The Re-Emergence of Real Estate Investment Trusts

By Scherrer, Phillip S. | Business Credit, January 1995 | Go to article overview

The Re-Emergence of Real Estate Investment Trusts


Scherrer, Phillip S., Business Credit


REITS were established by the United States Congress in 1960 as a conduit for pooled funds into professionally managed portfolios of real estate assets. The REIT is a trust organized to pool capital for the purpose of investing in real estate mortgage loans. Real estate investment trusts are creatures of the Internal Revenue Code. The REIT must comply exactly with the Internal Revenue Code requirements to qualify for the special tax treatment afforded to them.

REITS, similar to mutual funds, are capable of attracting investors with limited funds. The pooling of the invested funds into the trust allows for centralization of management and maximization of return. REITS are beneficial to individual investors because they do not require high individual investments. REITS have reduced liability and in an expanding economy they have a large upside. They provide more safety than most stocks because of the time proven stability, salability, and value of land. REITS can be traded on national stock exchanges and many REITS are in fact now publicly held.

REQUIREMENTS FOR A REIT

The crux of a REIT is that the earnings made by the investments are passed back to the investors without state and federal income taxation at the corporate level. The REIT is required to distribute 95 percent of its earned income annually to its shareholders. In addition, 75 percent of the REITs assets and income must be derived from real estate. The REIT must have a minimum of 100 shareholders. The real estate held in trust by the REIT must not be for sale in the ordinary course of business (in the event the REIT does sell real estate in its ordinary course of business then the income derived from such sales is subject to taxation at the corporate level and may be 100 percent taxable to the shareholders). The REIT must also operate in a passive manner, pursuant to the Internal Revenue Code and Regulations definition of passive.

TYPES OF REITS

There are basically three kinds of REITS, although Wall Street is creating several variations on the theme, they are:

1. Mortgage REIT--traditionally the highest yielding.

2. Equity REIT--has had best total returns.

3. Hybrid REIT--which combines both mortgage and equity positions.

Mortgage REITs invest in mortgage backed obligations and collect a stream of income from the payments made on the obligations. Mortgage REITs are capable of financing every phase of a real estate venture, including acquisition and development of the land. They can finance the construction and completion of the buildings and other improvements. A mortgage REIT can invest in residential and commercial projects, construction and development mortgages, interim-purchase mortgages, and mortgages purchased at a discount.

Equity REITs invest in real estate for the long term. They collect rents from the investment properties. They invest in properties which have prime tenants with leases which include escalation clauses to prevent erosion of the investment made by the REIT.

Hybrid REITs take both equity positions in real estate and also invest in real estate.

USES, ADVANTAGES, AND DISADVANTAGES OF REITS

REITS have been established for a variety of uses: construction loans, development loans, long term mortgages, condominiums, apartments, hotels, hospitals, property management, second mortgages, adjustable rate mortgages, and every other conceivable real estate related purpose including land acquisition.

The advantages of REITs are: Diversification--shareholders can have smaller investments and more shareholders can invest.

Liquidity--shares are often traded publicly and private funds have sufficient cash flow to repurchase shares.

Flexibility--concentration in growing markets with ability to change markets quickly.

Centralized management, limited liability, continuity of life, free transferability of shares.

Tax Shelter--distributions are deemed a return of capital, capital gain, income and/or a combination of all three. …

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