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J.B. Schag

Patrick Harden

Alexandra Fedyukova

A real estate investment trust (REIT) is a corporation or trust that pools the capital of many investors to purchase income property (equity REITs) and/or mortgage loans (mortgage REITs). An equity REIT owns and manages property, as opposed to a mortgage REIT which purchases mortgages and may also borrow money from banks to lend again at higher interest rates. Some REITs also originate loans or develop properties.

Shares in a REIT are publicly traded on stock exchanges, and as such present an opportunity for individual investors to hold a variety of property assets. REITs are eligible for corporate income tax exemptions, and in return, REITs are required to distribute 90% of their income in the form of dividends to their shareholders each quarter^[1]. This may be taxable in the hands of the investors. The REIT structure was designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks. To continue to grow and acquire new properties REITs have to issue equity or raise debt in the capital markets. A typical REIT raises billions of dollars post IPO.

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Related Concepts and Industries

Commercial Real Estate
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Equity REITs
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Health Care REITs
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LTV
Debt Service Coverage Ratio (DSCR)

Current Environment

Although REITs earnings for the second quarter of 2009 were better than expected, economic fundamentals continue to weaken in the real estate market. Unemployment levels are very high. Spending has deteriorated. Credit is contracting and financing is still very difficult to obtain. Property valuations as reported by the major property indexes are off appreciably. These endanger current ownership of properties with a high loan to value levels. It is best to follow REITs that have strong balance sheets with moderate debt levels. These companies can obtain favorable financing, and restructure debt at times when others are merely trying to make interest payments and have to sell assets to serve their debts.

In the first half of 2009 as the stock market was recovering there was a waive of equity issuance by REITs. This period has some similarities to the period about 18 to 20 years ago, just before the REIT IPO activity in the mid-'90s. Commercial real estate industry needs significant amounts of new equity to pay down debts. This referred to as recapitalization. In fact, from the beginning of 2009 to end of August there were 60 secondary equity offerings by REITs raising $15 billion in equity. Some of the most notable are:

Higher costs for electricity, oil and insurance costs pressure the bottom lines, and consequently dividends. Although in 2008 REITs paid investors ~ $17.8 billion in dividends, the previous years levels were higher. Some REITs started paying dividends in equity to retain much needed cash. Despite recent development REITs income returns are a lot more stable than their stock appreciation. Price returns fluctuated from year to year from 1986 to 2008 while income returns averaged 7.4 percent.

Overview

The ability to legally "pool" capital to gain leverage is a significant advantage offered by investment in REITs because the securities laws normally prohibit pooling in order to protect unsophisticated investors. The REIT investor enjoys the advantage of the power of the pool of capital to acquire interests in much larger opportunities than would be available to their personal capital alone. The "participatory" type of leverage of a REIT is significantly different in kind to the financial leverage normally available to a direct investor in real estate who utilizes a common strategy such as a 90/10 (90% financed/ 10% down payment). True leverage parity for a REIT would be trading on margin which is commonly limited to 50%.

Like stocks, REITs are traded on majorexchanges, and they have several benefits over owning pure properties. REITs are highly liquid, and there is no minimum investment, so shares can be bought and sold through stock brokers enjoying greater flexibility than real estate agents who must find buyers with large amounts of investment capital. Second, REITs enable investment in Commercial Real Estate, such as malls, hotels, movie theaters, and other industrial properties. REITs do not necessarily increase and decrease in value along with the broader real estate or stock markets. They pay yields in the form of dividends no matter how the shares perform, as they are valued differently than stocks.

Many factors affect the value of a REIT’s share price beginning with the earnings tied to generally predictable and growing streams of rental revenue and a price to earnings multiple assigned by the marketplace. The level and growth of rents are largely determined by economic fundamentals of supply and demand in real estate markets. These fundamentals include demographic factors such as population size, population growth, employment growth, construction and the level of overall economic activity. While differing from region to region, all of these factors typically have a direct impact on rents and occupancy rates, which affect projected earnings and property values.^[7]

Who Invests in REITs?

Many real estate investment professionals who build individual wealth (not necessarily corporate or institutional wealth) by direct private ownership of real estate consider REITs to be a "poor man's" strategy for investment in real estate. "Poor" means investors who lack sufficient capital to overcome barriers to entry in direct private investment in the power of real estate may still participate by means of a REIT. "Poor" also means "investors" who lack sufficient education and experience to competently apply sophisticated real estate investment strategies.

A professional investor designing a balanced risk real estate investment portfolio may consider using REITs for a small percentage of the total portfolio but would not likely give up the superior returns of more sophisticated real estate investment strategies because REITs only return 1) a small annual return percentage plus 2) dividends whereas the most commonly used professional strategy returns 1) monthly cash flow income; 2) phantom income (depreciation); 3) deduction of expenses against tax liabilities; 4)capital appreciation and 5) deferred taxation.

