Frequently Asked Questions About REIT?
What is a REIT?
A REIT is a company that owns and, in most cases, operates income-producing real estate such as apartments, shopping centers, offices, hotels and warehouses. Some REITs also engage in financing real estate. The shares of a REIT are freely traded, usually on a major stock exchange.
To qualify as a REIT, a company must distribute at least 90 percent of its taxable income to its shareholders annually. A company that qualifies as a REIT is permitted to deduct dividends paid to its shareholders from its corporate taxable income. As a result, most REITs remit at
least 100 percent of their taxable income to their shareholders and therefore owe no corporate tax. Taxes are paid by shareholders on the dividends received and any capital gains. Most states honor this federal treatment and also do not require REITs to pay state income tax.
Like other businesses, but unlike partnerships, a REIT cannot pass any tax losses through to its investors.
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Why Were REITs Created?
Congress created REITs in 1960 to make investments in large-scale, income-producing real estate accessible to smaller investors. Congress decided that the only way for average investors to invest in large-scale commercial properties was the same way they invest
in other industries, through the purchase of publicly traded stock. In the same way as shareholders benefit by owning stocks of other corporations, the stockholders of a REIT earn a pro rata share of the economic benefits that are derived from the production of income
through commercial real estate ownership. REITs offer distinct advantages for investors; greater diversification through investing in a portfolio of properties rather than a single building and expert management by experienced real estate professionals.
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How Does a Company Qualify as a REIT?
In order for a company to qualify as a REIT, it must comply with certain provisions within the Internal Revenue Code. As required by the Tax Code, a REIT must:
- be an entity that is taxable as a corporation;
- be managed by a board of directors or trustees;
- have shares that are fully transferable;
- have a minimum of 100 shareholders;
- have no more than 50 percent of the shares held by five or fewer individuals during the last half of each taxable year;
- invest at least 75 percent of the total assets in real estate assets;
- derive at least 75 percent of gross income from rents from real property, or interest on mortgages on real property;
- have no more than 25 percent of its assets consist of stocks in taxable REIT subsidiaries;
- pay dividends of at least 90 percent of its taxable income in the form of shareholder dividends.
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How are REITs Different from Limited Partnerships?
REITs are not partnerships, although as is the case with other corporations, REITs use partnerships to engage in joint ventures. There are important organizational and operational differences between REITs and limited partnerships.
One of the major differences between REITs and limited partnerships is how annual tax information is reported to investors. An investor in a REIT receives a traditional IRS Form 1099 from the REIT, indicating the amount and type of income received during the year. An
investor in a partnership receives a very complicated IRS Schedule K-1. Also a REIT investor must file less state tax returns than required by a partnership investment.
The oversight/corporate governance features of a REIT are believed to be far superior to those of a partnership.
Other important differences between REITs and limited partnerships are shown in the chart below.
| |
REITs |
Partnerships |
| Liquidity |
Yes; most REITs are listed on stock exchanges |
No. When liquidity exists, generally much less than REITs |
| Minimum Investment Amount |
None |
Typically $2,000-$5,000 |
| Reinvestment Plans |
Yes, including some at discounts |
No |
| Ability to Leverage Property Investments without Incurring UBIT for Tax-Exempt Accounts |
Yes; this makes REITs suitable for individual IRAs, 401(k), and other pension plans |
No |
| Investor Control |
Yes, investors re-elect directors |
No, controlled by general partner who cannot be easily removed by limited partners |
| Independent Directors |
Yes, stock exchange rules or state law typically requires majority to be independent of management |
No |
| Beneficial Ownership |
At least 100 shareholders required; most REITs have thousands |
Shared between any number of limited and general partners |
| Ability to Grow by Additional Public Offerings of Stock or Debt |
Yes |
Rarely |
| Ability to Pass Losses on to Investors |
No |
Yes |
| Information to Investors |
Form 1099 |
Form K-1 |
| Subjects investors to state taxes |
Only in state where investor resides |
Yes, for all states in which it owns properties |
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How Many REITs Are There?
As of Dec. 31, 2008, there were 136 REITs registered with the
Securities and Exchange Commission in the United States that trade
on one of the major stock exchanges - the majority on the New
York Stock Exchange. These REITs have a combined equity market
capitalization of $192 billion.
Additionally, there are REITs that are registered with the SEC but are
not publicly traded, and REITs that are not registered with the SEC or
traded on a stock exchange. Internal Revenue Service shows that
there are about 1,100 U.S. REITs that have filed tax returns.
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What Types of REITs are There?
The REIT industry has a diverse profile, which offers many attractive opportunities to investors.
REITs often are classified in one of the three categories: equity, mortgage or hybrid.
Equity REITs own and operate income-producing real estate. Equity REITs increasingly have become primarily real estate operating companies that engage in a wide range of real estate activities, including leasing, development of property and tenant services. One
major distinction between REITs and other real estate companies is that a REIT must acquire and develop its properties primarily to operate them as part of its own portfolio rather than to resell them once they are developed.
