MEMORANDUM
PRIVILEGED & CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGED / ATTORNEY WORK PRODUCT
CALDERWOOD & HARKNESS LLP 1700 K Street NW, Suite 900
TO: Douglas Fairchild, Partner (Real Estate) Calderwood & Harkness LLP 450 Park Avenue, 28th Floor New York, NY 10022
FROM: Sylvia Hartwell, Partner (Tax) Calderwood & Harkness LLP 1700 K Street NW, Suite 900 Washington, DC 20006
CC: Angela Fontaine, Partner (Real Estate) Grace Nakamura, Associate (Real Estate) Rafael Dominguez, Associate (Real Estate)
DATE: November 20, 2023
RE: Impact of Proposed Portfolio Acquisition on Fairwater Real Estate Investment Trust's REIT Qualification Under Sections 856–860 of the Internal Revenue Code
MATTER NO.: 1036-00004
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I. EXECUTIVE SUMMARY
This memorandum analyzes whether Fairwater Real Estate Investment Trust's ("Fairwater" or the "Company") proposed acquisition of a 14-property Sun Belt logistics and office portfolio (the "Portfolio") from Greystone Meridian Partners Fund III, L.P. ("GMP Fund III" or the "Seller") for a total purchase price of $1,100,000,000 (the "Acquisition") will adversely affect Fairwater's continued qualification as a real estate investment trust ("REIT") under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the "Code"). The analysis encompasses the organizational requirements, income tests, asset tests, distribution requirements, prohibited transaction rules, and related structural considerations applicable to Fairwater under the Code and the Treasury Regulations promulgated thereunder.
Conclusion. Based on our review of the transaction structure, the lease arrangements at each of the 14 properties, the nature and composition of the assets to be acquired, and the operational and financial data provided by Fairwater, its accountants at Ashford Prewitt LLP, and the Seller's data room, we conclude that the Acquisition will not adversely affect Fairwater's continued qualification as a REIT. To the contrary, the Portfolio is composed entirely of "real estate assets" within the meaning of Section 856(c)(5)(B) of the Code, and the rental income generated by the Portfolio constitutes qualifying "rents from real property" under Section 856(d) of the Code. The Acquisition will strengthen Fairwater's compliance margins on both the 75% gross income test and the 75% asset test by adding a substantial pool of qualifying income and qualifying assets to Fairwater's existing portfolio.
Transaction Structure. The Acquisition is structured as an entity-level purchase in which Fairwater will acquire 100% of the membership interests in 14 single-purpose Delaware limited liability companies (each, a "Target Entity"), each of which holds fee simple title to a single property within the Portfolio. Approximately $612,000,000 of existing mortgage debt secured by the properties will be assumed by Fairwater, and the remaining equity consideration of approximately $488,000,000 will be funded in cash through a draw on Fairwater's $750,000,000 unsecured revolving credit facility with Aldgate National Bank, N.A. (the "Revolving Credit Facility"), bearing interest at the Secured Overnight Financing Rate ("SOFR") plus 130 basis points.
Portfolio Overview. The Portfolio consists of 10 logistics properties (warehouse and distribution facilities) and 4 office properties located across five Sun Belt states: Georgia (4 properties), Texas (3 properties), Florida (3 properties), Tennessee (3 properties), and North Carolina (1 property). The Portfolio totals approximately 5,224,000 rentable square feet ("RSF"), with a weighted-average occupancy of 93.2% (96.1% for logistics properties and 82.7% for office properties). Annual in-place base rent across the 87 leases in the Portfolio is $74,800,000, yielding an in-place capitalization rate of 6.80%. The weighted-average remaining lease term across the Portfolio is 5.8 years.
Fairwater's Existing Portfolio. Fairwater is a publicly traded Maryland real estate investment trust listed on the New York Stock Exchange under the ticker symbol "FREIT." As of the fourth quarter of 2023, Fairwater holds 62 logistics, industrial, and suburban office properties across 11 states, totaling approximately 18.4 million RSF. Fairwater's market capitalization is approximately $4.8 billion. The Company is headquartered at 7200 Chesapeake Parkway, Suite 1100, Columbia, Maryland 21044.
Client Contacts. We have coordinated with the following Fairwater representatives in connection with this analysis: Jonathan R. Whitmore, Chief Executive Officer; Patricia Sung-Calloway, Chief Financial Officer; Marcus Devereaux, Executive Vice President — Acquisitions; David Elgin Park, General Counsel; and Camille Oduya, In-House Real Estate Counsel. We have also coordinated with Ashford Prewitt LLP, Fairwater's independent accountants, through Engagement Partner Martin Ashford, CPA, and Tax Partner Naomi Ikeda, CPA, who have provided us with Fairwater's existing REIT compliance data, including quarterly income and asset test computations through the third quarter of 2023.
The balance of this memorandum sets forth our detailed analysis of each of the REIT qualification requirements implicated by the Acquisition.
II. BACKGROUND ON FAIRWATER'S REIT STATUS
A. Fairwater's REIT Election and Structure
Fairwater Real Estate Investment Trust is a Maryland real estate investment trust organized under the laws of the State of Maryland. Fairwater has elected to be treated as a REIT under Section 856(c) of the Code, effective as of the first taxable year in which it commenced operations. Since that time, Fairwater has maintained continuous qualification as a REIT under Sections 856 through 860 of the Code without interruption. Fairwater's federal employer identification number is 52-2198437.
As a publicly traded REIT listed on the New York Stock Exchange, Fairwater is subject to ongoing compliance with the organizational requirements of Section 856(a) and (b), the income tests set forth in Section 856(c)(2) and (c)(3), the asset tests set forth in Section 856(c)(4), and the distribution requirements set forth in Section 857(a). Fairwater is also subject to the prohibited transaction tax under Section 857(b)(6), the excise tax on undistributed income under Section 4981, and various other provisions of the Code applicable to REITs. Fairwater's Board of Trustees and management, in coordination with its legal and accounting advisors, monitor compliance with these requirements on an ongoing quarterly and annual basis.
Fairwater's declaration of trust and bylaws include provisions designed to protect the Company's REIT qualification, including ownership limitations that restrict any person from beneficially or constructively owning more than 9.8% of the outstanding shares of any class or series of Fairwater's stock (in value or number of shares, whichever is more restrictive), consistent with the requirements of Section 856(a)(6) of the Code (the "closely held" prohibition) and Section 856(h) (the "five or fewer" test).
