those backed by long-term contracts could be suitable for a REIT. As such, these companies continue to weigh whether it makes sense to form a separate publicly-traded REIT around those assets. At the moment, both appear as if they'll stick with the status quo, though that could change -- especially if their valuations keep sinking.
An intriguing storyline to watch
Sinking MLP valuations as investors abandon the underperforming structure are forcing management teams to consider their alternatives, including forming a REIT. While they're not in any rush to go that route right now, that could change if MLP valuations don’t improve. That makes it an interesting theme for REIT investors to monitor this year, as a string of partial conversions could provide them with a few more enticing investment options.