Real Estate Investment Trusts

Financial markets transfer funds from those who have excess funds to those who need funds. A financial market is a market in which financial assets or securities such as stocks and bonds can be purchased or sold. Funds are usually transferred in financial markets when one party purchases financial assets previously held by another party. Financial markets facilitate the flow of funds and thereby allow financing and investing by households, firms, and government agencies. Real estate investment trusts or REITs is a good example of a financial market.

What are REITs?

According to investopedia, REITs are securities that sell like stocks on the major exchanges and invest in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate. REITs can also be defined as a real estate company or trust that has elected to qualify under a certain tax provision to become a pass-through entity that distributes to its shareholders substantially all of its taxable earnings in addition to any capital gains generated from the sale or disposition of its properties.

Individuals have the possibility to invest in REITs either by purchasing their shares directly on an open exchange market or by investing in a mutual fund that specializes in public real estate. An additional benefit to investing in REITs is the fact that many are accompanied by dividend reinvestment plans which allow shareholders to automatically reinvest cash dividends and capital gains distributions, thereby accumulating more stock without paying brokerage commissions. Among other things, REITs invest in shopping malls, office buildings, apartments, warehouses and hotels. Some REITs will invest specifically in one area of real estate such as shopping malls, or in one specific region, state or country. Investing in REITs is a liquid, dividend-paying means of participating in the real estate market.

REITs in the past

Real estate investment trusts dates back to the 1880s when trusts were not taxed if there income was distributed to beneficiaries. In the 1930s, a Supreme Court decision required all passive investment vehicles that were centrally organized and managed like corporations to be taxed as corporations. This included real estate investment trusts. Stocks and bond investment companies were also affected by this decision but were able to secure legislation in 1936 which exempted regulated investment companies, including mutual funds, from federal taxation. After World War II, the need for large sums of real estate equity and mortgage funds raised interest in more extensive use of the real estate investment trust. In the year 1960, Congress passed the necessary legislation which gave REITs special tax considerations comparable to those accorded to mutual funds. This was effective January 1st of 1961. Special income tax benefits were accorded a new type of investment institution by an amendment to the Internal Revenue Code. Under this amendment, the unincorporated trust or association ordinarily taxed as a corporation is not taxed on distributed taxable income when it qualifies for the special tax benefits. In this case, only the beneficiaries pay the tax on the distributed income.

Legal requirements

In order to qualify as a real estate investment trust for taxation purposes, the trust needs to satisfy certain requirements. These requirements were made in regards to asset, income, distribution, stocks and ownership of real estate investment trusts. Requirements include the following:

Asset Requirements

• At least 75 percent of the value of a REIT’s assets must consist or real estate assets, cash, and government securities.

• Not having more than 5 percent of the value of the assets may consist of the securities of any consist of the securities of any one issuer if the securities are not includable under the 75 percent test.

• REITs may not hold more than 10 percent of the outstanding voting securities of any one issuer if those securities are not includable under the 75 percent test.

• Not more than 25 percent of its assets can consist of stocks in taxable REIT subsidiaries.

Income Requirements

• At least 95 percent of the entity’s gross income must be derived from dividends, interest, rents, or gains from sale of certain assets.

• At least 75 percent of gross income must be derived from rents, interest on obligations secured by mortgages, gains from sale of certain assets or income attributable to investments in other REITs.

Distribution Requirements

• Distributions to shareholders must equal or exceed the sum of 90 percent of REIT taxable income.

Stock and Ownership Requirements

• The REIT must be taxable as a corporation.

• The REIT must be managed by a board of directors or trustees.

• Shares in a REIT must be fully transferable.

• Shares in a REIT must be held by a minimum of 100 persons

• No more than 50 percent of REIT shares may be held by five or fewer individuals during the last half of a taxable year.

Umbrella Partnership Real Estate Interest Trust

An umbrella partnership REIT also known as an UPREIT is a REIT that owns a controlling interest in a limited partnership that owns the real estate, as opposed to a traditional structure in which the REIT directly owns the real estate. This entity structure has been used by REIT’s since 1992 to allow selling property owners the ability to convert their ownership of one or more of their specific real estate properties into an interest which is‚ immediately‚ or can ultimately be converted into‚ a private or public security. In the basic UPREIT structure‚ all REIT properties are acquired and owned directly or indirectly by its umbrella partnership. The umbrella partnership is the entity through which the REIT operates and collects all income from the properties. Thus‚ the REIT owns substantial interests in the operating partnership by being both its sole general partner and one of its limited partners.

Types of Trusts

There are three different types of publically traded real estate trusts which include equity trusts, mortgage trusts and hybrid trusts. There are also private REITs which are not listed on an exchange or traded over the counter. Equity REITs invest in and own properties so they are responsible for the equity or value of their real estate assets. Their revenues come principally from their properties' rents. Up to the 1970s, equity trusts was the most prevalent type of REIT but in the mid 1970s mortgage trusts became more important. In most recent times, the equity trust has again grown in importance and is now the dominant REIT type by both number and market capitalization figures. Mortgage REITs deal in investment and ownership of property mortgages. These REITs loan money for mortgages to owners of real estate, or purchase existing mortgages or mortgage-backed securities. Their revenues are primarily generated by the interest that they earn on the mortgage loans. Hybrid REITs combine the investment strategies of equity REITs and mortgage REITs by investing in both properties and mortgages. These hybrids combine the advantages of both types of equity and mortgage REITs to suit specific investment objectives. On January 8th 2009, 91 percent of REITs were equity REITs, 7 percent were mortgage REITs, and 1 percent were hybrid REITs.

Equity Trusts

Most REITs specialize by property type, others specialize by geographic location. Some specialize by both property type and location. Some REITs do not specialize but diversify by both property type and geographic location. In regards to equity trusts, they have generally been broken down by property type specialization. The National Association of Real Estate Investment Trusts or NAREIT divides equity REITs into different property types. These include Industrial/Office, retail, residential, diversified, lodging/resorts, health care, self-storage and specialty.

Conclusion

Historically, REITs have offered increased diversification, lower volatility, enhanced yields, and an opportunity to increase returns. In the most recent uncharacteristic market, REITs have fallen along with U.S equities due to rough economic downturn. Overall, real estate investment trusts continued to outperform the major markets in 2011. Most REITs remain well-positioned in the middle of this economic uncertainty, primarily due to access to capital, improving underlying property fundamentals, and favorable market dynamics. Many REITs have used these market conditions to bolster their portfolios by deploying available capital for opportunistic and strategic acquisitions. REITs still have a great potential for growth in the up and coming future and appear to be a constantly growing market which make them attractive investments.

Work cited

• Brueggeman, William B., and Jeffrey D. Fisher. Real Estate Finance and Investments. Boston: McGraw-Hill, 2004. Print. • Investopidia.com