Interested in a real estate investment that you don’t have to take care of? Real estate investment trusts offer you a way to do this. Often called REITs (pronounced “reets”), these are businesses, often corporations, that buy real estate and manage the properties. You can buy shares and receive dividends.
There are quite a variety of kinds of REITs, including:
- Commercial buildings
- Senior housing
- Medical office buildings and other medical real estate
- Shopping malls
- Foreign holdings
- There are also mutual funds made up entirely of REITs.
Some Pros and Cons of REITs
REITs give you a way to invest in real estate without having a lot of money. Since they are required by law to distribute 90% of the taxable earnings, they often have attractive income yields. The taxable earnings that are distributed to shareholders are tax-free to the corporation. Remember that not every business HAS taxable earnings every year.
Since the rents they receive from their tenants are generally predictable, their dividends tend to be rather reliable.
They are only as good as their management, of course, and if you weren’t born yesterday, you know that means that some REITs are no doubt better than others. A REIT mutual fund would be composed of different REITs and thus mitigate this risk.
Also, in some times and places real estate investments go down rather than up. In some cases, dividends may be suspended.
You do pay taxes on the dividends you receive.
So it’s an investment where doing your homework is a very good idea. You can get financial information on any particular REIT by contacting the firm or often from its website.
REITs can be part of an IRA, though there are tax pluses and minuses to that choice.
REITs are more closely tied in to what is going on in the real estate market than to what is going on in the stock market.
Diversification Benefits of REITs
Now more than ever, investors have realized the importance of diversifying their investment portfolios. From conservative fixed income investors seeking to increase their income while protecting themselves from future inflation to stock and bond investors who seek to diversify away the volatility of a concentrated portfolio, REITs offer investors a new way to accomplish an age-old investment goal: “How can I increase my return without taking on more overall risk?”
Diversification Benefits of REITs:
- REITs offer an attractive risk/reward tradeoff
- The correlation of REIT returns with other asset classes has declined over the past 30 years
- REITs may boost return or reduce risk when added to a diversified portfolio
- REITs are worth investigating as an addition to many types of portfolios.
FAQs About REITs
Here are answers to basic questions about REITs for investors, financial planners, stock brokers, the media and the general public.
1. What is a REIT?
2. Why were REITs Created?
3. How Can a Company Qualify as a REIT?
4. How Many REITs are There?
5. What Types of REITs are There?
6. What Types of Properties do REITs Invest in?
7. Who Determines a REIT’s Investments?
8. How are REITs Managed?
9. How do REITs Quantify Financial Performance?
10. How can Shareholders Treat REIT Distributions for Tax Purposes?
11. What Real Estate Fundamentals Should I Consider Before Purchasing?
12. How has Real Estate Financing Changed Over Time?
13. How are REIT Stocks Valued?
14. What Factors Contribute to REIT Earnings?
15. Who Invests in REITs?
16. Why Should I Invest in REITs?
17. What Role do REITs Perform in 401(k) Plans?
18. If I Own a House, do I Need to Invest in REITs?
19. What Should I Look for When Purchasing in a REIT?
20. How Can I Invest in a REIT?
21. How are REITs Different from Limited Partnerships?
A REIT is a company that owns, and typically, operates income-producing property such as apartments, shopping centers, offices, hotels and warehouses. Some REITs also engage in financing real estate. The stocks of most REITs are publicly traded, usually on a major stock market.
A business that qualifies as a REIT is permitted to deduct dividends paid to its shareholders out of its corporate taxable income. Because of this, most REITs remit at least 100 percent of the taxable income for their shareholders and so owe no corporate tax. Taxes are paid by investors on the dividends received and any capital gains. Most states honor this national treatment and also don’t require REITs to pay state income taxation. To qualify as a REIT, a company must distribute at least 90 percent of its taxable income to its shareholders annually. However, as with other companies, but unlike partnerships, a REIT can’t pass any tax losses through to its shareholders.
Congress created REITs in 1960 to make investments in large scale, income-producing property available to smaller investors. Congress determined that a way for ordinary investors to invest in large scale commercial properties was the exact same way they invest in different businesses, through the purchase of equity.
In precisely the exact same manner as investors benefit by owning shares of other corporations, the stockholders of a REIT make a pro-rata share of the economic benefits that derive from the production of income through commercial real estate ownership. REITs provide different advantages for investors: greater diversification through investing in a portfolio of properties as opposed to a single construction and management by experienced property professionals.