B. Current Portfolio Composition
As of the date of this memorandum, Fairwater owns and operates 62 properties across 11 states, consisting of logistics, industrial, and suburban office properties. Fairwater's existing portfolio totals approximately 18.4 million RSF. The overwhelming majority of the gross income generated by Fairwater's existing portfolio constitutes "rents from real property" within the meaning of Section 856(d) of the Code. Fairwater's quarterly compliance reports prepared by Ashford Prewitt LLP confirm that Fairwater has maintained substantial compliance margins on both the 75% and 95% gross income tests and the 75% asset test throughout its operating history.
Following the Acquisition, Fairwater will hold a total of 76 properties comprising approximately 23.6 million RSF (18.4 million RSF from the existing portfolio plus 5,224,000 RSF from the acquired Portfolio). The addition of the Portfolio properties will expand Fairwater's geographic presence in the Sun Belt region, consistent with the Company's stated investment strategy of focusing on high-growth logistics and office markets in the southeastern and southwestern United States.
C. Post-Acquisition Entity Structure
The Acquisition is structured as an entity-level purchase of 100% of the membership interests in each of the following 14 single-purpose Delaware limited liability companies:
1. GMP Fairfield I LLC
2. GMP Fairfield II LLC
3. GMP Westlake LLC
4. GMP Katy LLC
5. GMP Alliance LLC
6. GMP Lakeland LLC
7. GMP Southport LLC
8. GMP Murfreesboro LLC
9. GMP Buckhead LLC
10. GMP SouthPark LLC
11. GMP Cool Springs LLC
12. GMP Brickell LLC
13. GMP Peachtree LLC
14. GMP Mount Juliet LLC
Each Target Entity is currently organized as a single-member Delaware limited liability company, with GMP Fund III (or an intermediate holding entity thereof) as the sole member. Upon the closing of the Acquisition, Fairwater will become the sole member of each Target Entity.
For federal income tax purposes, a domestic limited liability company with a single owner is treated as a disregarded entity under Treasury Regulation Section 301.7701-3(b)(1)(ii), unless it affirmatively elects to be treated as a corporation. None of the Target Entities has made, or is expected to make, an election to be treated as a corporation. Accordingly, upon acquisition by Fairwater, each Target Entity will be treated as a disregarded entity, and all of the assets, liabilities, income, deductions, and credits of each Target Entity will be treated as directly owned, owed, earned, incurred, and claimed by Fairwater for all federal income tax purposes, including REIT qualification purposes.
This treatment is critical to the analysis that follows, because it means that: (a) Fairwater will be treated as directly owning the underlying real property (rather than holding "securities" of the Target Entities) for purposes of the asset tests; (b) the rental income earned by the Target Entities will be treated as earned directly by Fairwater for purposes of the income tests; and (c) no "taxable REIT subsidiary" ("TRS") treatment is anticipated or required for any Target Entity under Section 856(l) of the Code. The disregarded entity treatment eliminates any concern about the acquisition of "securities" of the Target Entities for purposes of the diversification requirements under Section 856(c)(4)(B) of the Code.
III. REIT INCOME TESTS — SECTION 856(c)(2) AND 856(c)(3)
A. Overview of Income Tests
The Code imposes two gross income tests that a REIT must satisfy annually in order to maintain its REIT qualification:
75% Gross Income Test (Section 856(c)(3)). At least 75% of a REIT's gross income for each taxable year must be derived from the following qualifying sources:
(a) rents from real property, as defined in Section 856(d);
(b) interest on obligations secured by mortgages on real property or on interests in real property;
(c) gain from the sale or other disposition of real property (including interests in real property and interests in mortgages on real property) which is not property described in Section 1221(a)(1) (i.e., not dealer property);
(d) dividends or other distributions on, and gain from the sale or disposition of, transferable shares (or transferable certificates of beneficial interest) in other qualifying REITs;
(e) abatements and refunds of taxes on real property;
(f) income and gain derived from foreclosure property; and
(g) certain other qualifying sources specified in the Code, including qualified temporary investment income during a specified period following receipt of new capital.
95% Gross Income Test (Section 856(c)(2)). At least 95% of a REIT's gross income for each taxable year must be derived from sources qualifying under the 75% gross income test (enumerated above), plus the following additional qualifying sources:
(a) dividends;
(b) interest; and
(c) gain from the sale or disposition of stock or securities (as defined in Section 856(c)(2)(D)).
Both income tests are applied on a taxable-year basis. The consequences of failing either income test can include loss of REIT status, unless the REIT satisfies certain reasonable cause and good faith exceptions and pays a penalty tax. We analyze below the impact of the Portfolio's income on each of these tests.
B. Classification of Portfolio Income
1. Rents from Real Property — Section 856(d). The primary source of income from the Portfolio is rental income generated by the 87 leases in place across the 14 properties. Annual in-place base rent across the Portfolio totals $74,800,000. We have reviewed each of the 87 leases (or, where applicable, the lease abstracts and material excerpts provided in the Seller's virtual data room) and conclude that the rental income payable thereunder constitutes "rents from real property" within the meaning of Section 856(d) of the Code.
The five largest tenants by annual base rent are as follows:
Together, these five tenants account for approximately $33,446,000, or 44.7%, of the Portfolio's total annual in-place base rent. The remaining 82 tenants collectively contribute $41,354,000 in annual base rent.
Impermissible Percentage Rent — Section 856(d)(2)(A). Section 856(d)(2)(A) of the Code provides that "rents from real property" do not include any amount received or accrued, directly or indirectly, with respect to any real property if the determination of such amount depends in whole or in part on the income or profits derived by any person from such property. However, this exclusion does not apply to amounts based on a fixed percentage or percentages of receipts or sales. Our review of the 87 leases confirms that all leases provide for fixed base rent, with periodic escalations structured either as Consumer Price Index ("CPI")-based adjustments or fixed-step increases (e.g., 2.5% or 3.0% annual escalation). A limited number of retail or flex-space leases within the office properties include percentage rent provisions; however, in each case, the percentage rent is calculated as a percentage of the tenant's gross sales (i.e., total receipts), not as a percentage of net income or profits. Percentage rent based on a fixed percentage of gross sales qualifies as "rents from real property" under the express language of Section 856(d)(2)(A). We have identified no lease in which rent is determined by reference to the income or profits of any tenant.
