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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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