Taxes not main factor in A&B change, CEO says

Alexander &Baldwin Inc. is about to join a special group of companies — mostly mainland firms — that funnel almost all their profits to stockholders and qualify for a unique tax break.

The Honolulu-based company next year will start operating as a real estate investment trust, or REIT, after its board voted in July to undertake what it calls a historic transformation.

REITs have attracted considerable publicity in recent years locally because of highly debated, yet unsuccessful, legislative proposals to eliminate a Hawaii income tax break provided to REITs based on federal tax law. Yet A&B said the state tax break wasn’t a prime factor for its decision.

“We converted to a REIT for a lot of very compelling reasons that had nothing to do with income taxes in Hawaii,” company CEO Chris Benjamin said in an interview.

Sheila McGrath, a stock analyst with Evercore ISI who covers A&B, added in an email: “This is not about taxes.”

The biggest reason for the change, Benjamin said, is A&B’s ability to raise cash from stock investors and buy more Hawaii commercial real estate.

A&B, which is already Hawaii’s second-largest retail property owner, expects to sell more stock — and at higher prices — for cash it can use to expand a portfolio now dominated by retail centers that include Pearl Highlands Center, Manoa Marketplace, Waianae Mall, Kaneohe Bay Shopping Center, Waipio Shopping Center and Aikahi Park Shopping Center.

Historically, A&B largely used profits to fund real estate acquisitions.

As part of becoming a REIT, A&B intends to authorize issuing up to 225 million shares of common stock. That compares with a current authorization for 150 million shares and 49 million shares actually issued.

Without the REIT status, A&B contends that its stock is discounted by investors partly because most investors in public real estate companies aren’t interested in A&B because it isn’t a REIT, and thus converting to a REIT should boost demand and prices for A&B stock.

“We were missing out on a very large segment of the investment capital that is out there,” Benjamin said. “We believe the best way for us to continue growing is to have access to capital.”

Other financing advantages A&B expects as a REIT is borrowing money at lower interest rates, and the ability to pay for real estate using “operating partnership units” that can be thought of as a form of A&B stock that gives sellers tax advantages over cash.

“This could open doors for us,” Benjamin said on a conference call with stock analysts in July.

Tax savings are another benefit.

Under federal law, REITs must distribute at least 90 percent of profits to shareholders, so they aren’t required to pay income tax on those distributions. Instead, shareholders pay income tax on what they receive.

Every state except New Hampshire follows the federal practice. But Hawaii lawmakers have considered eliminating this break for several years with urging from local real estate investors who compete with REITs for property and argue that the state loses too much money because most investors in REITs who own very valuable property in Hawaii pay income taxes in home states outside Hawaii.

The state Department of Business, Economic Development and Tourism estimated that REITs saved $36 million on Hawaii income taxes in 2014.

About 40 REITs operate in Hawaii and own retail, hotel, office, apartment, storage and other commercial real estate. One of the biggest is Chicago-based GGP Inc., which owns Ala Moana Center, Whalers Village and Prince Kuhio Plaza.

A&B, which once lost a bid to GGP for buying what is now Ward Village in Kakaako, said it will be able to better compete with big institutional investors, including other REITs, that buy Hawaii property.

While Benjamin said expected tax savings aren’t as important to A&B as other factors, the tax break will still benefit the company.

A&B calculated that if it had been a REIT last year, it would have owed $6.3 million in income tax to the federal government and six states instead of a $2.6 million credit that was largely produced by federal solar tax credits.

A&B’s Hawaii income tax liability last year was $600,000, according to the company’s annual report. In 2015 and 2014, A&B’s Hawaii income tax liability was $4.4 million and $1.9 million, respectively.

A&B said less than 10 percent of its state and local tax liability is from income tax on its commercial real estate business, and that more than 90 percent is from income tax on businesses that aren’t eligible for the REIT tax break — agriculture, paving and development — along with property taxes, general excise taxes and real estate conveyance taxes.

For all the benefits, there is a big cost for A&B becoming a REIT.

The Internal Revenue Service requires that a company converting to a REIT calculate all the past profits it kept as a public company and pay that sum to shareholders. For A&B, which has been public since 1900, 117 years of profits minus paid dividends add up to around $800 million. The company expects to pay shareholders $775 million to $875 million, which includes some taxable income for this year and next year, by the end of January.

A&B intends to pay 80 percent of this bill by issuing stock to shareholders, and paying the roughly $165 million cash portion by borrowing $150 million so that the cost is spread over many years.

Other costs for becoming a REIT, including independent reviews and compliance work, should total $24 million to $28 million, A&B projects.

One operational drawback of being a REIT is that A&B will be limited by IRS rules as to how much business it can do outside of generating rental income from real estate it owns. That includes developing condominium projects for sale, its diversified agricultural operations on Maui, and its road paving and materials subsidiary Grace Pacific.

Benjamin said A&B will focus on acquiring or developing real estate it can hold, and won’t likely develop any more master-planned communities like Wailea or Kukuiula, but can still develop high-rise condos. A&B also can still operate Grace and its farm operations, but these non-REIT operations will be taxed normally.

Having fewer operations that don’t qualify for REIT treatment was a key to A&B’s decision to become a REIT.

Splitting Matson Inc. into an independent company in 2012 and closing its Maui sugar cane plantation last year supported the REIT change, as did an ongoing shift by A&B to sell off most of its mainland commercial properties and load up on Hawaii real estate.

Whether A&B realizes its growth goals as a REIT remains to be seen, especially because its non-REIT businesses and mix of Hawaii real estate that also includes industrial and office properties make it atypical among REITs.

“We will be a unique REIT,” Benjamin said on the analyst conference call. “And so valuing us will be a unique process.”