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  The Brouhaha Over Unit Investment Trusts Nearly $4 billion of unit investment trusts that invest in real estate investment trusts have been sold since late last year. So, what's the problem? by Barry Vinocur |
Why the flap over REIT UITs? To understand that, we need to review Salomon Smith Barney's twist on the REIT UIT. Rather than buy shares for an equity UIT on the open market (as most UITs do), Salomon Smith Barney went directly to the REITs. The investment bankers at the brokerage firm reasoned (and correctly it turns out) that since most REITs have an almost never-ending need for equity—because REITs have to pay out 95% of taxable income to maintain their tax-favored status—REIT managements not only would welcome an alternative to the traditional follow-on offering, but also the opportunity to broaden their individual investor shareholder bases.
Since REITs typically pay in the neighborhood of 5% to raise equity in a follow-on deal, Salomon Smith Barney offered to buy the newly minted shares destined for the UIT at a 5% discount to the current share price. (The discount at which the shares are purchased varies somewhat from UIT to UIT. In some instances, brokerage firms have had to buy some of the shares in the open market.) That meant the net proceeds to the REIT would be no different than if the company had sold shares via a secondary offering.
REIT managements also liked the idea that they were raising equity not only in smaller amounts—reducing the pressure to invest new dollars quickly to avoid diluting earnings—but also they didn't have to spend time on the road selling their deals. On top of that, REIT managements figured that shares sold to a UIT wouldn't get dumped back onto the market as soon as the deal was priced (typically, UITs "mature" two to four years after they are sold), as frequently happens after a follow-on equity offering.
On its face, the no-load REIT UIT sounds like a win-win-win. Investors benefit because they buy seasoned REIT shares without a commission. The REITs benefit for all of the reasons noted above. The brokerage firms and, in turn, their brokers win not only by creating yet another source of fees and commissions, but also by broadening the range of competitively priced equity financing sources they have to offer companies.
So what's wrong with this picture? Plenty, say some portfolio managers and analysts, some REIT managements, and even some investment bankers. Here's a brief rundown of their complaints.
Barry Greenfield, who runs Fidelity's real estate fund, has suggested that when investment bankers are making the choices, there's a risk that "heart transplants will be given to 95-year-olds." Put another way, companies that might be pressured to consider, for instance, a merger are given more time. On balance, Greenfield and others, including Lehman Brothers' chief REIT analyst Steve Hash, see REIT UITs as a negative.
Most of the issues related to REIT UITs would go away if, instead of buying direct, the UITs bought their shares on the open market. But that seems unlikely. As we were going to press, for instance, PaineWebber offered its first no-load REIT UIT (not included in the table on page 43). And other brokerage firms were reportedly considering offering additional REIT UITs to their firm's clients.
Is there nothing good to say about no-load REIT UITs? Some REIT executives argue that since they are selling very small amounts of equity, many of the issues that have been raised are overblown. Said one REIT CEO, "If I went out and sold $400 million of stock to a no-load UIT, I could understand the furor. But selling $30 to $40 million of new stock to a UIT for a company of our size really shouldn't be an issue."
Before the ink was dry on the final prospectus for Cohen & Steers Realty Majors, a $1 billion unit investment trust that bought shares in 27 real estate investment trusts in late- April, analysts and investors were lambasting the deal. The primary target of their ire, however, was neither Cohen & Steers Capital Management, the New York money manager that with roughly $6 billion under management is the largest dedicated manager of real estate securities portfolios, nor Merrill Lynch & Co., the UIT's lead manager. Instead, they were critical of the CEOs who agreed to sell stock to the UIT.
In an early-May research note, David Kostin, Goldman, Sachs & Co.'s senior REIT analyst, noted that with REITs down 4.5% this year [REITs were down more than that when we went to press]—and trailing the broader market by a wide margin—the CEOs of numerous REITs had called or visited in person to discuss how undervalued their shares were and to inquire why the stock market assigns such a low multiple to their shares. But if CEOs truly believe their stock is so cheap, Kostin wrote, investors must ask the management of each company that agreed to participate in Cohen & Steers Realty Majors, "Why did you sell undervalued equity?"
