The Basics of Reits

The Basics of REITs

What is a REIT?

A REIT is a company that mainly 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 many REITs are traded on major Stock exchanges.

To qualify as a REIT, a company must have most of its assets and income tied to real estate investment and 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. Shareholder pay taxes on the dividends received and also on all capital gains distributions. 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.

Why were REITs created?

Congress created REITs in 1960 to make investments in large-scale to make income-producing real estate accessible to average investors. Congress decided that a way for average investors to invest in large-scale commercial properties was the same way they invest in other industries — through the purchase of equity. In the same way 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: portfolio diversification, strong and reliable dividends, liquidity, solid long-term performance and transparency.

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 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 property or interest on mortgages financing real property
Have no more than 25 percent of its assets consist of Stock in taxable REIT subsidiaries
Pay annually at least 90 percent of its taxable income in the form of shareholder dividends

How many REITs are there?

As of Jan. 1, 2012, there were 166 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 $579 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.

What Types of REITs are there?

The REIT industry has a diverse profile, which offers many investment opportunities. REITs often are classified in one of two categories: equity or mortgage.

Equity REITs:

Equity REITs mostly own and operate income-producing real estate. They increasingly have become real estate operating companies engaged in a wide range of real estate activities, including leasing, maintenance and development of real 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:

Mortgage REITs mostly lend money directly to real estate owners and operators or extend credit indirectly through the acquisition of loans or mortgage-backed securities. Today's mortgages REITs generally extend mortgage credit only on existing properties. Many mortgage REITs also manage their interest rate and credit risks using securitized mortgage investments, dynamic hedging techniques and other accepted derivative strategies.

Who manages a REIT?

Like other publicly traded companies, a REIT's executive management team operates The Company, deciding what properties it will own and manage. Management's decisions are overseen by a board of directors that is responsible to the shareholders. As with other corporations, REIT directors are typically well-known and respected members of the real estate, business and professional communities. Many of today's REITs became public companies within the past 15 to 20 years, often transforming to public ownership what previously had been private enterprises. In many cases, the majority owners of these private enterprises became the senior officers of the REIT and contributed their ownership positions to the REIT.

What types of properties do REITs own and manage?

REITs own and manage a variety of property types: shopping centers, health care facilities, apartments, warehouses, office buildings, hotels and others. Most REITs specialize in one property type only, such as shopping malls, timberlands, data centers or self-storage facilities.

Some REITs invest throughout the country or in some cases, throughout the world. Others specialize in one region only, or even in a single metropolitan area.

How are REITs different from partnerships?

REITs are not partnerships. Most publicly traded REITs are vertically integrated real estate companies that develop, own and actively manage commercial real estate. Shares in these companies are traded, the same as other Stocks, on major exchanges, providing complete liquidity and market pricing. Publicly traded REITs are subject to the same financial disclosure requirements as other publicly traded companies. Independent corporate governance consultants have rated the REIT industry's governance among the best of all U.S. industry groups.

How do REITs use partnerships?

Like other industries, the real estate industry, including REITs, often uses partnerships to co-venture with others. In addition, REITs are typically structured in one of three ways: the traditional REIT, the umbrella partnership REIT (UPREIT) and the DownREIT.

A traditional REIT is one that owns its assets directly rather than through an operating partnership.

In the typical UPREIT, a REIT partners with others, and the partnership is termed the "operating partnership." In return for their respective contributions, the REIT as well as the other partners receives interests in the operating partnership called operating partnership units (OP units). The REIT typically is the general partner and the majority owner of the OP units. For the partners contributing property to the operating partnership, any capital gain tax liability is deferred until such time as the OP units are converted into common Shares of the REIT.

After a period of time (often one year), the non-REIT partners may enjoy the same liquidity of the REIT shareholders by tendering their units for either cash or REIT Shares (at the option of the REIT or operating partnership). This conversion may result in the partners incurring the tax liability that had been deferred at the UPREIT's formation. However, the unit holders may tender their units over a period of time, thereby spreading out such tax. In addition, when a partner holds the units until death, the estate tax rules operate in such a way as to provide that the beneficiaries may tender the units for cash or REIT Shares without paying income taxes.

