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'98 Year In Review
December 17, 1998

Loser #3 - Paired-Share REITs

by Warren Gump (TMF Gump)
Featured Stocks Down 56.4% to 71.6% as of 12/15/98

First they're hot, then they're pathetic. That's the sea change that hit paired-share Real Estate Investment Trusts (REITs) over the past year. The darling real estate ownership structure of the 1997 market became one to shun in 1998. The about-face in market favoritism was caused by some government meddling, the "new capital" spigot closing, and investors who might have been "irrationally exuberant" reevaluating prospects. Regardless of the causes, shareholders with long positions in these stocks saw their account values sucked down the drain.

To get an idea why these stocks plunged this year, one needs to understand a little about the paired-share REIT structure. Unlike traditional corporations (C-Corps), REITs don't pay any federal income taxes on their earnings. Instead, they are required to pay out as dividends 95% of their taxable income to shareholders each year. (Taxable shareholders will then pay taxes on those dividends.) To qualify for REIT status, however, a company can only own assets -- it can't operate them. So if you want to create a REIT, you can own that nice hotel, but you can't manage it. Someone else will have to do that for you.

Unfortunately, it costs money to hire people to manage these assets. The fees paid to managers in excess of the actual operating costs (i.e., the manager's profit) are called "leakage." Traditional REITs, due to being prohibited from operating real estate assets, are forced to endure a certain amount of leakage. Long ago, financiers had a brilliant concept. Why not create a security that represents ownership of both a REIT and a C-Corp? This security, known as a paired-share, would be traded like a single share of stock. In 1984, Congress saw the potential abuse of this structure and outlawed it. Since only a few small companies had already adopted this structure, Congress allowed existing paired-share REITs to continue to operate as they were.

Fast-forward to the early 1990s. A young financier named Barry Sternlicht realizes that there might be value in the essentially forgotten paired-share structure. He salvages a paired-share shell and purchases some hotels. As the 1990s progress, this company, re-christened Starwood Lodging -- now Starwood Hotels & Resorts, <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HOT)") else Response.Write("(NYSE: HOT)") end if %> -- experienced outstanding results. It purchased more hotels and became bigger and bigger. In late 1996 and early 1997, the paired-share phenomenon became exposed to all. Stories ran in the Wall Street Journal about the benefit of this structure. As only four publicly traded paired-share REITs were in existence (and no more could be created), stock values soared as investors become convinced these four companies were going to become huge players.

While Starwood already had the paired-share structure, Patriot American Hospitality <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PAH)") else Response.Write("(NYSE: PAH)") end if %> purchased the structure via its early 1997 acquisition of the California Jockey Club and Bay Meadows Operating Company for $195 million. Meditrust <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MT)") else Response.Write("(NYSE: MT)") end if %> then purchased the Santa Anita Companies for $383 million to obtain the paired-share structure a little later in the year. While the stock of First Union Real Estate Investments <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FUR)") else Response.Write("(NYSE: FUR)") end if %> surged, management didn't show any interest in leveraging its paired-share structure.

The hotel industry was already seeing significant consolidation in 1997, and the high valuations given Starwood and Patriot American helped them become leaders in the fray. Starwood announced the purchase of Westin, bringing it its first owned brand name. Patriot countered by announcing the acquisition of Wyndham. While all this was going on, Hilton Hotels <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HLT)") else Response.Write("(NYSE: HLT)") end if %> made a hostile bid for ITT (the owner of Sheraton and Four Points, among other assets). As there was bad blood between the two companies (among one of the more memorable barbs in the fight, one executive publicly accused another of being a "super weenie"), ITT sought a "white knight" to save it from Hilton. With its high-flying stock price, Starwood turned out to be the "savior." This transaction, which closed in February 1998, really stoked the flames of the paired-share REIT fire. If Starwood could take over ITT, people wondered what would be next.

