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Fiber company weighs benefits to REIT conversion after tax reform

U.S. tax reform could change the calculus for certain communications infrastructure companies weighing converting into real estate investment trusts, as demonstrated by comments from executives at fiber network operator Zayo Group Holdings Inc.

Just a few years ago, REIT conversion was a hot topic among a range of technology, media and telecom companies — from cell-tower and data center operators to billboard advertisers — looking to benefit from the special tax status afforded to REITs, or companies that own income-producing real estate assets and pay out that income to shareholders as dividends. While the trend has declined in recent years, U.S. tax law changes are raising new considerations for companies still weighing this strategy.

Analysts and industry observers remain divided on whether the tax changes will ultimately nudge those companies exploring a REIT conversion to abandon the process. The recently enacted Tax Cut and Jobs Act lowered the corporate tax rate to 21% from the previous statutory rate of 35%, making the tax efficiency gains for a company considering a REIT conversion comparatively smaller. However, the new tax legislation also included a number of provisions, including new pass-through deductions that will directly benefit REIT investors.

While Zayo is still considering a REIT conversion, executives' most recent comments on the matter stressed that the company's primary focus is its results and operational performance. "That's what's going to unleash value, a lot more so than a REIT conversion," Zayo Chairman and CEO Daniel Caruso said during a Jan. 9 investor conference. Asked whether tax reform had made the company less interested in a conversion, the CEO said it had not changed Zayo executives' thinking, though he noted the "incremental value" from being a REIT "does get tempered a bit" under the new tax structure.

Even so, the CEO acknowledged the tax differential will not impact Zayo in the near or immediate future. "We're not a taxpayer nor will [we] be a taxpayer for a long, long time. So from an actual financial standpoint, it's kind of like neither here nor there," he said, referring to the company's significant U.S. net operating loss carryforwards. According to Zayo's most recent Form 10-K, as of June 30, 2017, the company had a cumulative U.S. federal net operating loss carryforward balance of $1.66 billion, and during the fiscal year ended June 30, 2017, the company utilized $88.6 million of U.S. NOL carryforwards.

"Practically speaking, almost all REITs today pass through 100% of taxable income to their shareholders as dividends," Ron Kuykendall — spokesman for Nareit, a Washington, D.C.-based association representing real estate investment trusts — said in an interview, adding this structure gives most REITs a "100% tax deduction."

Given this, Kuykendall said, "I don't think there is anything at all in the tax reform bill that would influence a company one way or another in becoming a REIT."

Still, other industry observers note there are also advantages under the new tax structure for REIT investors. "I think tax reform makes a conversion more attractive because tax reform provides certain benefits to REITs," Daniel Martinez, an associate at the Stroock law firm, said in an interview, noting that investors will be able to take advantage of a 20% deduction on income from pass-through entities, a standard REIT corporate structure.

Kuykendall agreed that the 20% deduction on pass-through income could positively influence "the appeal of a company to its investors."

John Engle, president of the merchant banking venture Almington Capital, said that overall, while the new tax law may have some effects on the margins, it will likely not be the deciding factor for any company considering a conversion.

"The advantages of REIT conversion tends to be situational and company-specific. In the case of Zayo, the company is clearly looking at the comparatively favorable valuations given to companies in the fiber infrastructure business that have [converted to REIT status] already," Engle said in an interview, adding, "The pressure toward industry consolidation, in REITs generally and fiber particularly, makes conversion continue to make sense, even if the financial boons are muted in some scenarios."