Private Equity Real Estate Fundraising

Nearly Triples in Second Quarter

7/2/2013 | By Carisa Chappell

Fundraising for private equity real estate investment more than doubled in the second quarter of 2013 from the previous quarter, according to the latest data released by alternative assets research firm Preqin.

The firm noted in its July 1 report that between the 33 closed-end private real estate funds that held final closes in the second quarter raised $17.3 billion. This represented a significant increase on the $6 billion raised in the first quarter which marked a 10-year low for private real estate fundraising.
“The second quarter of 2013 has seen increasing momentum in the private equity real estate fundraising market, with the capital raised in the quarter increasing by 188 percent,” said Andrew Moylan, head of real assets products for Preqin.
Another positive sign for the fundraising market in the second quarter, according to Moylan, was that $16.1 billion were raised toward the targets of 51 funds that held interim closes. These are closes in which the accounting records to determine the fund’s position are closed prior to that fund’s final closing.
Moylan also pointed out that the amount of time spent on the market by funds has decreased. Funds that closed in the first half of 2013 spent an average of 18.7 months in the fundraising market, a decrease from the average of 19.2 months taken by funds that closed in 2012.
Preqin data indicate that there are currently 446 private real estate funds in the market, targeting aggregate commitments of $168 billion. Moylan said that while the number of funds in the market has increased by just 12 from the first quarter, the aggregate target amount of funds on the road has gone up by $12 billion.
“Investor appetite for the asset class continues to improve. However, the fundraising market remains extremely competitive.” Moylan said. “The aggregate target of funds on the road has increased from $156 billion at the start of the second quarter of 2013 to $168 billion at the beginning of the third quarter of 2013.”
North American-focused funds raised the most capital with 26 receiving aggregate commitments of $15.3 billion. Three Europe-focused funds raised $8 billion, and four funds focused on Asia raised $1.2 billion.

A DownREIT is structured much like an UPREIT, but the REIT owns and operates properties other than its interest in a controlled partnership that owns and operates separate properties.

This Space Intentionally Left Blank

Characteristics of Publicly Traded, Non-Exchange

Traded and Private REITs:

Comparison Chart

Commercial Real Estate Will Remain Attractive to Investors

Professor Says 6/28/2013

Dan French, director of The Smith Institute of Real Estate at the University of Missouri, joined REIT.com for a video interview in Chicago at REITWeek 2013: NAREIT’s Investor Forum.
French described which fields of the real estate industry his students are most interested in studying and some of the most common misconceptions that they have regarding the industry.
“I think that probably the most common goal of our students is to get into the commercial real estate industry,” he said. “Probably the common misconception among students is that the real estate industry is sales. Of course that’s an important part of it, but just like the banking industry is not just commercial loan officer and teller, there are many things involved in the industry.”
“French shared his research findings related to the most pressing issues pertaining to real estate and corporate governance.

“We’ve looked at the relationship between a strong mission statement and leverage,” he said. “You might expect that a company with a strong mission statement would be trusted more by potential lenders, and so we might expect to see a strong positive relationship between debt and a strong mission statement, and that is exactly what we find for REITs. Those REITs that have stronger statements are able to go to the markets and borrow more money.”

“French also shared his opinion on whether commercial real estate will continue to be an attractive asset class for investors.
“I do think it will continue to be an asset class that is popular—it’s certainly popular among our students,” he said. “Our Smith Institute of Real Estate Forum, which we held just last month—we had Kenneth Langone, the founder of Home Depot as our guest speaker. We had over 400 students and 165 professionals attending. Certainly real estate is cyclical, and the interest in it is cyclical, but it seems that every cycle builds on the previous one, and I see that continuing on for the intermediate future.”