In order for a company to qualify as a REIT, it must comply with specific 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 handled by a board of directors or trustees
Have stocks that are fully transferable
Have a minimum of 100 shareholders
Have no more than 50 percent of its shares held by five or fewer individuals during the last half of the taxable year
Invest at least 75 percent of its total assets in real estate assets
Derive at least 75 percent of its gross income from rents from real estate land or interest on mortgages on real property
Have no more than 20 percent of its assets consist of stocks in taxable REIT subsidiaries
Pay annually at least 90 percent of its taxable income in the form of shareholder dividends
There are approximately 180 REITs registered with the Securities and Exchange Commission in America. Their assets total over $300 billion. As of December 31, 2002, about two-thirds of those traded on the major national stock exchanges:
New York Stock Exchange — 139 REITs
American Stock Exchange — 30 REITs
Nasdaq National Market System — 7 REITs
Additionally, there are several REITs that aren’t traded on a stock market.
The REIT industry has a varied profile, which provides many different investment opportunities to investors. REIT industry analysts frequently classify REITs in one of 3 classes: equity, mortgage or hybrid vehicle.
Equity REITs own and operate income-producing property. Equity REITs have become primarily property operating companies which engage in a wide assortment of property activities, such as leasing, development of real property and tenant solutions. 1 big distinction between REITs and other real estate companies is that a REIT must acquire and develop its properties primarily to operate them within its portfolio rather than to resell them when they are developed.
Mortgage REITs lend money directly to property owners and operators or expand credit through the purchase of loans or mortgage-backed securities. Today’s mortgage REITs generally extend mortgage credit only on existing properties. Many contemporary mortgage REITs also manage their interest rate risk with securitized mortgage investments and dynamic hedging methods.
As its name implies, a hybrid REIT both possesses properties and makes loans to property owners and operators.
Although most REITs trade on an established securities market, there’s absolutely not any need that REITs be publicly traded businesses. REITs that aren’t listed on an exchange or traded over-the-counter are known as”personal” REITs.
There are three typical types of private REITs:
(1) REITs targeted to institutional investors who take large financial positions;
(2) REITs which are syndicated to investors as part of a bundle of services offered by a financial advisor (a few of them have more than 500 shareholders and must file statements with the Securities and Exchange Commission just like publicly traded companies); and
(3)”incubator” REITs which are financed by venture capitalists together with the anticipation that the REIT will create a sufficient track record to establish a public offering in the future.
REITs are usually ordered in one of three ways: Conventional, UPREIT and DownREIT. A conventional REIT is one which owns its resources directly instead of through a working partnership.
In the Normal UPREIT, the spouses of an Existing Partnership and a REIT become partners in a new venture termed the Operating Partnership. For their various interests in the Operating Partnership (“Units”), the partners contribute the properties in the Existing Partnership and the REIT contributes the money. The REIT generally is the general partner and the vast majority owner of the Operating Partnership Units.
After a period of time (often one year), the spouses may enjoy the exact same liquidity of the REIT shareholders by tendering their Units for cash or REIT shares (at the option of the REIT or Operating Partnership). This conversion may result in the partners incurring the tax deferred in the UPREIT’s formation. The Unitholders may tender their Units within a time period, thereby spreading such tax. Additionally, when a spouse holds the Units until death, the estate tax rules operate in a such a manner as to provide that the beneficiaries may tender the Units for cash or REIT shares without paying income taxes.
A DownREIT is structured much as an UPREIT, but the REIT owns and operates properties aside from its interest in a controlled partnership that owns and operates separate possessions.
REITs invest in various property types: shopping centers, apartments, warehouses, office buildings, hotels, and many others. Some REITs specialize in 1 property type only, such as shopping malls, self-storage facilities or factory outlet shops. Health care REITs specialize in medical care facilities, including acute care, rehabilitation and psychiatric hospitals, medical office buildings, nursing homes and assisted living facilities.
Some REITs invest throughout the nation or in some other countries. Others specialize in one region only, or even one metropolitan area.
A REIT’s investments are determined by its board of directors or trustees. Like other publicly traded firms, a REIT’s directors are elected by, and accountable to, the shareholders. Subsequently, the directors appoint the management employees. Like other corporations, REIT supervisors are generally well-known and honored members of the real estate, business and professional communities.
