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REITs: key to capital or fad?

Now that David Lerner has begun hawking real estate investment trusts known as REITs - on the radio, is it time to invest, time to package your properties into a REIT or time to pass?

Some analysts and real estate experts are convinced that certain REITs have become over-valued and are an accident waiting to happen. On the other hand, many REITs have been traded on the stock exchanges for decades and have proven performance and track records.

The lack of private financing is currecently driving privately held real estate to the public marketplace and some experts think eventually most properties be pooled into REITs. "Capital is the mother's milk to this business," noted analyst Robert A. Frank of Alex Brown & Sons in Baltimore.

What he predicts is a consolidation in the real estate industry to those who have access to capital through REITs.

"We think the REITs are really going to prevail as the new paradigm for real estate ownership and finance," Frank said. "This trend is one we would charaterize as a tsunami," he said. "it's a huge asset class that has not previously been securitized and was artificially encouraged by the old tax laws."

REITs allow real estate to be managed as a business as opposed to a transaction, Frank explained. "That's really important," he said.

But the success of REITs has naysayers and even industry cheerleaders troubled. "They had blistering success in the firs quarter -- up 20 percent but are off 8 percent since then," said Martin Cohen of Cohen & Steers Capital Management, an investment advisor who specializes in REITs and manages accounts for mutual funds anzl institutions. "They were appreciating at an unsustainable rate."

"We need corrections here and there and some REITs coming out and not trading above their offering price," agreed Mark O. Decker, president of the National Association of Real Estate Investment Trusts (NARET), an industry group.

Decker is undeterred by April's drop of about 5 percent overall in the value of the REIT stocks nor worried flint certain REITs are trading close to their recent offering prices. "There are no perfect investments," he noted.

Attorney Mark Edelstein, however, predicts flint some REITs are going to burn out. "The way people are talking they are going to be the cure for the economy," he observed.

Edelstein is a partner in the Milbank Tweed Hadley & McCloy real estate workout and bankcruptcy group representing many developers who have had to restructure their assets.

He said he is worried about the grandmothers, the widows and the orphans who are buying stock because they are getting a 12 percent to 19 percent return in a quarter while their accounts at Citibank are earning 2.9 percent.

Frank notes flint "because people are grasping for yields and you provide a yield flint is attractive, you see the demand." In new companies the risk/reward is fairly high, he added.

People are looking, however, for short returns, Edlelstein noted, and are not focusing on the assets. If a REIT buys an office building or a shopping center to add to its portfolio, but the leases are due to roll over in two years, Edlelstein believes the investors will get high income now but two years later the stock could plummet.

"It's exactly what's happening to Rockefeller Center," he said. "People are so interested they are not focusing on the underlying assets."

For investors, Decker advised obtaining information on the principals of the company and the motivation of the management. "Is there motivation to exit and sell to the greater fool -- in this case the public?," he asked.

Frank explained there are two sources of new REITs, one being the "go public or go broke" group, and then another group flint waits on the sidelines to see if forming a REIT is "for real" and then decides it is. "What the market has not done," Frank noted, "is malce adequate distinction between these companies. There's reason to be COnCerned."

For those who are looking for higher yields, Frank suggested buying REITs as a growth stock with a buy-and-hold strategy. "The highest yield may lock you out of a part of the growth and earnings flint comes through buying new properties.

"My suggestion to the little old ladies is to buy proven companies with proven track records," Frank continued. "They don't belong in the new companies. There is not enough visibility and you can't make a decision based on a track record.'

Frank suggested some REITs that have demonstrated track records include Weingarten Realty Investors, Kimco Realty Corp., Developer's Diversified Realty Corporation and Federal Realty Investors. there is a window of opportunity but he is concerned that REITs will continue to be created using "bad" properties. Another potential problem can occur, he foresees, if an equity REIT begins to loan money and takes back mortgages.

Some analysts are concerned that REITs with variable rate debt are still betting on the marketplace when they should be "refinancing their houses" to obtain currently low lured rates.