Kostin concluded that the answer to that question, and much of the secret as to why REITs are trailing the Standard & Poor's 500-Stock Index by such a wide margin over the past 12 months, is that REITs continually issue new equity, often regardless of the impact on their current shareholders. "How else can one explain the decision by 27 REITs to sell new primary shares to the UIT at an average net price that is roughly 10% below their share prices at the start of 1998?" Kostin asks.
A number of money managers agree with Kostin. A portfolio manager with a firm that, like Cohen & Steers, invests solely in property-linked stocks, speaking on the condition of anonymity, said he had called approximately a dozen of the CEOs who participated in the Cohen & Steers UIT after the deal's pricing was announced on the morning of April 24. "I wanted to know why they sold equity when they have been telling everybody that their stock is ‘too cheap.'" The portfolio manager said he asked a number of the CEOs whether they would be willing to sell shares to his firm at the same price they had sold them to the UIT—with one difference. Rather than a 5.25% discount, he said he was willing to buy the shares at roughly half the discount they had been willing to give the Cohen & Steers UIT. "We were willing to pay a higher price than they had just sold equity for and I didn't get a single taker."
A number of investment bankers expressed surprise that Cohen & Steers, which not only is widely viewed as an industry leader, but also has been quick to criticize companies for selling equity at a price it believed was too low at the time, would have engineered a UIT when stock prices were so low.
Marty Cohen, president of Cohen & Steers Capital Management, said he couldn't recall having criticized any company or investment banker for selling equity at too low of a price. "What I focus on," Cohen explained, "is the use of proceeds. If the company has a good use of proceeds, that is, it can put the money to work at an attractive rate of return, I don't have a problem if a company raises money by selling stock."
Not every company that was invited to participate in the Cohen & Steers UIT accepted, however. General Growth Properties, which had been on the proposed list, had to bow out at the last minute because it closed a deal to acquire a portfolio of properties, and that would have required an additional SEC filing that couldn't be completed in time. Boston Properties had planned to participate, but Mort Zuckerman, the REIT's chairman, said that when it came down to the wire, he and Ed Linde, the REIT's president and CEO, concluded the company's stock was simply too cheap. Barry Sternlicht, the chairman of Starwood Hotels & Resorts, also decided not to participate because he wasn't willing to sell equity at the price at which his stock was trading.
Why did so many CEOs go ahead if they thought their stock was so undervalued? Several said in the weeks leading up to the UIT's pricing, as well as subsequent to the deal being done, their decision to sell stock to the UIT was based on several factors. A number said their long-standing relationship with Cohen & Steers and/or Merrill Lynch made it tough to say no. "Cohen & Steers is one of our largest shareholders, and Merrill is our investment banker. So, saying no really wasn't an option," remarked one CEO who didn't want to be named.
Another reason some CEOs said they agreed to go into the Cohen & Steers UIT, though they had reservations because of their stock price, was the contention that somehow the UIT might end up being an industry benchmark. Cohen said he believes there are serious problems with all of the available industry benchmarks and indices. He stopped short, however, of predicting that the Cohen & Steers UIT would end up filling what he says is a very real void.
Goldman Sachs' Kostin said there was no question that the companies in the Cohen & Steers UIT were of a very high quality. But, he added, any thought that the UIT might actually end up being a benchmark wasn't realistic for a number of reasons. First, he said, money managers and institutions won't rely on a benchmark if one of the principal criteria for being in the benchmark was that the company was willing to sell equity to a newly formed UIT. Second, Kostin underscored that there are no hotel companies in the UIT. "Marty is correct when he says there are problems with the current indices. There are issues one can raise about any index. But I don't think anyone would suggest that you could have a worthwhile public company, real estate benchmark today that didn't include any hotel companies."
A New York hedge fund manager said he had heard talk that Cohen & Steers and Merrill were using the benchmark argument to help convince CEOs to participate. "No one is going to use the Cohen & Steers UIT as a benchmark except perhaps the investors in Cohen & Steers' mutual funds who may be unhappy if the firm's actively managed funds don't outperform the UIT, after fees."
Cohen acknowledges that's a risk. "It's something that we thought about," he said. He underscored that both he and Bob Steers, the firm's chairman, as well as other key members of the firm recognized that they were sticking their necks out by doing the UIT. "We did it because we thought it was the right thing to do," said Cohen. "Clearly, it would have been a lot easier not to have done it."
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