Clinton says rein REITs in

By Neal Templin
Wall Street Journal

      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 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 high-flying 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.
      "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.
      Prudential Real Estate Investors is 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 percent 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 operating 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 percent 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, 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 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 Crants' father, Doctor R. Crants, chairman of Corrections Corp. of America, to think differently about his Nashville, Tenn., prison operator. The younger 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.