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Is infrastructure on the road to REITdom?

By Ryan Chittum

The REIT universe may get a whole lot bigger down the road.

An Internal Revenue Service private-letter ruling a year ago opened an intriguing avenue for a potentially massive expansion of the REIT world: hundreds of billions of dollars in infrastructure assets that either already exist or are needed relatively soon. It has the potential to substantially enlarge what is thought of and classified commonly as real estate for purposes of the REIT rules.

In June 2007, the IRS ruled that an electric transmission and distribution company's wires and pipes meet the definition of real property, and that the relationship between the property's owners and its tenants constituted a true lease. It was the first time the IRS affirmed that this electric infrastructure qualified for inclusion in a REIT. More recently, a second ruling provided breathing room for landlords to generate electricity for tenants.

This could lead the way for other types of infrastructure assets to be classified as REIT ready. "These assets today, by and large, are regulated," says David Miller, a principal with Ernst & Young LLP. "But the need for capital and the efficiency of the REIT vehicle in the marketplace is compelling." He says the market for infrastructure investment is in the trillions of dollars.

Today, most infrastructure tied to energy is controlled by corporations engaged in the energy business. And, many of the existing energy-infrastructure assets that aren't part of energy companies are owned through master limited partnerships (MLPs), which have grown quickly in the last decade or so—they were worth approximately $126 billion at the end of last year, up from just $5.6 billion in 1995, according to Alerian Capital Management and Standard & Poor's.

		Keys to the REIT Highway For a glimpse at how a future class of infrastructure REITs might look five or 10 years down the line, look at datacenter REITs Digital Realty Trust (NYSE: DLR) of San Francisco and DuPont Fabros Technology Inc. (NYSE: DFT) of Washington, D.C. These companies own and run the buildings that house data storage for the Internet, including companies' Web servers and routers. Hossein Fateh, president and chief executive officer of DuPont Fabros, says that while "we're real estate guys, the definition of infrastructure is becoming broader and broader," and his company does have some things in common with infrastructure investments. Indeed, just 40 percent of DuPont Fabros' investors are typical REIT investors, Fateh says. The remainder is split between technology investors and generalists. Bringing other infrastructure assets into the REIT world would also attract new types of investors to the sector. "This is one very bright spot in the REIT world," he says. "I think we're going to see more and more specialized REITs." Fateh expects the rapid growth of the Internet to boost his company's growth faster than office or mall real estate companies. DuPont Fabros sells "available power" to its tenants, which basically means it rents energy, cooling and security infrastructure to them. Tenants, however, pay their own energy bills. Right now the company has 82 megawatts and is constructing four buildings with 74 megawatts that have the capacity to add another 74 megawatts. "It's really growing at the speed of the Internet, but it's real estate," Fateh says. Digital Realty Trust's Build-to-Suite data center.

"Energy-infrastructure assets [held through MLPs] share many of the same characteristics as REITs, such as not having a tax at the entity level," says Tim Toy, a partner at international law firm Bracewell & Giuliani LLP. "But MLPs have some inherent limitations, not only with respect to investors that are tax-exempt institutions, such as pension funds, but also for registered investment companies and mutual funds."

For that reason, some 80 percent of MLPs are owned by individuals versus just 20 percent by institutions. That leaves a lot of investment capital on the table. "I'm a true believer in REITs being a better way to finance energy infrastructure," Toy says.

Public and Private Transactions

For years, governments around the world have tapped private markets for infrastructure investment, but it's been far less common in the United States, especially with respect to bridges, highways and toll roads.

That resistance is fading somewhat as governments at the federal, state and local levels face budget constraints that are limiting their ability to create and improve infrastructure. That, in turn, is hampering economic growth, which is retarded by rotting highways that slow traffic and cause vehicle damage, or aging energy transmission lines that waste electricity and lift power prices.

In the last three years, the U.S. has seen increasing privatization of infrastructure, including high-profile cases in Chicago, Indiana and Pennsylvania. In 2005, Chicago sold a 99-year lease to its Chicago Skyway, an eight-mile toll road, for $1.83 billion. It marked the first privatization of a toll road in the United States.

However, the privatizations have been met with controversy. The new owners of the Chicago Skyway have the right to raise tolls to $5 by 2017, up from just $2 three years ago. The same issue could confront other forms of infrastructure investment, including energy, which is at the top of the political sensitivity meter these days because of soaring prices, though that sector historically has had far more private entities operating in it than have roads. Chicago is also requesting proposals to privatize its second-tier Midway Airport.

Indiana politics also was roiled by the privatization of its Indiana Toll Road in 2006. It sold a 75-year lease to Macquarie Infrastructure Group, the Australian investment firm that's the leader in private infrastructure across the world.

