The Wall Street Journal

REIT Revolution Hits a Bump; The Key Is a Sweet Tax Deal

REITs are on a roll. In the past year, real-estate investment trusts have snapped up cold-storage facilities, psychiatric hospitals, even prisons. One of the most prominent, Starwood Hotels & Resorts Trust , agreed to add ITT Corp. and its Caesars casinos to its portfolio, sparking a rush to buy gaming companies.

Indeed, there is talk that REITs could soon be buying just about anything that is attached to the ground. Some industry executives see them becoming dominant players in hospitals and car dealerships. Manufacturing plants and the timber industry are possibilities, analysts say. REITs "could become the conglomerates of the new millennium," says Richard Ziman, chairman of one in California, Arden Realty Inc.

But their breakneck expansion is drawing critics -- the kind who really count. As part of a revenue-raising proposal, President Clinton is expected to propose cracking down on REITs, or at least on a certain type of highflying REIT that includes Starwood. Word of his plan in The Wall Street Journal Thursday sent the stocks of this privileged type of REIT tumbling.

The plan is sure to be hotly debated. But "if Congress [perceives REITs to be] a way to be in the gaming industry and pay no taxes, that's political dynamite," says Bernard Winograd, chief executive officer of Prudential Real Estate Investors, a unit of Prudential Insurance Co. of America, which sold $1.8 billion worth of properties to REITs last year.

Of course, avoiding taxes is what REITs are all about. Created in 1960 to encourage real-estate investment by people of modest means, REITs don't pay corporate income taxes. For that privilege, they must pay out 95% of their taxable income as dividends, which, of course, are taxed when the individual shareholders pay their personal income taxes. In addition, REITs aren't allowed to directly operate properties, such as hotels, that generate substantial nonrent revenue.

But that is just what the hottest elite REITs can do. "Paired-share REITs," these are called. Thanks to a long-ago "grandfather clause," four publicly held REITS can run operating companies -- and thus shield most of those operating companies' profits from corporate taxes.

This paired-share permutation features an operating company and a REIT that trade as a single stock. Way back in 1984, Congress grew worried about the potential for abuse in such a structure, and put an end to it. But it let the few existing ones continue.

For a long time, nobody paid a great deal of attention to their special status. One reason was that for several years, real estate wasn't such a hot investment. But it got a lot hotter in 1996 and 1997. The stock market also was soaring. And, recognizing the value, companies rushed to buy these paired-share REITs, paying big premiums for their coveted and lucrative structure.

Once those were gone, then what? Well, an opportunist REIT called Crescent Real Estate Equities Co. cooked up a synthetic version of the paired-share REIT.

In this, the REIT itself doesn't own an operating company. Instead, it is affiliated with such a company, one that handles management duties. That company pays most of its revenue to the REIT as rent.

So as far as the REIT is concerned, what it has received isn't income from operating something like a hotel; it is simply rent. And as such, it isn't taxable, so long as 95% of it is passed on to the REIT's shareholders as dividends.

With this structure, the operating company is obviously not tightly bound to the REIT. It is just, one might say, attached by a paper clip. Now, the Crescent structure -- with the informal name of "paper-clip REIT" -- is being widely mimicked.

Underneath the financial mumbo-jumbo, the impact of the REIT frenzy has been far-reaching. Some companies feel they have been forced into unwanted takeovers or felt they had to convert from conventional corporations to REITs because the stock market values REITs so highly. Real-estate prices are climbing in virtually every major city in the country as REITs, flush with cash from public offerings and eager to grow, bid up prices.

Though the current boom is by far the largest, REITs have been popular investments before. In the 1970s, REITs holding mortgages financed a number of high-risk developments. When loans went sour after the 1973 Arab oil embargo, the REITs saw their share prices collapse.

The stock market then remained cool to REITs for years, until the early 1980s. At that point, some managers marketed REITs as a way for the public to invest in apartments and small office buildings. Hospitals, too, realized they could tap the equity markets by spinning off their buildings into a public REIT, to which they paid ever-increasing rents. But when the industry hit a pothole, the rents got harder to pay and many of the REITs were combined again with hospital operating companies.

Although the stock-market value of REITs rose fivefold in the 1980s, that was piddling compared with the recent surge.

The nation's biggest real-estate investors had been shying away from the REIT structure because they didn't want to pay capital-gains taxes when going public. But in 1992, Taubman Centers Inc.  figured out how to swap its holdings in a way that let it go public while deferring capital-gains taxes.

"That was what unleashed everything," says Chicago real-estate investor Sam Zell, who has since transformed much of his private holdings into REITs. Now chairman of the nation's largest office REIT, Equity Office Properties Trust, and the nation's largest apartment REIT, Equity Residential Properties Trust, Mr. Zell calls REITs "a train that's going down the track that meets every test: liquidity, accountability, predictability."

In seven years, the total market capitalization of REITs has soared to $140 billion from less than $10 billion, and the number of REITs has expanded to about 210 from 119, says the National Association of Real Estate Investment Trusts. Prudential believes that within a decade, REITs could have a market cap of $1.3 trillion -- representing half the investment-grade commercial property in the U.S.