Related-Party Rent — Section 856(d)(2)(B). Section 856(d)(2)(B) of the Code provides that "rents from real property" do not include rent from any person in which the REIT owns, directly or constructively (applying the constructive ownership rules of Section 318 of the Code, as modified by Section 856(d)(5)), a 10% or greater interest, or from any person that owns, directly or constructively, a 10% or greater interest in the REIT (unless the tenant is a TRS of the REIT and certain conditions are met). We have reviewed the organizational structure and ownership information of each of the 87 tenants, as well as Fairwater's shareholder records and beneficial ownership reports, and confirm that none of the 87 tenants is a "related party" to Fairwater within the meaning of Section 856(d)(2)(B). No tenant owns, directly or constructively, 10% or more of Fairwater's outstanding stock, and Fairwater does not own, directly or constructively, 10% or more of any tenant. Accordingly, no rents from the Portfolio are excluded from the definition of "rents from real property" on related-party grounds.
2. Impermissible Tenant Service Income — Section 856(d)(7). Section 856(d)(7) of the Code provides that if a REIT furnishes or renders services to the tenants of a property, or manages or operates the property, other than through (a) an independent contractor from whom the REIT does not derive or receive any income, or (b) a TRS of the REIT, then the services must be of a type "customarily furnished or rendered in connection with the rental of space for occupancy only." If a REIT furnishes non-customary services, the impermissible tenant service income (defined as the amount that would be received for such services if they were rendered at fair market value) is excluded from "rents from real property," and, if the impermissible tenant service income exceeds 1% of all amounts received or accrued (directly or indirectly) with respect to the property, then all of the rent from the property is disqualified.
The properties in the Portfolio are currently managed by Argyle Property Services LLC ("Argyle"), an affiliate of the Seller (Greystone Meridian Partners). Argyle's EIN is 83-2905441, and its office is located at 3300 Peachtree Road NE, Suite 2200, Atlanta, Georgia 30326. The portfolio manager assigned to the Properties is Sean Kilpatrick. Following the closing of the Acquisition, Fairwater intends to transition property management to Fairwater Property Management LLC ("Fairwater PM"), a wholly owned subsidiary of Fairwater (EIN 52-3847291; address: 7200 Chesapeake Parkway, Suite 1150, Columbia, Maryland 21044; SVP Operations: Leah Torrance).
We have reviewed the 63 service contracts currently in place across the Portfolio, including contracts for janitorial services, landscaping and grounds maintenance, HVAC maintenance, elevator maintenance, security, pest control, fire and life safety systems maintenance, and general building maintenance. All of the services provided under these contracts are of a type customarily furnished or rendered in connection with the rental of logistics warehouse/distribution and office space for occupancy. We have identified no service contract that provides impermissible non-customary services to any tenant. Accordingly, no TRS is required to provide tenant services at any of the 14 properties, and no impermissible tenant service income will arise from the Portfolio.
We address the property management transition in greater detail in Section IX of this memorandum.
3. CAM and Operating Expense Recoveries. In addition to base rent, tenants at the Portfolio properties are obligated to reimburse the landlord for their proportionate share of common area maintenance ("CAM") expenses, real property taxes, insurance premiums, and certain other operating expenses, pursuant to the terms of their respective leases. The majority of the logistics leases are structured on a "triple net" basis, under which tenants are responsible for substantially all operating costs, taxes, and insurance. The office leases are generally structured on a "modified gross" or "base year" basis, with tenants responsible for their proportionate share of operating expenses in excess of a base-year amount.
Tenant reimbursements for CAM, real property taxes, insurance, and operating expenses are properly characterized as additional rent and are treated as qualifying "rents from real property" under Section 856(d) of the Code, provided they are amounts received for the use of, or the right to use, real property and do not represent payment for services rendered to the tenant. The estimated annual CAM and operating expense recoveries across the Portfolio are consistent with this treatment and do not include payments for non-customary services. Accordingly, all tenant reimbursement income qualifies under Section 856(d).
4. Interest Income on Assumed Debt. The $612,000,000 of existing mortgage debt to be assumed by Fairwater in connection with the Acquisition does not generate income to Fairwater. Rather, the assumed debt represents obligations of the Target Entities (and, post-closing, of Fairwater as the successor borrower) payable to the following lenders:
Interest payments on these obligations are deductible expenses that reduce Fairwater's REIT taxable income. The assumed debt does not generate qualifying or non-qualifying income to Fairwater and is therefore not relevant to the income test analysis (except insofar as the interest expense reduces REIT taxable income and, consequently, the minimum distribution requirement, as discussed in Section V below).
C. Impact on 75% Gross Income Test
The Portfolio's entire rental income stream — consisting of base rent ($74,800,000 annually), periodic escalations, percentage rent (where applicable), and CAM/operating expense recoveries — qualifies as "rents from real property" under Section 856(d) of the Code. The addition of $74,800,000 in qualifying gross income (before tenant reimbursement income, which is also qualifying) to Fairwater's existing base of qualifying REIT income will materially strengthen Fairwater's compliance margin on the 75% gross income test. We have not identified any source of non-qualifying income in the acquired Portfolio that would count against the 75% threshold.
Conclusion. The Acquisition enhances Fairwater's compliance with the 75% gross income test under Section 856(c)(3) of the Code.
D. Impact on 95% Gross Income Test
Because all of the income from the Portfolio — base rent, escalations, CAM recoveries, and percentage rent — qualifies as "rents from real property" under Section 856(d), it automatically qualifies under the broader 95% gross income test as well. The Portfolio does not generate any dividends, interest income, or other non-real-property income that would need to be separately analyzed under Section 856(c)(2). The Target Entities do not hold marketable securities, do not generate fee income, and do not engage in any activities that produce income outside the categories enumerated in Section 856(c)(2) and (c)(3).
Conclusion. The Acquisition has no adverse impact on Fairwater's compliance with the 95% gross income test under Section 856(c)(2) of the Code. The Portfolio's income is entirely qualifying under both income tests.