Many times the high yields are being supported by floating rates, notes Frank. "They should be doing something to cap their exposure," he advised. "You just want to make sure, and be able to say with confidence, "If interest rates go up my exposure is this and it is capped."

While there is a lot of criticism about variable rate debt, Decker said, "that to me is not the story of the day. People who are rushing to proclaim the sky is falling are really missing the big picture of what is fundamentally wrong with U.S. real estate market. People can raise all kinds of risk factors."

Cohen agreed there are probably some abuses in the REIT industry as in any other industry. "There are people who make glib comments - and the REIT industry has raked some investors over the coals," he admitted.

Decker suggested that any prospective investors or real estate owners interested in forming REITs should become familiar with the REIT industry and network with the people who are doing the deals.

"It's an art more than a science," he observed. "There will be new REITs formed and we will continue to see not wild growth but strong REITs."

While for the most part, Decker believes the firms on their way to becoming REITs are good solid companies with impressive track records, he expects some REITs will form and not do as well.

Because there is no private funding for owners, they are turning to the REIT scenario because there is capital available in the form of a publicly traded company. Cohen explained that these companies are going public because they are starved for capital, and are using the proceeds to reduce indebtedness or to make acquisitions.

"The companies coming public are de-leveraging and retiring their debt," he noted, with the end result making them stronger companies.

Frank explained there is an arbitrage between real estate yields and the yields of REITs. "Anyone who owns real estate has realized their real estate is more valuable in the stock market and they are rushing to realize that gain," he said.

This is creating an atmosphere of haste that has some people like Edelstein apprehensive.

"These things are so popular that everyone and their grandmother wants to create a REIT and the properties may not be so healthy," Edelstein worried.

But becoming a REIT is not for everyone. Owners must have a good property portfolio, experience in making money for others and be willing to ahere to the fee structure and regulations.

"They can't do insider transactions, inside deals or get into pieces of this deal or that deal," explained one analyst who asked not to be identified. "They can't buy a company plane. Many of these entrepreneurs can't make that transition."

Frank said owners with this kind of temperament shouldn't be in the REIT business. "They will have a rude awakening," he said. "We're talking about a cultural chasm between the way the real estate industry operates and the public markets. The salad days are over in the real estate."

A REIT is not a private company with access to public funds, Frank continued. "They will have some snot-nosed kid calling them up and telling them how to run their business. That's going to be a rude awakening for people who start out framing houses."

Those owners that believe they can work within the bounds of the highly regulated REIT industry, must still have a substantial portfolio and be willing to pay a myriad of start-up costs.

To tap into the better known under-writers, the analysts say the portfolio must be sizable, in the $100 million range. Decker said there are several private underwriters, however, who will work with portfolios in the $30 million and up range. While Wall Street's threshold was $50 million and above not too long ago, Decker noted, today $200 million is on the small side.

The smaller operator who has $30 million or so should be developing relationships with the smaller under-writers, Decker advises. "A $30 million to $70 million property portfolio friar is well managed and well run needs to find someone to sell them," he said. "There is growing interest and a couple of firms have been formed to put up venture capital and take that risk."

Frank explained owners are being forced to have a "go public - go broke strategy."

"That's why you have to have critica1 mass," he said. "That's why you'll see a consolidation occur with portfolios combined or acquired by existing REITs.'

Another analyst said, "Some of these guys are a lot of talk and no money. They have $200 million in properties but won't spend $50,000 on legal fees to study forming a REIT."

Cohen explained there are start-up costs such as legal fees, audits, appraisers and accountants, and even then the owner's properties may not make it to the public market. "So they have to be willing to burn between $1 million and $2 million dollars," he said.

"They had a free ride for a long time because they made riskless transactions with other people's money," observed one industry expert on condition of anonymity. "The salad days are over. Now it's time to grow up or get out."
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Title Annotation:evaluation of real estate investment trusts
Author:Weiss, Lois
Publication:Real Estate Weekly
Date:Jun 16, 1993
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