Rei Ts Are Moving Away From Home

But their spin-offs could overtax management

Baby Crescent came first. Then plans for Baby Reckson were announced, followed by whispers about a son of Kimco. Lately, there's a buzz going around about a Baby Vornado.

What is this corporate baby boom all about? Real estate investment trusts (REITs), headed by some of the most aggressive and financially innovative executives around, are creating companies to operate related--and unrelated--lines of business. Most of these new companies are regular corporations that will be fully taxed. REITs, by contrast, were designed as passive investments and are exempt from corporate taxation if they pay out 95% of taxable income in dividends, earn income primarily from leasing, and follow other strict guidelines limiting their flexibility. "The stock market loves growth and a REIT can't deliver it in a very significant way through internally generated sources, so it needs to grow externally," says Robert A. Frank, director of research for Legg Mason Wood Walker Inc.

BLOW-UPS? It sounds like a good idea. Such entities could add 1 to 4 percentage points to a REIT's growth rate, says Prudential Securities' Louis Taylor. But some analysts fear that REITs, if they're not careful, may be headed for trouble. REIT management may understand real estate but not know much about some of the spin-offs' new businesses. And they may run into tax issues. To lessen taxable income of a spin-off, a REIT might be tempted to ratchet up the spin-off's expenses, such as its payments for various services to the REIT. Taylor worries that "if we get too many of these things and they get too aggressive in trying to minimize taxes, they could draw the attention of Congress and others." Says Jonathan Litt of PaineWebber Group Inc.: "In the right hands--Crescent, Vornado, Reckson--the structure can be very powerful. I worry that it could blow up in the wrong hands."

Investor interest in the new babies will be strong, if the market's reception of Crescent Operating Inc., a spin-off of Crescent Real Estate Equities Co., is any guide. It debuted in June at 8 and now trades at 25 3/4. Its holdings include a 50% stake in an operator of psychiatric hospitals and 100% of a firm that sells, leases, and services construction equipment. "With the operating company, we have the opportunity to look at deals that the REIT might not normally look at" and put the real estate into the REIT and the operating side into Baby Crescent, says Gerald W. Haddock, the REIT's chief executive. Because of shared business opportunities, management, and boards, such spin-offs are said to be "paper-clipped" to the REIT, which tends to own a chunk of the spin-off.

The next paper-clip stock due out is from Reckson Associates Realty Corp., an owner of office and industrial properties headed up by Donald Rechler. "The spin-off is almost like an early-stage real estate venture fund," says Scott Rechler, the REIT's president. It will be the general partner and have a one-third interest in a fund that will buy private real estate operating companies. It's negotiating to buy a company providing local and long-distance telephone service, Internet access, and video teleconferencing, and may also buy an executive office suites firm. It has the same management as the REIT, save for its chief investment officer, and will have a similar board.

After Vornado Realty Trust, which has focused on shopping centers and office prop- erties, teamed up with Crescent in a refrigerated warehouse deal, speculation grew that a Baby Vornado was in the works. "They're reviewing it," says Litt. "If they do it, it would be a big success." The entity could hold Vornado's 60% of the warehouse deal and operate businesses related to residential or commercial development.

Kimco Realty Corp. is taking another tack. After turning around a shopping center and signing tenants to long-term leases, it wants to borrow against the leases--which could mean taking on a higher level of debt than a rating agency might like. Kimco's plan: After borrowing against a lease, spin off the leveraged property to a separate REIT aimed at yield-oriented investors. Kimco will own 40% of the new REIT.

Most of these ventures will have higher risk profiles than their progenitors. "If you're confident of management, then their ability to be more forward-thinking and think outside the REIT framework may be to your benefit," says Martin Cohen of Cohen & Steers Realty Shares. If you're not confident in management, plain-vanilla REITs may be the best bet.

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