If you want a baseball team to produce home runs, there is no substitute for having a couple of truly consistent power hitters batting at three and four in the lineup.

But to get the big hitters, you have to be willing to spend the big bucks. The same is true in the corporate world. Having a heavy hitting management team is vital, but with competition for the best talent as fierce now as ever before, companies are having to work hard to find the best ways to compensate their management teams to make the companies big winners, without blowing the budget.

The market for top executives is tight with the private real estate sector and other industries (investment banks, dot coms, professional firms) competing for the same talent pool as REITs and REOCs. In order to succeed, companies must be willing to think out of the box and be prepared to structure competitive pay programs. These programs should be designed to align the interests of management with that of shareholders and address affordability in terms of cost and dilution. Peer group compensation surveys are helpful in determining general parameters for fair compensation, but cannot be viewed within a vacuum since, by their nature, they do not address a host of key dynamics, critical to the formulation of a competitive executive compensation program.

A Little Background

REIT IPO pricing models, developed in the early 1990s as the new wave of REIT's went public, were based on the fundamental that for every dollar of expense saved, the equity to the sponsors increased by the multiple used in pricing the new public REIT. REITs were priced based upon a multiple of funds from operations (FFO), and accordingly any increase in compensation that reduced FFO, decreased the remaining equity to the sponsors. For example, if a REIT with FFO of $10 million was priced at a multiple of 10, the REIT's total equity would be $100 million. If annual compensation was increased by $1 million, FFO would decrease to $9 million and the equity value of the company would decrease to $90 million. Thus, the increased compensation of $1 million would initially cost the sponsors $10 million in equity. This decrease also reduced the annual dividend payments to be made to the sponsors. This served as an incentive to REIT sponsors and their management teams to accept reduced base pay in exchange for a larger equity share of the company.

Consequently, major components of founder-executives' compensation typically included dividend income and stock options, with salaries existing at a modest level. This was appropriate, as management interests were strategically aligned with those of shareholders. However, as these companies began to grow and mature, they found themselves requiring additional talent, often with management and organizational skills that the founding entrepreneurs did not possess. These professional managers did not have a pre-existing equity interest in the company, and, as a result, the compensation dynamics required to attract such professionals were considerably different than those of founder-executives who generally had substantial equity interests in the company.

Pay for Performance

With tremendous growth in REIT stock values from 1992 through 1997, substantial equity value was realized by REIT executives through stock options and stock appreciation. During this period, a significant number of REITs also began to add meaningful long-term compensation incentive plans (primarily using restricted stock) to buttress their existing stock option plans and to address the concern of hiring key new executives who did not have a meaningful equity ownership in the company. Base salaries and bonuses for REIT executives also grew during this period. Competitive pay opportunities within the REIT industry generally exceeded those in the private real estate sector and were competitive with other industries. The "pay for performance" mantra appeared to be working well, with the most significant element of executive compensation being achieved through stock appreciation.

A Transitional Period

In 1998 and 1999, the real estate market recovered and moved toward equilibrium, while interest in REIT stocks waned. Stock prices suffered accordingly, and stock options were no longer as meaningful an element of compensation. In general, all existing equity-based compensation packages were negatively impacted. Notwithstanding this dismal period of time in the public real estate market, the private real estate sector and most other industries continued to flourish and alternative competitive pay opportunities within those sectors continued to grow.

REITs began to explore methods of creating new compensation packages, relying less on stock options and more on cash payments, bonuses and long-term restricted stock plans. Given fallen stock prices and shareholder sensitivity, this was and remains a challenge. At the same time, the need for executive talent is greater than ever. Given the foregoing background, REITs are now facing the challenge of designing competitive compensation packages in order to more effectively compete with the private sector and other industries. REITs that successfully accomplish this will be better able to attract and retain management as a major asset, thereby protecting and enhancing shareholder value.