IV. REIT ASSET TESTS — SECTION 856(c)(4)
A. Overview of Asset Tests
The Code imposes several asset composition tests that a REIT must satisfy, measured at the close of each calendar quarter in which the REIT acquires securities or other assets or increases its interest in existing securities or assets:
75% Asset Test (Section 856(c)(4)(A)). At least 75% of the value of a REIT's total assets at the close of each calendar quarter must consist of "real estate assets" (as defined in Section 856(c)(5)(B)), cash and cash items (including receivables), and government securities (as defined in Section 856(c)(5)(A)).
25% Securities Test (Section 856(c)(4)(B)(i)). Not more than 25% of the value of a REIT's total assets may be represented by securities (other than those described in the 75% asset test — i.e., other than REIT shares, government securities, and certain other qualifying securities).
5% Issuer Test (Section 856(c)(4)(B)(iii)(I)). The value of any one issuer's securities held by a REIT may not exceed 5% of the value of the REIT's total assets (with exceptions for TRS securities and certain qualifying securities).
10% Issuer Test (Section 856(c)(4)(B)(iii)(II)). A REIT may not hold securities possessing more than 10% of the total voting power or total value of the outstanding securities of any one issuer (with similar exceptions).
TRS Securities Limitation (Section 856(c)(4)(B)(ii)). Not more than 20% of the value of a REIT's total assets may be represented by securities of one or more TRS entities. (This limit was reduced from 25% to 20% by the Tax Cuts and Jobs Act of 2017.)
The asset tests are applied on a quarterly basis. If a REIT satisfies the asset tests at the close of a quarter and subsequently fails them due to changes in the relative values of its assets (as opposed to an acquisition of assets), the REIT is not treated as failing the tests, provided it did not acquire additional non-qualifying securities after the beginning of the quarter. This "look-back" rule provides a limited cushion against market-driven fluctuations.
B. Classification of Acquired Assets
1. Real Estate Assets — Section 856(c)(5)(B). Section 856(c)(5)(B) of the Code defines "real estate assets" to include: (i) real property (including interests in real property and interests in mortgages on real property); (ii) shares (or transferable certificates of beneficial interest) in other qualifying REITs; and (iii) interests in certain temporary qualified investment vehicles. Treasury Regulation Section 1.856-10 provides detailed guidance on the definition of "real property" for REIT purposes, including the concepts of "land," "inherently permanent structures," and "structural components."
All 14 properties within the Portfolio are "real property" within the meaning of Section 856(c)(5)(B) and Treasury Regulation Section 1.856-10. The Portfolio consists of:
• Logistics Properties (10 properties; 4,373,000 RSF): Warehouse, distribution, and logistics facilities. These are inherently permanent structures affixed to land, constituting real property under all applicable authorities. The structures include building shells, roofing systems, loading docks, concrete floors, structural steel, plumbing and electrical systems, HVAC systems, fire suppression systems, and other structural components. Land associated with each property, including parking areas, truck courts, and landscaped areas, is also real property.
• Office Properties (4 properties; 851,000 RSF): Multi-story and single-story office buildings. These are likewise inherently permanent structures constituting real property under all applicable authorities. The structures include structural framing, exterior walls and fenestration, roofing systems, elevators, HVAC systems, plumbing, electrical systems, and other building systems that are structural components of the buildings.
At each property, the land, buildings, structural components, and inherently permanent structures qualify as "real property" under Treasury Regulation Section 1.856-10(d). Leasehold improvements and tenant build-outs at the properties similarly qualify as real property to the extent they constitute structural components or inherently permanent structures. We have reviewed the property descriptions and improvement summaries provided in the due diligence materials and have not identified any leasehold improvement or tenant build-out that would be classified as tangible personal property in a manner that would affect the REIT asset tests.
2. Tangible Personal Property. Each of the 14 properties contains incidental items of tangible personal property, including furniture, fixtures, and equipment in common areas and management offices; maintenance equipment and tools; decorative elements; directory signage; and similar items. These items are typical of commercial real estate properties and are transferred pursuant to the Bill of Sale — Personal Property included as an exhibit to the Purchase and Sale Agreement.
The value of the tangible personal property at each property represents less than 15% of the aggregate fair market value of the real and personal property at such property. This is significant because Section 856(d)(1)(C) of the Code provides that rents attributable to tangible personal property leased in connection with real property do not cause rent to fail to qualify as "rents from real property" if the personal property represents 15% or less of the total fair market value of the real and personal property leased. Based on the appraisals prepared by Stonebridge Valuation Advisors, LLC and our review of the personal property inventories, the tangible personal property at each property is de minimis relative to the value of the underlying real property, well within the 15% safe harbor.
Conclusion. No material non-real-estate assets are being acquired in the Acquisition. The tangible personal property associated with the Portfolio is incidental and does not affect Fairwater's compliance with the REIT asset tests.
3. Disregarded Entity Treatment. As discussed in Section II.C above, because Fairwater will own 100% of the membership interests in each Target Entity LLC, each Target Entity is treated as a disregarded entity for federal income tax purposes under Treasury Regulation Section 301.7701-3(b)(1)(ii). As a consequence, Fairwater is treated as directly owning the underlying real estate assets of each Target Entity. No "securities" of the Target Entities are deemed to be held by Fairwater for purposes of the asset tests, and the diversification tests under Section 856(c)(4)(B) are not implicated. No TRS election has been or will be made with respect to any Target Entity, and no TRS implications arise from the Acquisition.
C. Impact on 75% Asset Test
The total purchase price for the Portfolio is $1,100,000,000 (adjusted to $1,098,930,000 after a $1,070,000 credit related to property condition assessment findings, though for REIT asset testing purposes, the assets are measured at fair market value). The allocated purchase price per Exhibit K to the Purchase and Sale Agreement, based on appraisals prepared by Stonebridge Valuation Advisors, LLC (led by Maureen Alcott, MAI), reflects the fair market value of the individual properties. We expect that the fair market value of the assets as reported for REIT asset test purposes will be consistent with the allocated purchase price.
The entire $1,100,000,000 portfolio (less de minimis tangible personal property, which is immaterial) constitutes "real estate assets" within the meaning of Section 856(c)(5)(B). The addition of this substantial pool of qualifying assets to Fairwater's existing asset base further increases the proportion of real estate assets in Fairwater's total asset base. Fairwater's existing market capitalization is approximately $4.8 billion, and its existing portfolio is composed overwhelmingly of qualifying real estate assets. The incremental addition of $1.1 billion in qualifying real estate assets significantly bolsters the Company's compliance margin on the 75% asset test.