Non-Traded Private REITS Pros & Cons

By ROBBIE WHELAN

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June 15, 2014 4:51 p.m. ET

When Marcelo Hernandez, age 62, retired from his job designing Cadillacs and Buicks for module article chicletGeneral Motors Co. up, down, neutral GM +0.40% ticker content box a decade ago, he had about $450,000 in retirement funds to keep him afloat though the rest of his life.

But after the convulsions of the financial crisis that began in 2008, he decided he needed a different strategy for investing in his retirement.

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In 2010, after consulting with his financial adviser, he decided to take half of what remained in one of his retirement accounts, about $70,000, and invest in an increasingly popular alternative type of real-estate fund called nontraded real-estate investment trusts. From June 2010 through February 2014, Mr. Hernandez invested in a series of three nontraded REITs sponsored by American Realty Capital and distributed by Boston-based Realty Capital Securities LLC. From the time of his initial investment to the liquidation of the last fund, those REITs produced total returns, after fees, for Mr. Hernandez of 9%, 35.5% and 17.5%, his adviser says.

"I'm afraid of the stock market," Mr. Hernandez says in an interview from his home outside Detroit. "For the little guy, losing a little is losing a lot… . These funds have been great, because the market might go through a down period, and yet you're surviving it."

Many Takers

Nontraded REITs are attracting new funds at their fastest clip ever, according to Robert A. Stanger & Co., a Shrewsbury, N.J.-based investment bank that tracks the industry. After raising a record $19.6 billion last year, nontraded REITs in the first quarter raised $4.2 billion, or about 5% more than in the year-earlier quarter.

Most industry experts ascribe the rapid growth of the industry, which is not without its critics, to investor fears about the volatility of the stock market and a rising number of successful "liquidity events." Shares of most nontraded REITs are initially sold at $10 apiece and pay dividends; after a few years, the sponsors of the funds liquidate them through a sale, merger or public listing, returning cash to shareholders.

Data on returns are difficult to analyze because each fund starts raising money and eventually liquidates its holdings on its own timeline. But in an analysis prepared for The Wall Street Journal of 30 nontraded REITs that have completed the cycle of raising money, buying property and liquidating their assets, Stanger found an average annual return, including dividends and fees, of 8.4% for investors who bought at the midpoint of an offering.

Over the past five years, shareholders in nontraded REITs have cashed out $35.2 billion through liquidity events, according to Stanger. As a measure of how fast the industry is growing, consider that in 2003 investors received $127 million, compared with $16.2 billion in 2013. Through May of this year, nontraded REITs have completed $8.3 billion in liquidity events. Stanger acts as an adviser to sponsors of nontraded REITs in return for fees paid for investment-banking services.

"Investor value is creating investor demand," says Kevin Hogan, chief executive of the nontraded REIT industry's main trade group, the Ellicott City, Md.-based Investment Program Association. "These products are delivering the return people are starving for in the current low-interest-rate environment, and investors are voting with their pocketbooks," Mr. Hogan says.

High Fees

Skeptics of nontraded REITs, however, have been unsparing in their criticism of the sector, noting that the shares are highly illiquid and typically come with high fees. According to information on the Investment Program Association website, most nontraded REITs come with front-end fees ranging from 12% to 15% and could feature other fees over the life of the investment.

According to Craig McCann, a former economist with the Securities and Exchange Commission and president of Securities Litigation & Consulting Group, a research company in Fairfax, Va., "Nontraded REITs are costing investors, especially elderly, retired, unsophisticated investors, billions. They're suffering illiquidity and ignorance, and earning much less than what they ought to be earning." Says Mr. McCann, "No brokerage should be allowed to sell these things."

Joseph Harvey, chief investment officer at investment-management firm module article chicletCohen & Steers, up, down, neutral CNS +1.07% ticker content box a buyer of large stakes in publicly listed REITs, says the growth of nontraded REITs is a product of investors' attraction to dependable income in the form of high dividends, fear of stock-market volatility, and aggressive marketing by brokers. "These have been positioned as investments that don't have volatility so you can sleep well at night," he says. "It's misdirection. You can't measure the volatility of these investments because they do not trade."