Such as other public companies, the corporate officers and professionals who manage REITs are liable to both their boards of directors in addition to their shareholders and lenders. Many REITs became public companies over the previous 10 decades, frequently shifting to public ownership what formerly had been private enterprises. Oftentimes, the majority owners of these private enterprises became the senior officers of the REIT and rolled their ownership positions into stocks of the new public companies. Therefore, the senior management teams of several REITs today own a substantial part of the provider’s stock, which helps to align the financial interests of management with shareholders.
Like the rest of corporate America, the REIT industry believes net earnings as defined under Generally Accepted Accounting Principles (GAAP) are the principal operating performance measure for real estate businesses.
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 (calculated in accordance with GAAP) excluding gains or losses from sales of the majority of property and depreciation of property. When real estate businesses use FFO in public releases or SEC filings, the legislation requires them to reconcile FFO to GAAP net income.
Many real estate professionals in addition to investors think that commercial property maintains residual value to a far greater extent than machines, computers or other private property. Thus, they believe the depreciation measure utilized to arrive at GAAP net income generally overstates the economic depreciation of REIT property assets and the real cost to keep and replace those assets over time, which may actually be appreciating. Thus, FFO excludes property depreciation charges from regular operating performance. Many securities analysts estimate that a REIT’s performance based on its Adjusted FFO (AFFO), thereby devoting certain recurring capital expenses from FFO.
NAREIT’s April 2002″White Paper” on FFO discusses the definition of detail, advises REITs to adopt particular computational and disclosure practices and urges that REITs disclose additional information regarding other financial calculations including details about capital expenditures.
REITs are required by law to distribute annually to their shareholders at least 90 percent of their taxable income. Thus, as investments, REITs tend to be one of those companies paying the greatest dividends. The dividends come primarily in the relatively stable and predictable flow of contractual rents paid by the tenants that occupy the REIT’s properties. Since rental prices tend to rise during times of inflation, REIT dividends are usually guarded in the long-term corrosive impact of rising costs.
For REITs, dividend distributions for tax purposes are allocated to ordinary income, capital gains and return of capital, each of which could be taxed at a different speed. All public companies, including REITs, need to provide their shareholders early in the year with information clarifying how the prior year’s dividends must 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 involving average income, return of capital and capital gains are seen in NAREIT’s web site, www.nareit.com.
A return of capital distribution is defined as that area of the dividend which exceeds the REIT’s taxable income. Because property depreciation is such a large non-cash investment that may overstate any decrease in property values, the dividend rate divided by Funds From Operations (FFO) or Adjusted Funds From Operations (AFFO) is used by many as a step of the REIT’s ability to pay dividends.
A return of capital distribution isn’t taxed as ordinary income. Instead, the investor’s cost basis in the stock is decreased 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. As long as the suitable capital gains rate is less than the investor’s marginal ordinary income tax rate, a high yield of capital distribution might be particularly appealing to investors in higher tax brackets.
REIT investors frequently compare current stock prices to the net asset value (NAV) of a provider’s assets. NAV is the per share measure of the market value of a business’s net assets. Occasionally, the stock price of a REIT could be more or less than its NAV. Investors must understand some of the basic factors that influence the value of a REIT’s property holdings. 1 critical element is how well balanced the distribution of new buildings is with the demand for new space. When building adds new space into a marketplace more quickly than it can be consumed, building vacancy rates increase, rents can weaken and property values decrease, thereby depressing net asset values.
In a strong market, growth in employment, capital investment and household spending increase the demand for new office buildings, apartments, industrial facilities and retail shops. Population growth also boosts the demand for flats. However, the economy isn’t always equally strong in all geographic regions, and economic growth may not raise the requirement for all property types in exactly the exact same time. Therefore, investors should compare the locations of properties of different businesses with the relative strength or weakness of property markets in those places.
Information on business properties can be obtained at their Web sites, while information on local and regional property markets can be obtained in the financial press or in research sites on the Internet such as www.lendlease.com or www.tortowheatonresearch.com.
Historically, income-producing commercial property frequently was funded with high levels of debt. Properties supplied tangible security for mortgage funding, and the rental income from these properties was a definite source of revenue to cover the interest cost on the loan. Property markets often were dominated by programmers or entrepreneurial businessmen who had been trying to build personal fortunes and that were eager to undertake huge risks to achieve that. Before the real estate downturn of the early 1990s, it wasn’t unusual for individual properties to take mortgages that represented over 90 percent of their properties’ estimated market value or cost of building. Sometimes, loan-to-value ratios went even higher. The severe real estate recession of the early 1990s forced many property lenders, owners and developers to rethink the suitable use of debt financing on real estate projects.
