REITs may bring long-term stability to market.

In 1993, real estate investment trusts played a vital role in the financial markets and built a reputation as the "vehicle of choice" for investment in real estate. But a recent turn in the REIT market suggests that, in 1994, too many REITS could be chasing a declining number of investors.

That's the word from KPMG Peat Marwick's National Real Estate Practice, which recently published a report devoted to the REIT market.

The report, sent to more than 20,000 real estate professionals nationwide, provides guidance on important tax and accounting issues relating to REITS, along with perspective on the process of launching a REIT and what ingredients Wall Street considers key to a successful initial public offering.

"While the party in the REIT market is certainly not over, it looks like it's going to be a lot less fun than it was the past two years," said Roger L. Johnson, the firm's National Industry Director of Real Estate.

"The threat of rising interest rates could drive investors away at a time when a record number of real estate companies are going public," Johnson said. "Should this happen, the market for REIT initial public offerings is going to get increasingly difficult to crack."

A Look Ahead

While Johnson said that financing for real estate - whether in the form of REITS or more traditional financing vehicles - will continue to offer opportunity for investors and asset-holders alike, he predicts that the 1994 REIT market will not be as active as originally expected.

"There's currently an oversupply of new issues and the market is no longer greeting with open arms each and every real estate company that's going public," he said. "The market is demanding performance and yield requirements that many of these new issues may not be able to deliver."

That pressure will continue to increase if interest rates heat up.

"With interest rates at all-time lows, investors have been more than happy to trade cash for a stake in a real estate investment that has out-performed not only certificates of deposits and other yield-oriented investments but the stock market in general," Johnson said. "But if rates begin inching up, investors are going to get harder and harder to please."

New Product Focus

To attract new investment in today's fast-changing climate, Johnson said real estate companies should take a harder look at the product they're offering to see if it's something the market really wants.

"There has been too much product peddled in certain narrow asset-types," Johnson said. He cited REITs holding shopping centers and retail properties as examples of segments that may be approaching the limit.

Other segments still have life in them, however.

"Over the next 12 to 24 months, we expect that REITS holding office, multi-family housing, hotels, industrial and various other focused property types will continue to be attractive to investors," he said. "Certainly there are going to be winners in the new crop of REITs that come along in 1994 - it's just going to be harder to pick them."

Other Developments

KPMG also predicts that the REIT market will expand to take in more foreign investors, while gaining a strong following among institutional investors who are just now beginning to fully understand REITS and taking a long -term orientation.

"Major institutional players have come to view securitized equity as a means to manage a portfolio in terms of property type and geographic mix," Johnson said. "This kind of approach is more consistent, and counter to the more volatile yield-driven stock market."

At the same time, the Omnibus Budget Reconciliation Act of 1993, which included two improvements for REIT investors, is expected to further increase pension fund investment in REITs.

"The so-called five/fifty rule was modified to allow pension funds greater flexibility in investing in REITS," Johnson said. "And the differentiation between the top marginal income tax rate and the capital gains rate should help make REITS more attractive to individuals as well as corporate investors."

Issues and Trends

The latest report presents several important tax and accounting issues relating to REITS, along with guest perspectives on the process of launching a REIT and what ingredients Wall Street considers key to a successful initial public offering.

According to the report:

* Unlike a corporation, REITS are exempt from income tax - provided they pass four IRS-mandated tests. Complying with these requirements ensures that the entity can take full advantage of this six benefit.

* REIT offerings usually involve complex partnership arrangements and often receive intense scrutiny from the Securities and Exchange Commission. Consulting directly with the SEC before filing speeds the review process and gets the offering to market faster.

* Though many real estate companies are enamored with the notion of securing a stable source of capital - a benefit of being a publicly traded REIT - the process of becoming one is arduous and more costly than most imagine.

* Underwriters look for three critical elements when considering a REIT public offering: a commitment to operating a public company; a positive relationship between the cost of the real estate and the return it's producing; and potential for growth.

Becoming a REIT: An Arduous Process

Though the benefits of becoming a publicly traded REIT are often substantial, the process itself is often arduous and fraught with uncertainty, Thomas Carr, president and CFO of Carr Realty Corporation, explains in the report.

"The process was substantially more costly and demanding than we had anticipated," said Carr, who successfully concluded an initial public offering last February. "We spent over a year of intense work in preparing for the offering."

Carr recommends that a real estate company consider the following key questions before making the decision to jump on the "REIT bandwagon":

First, the product should be something the market really wants. Carr said companies should honestly assess their geographic location, financial profile, size, capitalization and management expertise to be sure that these individual parts add up to a package the market is truly interested in.

Next, a basic risk/reward analysis should be conducted. The company must ask itself if it can afford the cost of the process in both money and executive time - and be prepared to lose substantial amounts of both if the process does not go forward successfully.

A third and critical question is whether the stakeholders' interests will be served by going public. According to Carr, it's important to the ultimate success of the offering that all parties - partners, lenders, public entities and so on - "sign on" to the idea. "If these groups aren't convinced that they will benefit, the offering is destined to fail," he said.

Finally, does the company welcome, or is it at least prepared for, the increased burden of accountability it must bear as a public company? Public ownership introduces a level of scrutiny that privately held companies aren't used to. On this point, Carr cautioned about the lure of going public by paraphrasing the Confucian curse: "Beware that your wish may be granted."

The Investment Banker's View

KPMG also asked Richard Moore, vice president of Goldman, Sachs & Co., to outline in the ingredients that make for a successful REIT public offering. Moore cited three key factors:

Investment bankers first take a close look at the company's senior management to identify whether it is committed to becoming a public company, Moore said.

"It goes without saying that the company must have experienced management in place. But REIT managers must be aware of the discipline required to operate a public company - and similarly, to recognize the opportunities that go along with being public."

Underwriters also look at the relationship between the physical quality of the real estate and the cash flow that real estate is producing. "One must go beyond the physical characteristics of the real estate and understand the relationship between the cash return a property is producing and the cost of that asset," Moore said.

Finally, underwriters consider a REIT's potential for growth.

"A REIT should be an integrated company - not just a group of properties - that has a clear plan for growth," Moore said. "That includes being able to attract and maintain good management as wells as showing a potential for acquiring or developing new properties, increasing rent income and ensuring continued growth to allow for investment."

Consult With the SEC on REIT Filing

Consulting directly with the SEC before filing the initial registration for a REIT public offering usually speeds the review process and helps get the offering to market faster, the report also notes.

"Since each REIT formation differs, the SEC hasn't created any clear road maps through the registration process," said Craig Wagner, a partner in the practice's Washington, D.C., office.

"In addition, most of the REIT initial public offerings over the last 18 months have been relatively complex transactions from an accounting, tax and financial statement presentation perspective. As a result, these offerings have received intense scrutiny from the SEC staff."

KPMG, which is currently advising numerous initial and secondary REIT offerings in the registration process, recommends that the best course is to consult directly with the SEC staff before filing.

"It's been our experience that direct consultation with the SEC prior to filing the initial registration expedites the review process and helps get the offering to the market on a timely basis," Wagner said.