The real estate investment trust (REIT) structure has been in existence for quite some time. For most of that existence, however, they were largely obscure investments relegated to “mom and pop” investors in search of yield. That’s changed over the last five to 10 years, as REITs have moved into the mainstream and are now on to the radars of institutional money managers. This has raised their profile and the multiples afforded these income producing securities.

REITs are specifically designed to allow investors access to institutional level properties without the cost or ongoing expense of buying and managing a physical building. An integral aspect of these securities is their business structure, which mandates that 90% of earnings be distributed to shareholders. The key is that REITs are considered pass through entities and, thus, don’t pay taxes. The shareholders pay the taxes, with distributions treated like income. Avoiding this double taxation is a huge plus, but if held in a Roth IRA, all taxation of dividends can be avoided. It’s easy to see why REITs have been popular with individual investors and why institutions have gotten on the bandwagon to provide REIT based products, for a fee of course.

Now, however, more and more companies are looking at the benefits of the REIT structure and are weighing the positives of changing from a regular corporation into a REIT. This isn’t, in and of itself, a bad thing, however, the increasing prevalence of such conversions should at least raise an eyebrow or two. There is a material risk that companies could become too aggressive with their conversion, efforts and either cause changes to be made to the REIT structure, or that individual companies could change inappropriately and cause more harm than good for their shareholders.

Some of the converts of the past included paper companies, such as Weyerhaeuser (WH). Paper companies had historically been managed as businesses, but realized that their forests could allow them to qualify for REIT status. Clearly this made sense, since their businesses were, in fact, highly dependent on property-based assets. A more recent example is American Tower (AMT), which owns cell towers—technically a property that involves the rental of “space” on a “building” of sorts.

More recent examples of potential converts include Gaylord Enterprises (GET), which has decided that managing its conference hall properties isn’t as beneficial as simply collecting rent from other companies who might run them. Then there is Iron Mountain (IRM) which provides secure document storage services. Although the company’s business is selling secure storage, that basically breaks down to renting out space at its facilities. It is looking to make the shift to a REIT, having decided that it is no longer a growth business.

It doesn’t appear that there is a near-term risk of companies making inappropriate conversions, however in the recent conversions are seeds of concern. For example, both American Tower and Iron Mountain chose to be regular companies until their growth profiles slowed down—then they chose to convert to REIT status. There are plenty of REITs that focus on growth over dividends, so why should a company that could be a REIT start life as some other entity? Moreover, if that question passes through a regulator’s mind, the next logical question should be, “Does the REIT structure offer advantages that are being exploited in some way by these conversions?”

So far, there appears to be a logical reason for conversion to a REIT in most, if not all, cases. However, Canadian Royalty Trusts had a similar pass through structure that attracted many converts. The stampede to convert from a regular corporation to a Royalty Trust in Canada got so large that Canada eventually decided to, effectively, end the advantages of the structure and, thus, the structure itself. The result, often dubbed the “Halloween Massacre” because of the timing of the announcement of the change on October 31st, 2006, led to a widespread selloff in Canadian Royalty Trust shares. In other words, tax advantaged structures have been abused before and the result wasn’t good for shareholders.

Although the REIT structure doesn’t appear as though it is being abused at present, this is an issue investors in this asset class should consider monitoring. This is particularly true in light of the very high valuations many REITs are currently being afforded. It isn’t much of a stretch to think that a restaurant or retail chain that owns its properties could consider a change to a REIT and, in the process, turn enough heads to cause problems.

At the time of this article’s writing, the author did not have positions in any of the securities mentioned.