The US power industry has not widely embraced transmission real estate investment trusts (REITs), but a ramp-up in transmission projects could change that, industry sources told this news service.
REITs make sense for new build transmission and distribution assets, as projects can be structured in a manner appropiate to turn them into REITs after they begin producing an income stream, an industry banker and two industry lawyers said.
“I think the lending markets are getting comfortable with the structure, and as people see more and more of that, they will see REITs as a consideration for new builds,” the banker said.
Transmission REITs could also attract an order of investment that may not otherwise flow into the industry, from foreign investors and retirement funds to investors in annuities, the banker and lawyers said. REIT yields range from 3% to over 6%, depending on the industry, the banker said.
“There are all these people familiar with the REIT asset class and invest in REITS, and they’re not necessarily utility investors, so essentially you bring them into a space that needs a ton of capital over the next couple of decades,” the banker said.
The US utility industry is expected to invest $35bn in transmission over the next three years, according to the Edison Electric Institute.
High valuations of transmission companies like ITC Holdings (NYSE:ITC) may be deterring transmission developers from pursuing a more complex vehicle, the banker speculated. He added that there may not have been enough new build activity for REITs to be widely adopted, but that as construction increases, use of the REIT may, too.
Dewey & LeBoeuf partner Eli Farrah speculated REITs may not be used because interest rates are low.
“The REIT is going to be good for an asset that’s constructed and producing income, and by the time you get to that point, the debt costs are pretty attractive,” Farrah said.
Another reason REITs may not have taken off may be for regulatory reasons, said Dan Watkiss, a partner with Bracewell Guiliani.
“If you were to take a transmission or distribution sytem and spin it off into a REIT, particularly at the transmission level, you’d have to completely take it out of the traditional vertically integrated utility strucutre,” Watkiss said. “Once you do that, the state regulators lose regulatory control because it becomes a standalone transmission asset strictly subject to federal regulation. I think they’re very reluctant to let that happen.”
Developers have been considering the investment vehicle since the IRS in a 2007 public letter ruling said transmission and distribution assets qualified for REITs. The Electric Infrastructure Alliance of America created the first transmission REIT in 2010.
REITs own and operate income-producing real estate but because they are pass-through entities, avoid double taxation. Among the requirements to qualify, a REIT must have 75% of its assets in REIT-type real estate assets or cash and equivalents, have at least 100 investors, and pay out 90% of its income.
By being able to sell interest in a REIT to investors who may not have the same return hurdles that others might have, like private equity, a REIT has access to capital at a lower cost, Farrah noted.
“To me the economics work today and you don’t need a different capital markets environment or anything like that,” the banker said, adding that transmission REITs will play a more prelevant role in the industry given the passage of time and increased visibility.