Mortgage REITs lend money directly to real estate owners and operators or extend credit indirectly through the acquisition of loans or mortgage-backed securities. Today's mortgage REITs generally extend mortgage credit only on existing properties. Many modern mortgage REITs also manage their interest rate risk using securitized mortgage investments and dynamic hedging techniques.
Hybrid REITs both own properties and make loans to real estate owners and operators.
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Who Determines a REIT's Investments?
A REIT's investments are determined by its board of directors or trustees. Like other companies, a REIT's Directors are elected by, and responsible to, the shareholders. In turn, the directors appoint the management personnel. As with other public corporations, REIT directors are typically well-known and respected members of the real estate, business and professional communities.
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How are REITs Managed?
Like other public companies, the corporate officers and professionals that manage REITs are accountable both to their boards of directors as well as their shareholders and creditors. Many REITs became public companies within the past 10 years, often transforming to public ownership what had previously been private enterprises. In many cases, the majority owners of these private enterprises became the senior officers of the REIT and rolled their ownership positions into shares of the new public companies. Thus, the senior management teams of many REITs have ownership interest which are aligned with interests of shareholders.
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How do REITs Measure Financial Performance?
Like the rest of corporate America, the REIT industry uses net income as defined under Generally Accepted Accounting Principles (GAAP) as the primary operating performance measure for real estate companies.
The REIT industry also uses Funds From Operations (FFO) as a supplemental measure of a REIT's operating performance. NAREIT defines FFO as net income (computed in accordance with GAAP) excluding gains or losses from sales of most property and depreciation of real estate. When real estate companies use FFO in public releases or SEC filings, the law requires them to reconcile FFO to GAAP net income.
Many real estate professionals as well as investors believe that commercial real estate maintains residual value to a much greater extent than machinery, computers or other personal property. Therefore, they view the depreciation measure used to arrive at GAAP net income as generally overstating the economic depreciation of REIT property assets and the actual cost to maintain and replace these assets over time, which may in fact be appreciating. Thus, FFO excludes real estate depreciation charges from periodic operating performance. Many securities analysts judge a REIT's performance according to its Adjusted FFO (AFFO), thereby deducting certain recurring capital expenses from FFO.
NAREIT's April 2002 "White Paper" on FFO discusses the definition in detail, advises REITs to adopt certain computational and disclosure practices and recommends that REITs disclose additional information about other financial calculations such as details on capital expenditures.
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How do Shareholders Treat REIT Distributions for Tax Purposes?
REITs are required by law to distribute each year to their shareholders at least 90 percent of their taxable income. Thus, as investments, REITs tend to be among those companies paying the highest dividends. The dividends come primarily from the relatively stable and predictable stream of contractural rents paid by the tenants who occupy the REIT's properties. Since rental rates tend to rise during periods of inflation, REIT dividends tend to be protected from the long term corrosive effect of rising prices.
For REITs, dividend distributions for tax purposes are allocated as ordinary income, capital gains and return of capital, each of which may be taxed at a different rate. All public companies, including REITs, are required to provide their shareholders early in the year with
information clarifying how the prior year's dividends should be allocated for tax purposes. This information is distributed by each company to its list of shareholders on IRS Form 1099-DIV. An historical record of the allocation of REIT distributions between ordinary
income, return of capital and capital gains can be found on NAREIT's web site.
A return of capital distribution is defined as that part of the dividend that exceeds the REIT's taxable income. Because real estate depreciation is such a large non-cash expense that likely overstates the decline in property values, the dividend rate divided by FFO is
used as a more appropriate measure of the REIT's ability to pay dividends.
A return of capital distribution is not taxed as ordinary income. Rather, the investor's cost basis in the stock is reduced by the amount of the distribution. When shares are sold, the excess of the net sales price over the reduced tax basis is treated as a capital gain for
tax purposes. So long as the appropriate capital gains rate is less than the investor's marginal ordinary tax rate, a high return of capital distribution may be especially attractive to investors in high tax brackets.
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What Real Estate Fundamentals Should I Consider Before Investing?
REIT investors often compare current stock prices to the net asset value (NAV) of a company's shares. Net Asset Value is the per share measure of the market value of a company's net assets. At times, the stock price of a REIT may be more or less than its NAV. Investors should understand some of the fundamental factors that influence the value of a REIT's real estate holdings. One critical factor is how well balanced the supply of new buildings is with the demand for new space. When construction adds new space into a market more rapidly than it can be absorbed, building vacancy rates increase, rents can weaken and property values decline, thereby depressing net asset values.
In a strong economy, growth in employment, capital investment and household spending increase the demand for new office buildings, apartments, industrial facilities and retail stores. Population growth also boosts demand for apartments. However, the economy is not
always equally strong in all geographic regions, and economic growth may not increase the demand for all property types at the same time. Thus, investors should compare the locations of properties of different companies with the relative strength or weakness of real
estate markets in those locations. Information on company properties is available at their Internet sites, while information on local or regional real estate markets is available in the financial press.