Conclusion. The Acquisition improves Fairwater's compliance with the 75% asset test under Section 856(c)(4)(A) of the Code.
D. Impact on Diversification Tests (25% / 5% / 10%)
Because the 14 Target Entities are disregarded entities for federal income tax purposes (and not TRS entities), the membership interests acquired by Fairwater are not treated as "securities" for purposes of the diversification tests under Section 856(c)(4)(B). Fairwater is treated as directly owning the underlying real estate assets rather than holding securities of an issuer. Accordingly, no new issuer concentration arises from the Acquisition, and the 25%, 5%, and 10% limitations are not implicated.
Conclusion. The Acquisition has no adverse impact on Fairwater's compliance with the 25%/5%/10% diversification tests under Section 856(c)(4)(B) of the Code.
E. Quarterly Testing Considerations
The Acquisition is expected to close on or about May 31, 2024, based on the timeline set forth in the Purchase and Sale Agreement. However, the actual closing date may be delayed to approximately June 6, 2024, due to the timing of lender consent from Pinnacle Federal Bank, N.A. with respect to the change-of-control provisions in the Master Loan Agreement. In either case, the closing is expected to occur during the second quarter of 2024.
If closing occurs in the second quarter of 2024, the REIT asset tests will be evaluated as of the close of that quarter — i.e., June 30, 2024. The draw on the Revolving Credit Facility of approximately $488,000,000 at SOFR plus 130 basis points increases Fairwater's total liabilities but does not create any non-qualifying assets; the proceeds of the draw are immediately deployed to acquire qualifying real estate assets. At the close of the quarter, the assets acquired will be on Fairwater's balance sheet as real estate assets, and the revolver balance will appear as a liability.
We note that cash on hand and the outstanding balance on the Revolving Credit Facility at each quarter-end should be monitored by Fairwater's finance team and Ashford Prewitt LLP to ensure that the 75% asset test threshold is maintained. However, given that the cash proceeds of the revolver draw are immediately deployed to acquire qualifying real estate assets (rather than held as cash or invested in non-qualifying assets), we do not anticipate any compliance issue. Cash and cash items are themselves qualifying assets for purposes of the 75% test, providing an additional buffer.
V. DISTRIBUTION REQUIREMENTS — SECTION 857(a)
A. Overview. Section 857(a)(1) of the Code requires that a REIT distribute to its shareholders, as dividends, an amount equal to at least 90% of its "REIT taxable income" for each taxable year. REIT taxable income is computed without regard to the dividends paid deduction and excluding any net capital gain. A REIT that fails to satisfy this distribution requirement loses its REIT status for the taxable year in question (subject to certain deficiency dividend procedures under Section 860).
In addition, Section 4981 of the Code imposes a 4% excise tax on a REIT to the extent that it does not distribute at least the sum of (a) 85% of its ordinary income for the calendar year, (b) 95% of its capital gain net income for the calendar year, and (c) any undistributed amounts from prior years, by January 31 of the following calendar year (with adjustments).
B. Impact of Acquisition on Distribution Requirements
The Acquisition will increase Fairwater's REIT taxable income by the net rental income generated by the Portfolio, after deduction of the expenses attributable to the Portfolio properties. The key components of this calculation are as follows:
Gross Rental Income. Annual in-place base rent of $74,800,000, plus CAM and operating expense recoveries, escalation income, and any percentage rent. Gross rental income is expected to exceed $74,800,000 on an annualized basis when tenant reimbursements are included.
Interest Expense on Assumed Debt. The annual interest expense on the $612,000,000 of assumed mortgage debt is calculated as follows:
• Pinnacle Federal Bank, N.A.: $421,600,000 × 4.22% = $17,791,520
• Veltrano Capital Lending Corp.: $142,300,000 × 4.68% = $6,659,640
• Sycamore Life Insurance Company: $48,100,000 × 3.95% = $1,899,950
• Total annual interest on assumed debt: approximately $26,351,110
Interest Expense on Revolver Draw. The anticipated draw on the Revolving Credit Facility is approximately $488,000,000. At an assumed SOFR rate of approximately 5.30% (based on current market conditions), the all-in borrowing rate would be approximately 6.60% (SOFR + 130 bps), yielding annual interest expense of approximately $32,208,000. This interest expense is expected to decrease over time as Fairwater repays the revolver balance through operating cash flow, capital recycling, or other financing activities.
Depreciation. The acquired properties will have a stepped-up depreciable basis under the entity-purchase structure (as discussed in Section XI below). Depreciation deductions on the acquired properties will shield a portion of the rental income from REIT taxable income, reducing the minimum distribution requirement. The precise amount of annual depreciation will depend on the final purchase price allocation and any cost segregation studies undertaken post-closing.
Operating Expenses. Property-level operating expenses, including property management fees, insurance, maintenance, and other expenses, are deductible against rental income and further reduce REIT taxable income.
Net Effect. The net increase in Fairwater's REIT taxable income attributable to the Portfolio will be the excess of gross rental income over the sum of interest expense, depreciation, and operating expenses. While the precise amount will depend on the final closing date, the allocated purchase price, and the actual operating results of the properties, the increase in REIT taxable income will require Fairwater to plan its shareholder distributions accordingly. This is a routine cash management and tax planning matter for a REIT of Fairwater's size and sophistication and does not present any threat to Fairwater's REIT status.
Recommendation. We recommend that Fairwater coordinate with Patricia Sung-Calloway (CFO) and Ashford Prewitt LLP (Martin Ashford and Naomi Ikeda) on distribution planning for the remainder of 2024 to ensure that the 90% distribution requirement under Section 857(a)(1) and the excise tax avoidance requirements under Section 4981 are satisfied, taking into account the incremental REIT taxable income from the Portfolio.
VI. PROHIBITED TRANSACTION ANALYSIS — SECTION 857(b)(6)
A. Overview. Section 857(b)(6) of the Code imposes a 100% tax on the "net income derived from prohibited transactions." A "prohibited transaction" is defined as a sale or other disposition of property described in Section 1221(a)(1) of the Code — i.e., property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business (commonly referred to as "dealer property"). The purpose of this provision is to ensure that REITs function as long-term holders and operators of real estate, rather than as dealers or developers engaged in frequent property sales.
