Real Estate Investment Trusts (REITs)—companies that own, operate, or finance income-producing real estate—have thrived by breaking the fundamental rules of good business, and two UCLA School of Law professors think they've figured out why. Jason Oh, professor, faculty co-director of the Lowell Milken Institute for Business Law and Policy and the Lowell Milken Chair in Law at UCLA Law, and Andrew Verstein, professor and faculty co-director of the Lowell Milken Institute for Business Law and Policy, have developed the first comprehensive theory explaining why REITs succeed despite governance structures that conventional wisdom suggests should cause them to fail.

In "A Theory of the REIT," published in the Yale Law Journal, Oh and Verstein focus on why REITs thrive precisely because of rules that appear detrimental to business success—namely, their inability to reinvest profits and immunity to hostile takeovers.

In this edited conversation, Oh and Verstein explain how their theory resolves a longstanding puzzle in corporate law and why policymakers should think carefully about proposed changes to REIT regulations.

Your paper argues that REITs are successful because they can't reinvest profits and are immune to takeovers—two things conventional wisdom would tell us is “bad for business.” Can you walk us through why these apparent disadvantages are strengths?

Verstein: It's conventional to think that takeovers help encourage company managers to do a good job, and that the ability to reinvest profits is normally a major advantage of the corporate form because it lets experts figure out the best way to internally allocate funds. So, giving up on the possibility of takeovers and reinvestment would seem to put REITs at a strong disadvantage. But we think that they are successful because they turn those disadvantages into advantages in a way that's interlocking, where each problem solves another problem.

This starts with a fundamental issue in how real estate is taxed and transferred. There are strong tax reasons that people really don't like to sell real estate, instead waiting to transfer real estate when they die. That tax stickiness makes it hard to get real estate to the best users.

Oh: This is a pervasive problem that we see in Los Angeles. There are elderly people who stay in large two-story homes even after their kids leave home and even when they can’t get up and down stairs very well anymore. And why is that? One big reason is that property and income taxes create "lock-in." These are assets that were purchased at much lower prices decades ago and selling that house and moving into a condominium creates an incredible tax cost.

The tax code does allow for tax free transfers to a partnership, so that is one way that real estate does transfer. But there's a special rule that if the partnership sells the property, the tax law is going to go back and tax the person who originally contributed it.

This is a very scary thing for someone who's going to contribute property to a partnership. "Okay, I can make the initial contribution to the partnership without paying any tax, but if they turn around and sell it to a buyer tomorrow, I'm hit with the same tax that I was trying to avoid."

How do REITs solve this problem?

Oh: REITS are takeover proof. Remember Richard Gere in Pretty Woman—he’d buy up a bunch of shares, push management out, and then do whatever he wanted with the assets of the company. Sorry, Richard, it's impossible to do that with a REIT. There are specific tax rules that prevent ownership from becoming too concentrated.

This is reassuring for a person holding valuable real estate and thinking about contributing to a REIT. You can feel pretty comfortable that whoever you're dealing with is going to be the same person a year from now, two years from now, five years from now. You're not worried about Richard Gere swooping in, buying up a bunch of shares and then selling all the real estate, triggering taxes for you and everyone else who contributed property.

Of course, insulating management from being pushed out is its own problem. The tax rules effectively say, "Hey management, you don't have to worry about getting pushed out for poor performance." Now what do you do about that problem? This is where Andrew was referring to these interlocking steps.

One way to prevent managerial overreach is to require them to go out and seek new stock investors anytime they want to acquire a new property. The tax rules require REITs to distribute 90% of their profits each year. REIT managers can’t use their internally generated profits to expand their REIT empire. So they have to do a good enough job to encourage new investment.

Verstein: It's a tax puzzle that's solved by corporate and tax law. And the reason we know this works is because we see REITs everywhere.

Your paper was originally published in 2024. Looking forward, do you have any thoughts or suggestions about how policymakers should evaluate proposed changes to REIT regulations?

Verstein: One suggestion is to remember that things that look like they might be holding REITs back may be, in reality, helping REITs. So, it's challenging for a REIT to pay out its profits every year. It's challenging for a REIT to be restricted in what kinds of business it can conduct. A policymaker who wanted to be pro-REIT might be tempted to soften some of those restrictions. But that may not be good for the industry in the long term. It's precisely that there are restrictions that make this structure feel safe to the people who are trusting it. We should be cautious about liberalizing too many things.

Oh: What has generally happened during economic downturns is a loosening of the requirement for mandatory distributions. But those changes have been temporary, which makes sense. Liberalizing distributions permanently would change the fundamental calculus on the front end of REIT formation. Will property owners be as willing to contribute property to a REIT if they know that management can't be pushed out and can hold onto cash indefinitely? We think not.

Verstein: Maybe there should be REITs for things that have nothing to do with real estate. The REIT structure is helpful for solving some problems that are attendant to real estate investing. But those problems exist outside of real estate investing, too, and they exist anywhere that people have long-lived assets that there's a tax penalty to transferring and yet transfer would be nice for the economy to get things into higher value uses.

Oh: There's nothing magical about real estate. The definition of real estate has expanded over the last 30 years. You might be surprised to find out what is included in real estate now: billboards, prisons, cell towers.

In expanding that definition, the IRS asks themselves, "Does this asset resemble real estate?" We think that's asking the wrong question. The right question is, “Do these assets have the qualities that the REIT structure solves?” If so, maybe something like a REIT could be a good solution.

How do you see your theory fitting into broader corporate governance debates?

Oh: It's like evolutionary biology for organizations. What you see is that some organizational structures really take off and some organizational structures go nowhere. They're in the tax code, they're in corporate law, they're in LLC law, but you don’t see them in the real world. One of the things that drew us to the project is why the REIT? Why has the REIT done so well?

It solves a problem—it solves an important tax real estate problem. And the interesting thing is, if you go to the history of the REIT, REITs didn't really take off when they were first enacted by Congress. It was only when someone figured out you could combine REITs with a partnership to solve a problem. And that's when REITs really took off.

Verstein: That's right. And it took 25 years for people to discover that combination, and nobody cared about REITs in the first 25 years. You are not allowed to contribute real estate to a REIT directly without recognizing tax. You can use a partnership, though, and then you stick a REIT on top of it, and suddenly you have magic.