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How Are REIT Stocks Valued?
Like all companies whose stocks are publicly traded, REIT shares are priced every day in the market and give investors an opportunity to value their portfolios daily. To assess the investment value for these shares, typical analysis involves one or more of the following
criteria:
- Management quality and corporate structure;
- Anticipated total return from the stock, calculated from the anticipated price change and the prevailing yield;
- Current dividend yield relative to other yield-oriented investments (e.g., bonds, utility stocks and often high-income investments);
- Dividend coverage from funds from operations;
- Anticipated growth in funds from operations per share; and
- Underlying asset value of the real estate and/or mortgages, and other assets.
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What Factors Contribute to REIT Earnings?
Growth in earnings typically comes from several sources, including higher revenues, lower costs and new business opportunities. The most immediate sources of revenue growth are higher rates of building occupancy and increasing rents. As long as the demand for new properties remains well balanced with the available supply, market rents tend to rise as the economy expands. Low occupancy in under-utilized buildings can be increased when skilled owners upgrade facilities, enhance building services and more effectively market properties to new types of tenants. Property acquisition and development programs also create growth opportunities, provided the
economic returns from these investments exceed the cost of financing. Like other public companies, REITs and publicly traded real estate companies also grow earnings by improving efficiency and taking advantage of new business opportunities.
The REIT Modernization Act (RMA), which took effect on January 1, 2001, provides REITs with other opportunities to grow earnings. Prior to the enactment of the RMA, REITs were limited to providing only those services that were long accepted as being "usual and customary" landlord services, and were restricted from offering more cutting-edge services provided by other landlords. The RMA allows REITs to create subsidiaries that can provide the competitive services that many of today's tenants desire.
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Who Invests in REITs?
Tens of thousands of individual investors, both U.S. and non-U.S., own shares of REITs. Other typical buyers of REITs are pension funds, endowment funds and foundations, insurance companies, bank trust departments and mutual funds.
Investors typically are attracted to REITs for their high levels of current income and the opportunity for moderate long-term growth. These are the basic characteristics of real estate. In addition, investors looking for ways to diversify their investment portfolios beyond
other common stocks as well as bonds are attracted to the unique characteristics of REITs.
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Why Should I Invest in REITs?
REITs are total return investments. While past performance is no guarantee of future results, REITs typically have provided high dividends plus the potential for moderate, long-term capital appreciation. Long-term total returns of REIT stocks have been likely to be somewhat less than the returns of high-growth stocks and somewhat more than
the returns of bonds. Because most REITs also have a small-to-medium equity market capitalization, their returns should be comparable to other small to mid-sized companies.
There is a relatively low correlation between REIT and publicly traded real estate stock returns and the returns of other market sectors. Thus, including REITs and publicly traded real estate stocks in your investment program helps build a diversified portfolio.
REITs offer investors the potential for:
- Attractive dividend income;
- Dividend growth that has consistently exceeded the rate of consumer price inflation;
- Liquidity: shares of publicly traded REITs are readily converted into cash because they are traded on the major stock exchanges;
- Professional management: REIT managers are skilled, experienced real estate professionals;
- Portfolio diversification: minimizes overall risk;
- Performance Monitoring: a REIT's performance is monitored on a regular basis by independent directors of the REIT, independent analysts, independent auditors, and the business and financial media. This scrutiny provides the investor a measure of protection and more than one barometer of the REIT's financial condition.
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What Should I look for when Investing in a REIT?
The market usually rewards companies that demonstrate consistent earnings and dividend growth with higher price-earnings multiples. Thus, investors should look for REITs and publicly traded real estate companies with the following characteristics:
- A demonstrated ability to grow their earnings in a responsible manner. For example, look for companies with properties in which rents are below current market rents. Such properties provide upside potential in equilibrium markets and downside protection when economic growth slows
- Management teams able to quickly and effectively reinvest cash flow.
- The ability to consistently complete new projects on time and within budget.
- Creative management teams with sound strategies for developing new revenue opportunities.
- Strong operating characteristics, including effective corporate governance procedures, conservative leverage, widely accepted accounting practices, strong tenant relationships and a clearly defined operating strategy for succeeding in competitive markets.
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How Do I Invest In a REIT?
An individual may invest in a publicly traded REIT, which in most cases is listed on a major stock exchange, by purchasing shares through a stock broker. An investor can enlist the services of a broker, investment advisor or financial planner to help analyze his or her
financial objectives. These individuals also may be able to recommend an appropriate REIT for the investor. An investor also can contact a REIT directly for a copy of the company's annual report, prospectus and other financial information. Much of this information is now available on individual REIT companies' web sites. The NAREIT web site also lists all publicly traded REITs with their stock exchange symbols. Many local libraries offer a wide range of publications which provide investment research and information on public companies such as REITs.
Another alternative is to diversify your investment further by buying shares in a mutual fund that specializes in investing in real estate securities. A list of such mutual funds is available on the NAREIT web site.
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Source: NAREIT
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