REITs have become all the rage these days as a flood of companies from prisons to billboards to casinos are looking to take advantage of the structure with no double taxation, a low cost of capital, and premium valuations,. Fueled by healthy capital markets, a low interest rate environment, favorable supply/demand dynamics, and an improving outlook for fundamentals, valuations continue to reach new heights. The sector has outperformed the broader market for the last four years, returning over 115% to investors over that time period, or ~21% per year on average, as the vehicles have attracted increased fund flows from domestic and global funds.

As a result, we have seen a number of companies successfully convert to REITs over the last few years to take advantage of market conditions and tax regulations favoring them, including American Tower Corp (NYSE:AMT), Sabra Health Care REIT Inc (NASDAQ:SBRA), Weyerhaeuser Company (NYSE:WY), and W.P. Carey Inc. REIT (NYSE:WPC). Additionally, the backlog of companies that are pursuing REIT status or have announced intentions to explore conversion has multiplied, as companies across the real estate spectrum convert.

What Does REIT Conversion Entail?: Conversion to a REIT can be a very long and expensive process, as REIT qualification carries a number of requirements. In order to claim certain asset types as “real property”, a Private Letter Ruling (PLR) must also be obtained from the IRS. Nonetheless, with the IRS increasingly willing to broadly define “real property”, manyexpect more REIT conversions in more esoteric property types to emerge.

When Does REIT Conversion Make Sense?: REIT conversion can offer a number of benefits, including elimination of double taxation, freeing up capital tied up in real estate, a cost-effective way to distribute cash to shareholders, and expansion of the shareholder base. However, it also carries a number of risks. Simply converting to a REIT does not change underlying fundamentals, and investors need to be mindful of tenant/geographic diversification, management expertise, corporate governance, growth opportunities, and prudent capital management as key factors to success. C-Corps with these characteristics will likely see rapid multiple expansion in their stocks if they convert to REIT status.

How Have Recent REIT Conversions Performed?: Jefferies studied the performance of recent REIT converts and found that the group significantly outperformed REITs since their respective conversions. In addition, stocks have significantly outperformed the REIT sector (~600 bps) on the day after announcing plans to pursue REIT status, reflecting the market’s positive view on REIT conversion. Jeffries’ analysis suggests the stocks of C-Corps are worth at least 15% to 20% more as REITs just on the tax arbitrage alone.

Who is Expected to Convert?: Following the prison REITs (CXW and GEO), which recently received PLRs, a number of other players are in the process of pursuing REIT conversion or spin-off, including billboard owners CBS Corporation (NYSE:CBS) and Lamar Advertising Co (NASDAQ:LAMR), casino owner Penn National Gaming, Inc (NASDAQ:PENN), and document storage giant Iron Mountain Incorporated (NYSE:IRM) (ASX:IRM).

Where Else Could We See Conversions?: With the IRS becoming more liberal with its interpretation of “real property”, potential for a number of new REIT sectors in the future, including energy infrastructure (midstream pipelines, solar & wind farms, etc), railroads, public infrastructure (private highways, bridges, ports, etc.), farmland, cemeteries, and others. While retail is often sighted asset sales or sale-leaseback transactions are more likely to occur within that sector to monetize real estate. Jefferies also believe MLPs converting to REITs could be compelling.

What Does All This Mean for the Industry?: While the influx of so many new REITs and asset classes is a positive for the industry as a whole, man worry that the wave of conversions could raise some eyebrows from legislators, particularly in light of the US fiscal challenges. Whilethe repeal of the REIT structure is unlikely, some worry that it could potentially draw increased scrutiny and open the door to stricter REIT rules, especially as conversions often lead to LESS not MORE taxes collected by the IRS.  MSCI’s stricter stance on what constitutes real estate may prevent more esoteric REIT property types from inclusion in the RMZ index. This may limit the investor base for such REITs. Therefore, while Jefferies expects a proliferation of REIT conversions, not all REITs will be created equal.