Wires REITs: The Holy Grail of Income

It sounds crazy at first: carving up pieces of the grid and putting them into real estate investment trusts. But it already has the blessing of the IRS.

To be sure, the spin-off of electric transmission and distribution assets into a real estate investment trust (REIT) is a relatively new idea. But if the trend catches on it could provide the stability and yields that income investors crave.

So far, the REIT structure has been adopted by just a couple of transmission companies. Unfortunately, they’re too small to meet our minimum criteria for income investors.

More recently, however, two Texas-sized (and Texas-based) utilities, CenterPoint Energy Inc. (NYSE: CNP) and Energy Future Holdings (EFH), the utility formerly known as TXU, have each been exploring the possibility of putting their transmission and distribution assets into a REIT structure.

While CenterPoint has only just begun contemplating such a move, EFH is in the process of emerging from Chapter 11 bankruptcy protection and is actively seeking to spin off regulated subsidiary Oncor into a REIT as part of its restructuring plan.

This reorganization is not without controversy, and it must still win over state regulators, who are expected to rule on the plan sometime in March. If approved, the $18 billion proposal would make Oncor the nation’s largest Wires REIT.

The REIT would be created pursuant to a bid for the assets by a consortium led by oil and gas producer Hunt Consolidated. The new structure would split Oncor in two: An asset company would own the infrastructure, leasing the wires to an operating company that would retain the Oncor name and be responsible for running the grid.

Meanwhile, CenterPoint announced in early February that it would be undertaking a strategic review that, in addition to possibly leading to the sale of its stake in master limited partnership Enable Midstream Partners LP (NYSE: ENBL), would also look into adopting the REIT business model for all or part of its utility businesses.

CEO Scott Prochazka said, “The REIT structure has recently received significant attention in the regulated utility industry in Texas and could have substantial potential for CenterPoint.”

We couldn’t agree more about the potential of Wires REITs to deliver a stable, income-producing business model. In recent years, the absence of a master limited partnership (MLP) alternative in the electric utilities space created a vacuum where misguided bankers tried to push inferior, gimmicky, so-called YieldCos that were too small, too volatile and offered negligible tax benefits.

The REIT structure, by contrast, has given retail investors the opportunity to participate in the returns generated by real estate on a tax-advantaged basis for decades.

To obtain favored tax status, a REIT must meet certain income, asset, distribution and stock owner­ship tests. And the IRS has confirmed that transmission and distribution (T&D) assets can qualify for a tax-advantaged REIT struc­ture.

I, myself, am intimately familiar with the Wires REIT structure, as several years ago I advised various multi-billion-dollar funds on creating what could one day be Latin America’s first and largest Wires REIT, though I’ve been sworn to secrecy on that score.

What I can say is that when looking to identify income-oriented investments for these funds, I found the Wires REIT model the most compelling structure for such assets.

And Hunt’s proposal to turn Oncor into a REIT offers income investors sufficient scale for what one day may be considered the safest of the safe investments in the utilities space.

The reason that T&D assets are arguably superior to regulated, vertically integrated utilities is that they don’t have the commodity risks associated with power plants.

And because they make up the smallest portion of a consumer’s electric bill, they are more insulated from drawing the ire of regulators when unexpected cost increases occur.

Regulated T&D assets also enjoy significant stability because they have a virtual monopoly in the service territory in which they operate.

Additionally, transmission assets, which are regulated by the federal government, typically earn the highest authorized returns in the utility sector.

The feds know the grid is costly to expand, and they want to incentivize a buildout to accommodate new renewable and distributed generation.

Consequently, we consider the wires among the most valuable assets of the 21st century electric utility.

Details, Details …

Despite the clear value proposition of a Wires REIT, the structure still has to clear a few hurdles before it can become tomorrow’s ultimate income investment.

Regarding the Energy Futures Holding proposal, Texas regulators have been critical of the very thing that makes this Wires REIT so attractive, namely the tax benefit, which they believe should be shared with ratepayers. Thus, some have threatened to block the deal, though observers suspect that it’s just a negotiating tactic for ratepayers to capture more of the tax windfall.

Either way, there is not a lot of regulatory precedent for Wires REITs, and policymakers at the state and federal levels still have a lot of details to sort out before this investment model could become a staple of the utility industry.

The thorny issues include: 1) state regulators not wanting to cede jurisdiction to the feds; and 2) uncertainty as to how the feds would apply tax benefits to the structure.

Beyond that, most utilities may not be ready to pursue a new structure for their wires assets, since they view transmission as an integral part of their business.

And right now, at least, it’s not an especially pressing matter from a financial standpoint.

From a company perspective, a sponsorship structure allows them to monetize assets at a premium by spinning them off into a new entity, then redeploy the proceeds toward new growth projects.

But in an environment of historically low interest rates, U.S. utilities have had no difficulty finding financing for their transmission infrastructure projects, or any project for that matter. That has been the principal reason that Wires REITs have been slow to form.

However, rates will eventually rise, and when that happens it will become more costly to raise capital, making a tax-advantaged REIT structure much more appealing.

Certainly, it would be great to see another stable income investment opportunity in a world where such opportunities are few and far between.

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