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Interest grows in taking REITs private.

The continuing weakness in REIT stocks and the relative strength in the underlying real estate markets continues to generate interest in taking REITs private.

The management teams of many REITs have grown frustrated with the valuations placed on their companies by Wall Street and with the burdens of operating in the public arena. At the same time, outside investors, ranging from opportunity funds to private real estate developers, see opportunity in the gap between the Wall Street valuations for REITs and the private market values of the assets held by REITs.

These dynamics have resulted in a number of successful LBO transactions in 1999, and will likely result in a continuing stream of "going private" transactions until the public REIT market rebounds.

The recent LBO activity in the REIT market and broader experience from other industries provide a number of useful guidelines which should be considered at the planning stage of any proposed transaction to take a REIT private:

Enhanced Disclosure

Extensive disclosure is required by Rule 13 e-3 under the Securities Exchange Act particularly with regard to contacts and negotiations leading up to the transaction where the acquiror group includes management or any other affiliate of the target REIT. It is critical, therefore, for persons involved in the consideration and planning of a going private transaction to use extreme care as to the process followed and the documentation of each stage of the transaction. Matters that occur very early in the process can come back to haunt the participants in a transaction if not thought through and documented properly in advance.

Managing Conflicts of Interest

LBOs and other going private transactions which involve management or members of the board of directors necessarily raise potential conflicts of interest. In the UPREIT context, there is an additional layer of conflicts because of the potentially divergent interests of the OP Unitholders. In all cases, procedures should be implemented to ensure that the potential conflicts do not taint the "fairness" of the transaction, since going-private transactions frequently attract shareholder litigation, which has the potential to derail the transaction or even expose the participants to liability. As a practical matter, this usually means that it is advisable to have the transaction evaluated and negotiated by a special committee of directors who do not have a financial interest in the proposed LBO. In order to provide the desired legal protection, the special committee should have independent financial and legal advisors, be well informed, and have the ability and bargaining power to negotiate on behalf of the public shareholders.

Inability to Control Outcome

A corollary to the use of a properly functioning special committee is that management and other insiders who propose a transaction will not be able to control the process or to assure a particular outcome. The special committee typically has the power to say no to the proposed transaction, and is often granted the authority to consider, or even solicit, alternatives. Management-led buyouts thus typically result in auctions in which third party bidders have the opportunity to compete with the insider group on a "level playing field." Bidders should also keep in mind that the ultimate decision rests in the hands of the shareholders, whose approval will generally be required for a transaction to proceed.

Pricing Considerations

It is important to understand at the outset that the procedural constraints outlined above, competition from other bidders, the need to deliver value to the shareholders in order to induce them to approve the transaction, and transaction expenses typically will push up the cost of the deal. Bargain basement bids (measured by real value, not current stock price) usually attract competition, litigation and other scrutiny, and are unlikely to succeed in their initial form.

REIT Rules

In any transaction involving a REIT, consideration should be given early on to the impact of the special tax rules that apply to REITs and to the target REIT's charter provisions that are designed to preserve its REIT tax status. In that regard, careful thought must be given to the decision to continue the target's status as a REIT or to operate as a taxable real estate company. The decision to continue as a REIT should be made only after analyzing the entity's ability to service its debt after the going private transaction and still satisfy the REIT income distribution requirement. In addition, implementation of any decision to terminate REIT status must take into account the tax consequences of the loss of REIT status for the year in which the REIT goes private and the distribution requirement for that year. Importantly, the mechanical steps necessary to obtain a waiver of the target REIT's excess share ownership limitation provisions (typically imbedded in REIT charters) must be provided for as part of an y going private transaction.

Properly planned and executed going private transactions of course often do succeed and yield the expected benefits. It is important, however, to set realistic expectations at the outset and to exercise care in weaving through the legal, regulatory and market challenges.
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Author:Einhorn, David M.
Publication:Real Estate Weekly
Date:Jan 26, 2000
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