Section 857(b)(6)(C) provides a safe harbor from the prohibited transaction tax if certain conditions are met, including, among others, that (i) the REIT held the property for at least two years prior to the sale, (ii) the aggregate expenditures made by the REIT during the two-year period preceding the sale that are includable in the basis of the property do not exceed 30% of the net selling price, and (iii) in the case of a net lease property, the REIT either did not make more than seven sales of property during the taxable year or the aggregate adjusted bases of all properties sold during the taxable year did not exceed 20% of the aggregate adjusted bases of all REIT assets at the beginning of the year (among other requirements, as modified by subsequent legislative changes). The safe harbor requirements have been modified and expanded in recent years, and the specific conditions applicable at the time of any future sale should be carefully evaluated.
B. Analysis. Fairwater is acquiring the Portfolio as a long-term strategic investment intended to expand its Sun Belt logistics footprint, capture below-replacement-cost basis, and benefit from the Portfolio's 6.80% in-place capitalization rate. The Acquisition is consistent with Fairwater's publicly stated investment strategy and is not undertaken with any intent to resell the properties in the near term.
The Seller's motivation for the disposition — end-of-fund-life monetization by GMP Fund III (a 2018-vintage, $2.4 billion private equity real estate fund) — is a function of the Seller's own fund lifecycle and fiduciary obligations to its limited partners. The Seller's "dealer" status (if any) with respect to the properties does not transfer to the Buyer. Fairwater's acquisition of the Portfolio for long-term hold does not give rise to any prohibited transaction risk under Section 857(b)(6).
To the extent Fairwater determines in the future to dispose of any of the acquired properties, such dispositions should be planned and executed in compliance with the safe harbor requirements of Section 857(b)(6)(C), including the two-year holding period and the other conditions described above. Our office should be consulted in advance of any proposed disposition to ensure compliance.
Conclusion. No prohibited transaction risk arises from the Acquisition itself. Future dispositions of properties within the Portfolio should be carefully analyzed for compliance with the safe harbor and the general dealer property rules.
VII. IMPACT OF DEBT ASSUMPTION ON REIT TESTS
A. Assumed Mortgage Debt
In connection with the Acquisition, Fairwater will assume a total of $612,000,000 in existing mortgage indebtedness encumbering the Portfolio properties. The assumed debt is structured as follows:
Pinnacle Federal Bank, N.A. — Master Loan Agreement dated September 15, 2020; outstanding principal balance of $421,600,000; fixed interest rate of 4.22% per annum; maturity date of July 1, 2028. The Pinnacle loan is secured by first priority mortgages (or deeds of trust, as applicable) on eight logistics properties within the Portfolio, designated as Loans 1-A through 1-H. The Master Loan Agreement requires the lender's prior written consent to any direct or indirect change of control of the borrower entities, which consent is a condition to the closing of the Acquisition.
Veltrano Capital Lending Corp. — Loan Agreement dated February 1, 2021; outstanding principal balance of $142,300,000; fixed interest rate of 4.68% per annum; maturity date of March 1, 2029. The Veltrano loan is secured by first priority mortgages (or deeds of trust) on all four office properties within the Portfolio, designated as Loans 2-A through 2-D. The Loan Agreement contains a change-of-control provision requiring the lender's consent to a transfer of the borrower's ownership interests.
Sycamore Life Insurance Company. — Note Purchase Agreement dated November 22, 2019; outstanding principal balance of $48,100,000; fixed interest rate of 3.95% per annum; maturity date of December 1, 2030. The Sycamore debt is secured by two logistics properties within the Portfolio, designated as Loans 3-A and 3-B. The Note Purchase Agreement requires lender consent to any change in the identity of the guarantor or the direct or indirect ownership of the borrower entities.
Change-of-control consents are required from all three lenders as a condition to the closing of the Acquisition. Upon consummation of the Acquisition, Fairwater will replace GMP Fund III (or its designee) as the carve-out guarantor under each of the loan agreements, subject to compliance with the guarantor financial covenants, which include a minimum tangible net worth of $500,000,000 and minimum liquid assets of $50,000,000. Fairwater satisfies both thresholds.
B. Impact on REIT Qualification
The assumption of $612,000,000 in mortgage debt does not create any non-qualifying assets or non-qualifying income for purposes of the REIT income or asset tests. The assumed debt is an obligation payable by Fairwater (as successor borrower) to the lenders; the interest payments made on the debt are deductible operating expenses that reduce Fairwater's REIT taxable income. The mortgage debt is secured by real property that constitutes qualifying "real estate assets" under Section 856(c)(5)(B); the existence of mortgage debt on the properties does not change the character of the underlying assets.
The Code does not impose any leverage limits on REITs. While excessive leverage could raise practical concerns regarding a REIT's ability to satisfy its distribution requirements and maintain adequate liquidity, the level of indebtedness associated with the Portfolio is consistent with market norms for institutional-quality logistics and office properties. Fairwater should, however, monitor its compliance with the financial covenants under the Revolving Credit Facility with Aldgate National Bank, N.A. and under the assumed loan agreements to ensure that the additional indebtedness does not trigger a covenant violation.
Conclusion. The assumption of $612,000,000 in mortgage debt has no adverse impact on Fairwater's REIT qualification.
C. Revolving Credit Facility Draw
Fairwater anticipates drawing approximately $488,000,000 on its $750,000,000 unsecured revolving credit facility with Aldgate National Bank, N.A. (facility dated August 14, 2022) to fund the equity portion of the acquisition price. The Revolving Credit Facility is an unsecured borrowing and does not create a mortgage interest or affect the character of any income received by Fairwater. The interest expense incurred on the revolver draw is deductible and reduces Fairwater's REIT taxable income, thereby reducing the minimum distribution requirement.
The draw on the Revolving Credit Facility does not implicate any of the REIT income or asset tests. The proceeds are immediately deployed to acquire qualifying real estate assets, and the outstanding revolver balance is a liability rather than an asset for balance sheet purposes. To the extent Fairwater holds any undeployed cash from the revolver draw at a quarter-end, such cash qualifies as "cash and cash items" under Section 856(c)(4)(A) and counts as a qualifying asset under the 75% asset test.
VIII. TENANT CONCENTRATION AND RELATED-PARTY CONSIDERATIONS
A. Tenant Concentration
The Portfolio's tenant base is diversified across 87 leases with no single tenant representing more than 11.7% of total Portfolio annual base rent. The largest tenant, Cascade Supply Chain Solutions Inc., contributes $8,736,000 in annual base rent, representing 11.7% of the Portfolio's total. The remaining tenants each contribute less than 10.1% of total Portfolio ABR.