A "Star System" vs. a "Mayonnaise System"

Our experience in the compensation field has shown that the development and implementation of flexible compensation programs enable companies to attract and retain top talent (i.e., pay what it takes to get and keep the best people). The best performing individuals should be paid above competitive rates rather than positioning the whole compensation structure above competitive rates. Star executives should be paid what they are worth and superior performance should be acknowledged and differentiated. Companies should resist the temptation to simply spread compensation among executives attempting to keep pay in line as a group in order to balance and simplify social dynamics. This mayonnaise approach tends to serve as a disincentive and frustrate top performers. We refer to this as the "star system" vs. the "mayonnaise system."

Compensation reviews and pay levels should be clearly based on the value and contribution of the individual executive as opposed to a "herding and grouping effect" wherein categories of executives are treated the same, regardless of value and contributions. Companies need to create an environment in which outstanding contributions are recognized and acknowledged on an individual basis to differentiate between those who provide the "jet fuel" and those who do not. This is a common characteristic of high performing companies.

The Elements of Compensation

Current REIT executive compensation plans typically include:

• Base salaries
• Short-term incentives
• Long-term incentives
• Fringe benefits

Consistent with a "star system," pay packages structured to attract, retain and motivate top professionals should primarily be built upon incentives tied to performance as opposed to high base salaries. Base salaries should be measured against tangibles such as company size, executive responsibilities and company revenues.

Short-Term Incentives

Short-term incentives are based on performance typically measured over a one-year period. Annual incentives should generally be determined on a formalized basis with a meaningfully formulaic component. For example, annual incentives should link pay with performance and provide for company and individual accountability via the establishment of performance standards. Consideration should be given to annual incentives paid in the form of stock, as well as deferral provisions. Formulaic incentives would typically be based on financial results such as FFO growth, but should also allow for qualitative factors, market conditions, and performance relative to peers. Assessments of individual performance, although more judgmental, should still require agreement and understanding of the most important factors.

Long-Term Incentives

Long-term incentives should be earned based on performance and continued employment over a period of years. For top professionals, this should be the most important element of their total compensation program. Stock option plans alone do not provide or encourage the accumulation of meaningful stock ownership, nor do they provide for a dividend yield, which is a meaningful component of total REIT shareholder return. Accordingly, in addition to a stock option program, we would encourage consideration of a long-term restricted stock award program that addresses and links long-term company performance with long-term executive stock awards. As part of a program, the use of performance hurdles (i.e. FFO, cash flow, etc.) and graduated vesting based upon an extended long-term employment period is also encouraged.

Fringe Benefits

Executives, at a minimum, generally have the same fringe benefits as other management employees. Beyond this point, fringe benefits vary greatly and should pass "the smell test" in terms of amount and appropriateness, since they send a message and set an example.

Have a Program

The components of an executive compensation plan are not magical. What is most important is that there be an established "program" designed to attract, retain and motivate top professionals as opposed to a series of independent compensation events. The program should align the interests of management with those of shareholders and have a mechanism to clearly differentiate executives and identify and recognize outstanding contributions. Factors such as relative value, competitive opportunities and individual performance should be considered. The program should address all the components of compensation and be structured around a "pay for performance" mantra. Of course, care must be given to assure that the cost of the program is affordable within a company's budget and reasonable in terms of FFO and share dilution.

Peer group analysis is useful, but alternative competitive pay opportunities, inside and outside the REIT world, along with the measurement of value that a top professional brings to a company, are more important factors. The pilots must be distinguished from the passengers on the plane.

In his hey day, Babe Ruth's individual salary approached that of whole other teams, exceeding that of the President of the United States. The "Babe" typically answered inquiries about the level of his salary with the comment, "Why not? Judging by my value and performance, I am worth it." No company should overpay in any area, including executive compensation, but, the question of value does need to be addressed.

Each REIT has its own unique characteristics and executive needs. In turn, REIT executives have differing levels of expertise and job performance requirements. These should be evaluated, understood and agreed upon by all concerned. The obtaining and retention of quality assets, be it real estate or key management, will, in the long run, provide added value and greater return to shareholders.

Bruce S. Schonbraun, CPA, is the managing partner and Michael D. Schindler, Esquire, is a tax partner of Schonbraun Safris McCann Bekritsky & Co., L.L.C., a real estate consulting and accounting firm.