How REITs Work

Investment in REITS results in a "shift" in market risk for the investor. Direct investment in real estate exposes the investor to changes in price volatility spread over the weeks and months that real estate markets normally takes to change significantly. Investment in REITS exposes the investor to the risk of much shorter term, moment by moment and or daily, price volatility driven by the largely emotionally based forces ("support" and "resistance") of the securities markets and the uncertainties and whims of the "Electronic Herd" of global securities traders and institutions.

REITs are also expose the investor to the risk of price volatility driven by global economic factors and crises in other electronic markets and countries whereas direct investment in real estate is normally driven by local, regional and to a smaller degree national market pressures.

Simple Interest Calculated Rates of Return on REITS are considered low when compared to "standard" real estate investment strategies that commonly offer low-risk 90/10 or 95/5 leverage and 40%-90% annual return for the most common strategy and 50% to 200% returns on another common strategy. Time-based analysis (CAGR) of REIT returns are also normally low when compared to direct investment in real estate.

REIT Tax Code Requirements

A REIT must be formed in one of the 50 states or District of Columbia as an entity taxable for federal purposes as a corporation. It must be governed by directors or trustees, and its shares must be transferable. Beginning with its second taxable year, a REIT must meet two ownership tests: it must have at least 100 different shareholders (the "100 Shareholder Test"), and 5 or fewer individuals cannot own more than 50% of the value of the REIT's stock during the last half of its taxable year (the "5/50 Test"). These ownership requirements generally mean that the REIT structure is not a good choice for a closely held family business. A number of "look through" rules currently apply when determining whether the REIT meets the 5/50 Test.

In an attempt to ensure compliance with these tests, most REITs include percentage ownership limitations in their organizational documents. For example, many REITs do not permit any one shareholder to own more than at most 9.9% of a REIT's stock without a waiver by the REIT's board of directors. Because of the need to have 100 shareholders and the complexity of both of these tests, general legal, and tax and securities law advice are strongly recommended prior to beginning the process of forming a REIT.

The REIT must satisfy two annual income tests and a number of quarterly asset tests that are designed to ensure that the majority of the REIT's income and assets are derived from real estate sources.

Annually, at least 75% of the REIT's gross income must be from real estate-related income such as rents from real property and interest on obligations secured by mortgages on real property. Additionally, 95% of the REIT's gross income must be from the above-listed sources, but can also include other passive forms of income such as dividends and interest from non-real estate sources (like bank deposit interest). As a result of these rules, no more than 5% of a REIT's income can be from nonqualifying sources, such as from service fees or a non-real estate business. A REIT can own up to 100% of the stock of a "taxable REIT subsidiary" ("TRS"), a corporation with which a REIT makes a joint election that can earn such income.

Quarterly, at least 75% of a REIT's assets must consist of real estate assets such as real property or loans secured by real property. Although a REIT can own up to 100% of a TRS, a REIT cannot own, directly or indirectly, more than 10% of the voting securities of any corporation other than another REIT, TRS or qualified REIT subsidiary ("QRS"), a wholly-owned subsidiary of the REIT whose assets and income are considered owned by the REIT for tax purposes. Nor can a REIT own stock in a corporation (other than a REIT, TRS or QRS) the value of whose stock comprises more than 5% of a REIT's assets. Finally, the value of the stock of all of a REIT's TRSs cannot comprise more than 20% of the value of the REIT's assets.

In order to qualify as a REIT, generally, the REIT must distribute at least 90% of the sum of its taxable income. To the extent that the REIT retains income, it must pay tax on such income just like any other corporation.

In order to qualify as a REIT, a company must make a REIT election. The REIT election is made by filing an income tax return on Form 1120-REIT. Because this form is not due until, at the earliest, March 15th following the end of the REIT's last tax year, the REIT does not make its election until after the end of its first year (or part-year) as a REIT. Nevertheless, if it desires to qualify as a REIT for that year, it must meet the various REIT tests during that year (with the exception of the 100 Shareholder Test and the 5/50 Test, both of which must be met beginning with the REIT's second taxable year.) Additionally, the REIT annually must mail letters to its shareholders of record requesting details of beneficial ownership of shares. Significant monetary penalties will apply to a REIT that fails to mail these letters on a timely basis.

REIT - Residential

REIT - Healthcare

REIT - Hotel/Motel

REIT - Diversified

REIT - Retail

REIT - Mortgage

REIT - Industrial

REIT - Office

References

1. ↑ National Association of Real Estate Investment Trusts. What is a REIT?
2. ↑ BXP Press Release as of July 8, 2009
3. ↑ SPG Press Release as of May 7, 2009
4. ↑ VNX Press Release as of April 22, 2009
5. ↑ PLD Press Release as of April 8, 2009
6. ↑ KIM Press Release as of April 3, 2009
7. ↑ The Investor's Guide to REITs. by NAREIT, page 6