The REIT provisions of the Code do not impose tenant concentration limits per se — that is, there is no statutory requirement that a REIT diversify its tenant base across a minimum number of tenants or cap the percentage of income derived from any single tenant. However, tenant concentration is a factor that affects the risk profile of the REIT's income stream and should be monitored as a matter of prudent business management. For REIT qualification purposes, the relevant consideration is whether each tenant's rent qualifies as "rents from real property" under Section 856(d), which, as discussed in Section III.B.1 above, it does.
B. Related-Party Rent Analysis — Section 856(d)(2)(B)
As set forth in our analysis under Section III.B.1 above, none of the 87 tenants in the Portfolio is "related" to Fairwater within the meaning of Section 856(d)(2)(B) of the Code. Specifically:
(a) No tenant owns, directly or constructively (applying the constructive ownership rules of Section 318 of the Code, as modified by Section 856(d)(5)), 10% or more of the outstanding stock of Fairwater; and
(b) Fairwater does not own, directly or constructively, 10% or more of the total combined voting power or total value of the outstanding stock (or total interests in the assets or net profits, in the case of a tenant that is not a corporation) of any tenant.
This confirmation has been obtained through a review of tenant organizational information provided in the Seller's data room (including certificates of formation, operating agreements, and publicly available organizational records) and Fairwater's own shareholder records and beneficial ownership reports filed with the Securities and Exchange Commission. Based on this review, all rents from the Portfolio tenants qualify as "rents from real property" under Section 856(d) without any related-party disqualification.
We recommend that Fairwater maintain documentation confirming the absence of related-party relationships with each of the Portfolio tenants as part of its ongoing REIT compliance records. Any future changes in the ownership of Fairwater's stock or the ownership interests of any tenant should be evaluated for potential related-party implications.
IX. PROPERTY MANAGEMENT TRANSITION — IMPACT ON REIT STATUS
A. Current Management
The 14 properties in the Portfolio are currently managed by Argyle Property Services LLC ("Argyle"), an affiliate of the Seller (Greystone Meridian Partners). Argyle's principal office is located at 3300 Peachtree Road NE, Suite 2200, Atlanta, Georgia 30326, and its EIN is 83-2905441. The portfolio manager assigned to the Properties is Sean Kilpatrick. Argyle performs property management, leasing coordination, and building operations services across the Portfolio pursuant to property management agreements with each of the Target Entities.
In connection with the Acquisition, Fairwater and Argyle will enter into a 90-day post-closing transition services agreement (the "TSA") pursuant to which Argyle will continue to provide property management services for the Portfolio during the transition period. The TSA provides for a monthly fee of $375,000, resulting in a total transition services fee of $1,125,000 for the 90-day period. During the transition period, Argyle functions as an independent contractor that is not related to Fairwater within the meaning of the REIT provisions of the Code. Accordingly, services provided by Argyle during the transition period do not raise impermissible tenant service income concerns under Section 856(d)(7), regardless of the nature of the services, because Argyle is an independent contractor from which Fairwater does not derive or receive any income.
The fees paid to Argyle under the TSA are deductible operating expenses and do not create any REIT qualification issues.
B. Post-Closing Management
Following the expiration of the 90-day transition period, property management of the Portfolio will be assumed by Fairwater Property Management LLC ("Fairwater PM"), a wholly owned subsidiary of Fairwater. Fairwater PM's EIN is 52-3847291, and its office is located at 7200 Chesapeake Parkway, Suite 1150, Columbia, Maryland 21044. The senior officer responsible for Portfolio operations at Fairwater PM is Leah Torrance, Senior Vice President — Operations.
Because Fairwater PM is a single-member LLC wholly owned by Fairwater, it is treated as a disregarded entity for federal income tax purposes. Services provided by Fairwater PM are treated as services provided by Fairwater itself. Accordingly, the impermissible tenant service income rules of Section 856(d)(7) apply to services provided by Fairwater PM. To avoid the risk of impermissible tenant service income, the services provided by Fairwater PM must be of a type "customarily furnished or rendered in connection with the rental of space for occupancy only."
Based on our review of Fairwater PM's service offerings and the planned scope of services for the Portfolio, Fairwater PM will provide the following services at the Portfolio properties: building maintenance and repair, landscaping and grounds maintenance, janitorial services in common areas, HVAC maintenance, elevator maintenance, fire and life safety systems monitoring and maintenance, security services (including access control and surveillance in common areas), pest control, snow and ice removal (where applicable), and general building operations oversight. All of these services are of a type customarily furnished or rendered in connection with the rental of logistics warehouse/distribution and office space for occupancy. No non-customary services — such as concierge services beyond industry norms, specialized laboratory services, data center management, or other services not typically associated with the rental of commercial space — have been identified or are planned.
Conclusion. The transition from Argyle to Fairwater PM does not create impermissible tenant service income under Section 856(d)(7) of the Code and does not adversely affect Fairwater's REIT qualification. Fairwater PM should be counseled to limit its services to those customarily furnished in connection with the rental of logistics and office space, and any expansion of the service offering in the future should be reviewed for compliance with Section 856(d)(7).
X. TRANSFER TAX AND ACQUISITION COST CONSIDERATIONS
The Acquisition involves the transfer of controlling membership interests in the 14 Target Entities, which may trigger controlling-interest transfer taxes (sometimes referred to as "real estate transfer taxes on entity transfers") in the states where the properties are located. The estimated transfer tax liability across the four applicable states is as follows:
Texas does not impose a real estate transfer tax or a controlling-interest transfer tax, and accordingly no transfer tax is payable in connection with the three Texas properties.
Transfer taxes incurred in connection with the Acquisition are capitalized as part of the acquisition cost basis of the properties. These capitalized costs are included in the depreciable basis of the properties and are recovered through depreciation deductions over the applicable recovery periods. Transfer taxes do not constitute income to Fairwater and therefore do not affect the REIT income tests. Likewise, transfer taxes do not alter the character of the acquired assets for purposes of the REIT asset tests. The capitalized transfer taxes simply increase the tax basis of the qualifying real estate assets.
