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Real Estate Investment Trust (REIT)

A REIT is a real estate investment company whose shares trade on the stock exchanges. Its assets must be primarily invested in real estate, and the trust acts as a tax conduit. REIT’s are taxed at the shareholder level, not at the corporate level, thus avoiding double taxation, similar to an S corporation.   

Investors benefit by a combination of having a high yielding dividend and through stock price appreciation. With the population in the United States doubling approximately every 50 years, there is a constant need for real estate, making REITs an attractive investment vehicle.

There are three types of REITs:

·        Equity REIT: Owns and manages the actual properties.

·        Mortgage REIT: Makes investments in real estate mortgages or mortgage backed securities.

·        Hybrid REIT: Owns both the actual properties, as well as investments in real estate mortgages or mortgage backed securities.

The typical types of real estate involved with REITs are hotels, shopping malls, factory outlet centers, apartment buildings, office and industrial properties, healthcare facilities and self storage units.

REITs must comply with strict IRS guidelines to maintain their free corporate income tax status. The most important regulations are:  

·        90% of their taxable income must be paid to its shareholders.

·        75% or more of their assets must be invested in real estate or mortgages.

·        75% or more of their gross income must be from real estate or mortgages.

They must have at least 100 shareholders and must have less than 50% of their shares outstanding concentrated in 5 or fewer shareholders (5/50 test).

Investors’ tax concerns are also important. Accounting for dividends on individual tax returns is complicated. Dividends have three components: ordinary income, long term gains or losses, and return of capital (when the payout exceeds net income), each having different tax ramifications. Additionally, investors may need to contact the company after year-end for the break out of the dividend, if it’s not included with the company’s form 1099.

When a REIT is included in a tax deferred account such as an IRA or 401k plan, some of the tax advantages are reduced.  For example; the cash dividend of a REIT included in a tax deferred plan is tax deferred when paid; however, when disbursed from an IRA or 401k plan, it is all considered ordinary income. Thus, some of the capital gains and depreciation tax benefits are lost.  

REITs’ values are determined by their potential cash flow, which is normally greater than GAAP net income. The cash flow is what is distributed to investors, as dividends. GAAP accounting requires companies to depreciate property, thus reducing net income by a non-cash expense. Investors are more concerned with a REIT’s cash flow than GAAP earnings. Funds From Operations (FFO) has become the industry standard for calculating operating cash flow that is available to the company.

AFFO is more commonly used by investors, because it emphasizes free cash flow available to shareholders, and is a good indicator of the REIT's ability to pay dividends.

The share prices of REITs are determined by using a multiple of AFFO.  

REITs have many advantages: They allow small investors with limited resources to purchase pro-rated shares of multiple commercial real estate properties. The companies have stable cash flows and predictable rent rolls, limiting their price swings. Like stocks, they are liquid and one’s investment risk is limited to the amount invested. REITs have high yields, plus capital appreciation potential. In the future, retail stores such as Sears, Toys-R-US or McDonalds, could package their real estate holdings into REITs and sell them or spin them off to their shareholders, offering additional asset categories to investors.    

 

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