The hotel buying spree heated up in early 1998. Meditrust announced that it was going to buy La Quinta. Patriot announced the acquisition of Interstate Hotels. Then an unexpected problem emerged. Steve Bollenbach, the CEO of Hilton, was not too happy about losing the battle for ITT to Starwood because it had a structure he couldn't have. The chairman of Marriott International <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MAR)") else Response.Write("(NYSE: MAR)") end if %>, Bill Marriott, was also concerned about this upstart competition. They both lobbied Congress and the President to put restrictions on the paired-share structure. The values of the REITs started to fall as investors became wary of what Congress might do.

In the heat of the merger frenzy, as paired-share stocks were only going up, the companies found a nifty way to borrow money. Instead of taking out a traditional loan, they would enter an "equity forward." This transaction allowed the REITs to issue new shares of the company as collateral for the loans. When the stock price rose (as everyone expected), they would settle the transactions based on the stock's then-current price. If for some inexplicable reason the stocks fell, the companies would just pay off the equity forwards with freshly borrowed cash.

In March, President Clinton proposed legislation that would halt the use of the paired-share structure in future transactions. Investors at the time weren't too concerned about the legislation, as they weren't sure if Congress would pass it. Stocks continued to decline slightly as it became clearer that the legislation would become law. As this was going on, hotel acquisitions began to slow down. Investor interest in the sector also waned as concerns about an economic slowdown increased. The hotel REITs advised investors not to include any substantial acquisition assumptions in their projections -- growth would be based on internal improvements.

Meditrust was the first stock to truly get pounded. Many investors felt it had paid a lot for the paired-share structure and would not be able to reap many of the benefits because it had not developed a critical mass in hotels. Then Patriot and Starwood joined the plunge as investor disdain for hotel stocks turned to hatred. (The hotel business is extremely cyclical, and investors tend to run away on any inflation threat.) The highest-flying companies were the hardest hit. Not only were acquisitions going to slow down, but people became concerned about prospects for the properties already acquired.

To handle the REIT legislation that was finally passed in July, Starwood announced that it would adopt the C-Corp structure and cut its dividend to fund growth. Patriot said that it would maintain its paired-share structure and grow through internal growth and selective acquisitions. Meditrust decided to split itself into two separate REITs, one of which would maintain the paired-share structure. It also announced a dividend cut. Patriot then announced it was omitting its Q3 dividend. Investors were not too happy about all three of these companies cutting or omitting their dividends.

Oh, remember those equity forwards? The bankers certainly didn't forget them. Starwood, Patriot, and Meditrust needed to pay off these forwards. They could have issued stock to cover them, but that would have really diluted the ownership of current shareholders. For example, when Patriot was at $25 per share, it would have needed to issue 1 million shares to cover a $25 million equity forward. With the stock at $8, it would need to issue over 3 million shares. Well, then it could just borrow the money, right? Oops... no one wants to lend to a hotel company that's in trouble. The need to repay equity forwards combined with hundreds of millions of dollars in debt maturities over the next six months have created a liquidity squeeze. Patriot will have to find someone to refinance its debt, sell assets (at fire-sale prices) to cover its obligations, or file for bankruptcy to solve its problems.

Starwood, which had longer debt maturities than Patriot, has reached agreements to close its equity forwards, but has recently lowered expectations for Q4 because of delays in opening a riverboat casino. Results for next year are also expected to be lower than anticipated because of delays in certain asset sales, fewer acquisitions, and higher financing fees.

Meditrust is moving ahead with its split and asset sales to lower its debt levels.

What about First Union Realty? After management didn't do anything to take advantage of the paired-share structure, shareholders kicked management out in a proxy vote in May. The new managers haven't been able to do too much, though, since the law now prevents deals that would benefit from the paired-share structure.

It's been a rough year for these stocks. If the economy doesn't worsen and the companies restructure their balance sheets to avoid liquidity problems, investors might find these stocks worth considering in the future. However, there isn't any need to rush onboard.

Related Links:
Get a Quote or Other Data on These Stocks
Patriot American Daily Trouble -- 12/8/98
Meditrust Restructures -- Breakfast With the Fool -- 11/12/98
Starwood Restructures -- Fool on the Hill -- 8/31/98
Paired-Share Shenanigans -- Fool on the Hill -- 2/3/98

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