Nowadays, properties owned by REITs are financed on a far more conservative foundation. Normally, REITs are funding their jobs with about half debt and half equity, which considerably reduces interest rate exposure and makes a much stronger business performance. Two-thirds of those REITs with senior unsecured debt ratings are investment grade.
Like all companies whose shares are publicly traded, REIT stocks are priced daily in the marketplace and give investors a chance to appreciate their portfolios daily.
To assess the investment value of REIT stocks, average analysis involves one or more of these criteria:
- Management caliber and corporate structure
- Anticipated total yield from the stock, estimated from the expected price change and the prevailing dividend yield
- Present dividend yields relative to other yield-oriented investments (e.g. bonds, utility stocks and other high-income investments)
- Dividend payout rates as a percentage of REIT FFO
- Anticipated increase in earnings per share
- Underlying asset values of the actual estate or mortgages, and other resources.
Growth in earnings typically comes from several sources, including higher revenues, lower costs and new business opportunities. The most immediate sources of earnings growth are higher rates of building occupancy and raising rents. Provided that the demand for new properties remains well balanced with the available supply, market rents tend to grow as the market expands. Low prices in under-utilized buildings may be increased when proficient owners update facilities, improve building services and more effectively market properties to new kinds of tenants. Property acquisition and development plans also create growth opportunities, given the financial returns from such investments exceed the expense of financing. As with other public companies, REITs and publicly traded real estate firms also increase 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 different opportunities to increase earnings. Before the enactment of the RMA, REITs were limited to providing only those services which were long accepted as being”usual and customary” landlord services, and were restricted from providing more cutting edge services offered by other landlords. The RMA allows REITs to create subsidiaries that may offer the competitive solutions that many of the tenants want.
Tens of thousands of individual investors, both U.S. and non-U.S., own stocks 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 drawn to REITs due to their high levels of current income and the chance for moderate long-term expansion. These are the basic features of real estate. Additionally, investors searching for ways to diversify their investment portfolios beyond other common stocks in addition to bonds are drawn to the distinctive characteristics of REITs.
Today, a wide assortment of investors are using REITs to help achieve their investment targets, from large pension funds seeking diversification to the retired school teacher looking for a high-quality revenue investment.
REIT shares typically may be bought on the open market, with no minimum purchase required. Many investors also are opting to have REITs through mutual funds or exchange traded funds that focus on public real estate companies.
REITs are complete return investments. They typically offer high dividends in addition to the prospect of medium, long-term capital appreciation. Long-term total returns of REIT stocks will probably be somewhat less than the yields of high-growth stocks and marginally more than the yields of bonds.
Since most REITs have a small-to-medium equity market capitalization, their yields must be comparable to other small to midsize businesses.
There’s a relatively low correlation between REIT and publicly traded real estate stock returns and the returns of other market sectors. Therefore, including REITs and publicly traded real estate stocks on your investment plan helps build a diversified portfolio.
REITs offer investors:
- Present, stable dividend income
- High dividend yields
- Dividend growth that has surpassed the rate of consumer price inflation
- Liquidity: stocks of publicly traded REITs are easily converted to cash because they are traded on the major stock exchanges
- Professional management: REIT managers are skilled, experienced property professionals
- Portfolio diversification, which reduces risk
- Performance monitoring: a REIT’s performance is monitored on a regular basis by independent directors of the REIT, independent analysts, independent auditors, the Securities and Exchange Commission and the business and financial media. This evaluation provides the investor a measure of security and over 1 barometer of the REIT’s financial condition
Many 401(k) plans provide many different stock and bond investment choices. However, property is largely non-existent in the majority of the defined contribution plans. Real estate stocks’ competitive rates of return, steady levels of risk, and low correlation with the investment yields of other stocks and bonds provide significant diversification benefits to a multi-asset portfolio. Participants and sponsors should be certain their 401(k) plans include actual estate, one of the most powerful sources of portfolio diversification among their investment decisions. Historically, institutional investors have invested in broadly diversified portfolios of numerous investments, fulfilling their plan liabilities while controlling the risk of catastrophic losses in any 1 year. Individual investors may not realize the significance of this investment idea.