Florida, California and West Virginia also have been involved in public and private partnerships for infrastructure investment over the last few years, to varying degrees of political backlash. Mark Weisdorf, chief investment officer of the infrastructure-investments group at JPMorgan Asset Management, says toll-road privatizations are governed by concession agreements that are thousands of pages long with detailed requirements on how the road must be operated and maintained.

Miller says it's likely that these investments will win rulings like the IRS energy ruling last summer. "A toll road is likely real property for REIT purposes," he says.

Investor Incentives

Why the growing interest by private capital in infrastructure investing? It's not hard to see once you dig into the details just a bit. Infrastructure tends to be must-have, not discretionary, and monopolistic to boot.

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For instance, drivers may be able to bypass a toll road, but it will likely cost them more time and gasoline. Additionally, a government or company that controls such a road doesn't have much competition to fear. The barriers to entry are nearly impossible to overcome. Upfront capital costs are prohibitive, but it's also highly unlikely that a competitor could build a parallel road piggybacking the existing one.

Another component of the infrastructure spectrum is energy distribution lines, which represent similarly recession-proof, competition-resistant assets.

Investors are looking for alternative asset classes that produce consistent cash flows and are protected against inflation, Weisdorf says. Infrastructure assets do just that in ways that are somewhat similar to the benefits of real estate investments. They don't produce spectacular returns because their pricing power and maintenance requirements are heavily regulated, but they tend not to suffer severe downturns in recessionary environments. They're good inflation-protected assets because most of their leases contain provisions that allow for price increases that at least keep pace with inflation.

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Robert P. Thornton, president of the International District Energy Association, which promotes on-site power generation and distribution, says the assets provide "very stable revenue at pretty nice rates of return that are predictable." He says district energy, also known as distributed generation, can provide steady annual returns of 8 percent to 20 percent. That's more than old-line energy assets like power lines, but the principle is similar.

"Macquarie historically has looked at long-life capital assets," Thornton says. "District cooling has a similar profile. There's not a lot of volatility in the revenue, and once the asset is constructed, it's a fairly low-rise asset serving high-profile, sometimes institutional-grade clients."

Its inflation-hedging nature is one reason why infrastructure assets are more popular overseas than in America, Weisdorf says. In the United Kingdom and Australia, for instance, defined benefit pension plans have payouts to retirees pegged to inflation. "If you're a CIO or a pension portfolio manager and your liabilities are growing every year at the rate of inflation, finding assets that grow at the rate of inflation is a very good thing to do," he says.

However, in the U.S., fewer than one quarter of such pension plans are linked directly to inflation, so there hasn't been as much demand for such infrastructure investments.

There hasn't been much supply, either. "Since World War II, governments have always funded, managed and operated toll roads and airports, which is not the case in Europe," Weisdorf says. "Spain and Italy have operated private toll roads for decades."

Splitting the Baby

Additionally, there's going to be serious demand over the next several decades with the country facing an infrastructure crisis. In energy infrastructure alone, the Department of Energy says the transmission system has become congested with little new investment on the horizon.

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According to the U.S. Energy Information Administration, the country's energy consumption will grow by 19 percent between now and 2030. Despite the new efficiency provisions in the 2007 Energy Independence and Security Act, electricity consumption is expected to grow by 1.1 percent each year until 2030. This may not sound alarming, but transmission of generated energy has been made increasingly difficult by wires already at capacity and grid systems incapable of meeting demand.

The interest in the U.S., though increased of late, is not exactly new. In the late 1960s, railroad tracks were ruled to be real property, and microwave signals followed in the 1970s, says Harold Levine, REIT specialist and partner at New York law firm Herrick, Feinstein LLP. "It's been kind of quiet since," he says. However, other non-traditional real estate assets like timber and cell phone towers have been plunked into REITs.

Weisdorf says budget constraints caused by the massive spending on war and homeland security have helped speed up the demand for private infrastructure in the U.S. "The money needed to be spent on homeland security and the military means there's less money to spend on health care, education and the growing amount of deferred maintenance of infrastructure assets."

Private letter rulings by the IRS aren't a broad rule generally applicable to everyone in the industry. They apply only to the specific applicant who requested the ruling. Still, tax attorneys say last year's ruling has stirred interest among energy companies in particular to take advantage of the tax efficiency and access to capital they might get from forming REITs. The tradeoff, the IRS says, is that if companies receive the corporate entity-level REIT tax treatment, they also will have to take the less aggressive depreciation schedules of commercial real estate.

"Before, people were trying to split the baby," Levine says. "If you can treat it as real estate for the purposes of taxes, you've got to take depreciation the same way. The (Internal Revenue) Service is saying they want symmetry if you want it to be real estate."