Real Estate Investment Trusts (REITs)

A Real Estate Investment Trust, (REIT), is a corporation or trust that combines the capital of many investors to acquire or provide financing for all forms of real estate. A corporation or trust that qualifies as a REIT generally does not pay corporate income tax to the Internal Revenue Service. Most states honor this federal treatment and do not require REITs to pay state income tax either. This means that nearly all of a REIT's income is distributed to shareholders, without double taxation on the income. Unlike a partnership, a REIT cannot pass its tax losses onto its investors.

President Dwight D. Eisenhower signed the Real Estate Investment Trust Act of 1960, creating an industry mat grew over the next 34 years to more than 270 REITs with combined real estate assets in excess of $60 billion. The basic provisions of the law have not changed since it was enacted, although several improvements have been made. REITs were created to provide investors with the opportunity to participate in the benefits of ownership of larger-scale commercial real estate or mortgage lending and receive an enhanced return because me income is not taxed at the REIT level.

In order for a corporation or trust 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 a corporation, business trust, or similar association; be managed by a board of directors or board of trustees; have shares mat are fully-transferable; have a minimum of 100 shareholders; have no more than 50%of the shares held by five or fewer individuals during the last half of each taxable year; invest at least 75% of the total assets in real estate assets; derive at least 75% of gross income from rents from real property, or interest on mortgages on real property; derive no more than 30% of gross income from the sale of real property held for less than four years, securities held for less than one year, or certain prohibited transactions; and pay dividends of at least 95% of REIT taxable income.

The REIT industry started off slowly, following its 1960 inception. By 1968, industry assets totaled only $1 billion. By 1974, however, total assets exceeded $20 billion. But rising interest rates, a national recession, and an overbuilt real estate market affected the performance of the early REITs, and the industry experienced its first general shakeout.

A restructuring and stabilization period followed. 1984 tax law changes made competitive tax-motivated real estate syndications less attracts causing renewed growth in REITs.

According to Richard Saltzman, managing director and head of Merrill Lynch's Real Estate Investment Banking Division, the real watershed event for the industry was the tax law change of the late 1980s that permitted the management of properties directly by the REIT.

REIT industry analysts classify REITS in one of three investment approaches: equity REITs, mortgage REITs, and hybrid REITs. Equity REITs own real estate, and their revenue principally comes from rent. Mortgage REITs lend money to real estate owners, and their revenue principally is derived from interest earned on mortgage loans. Some mortgage REITs also invest in residuals of mortgage-backed securities. Hybrid REITs combine the investment strategies of both equity REITs and mortgage REITs.

Pension funds, endowment funds, insurance companies, bank trust departments, mutual funds, and investors — both U.S.-based as well as non-U.S.-based — own shares of REITs. An individual who chooses to invest in a REIT seeks to achieve current income distributions and long-term stock appreciation potential, REIT shares typically can be purchased for $2 to $40 each, with no minimum purchase required.

Over 80% of the REITs operating in the United States today are traded on the national stock exchanges, including the New York Stock Exchange, the American Stock Exchange, and the NASDAQ National Market System. Dozens of REITs, however, are not traded on a stock exchange.

Analyzing the performance and value of current REITs values is not an easy task. Asset values may be derived using different rent multipliers and capitalization rates; but these values are derived from appraisal reports, which do not always reflect the same standards.

Rather than using asset values to analyze performance, the following criteria are recommended:

- management (prospective investors in a particular REIT should carefully examine the experience level of the management team); and
- future growth (which is contingent on the future income from the REIT s holdings).

Income, in turn, depends on rent which is influenced by vacancy levels, regional economic growth, and units available in an area. It is also affected to some degree by the sales level of the REIT's properties.