How REITS Could Destroy the Gaming Industry

Penn National was the first to launch a gaming REIT, and there could be unintended consequences for the industry. Image source: PENN National.

Financial engineering is all the rage on Wall Street right now, and it's made its way to the gaming market. Real estate investment trusts, known as REITs, have become a popular way to extract value from real-estate-rich gaming companies, and even the rumor of a REIT can send a company's shares soaring.

Penn National Gaming was the first to launch a REIT when it spun off Gaming and Leisure Properties . Recently, Caesars Entertainment has proposed a REIT in the bankruptcy restructuring of its subsidiary, and Pinnacle Entertainment has talked about launching or selling to a REIT, even getting an offer from GLPI.

But REITs are a risky structure in gaming, separating the real estate assets from operations and putting their management in different hands. The two are tied at the hip, and long term, this may be a disaster for the gaming industry.

The Las Vegas Strip as it used to look. Real estate is at the heart of The Strip.

Casinos are real estate It may seem like a casino's operations and its real estate are two different things, but the reality is that a casino's real estate is critical to its operations. If it wasn't, you wouldn't care whether you stayed at Bellagio, or across the street at Bally's. If you've ever been to Las Vegas, however, you know that those two resorts offer very different experiences.

So, what happens to a property when a casino operation's best interest is to build an addition, or demolish a portion of the resort, and the REIT's best interest is not to make those changes? Splitting the real estate and the casino operations into companies with different vested interests doesn't make a lot of sense.

What happens when the lease expires? The next complication comes when leases expire. Penn National has 15-year leases with Gaming and Leisure Properties, with a five-year extension option. At the end of that lease, it will be beneficial for Penn National to negotiate the lowest lease extension possible, while Gaming and Leisure Properties' interest is to maximize the lease, from Penn National or someone else.

It would become even more complicated if a company like Gaming and Leisure Properties were to buy Pinnacle Entertainment's real estate. Could that just become a backdoor acquisition after the 20-year lease is completed?

What do I care about 20 years from now? The problem with financial engineering like REITs is it highly values the short-term interests of hedge funds and activists -- many of whom won't be around in a year or two -- over the long-term interest of the companies themselves.

Real estate is actually one of the biggest assets a gaming company has, and it's an essential piece of the companies' operations. So, why would you want someone else to own that valuable asset?

What happens when your biggest asset is gone? The problems with selling real estate into a REIT won't be seen today, but could spell trouble when the next recession hits. One of the reasons Caesars Entertainment, Penn National, and others survived the recession was because they had real estate to use as collateral to obtain debt.

In a REIT situation, the operating companies would have to fund operations without the backing of real estate, and if revenue declines, they could see profits and debt funding dry up. Instead of having a safety blanket like real estate to fall back on, companies could go bankrupt when the gaming industry goes into a lull.

In my opinion, valuing the short-term interests of hedge funds and searching for tax savings through REITs is a short-term value creator that could have terrible long-term consequences. Consider the downside next time your favorite gaming company talks about a REIT, because it's probably not as good an idea as they want you to think.

The article How REITS Could Destroy the Gaming Industry originally appeared on Fool.com.

Travis Hoium has no position in any stocks mentioned. The Motley Fool is short Caesars Entertainment. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.