Commentary: Not All Real Estate Trusts Are To Be Trusted

McDonald's Corp.'s latest concept for fixing its lagging stock has no ketchup, no special sauce, and no sesame seed bun. Instead, it's sort of a McREIT. The fast-food company is said to be considering selling off its huge real estate holdings--playgrounds, parking lots, even the restaurants--to a new real estate investment trust.

Most REITs focus on the business of acquiring, developing, and managing properties. But a new breed of so-called captive REITs is proliferating rapidly and raising potential problems for investors. Typically, the new REITs, in which the parent retains partial ownership, are taken public to buy the real estate holdings. "It's phase two of the REIT boom," says Lehman Brothers Inc. analyst Steven R. Hash. "Now you have nonreal estate companies trying to get real estate off the books." In the last year, companies have created REITs to hold such hard assets as prisons, car dealerships, cinema multiplexes, and golf courses. Even Walt Disney Co. has raised money by packaging some of its properties.

For McDonald's, as well as the other captive REIT sponsors, the move may make sense. The fast food chain hasn't announced its plans. But by keeping its burgers and fries businesses but selling off its more than 12,000 restaurants, analysts estimate it could raise more than $5 billion by selling shares to the public. That could free up capital for McDonald's to buy back shares or lower its debt.

CHEAP FINANCING. But for investors in these captive REITs, the returns may be much less palatable than expected. The cyclical recovery in the property market that has driven the boom in REIT stocks seems over. The new REITs face more limited growth due to their narrow niches. They won't necessarily benefit if their parents do well since their only source of revenue is from the leases they hold. If McDonald's does strike gold with a new blockbuster McSandwich, the REIT won't get much of the upside. Says Fredrick Carr of Penobscot Inc., a real estate research firm that is based in Boston: "McDonald's would do a REIT because it decided it is cheaper financing than it can get elsewhere, not because it wants the REIT to grow."

It might be different if McDonald's were in a growth industry, like prison construction. The stock price for CCA Prison Realty Trust has doubled since its IPO last spring. But the REIT is still merely a financing vehicle for its parent, the Corrections Corp. of America. Others, such as REITs created from new car dealerships, face less certain futures. Take the AMC Entertainment Inc. theater chain that spun off $270 million worth of multiplexes in Nov. 18 into a new REIT, Entertainment Properties Trust. Facing a potential glut of screens, the REIT's shares are selling just below their offering price. "You're not getting the most interesting part of the action" with captive REITs, says Michael Kirby of Green Street Advisers, a REIT research firm based in Newport Beach, Calif.

So, why would someone buy shares in these captive REITs? There are pluses. With its stellar investment-grade credit, McDonald's isn't likely to default on any of its debt or leases. That means that it can, and likely will, offer shareholders a stable, high dividend of 8% or so. Against a 5.7% Treasury yield, that's attractive to some investors. But there will be little or no additional capital appreciation because growth will most likely be limited to the 2% annual increases McDonald's would likely write into them. What investors will likely get will look a lot more like a bond than the kind of REIT equities that have climbed by 20% a year or more for much of the last few years.

Conflicts of interest could also work against the growth of those dividend yields. Although the REIT and its parent are separate entities, often the same management controls both, as with Prison Realty Trust and Entertainment Properties. If management has a much larger stake in the parent than in the REIT, which is typical, it would have an incentive to favor the parent over the real estate entity. It could, for example, prevent the REIT from getting rent increases at the market rate.

All in all, for investors, many of the captive REITs are about as scrumptious as an Arch Deluxe. You're betting the management of a company you don't really own will be looking out for your interests as well.

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