The following additional acquisition costs are expected to be incurred in connection with the Acquisition:
• Title insurance premiums: $2,420,000
• Survey costs: $196,000
• Legal fees (Calderwood & Harkness LLP): Fee cap of $2,800,000, plus disbursements
• Representations and warranties insurance premium: $1,402,500 (Sentinel Specialty Insurance Company; policy limit of $55,000,000; retention of $11,000,000)
• Lender consent fees: Total of $1,825,625 (Buyer's share: $912,812.50, pursuant to the fee-splitting arrangement set forth in Section 8.4 of the Purchase and Sale Agreement)
Title insurance premiums, survey costs, and legal fees are generally capitalized as part of the acquisition cost basis of the properties or amortized as appropriate under the applicable provisions of the Code. The representations and warranties insurance premium is treated as an acquisition cost and capitalized. Lender consent fees are treated as loan assumption costs and are amortized over the remaining terms of the respective loan agreements.
None of these acquisition costs affects Fairwater's REIT income or asset test calculations in a manner that would jeopardize REIT qualification.
XI. DEPRECIABLE BASIS AND COST RECOVERY
The Acquisition is structured as an entity-level purchase of 100% of the membership interests in each of the 14 Target Entities. Because each Target Entity is a disregarded entity for federal income tax purposes, Fairwater is treated as acquiring the underlying assets of each Target Entity directly. Unlike a tax-free exchange under Section 1031 of the Code (in which the acquired property takes a carryover basis from the relinquished property), the Acquisition is a taxable purchase, and Fairwater obtains a stepped-up basis in the acquired assets equal to the allocated purchase price.
The allocation of the total purchase price among the individual assets of each Target Entity is governed by Section 1060 of the Code and the regulations thereunder, which incorporate the residual allocation methodology of Section 338(b)(5). The agreed-upon allocation is reflected in Exhibit K to the Purchase and Sale Agreement and is based on appraisals prepared by Stonebridge Valuation Advisors, LLC (led by Maureen Alcott, MAI). Both the Buyer and the Seller are required to file consistent allocations on IRS Form 8594 (Asset Acquisition Statement Under Section 1060) in connection with their respective tax returns.
Depreciation of Real Property. The acquired office properties are classified as "nonresidential real property" and are depreciated on a straight-line basis over a 39-year recovery period under Section 168(c) of the Code. The acquired logistics/warehouse properties are similarly classified as "nonresidential real property" (rather than "residential rental property," which has a 27.5-year recovery period) because they are not dwelling units or residential facilities. Accordingly, the logistics properties are also depreciated on a straight-line basis over a 39-year recovery period.
Cost Segregation Opportunity. Following the closing of the Acquisition, Fairwater may elect to commission cost segregation studies for the acquired properties. A cost segregation study is an engineering-based analysis that identifies and reclassifies building components and site improvements into shorter-lived asset categories eligible for accelerated depreciation. Components that qualify as 5-year or 7-year personal property (e.g., certain specialized electrical systems, decorative fixtures, movable partitions, and similar items) or 15-year land improvements (e.g., parking lots, site lighting, fencing, and landscaping) can be depreciated over significantly shorter recovery periods than the 39-year period applicable to the building shell and structural components. In addition, qualifying components may be eligible for bonus depreciation under Section 168(k) of the Code (subject to the phase-down schedule enacted by the Tax Cuts and Jobs Act of 2017).
Accelerated depreciation deductions reduce Fairwater's REIT taxable income for the taxable year in which they are claimed, which in turn reduces the minimum distribution requirement under Section 857(a)(1). This provides Fairwater with greater flexibility in managing its cash flow and distribution planning. We recommend that Fairwater coordinate with Ashford Prewitt LLP on the engagement of a qualified cost segregation firm to perform these studies promptly following the closing.
PCA Credit Adjustment. The Purchase and Sale Agreement provides for a credit of $1,070,000 to the Buyer in respect of property condition assessment findings at certain of the Portfolio properties. This credit reduces the net acquisition price to $1,098,930,000 but does not affect Fairwater's REIT qualification in any respect. The credit is reflected in the final allocation of the purchase price and marginally reduces the depreciable basis of the affected properties.
XII. SUMMARY OF CONCLUSIONS AND RECOMMENDATIONS
A. Conclusions. Based on the analysis set forth in this memorandum, we reach the following conclusions regarding the impact of the proposed Acquisition on Fairwater's continued qualification as a REIT under Sections 856 through 860 of the Code:
1. 75% Gross Income Test (Section 856(c)(3)). All rental income from the 14-property Portfolio — including base rent, periodic escalations, percentage rent, and CAM/operating expense recoveries — qualifies as "rents from real property" under Section 856(d) of the Code. The Acquisition adds $74,800,000 in annual in-place base rent (plus tenant reimbursement income) to Fairwater's qualifying gross income, strengthening the Company's compliance margin on the 75% gross income test.
2. 95% Gross Income Test (Section 856(c)(2)). No non-qualifying income has been identified in the Portfolio. All Portfolio income qualifies under both the 75% and 95% gross income tests. The Acquisition has no adverse impact on the 95% test.
3. 75% Asset Test (Section 856(c)(4)(A)). All assets acquired in the Portfolio — consisting of 10 logistics properties, 4 office properties, and incidental tangible personal property — are "real estate assets" within the meaning of Section 856(c)(5)(B). The addition of approximately $1.1 billion in qualifying real estate assets improves Fairwater's qualifying asset ratio.
4. 25%/5%/10% Diversification Tests (Section 856(c)(4)(B)). Because the 14 Target Entities are disregarded entities for federal income tax purposes, the membership interests acquired by Fairwater are not "securities" for purposes of the diversification tests. No new issuer concentration arises from the Acquisition, and the diversification tests are not adversely affected.
5. Distribution Requirements (Section 857(a)). The Acquisition will increase Fairwater's REIT taxable income by the net rental income from the Portfolio (after deduction of interest expense, depreciation, and operating expenses). This increase requires adjusted distribution planning but is a routine cash management matter that does not threaten Fairwater's REIT status.
6. Prohibited Transactions (Section 857(b)(6)). Fairwater is acquiring the Portfolio as a long-term strategic investment, and no prohibited transaction risk arises from the Acquisition itself. Any future dispositions of Portfolio properties should be planned in compliance with the safe harbor requirements of Section 857(b)(6)(C).
7. Related-Party Rents (Section 856(d)(2)(B)). None of