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Help or hindrance?

REITS MULL BUSH’S DIVIDEND TAX PLAN

BY DONNA MITCHELL

For three years straight, REITs have dodged just about every blow rocking the rest of corporate America: stock market turbulence, accounting scandal, economic weakness. Some wonder, however, whether the industry will be as fortunate under President Bush’s economic stimulus plan.

In January Bush introduced his 10-year, $674 billion strategy, which includes a proposal to abolish dividend taxes. The goal is to do away with the so-called double taxation of corporate revenue, under which taxes are imposed first on a company’s gross profits, and then again on shareholders’ dividends from those same profits.

But because REITs do not pay corporate taxes, they don’t stand to benefit from the dividend proposal. On the contrary, many say, REITs could suffer if the reforms make other kinds of companies more attractive to investors.

It all comes down to dividend yields, which are calculated by dividing a company’s stock dividend by the share price. The consensus is that if dividend taxes are abolished, regular taxpaying companies (called C-corporations) will be encouraged to distribute more of their earnings as dividends.

“The dividend yield [for REITs] will be relatively less attractive” if the plan is put through, said Gregory Whyte, a Morgan Stanley REIT analyst.

Opponents of the plan point to early signs of ground being lost to other stocks. The Morgan Stanley REIT index fell 1.5 percent the day after Bush unveiled his plan. By the end of the week, the index had dropped 2.1 percent from the week before, while the Standard & Poor’s 500 index had risen by the same amount.

Industry watchers hesitate to specify how yields would increase for other industries or decrease for REITs, because no one knows what the final version of the Bush proposal will be. But some offer a few first impressions of how tax-free corporate dividends could affect REITs.

“It will make the cost of capital for REITs go up, because income-oriented capital will go to other investments,” said Ed Glickman, CFO of Philadelphia-based Pennsylvania Real Estate Investment Trust. “Eventually that makes us less advantageous acquirers of property.”

Individual REIT investors, he added, could see the value of their holdings decrease — an irony because REITs were created to give small investors access to the real estate market. Further, REITs could question the rationale of retaining their status and convert to C-corporations themselves, Glickman said.

“Every time the government makes massive changes to real estate tax policy, it hurts real estate,” he added. “This is another major de facto change in tax policy for real estate.”

In 1986, Glickman points out, the federal government eliminated real estate tax shelters without giving the public time to adjust, which was one factor that led to the savings-and-loan crisis. The rule change on passive-loss deductions also hurt professional real estate developers. (The rule has since been modified, in part because of intense lobbying by ICSC).

AVERAGE REIT DIVIDEND YIELD VERSUS OTHER SECTORS

Source: Standard & Poor’s Compustat Data

REITs outpaced all other major sectors. According to Standard & Poor’s, the average REIT dividend yield as of Dec. 31, 2002, was 7.5 percent, while its nearest competitor, utilities, came in at 5.6 percent.

But not everyone is concerned about how REIT stocks will fare under the Bush initiative. Some in the industry, though acknowledging a few potential pitfalls, expect REIT stocks to absorb the shock and continue to perform well. REITs arguably have the best dividend yield: 7.5 percent, according to Morgan Stanley, while the companies in the S&P 500 average less than 2 percent.

“We were not surprised by the news that REIT dividends would not qualify for an exemption,” said a spokesman for the National Association of Real Estate Investment Trusts, or NAREIT, who asked not to be named. “The fact is that other equities have a long road before they would approach the dividend power of REITs.”

According to the NAREIT composite index, REITs gained 5.2 percent in 2002, their third consecutive year of positive returns. The NAREIT index was miles ahead of the Nasdaq, which slipped 31.5 percent from 2001, and the S&P 500, which finished the year down 22.1 percent.

If tax changes put corporate dividends into the spotlight, REITs can only benefit from the inquiries of individual investors, said the NAREIT spokesman.

As for the Bush proposal’s impact on investor portfolios, it will do REITs no substantial harm, some industry participants said. For one thing, banks, investment advisory firms, mutual funds, pension and retirement funds, and other institutional investors own 58 percent of all REIT stocks, and these institutions are already tax-exempt. Individuals own the rest.

Pension funds are now looking at how they want to allocate their money, said Judith M. Johnson, chief investment officer of the Minneapolis Employees Retirement Fund, and they’ll almost surely double their current real estate allocations because of REITs’ dividend strength relative to other equities and most bonds.

“REITs have a lot going for them now and will have a lot going for them when this legislation is signed into law,” Johnson asserted.

Even if these companies experience a stock price drop, it would only be short-term, said Tracy Pursell, director of investor relations for Houston-based Weingarten Realty Investors.

“As long as the company is using good discipline and good strategies, people will still make money off of the investments,” said Pursell.

And many expect Bush’s proposal to be eventually watered down in any case. Industry sources say he is strategizing for re-election in 2004 and has merely set a bar high enough from which to negotiate downward. None of those who spoke to SCT predict that Congress will completely repeal dividend taxes.

“It’s too controversial,” said Bernard Freibaum, CFO of General Growth Properties, noting that he is not speaking on behalf of the REIT. “What’s more likely is a modest amount of dividend exclusion.”

In such an exclusion, a shareholder can collect a capped amount of tax-free dividend income, Freibaum explained. There was a similar situation 15 years ago, when shareholders were allowed up to $400 in dividend income before incurring taxes.

Congress could also pass a tax credit for investors based on the amount of taxes paid by the corporation on dividend distributions, Morgan Stanley’s Whyte suggests in a December report. So if a corporation pays out all of its earnings as dividends, the shareholders would get a credit equal to the company’s corporate-level taxes.

REITs aren’t likely to lose much to regular corporate stocks, said the NAREIT spokesman, from either a dividend-yield standpoint or that of portfolio diversification.

“We tend to move and behave differently than equities and bonds,” he said. “That is not going to change under any legislative scenario.”

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