Ibbotson Associates, a leading authority on asset allocation examined the historical investment performance of the publicly traded equities of real estate companies to decide whether REITs provide meaningful diversification benefits in diversified portfolios. Ibbotson found that, historically, REITs have earned competitive returns and exhibited lower volatility than other kinds of stocks. Ibbotson also discovered that REIT returns are relatively uncorrelated with those of other stocks and bonds. In actuality, as the whole equity market capitalization of REITs increased and the firms attained wider analytical coverage from Wall Street analysts, the correlation of REIT returns with those of other investments declined appreciably. As a consequence of these investment attributes, the Ibbotson analysis shows that REITs are a powerful source of portfolio diversification, increasing returns and lowering risk in a broad assortment of diversified portfolios.
By way of example, the analysis by Ibbotson found that allocating 10 percent of your portfolio to REITs every year from 1972 to 2001 could have boosted the average yearly yield from 11.3 percent to 11.5 percent while reducing portfolio risk from 10.9 percent to 10.5 percent. Allocating 20 percentage points to REITs could have boosted average yearly yield to 11.7 percent while reducing portfolio risk to 10.2 percent.
REIT investing complements homeownership. While owning a home can be a fantastic investment, the investment advantages are enhanced when combined with REIT stocks.
Significantly, homeownership differs from additional investments in certain substantial ways. A home is a cost as much as it’s an investment, especially when funded with a mortgage that is sizable. It doesn’t produce current income, but instead requires monthly mortgage interest payments and other occasional expenses to be correctly maintained.
A widely-used indicator of single-family home prices nationally gained 5.7 percent annually on average from 1976 to 2001. Equity REITs, meanwhile, produced a 6.1 percent annual average yield on a price-only foundation, but with dividends reinvested, REITs’ average annual total return for its length was 15.2 percent.
The reduced correlation between REIT returns and home prices, combined with the attractive total return and moderate volatility of REITs, make it no surprise that REITs appear in the best portfolios estimated for both homeowners and tenants. In the last analysis, investors may have the ability to build greater long-term financial wealth when they unite homeownership and REIT stocks as part of a diversified investment portfolio.
The industry usually rewards businesses that demonstrate consistent earnings and dividend growth with greater price-earnings multiples. Thus, investors should look for REITs and publicly traded real estate companies with the following attributes:
A proven ability to increase earnings in a trusted manner. By way of instance, start looking for companies with properties where rents are below current market levels. Such properties offer upside potential in equilibrium markets and downside protection when economic growth slows.
Management teams able to rapidly and efficiently reinvest available cash flow. The capacity to consistently complete new projects on time and within budget. Creative management teams with solid strategies for creating new revenue opportunities under the REIT Modernization Act. Strong working features, including powerful corporate governance processes, conservative leverage, broadly accepted accounting practices, strong tenant relationships and a clearly defined working strategy for success in competitive markets.
A person can invest in a publicly traded REIT, which ordinarily is recorded on a major stock market, by buying shares through a stockbroker. An investor can enlist the assistance of a broker, investment advisor or financial planner to help assess their financial objectives. These professionals may have the ability to recommend appropriate REIT investments for the investor. An investor can also contact a REIT right to get a copy of the business’s annual report, prospectus and other financial details. Much of this information can be found on a organization’s web site.
The NAREIT website, www.nareit.com, also lists all publicly traded REITs using their trade symbols. Many regional libraries offer a wide assortment of books which provide investment research and data on public companies such as REITs.
Another choice is to increase your investment further by purchasing shares in a mutual fund that specializes in investing in real estate securities. A list of these mutual funds is available at the NAREIT web site. Investors can compare and assess the performance of mutual funds through public data sources like Morningstar, Inc., which may also be found in many regional libraries. These sources can provide detailed information on past performance, current portfolio holdings and information dealing with the many expenses of investing in funds. Additionally, there are a variety of real estate and REIT exchange traded funds and closed end funds.
REITs aren’t partnerships, though, as is the case with other businesses, REITs use partnerships to participate in joint ventures. There are significant organizational and operational differences between REITs and limited partnerships.
One of the significant differences between REITs and limited partnerships is the way that annual tax information is reported to investors. Annually, an investor at a REIT receives a conventional IRS Form 1099 in the REIT, indicating the amount and type of income received during the previous tax year. However, an investor in a venture receives a more complex IRS Program K-1 which must be supplied to taxpayers later in the year than a 1099. Additionally, a REIT investor must file fewer state tax returns than demanded by a venture investment. The corporate governance characteristics of a REIT are thought to be far superior to those of a partnership. Other significant differences between REITs and limited partnerships are outlined in the accompanying graph.