The REIT rush has led to some pretty strange creations, like Prison Realty Trust. D. Robert Crants III and Michael Devlin, two Wall Street financiers, persuaded Mr. Crants' father, Doctor R. Crants, chairman of Corrections Corp. of America , to think differently about his Nashville, Tenn. prison operator. The younger Mr. Crants argued that putting prisons in a REIT would give Corrections Corp. more capital to grow. Starting with nine prisons and five under construction, Prison Realty now has 13 prisons and nine more under construction. It is also negotiating to buy prisons from other private prison operators and from governments.

For the first time, prisons are being viewed as real estate. When Mr. Devlin, now the REIT's chief operating officer, goes back to Wall Street, he tells investors prisons are sturdy assets. "They're built to withstand a lot," he says. "And they won't be subject to real-estate cycles: There's crime in good times and crime in bad times."

Forced to Follow

With the market valuing REITs based on both their dividends and their potential growth, traditional real-estate companies, both public and private, are feeling a pinch. In a decision it wrestled with for some time, Interstate Hotels Inc. of Pittsburgh went public as a garden-variety tax-paying corporation in June 1996. It had been buying luxury hotels and wanted capital to keep growing. But as it acquired properties, Interstate found its stock price badly lagging behind those of REITs with similar operating earnings.

Faced with that reality, Interstate agreed in December to be acquired for $1.34 billion by Patriot American Hospitality Inc. -- one of those four grandfathered -- inpaired-share REITs. Dallas-based Patriot American wanted Interstate's operating expertise, as well as its properties. W. Thomas Parrington Jr., Interstate's chief executive, remarked at the time that Patriot American's tax structure would "give it a competitive advantage in future acquisitions."

Similarly, Rouse Co., the festival-market developers, had been a plain-vanilla public company for more than 40 years. It had paid hardly any federal income taxes because its $5 billion in developments created such big depreciation deductions. But recently it found many of its properties fully depreciated. The tax bill was headed up. "We would have had the worst of all worlds -- paying taxes, and all our competitors wouldn't be paying taxes," says Rouse Chief Financial Officer Jeffrey Donahue. So it became a REIT.

Possible Hazards Ahead

Still, Rouse and others may find the structure a mixed blessing. In the past few years, conditions have been almost perfect: Real-estate rents and prices are rising and interest rates are low, making the yields on REIT stocks alluring to investors. Because REITs pay out so much of their taxable income, they often look to the stock market for the fresh capital they need to grow. But to grow -- and keep the stock market happy -- REITs must continually add to their portfolios. That has led to heavy bidding for properties and pushed properties' selling prices up in many cities. It threatens to become a vicious circle.

Take Houston, which was hammered after oil prices crashed in the mid-1980s. Though occupancy was improving, the office market was still in a funk as recently as mid-1996. Crescent bought a huge and somewhat dowdy 4.2 million-square-foot complex, Greenway Plaza, there for just $48 a square foot that fall. But then came a series of property sales in which REITs won nearly every major deal.

Last year, Crescent paid approximately $115 a square foot for the U.S. Home building, a middling tower near the posh Galleria area. The better properties, which brought rents of about $14 a foot per year just 18 months ago, now command rents in the high teens. Around the same time, Equity Office Properties shocked the Houston market by paying an estimated $130 to $140 a square foot for the 574,000-square-foot Destec building in suburban Houston.

The price was partly due to Destec's premier image, but it also reflected a pumped-up market. The building, while collecting some of the highest rents in the city, could face competition, because it is surrounded by several prime development sites and Houston is one of the easiest cities in which to build.

Equity Office Properties officials say they bought the building well below replacement cost and expect big savings on items like janitorial contracts as they add it to their Houston portfolio. "The winner [of an auction] is always accused of overpaying," says Thomas Bakke, an Equity Office vice president. "We had the foresight to overpay."

Ways to Join Forces

Even if the government clamps down on the hottest REITs, the paired-share elite, executives are confident they will find new ways to both grow and enjoy their tax breaks. Using two perfectly legitimate structures -- a REIT and a regular corporation -- Crescent chief executive officer Gerald Haddock boasts that he could buy a company like McDonald's Corp., put the real estate in the REIT, and use the operating corporation to run the restaurant chain.

Crescent is using that structure to buy Station Casinos Inc. in Las Vegas for $635 million in stock plus the assumption of $919 million of debt. A management affiliate will run the casinos, which generate between $185 million and $195 million in operating profits a year. The deal is structured so that all but about $5 million of that will flow to Crescent in the form of rents, and will thus be protected from taxes. The result is greater potential rewards -- since Crescent will grab the lion's share of any future increase in operating profits -- but also greater risks if operating income falls, Mr. Haddock says. "It's a bet on slot machines," he says.

As REITs like Crescent move into nontraditional areas such as hospitals, car dealerships or fast-food restaurants, growth could accelerate. "You could essentially go down the list of the Fortune 500 and carve out all their real estate," says Larry Raiman, an analyst at Donaldson, Lufkin & Jenrette Securities Corp.

Other REITs are talking about investing abroad, particularly in Japan, where property prices are depressed. Wherever they buy, executives argue, they can free up capital tied up in bricks and mortar and run the buildings more efficiently, allowing operators to focus on their core businesses.

But others worry about what could happen when the REITs hit a tough real-estate market, or lose the lofty stock prices that now fuel their buying binge. In addition, Anthony Downs of the Brookings Institution questions whether REITs have overreached in getting into businesses they know little about.

"Conglomerates haven't proven to be very efficient way to operate," Mr. Downs says. "I don't think it will prove any different with REITs."