REITs Chapter 21 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? REITs (Real Estate Investment

REITs Chapter 21Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

What is it?

• REITs (Real Estate Investment Trust)– A publicly-traded closed-end investment company that invests in

a managed, diversified portfolio of real estate or real estate mortgages and construction loans rather than in financial securities such as stocks and bonds

• Set up as corporations or trusts• Not subject to tax at the corporate level if they distribute at

least 90% of their net annual earnings to shareholders and meet certain other requirements

• Investors must pay tax on the REIT’s earnings as the earnings are distributed.


Investment Planning


What is it?

• Investors have three types of REITs to choose from:– Equity REITs

• Acquire ownership interests in commercial, industrial, or residential properties

• Income is primarily received from the rentals of these properties

– Mortgage REITs• Invest in real estate indirectly by lending funds for construction

and/or permanent mortgages

– Hybrid REITs• Combine the features of both equity and mortgage REITs


Investment Planning


When is the use of this tool indicated?

• When an investor has limited capital and cannot afford to purchase real estate properties or mortgages directly

• When an investor wants the added safety that a broadly diversified portfolio of real estate investments or mortgages provides

• When an investor does not have the skill or inclination to manage his own real estate investments

• When an investor desires a long-term hedge against inflation, equity REITs are indicated


Investment Planning


When is the use of this tool indicated?

• When an investor desires an investment that provides potentially increasing cash flows and the possibility for long-term capital appreciation, equity REITs are indicated

• When an investor desires high current income, mortgage REITs are indicated

• When an investor desires an investment combining the features of equity REITs and mortgage REITs, hybrid REITs are indicated


Investment Planning


Advantages

• Limited Liability– REIT shareholders are treated like holders of common stock in a

regular corporation– Liability limited to the amount of their investment

• No Corporate-Level Tax– If the REIT distributes 90% of its income to shareholders (and meets

certain requirements), there is no corporate level tax

• Pooling of Resources– REITs pool individual investors’ funds to acquire real estate interests

and provide small investors with access to real estate investment opportunities

• Knowledgeable Professionals– REITs use the services of knowledgeable professionals who provide

expert management and have a proven track record


Investment Planning


Advantages• Record Keeping

– The REIT keeps detailed records of transactions, income and losses, distributions, and expenses and reports such information regularly to investors.

– Spares investors the responsibility and inconvenience of record keeping• Small Denominations

– Most REITs sell for less that $50 a share.– There is no minimum number of shares an investor must buy.

• Ability to Leverage Investments– Many REITs use both short-term and long-term debt to finance their asset

purchases• Utility of Collateral

– An investor’s shares in a REIT may also be used as collateral for loans from the investor’s bank or broker

– Subject to limits set by the Federal Reserve


Investment Planning


Advantages

• Liquidity– REITs are easily marketable and are widely traded on the various

exchanges– Direct investments in real estate are not

• Discounts from Book Value– REITs generally have sold at discounts ranging from 5% to 20% of

their book values.– The price paid for a share has typically been less than an investor

would have to pay to buy a pro rata share of the assets in the REIT portfolio directly.

• High Dividend Payouts– REITs distribute 90% of their income


Investment Planning


Advantages

• Automatic Dividend Reinvestment– Most REITs allow investors to automatically reinvest dividends

• Diversification in a Real Estate Portfolio– REITs can provide investors with a high degree of risk reduction

through diversification

• Inflation Hedge– Equity REITs should provide the same inflation-hedging potential as

direct real estate investments– Mortgage REITs are poor inflation hedges

• Diversification beyond Stocks and Bonds– Investors can reduce their risks and enhance their expected returns

beyond what they would enjoy with a portfolio containing only stocks and bonds, or only real estate.


Investment Planning


Disadvantages

• Loss of Control– Professional management reduces the investor’s control and flexibility

in the management of the investment.

• Lower Potential Returns– Although diversification reduces risk, it also reduces the potential for

substantial gains.

• Management Fees and Administrative Charges– Relatively small, but not incurred if the investor manages the

investment• .5% to 1.5% of the value of the investment

• No Flow-Through of Tax Benefits– Only tax-sheltered income can be passed through to the investor– Losses cannot be passed through


Investment Planning


Disadvantages

• Discounts from Book Values– If a discount increases after investors have acquired shares in a REIT,

they may suffer a capital loss when they sell their shares.

• Considerable Risk– REIT share prices can be just as volatile as stock prices.– The amount and sources of risk vary considerably depending on:

• The type of REIT• Management philosophy• Actual asset / liability makeup

• Poor Inflation Hedge– Mortgage REITs are not likely to be good inflation hedges.

• If inflation rises and causes interest rates to rise, the value of the underlying mortgages and loans will typically fall.

• Consequently, in inflationary times, share values in mortgage REITs are likely to decline.


Investment Planning


Tax Implications

• REITs will not be subject to federal income tax if they satisfy several Internal Revenue Code provisions that require that:– Distribution of 90% of net annual earnings be made to shareholders– At least 75% of gross income be derived from real estate– At least 75% of the REIT’s portfolio be invested in real estate, loans

secured by real property or mortgages on real estate, shares in other REITs, cash or cash items, or government securities

– There be at least 100 shareholders• No more than 50% of the outstanding shares may be owned by 5 or

fewer individuals at any time during the second half of each taxable year

– The REIT is to be managed by one or more trustees or directors

• Distributions are treated as investment income.– Not passive activity income


Investment Planning


Tax Implications

• Shareholders pay taxes on distributions from the REIT’s earnings.– REITs cannot offer flow-through tax benefits– Distributed income is generally taxed as ordinary income to

shareholders.• Subject to JGTRRA “qualified dividend income” rules

– Capital gains and losses on the sale of assets in the REIT’s portfolio retain their character and are taxed as gains or losses to the investors when distributed.

• Cash disbursements in excess of net income are treated as a nontaxable return of capital.

• Shareholders must reduce their basis in their shares by any such excess distributions.


Investment Planning


Tax Implications

• Gains or losses realized when investors sell their shares in a REIT are treated as capital gains or losses.– The cost basis for determining gain or loss on sale is the

original cost of the shares less cash distributions received in excess of the REIT’s net income.

• REITs are exempt from the requirement that certain pass-through entities report to shareholders, as income, their share of expenses of the fund.– These would be miscellaneous itemized deductions if incurred

by the shareholder individually


Investment Planning


Alternatives

• Direct Real Estate– Passive activity income– Losses flow through to investor

• Real Estate Limited Partnerships– Offer investors a pooled real estate investment similar to an

equity REIT– Have flow-through characteristics

• Mutual Funds– Those that invest in mortgages or mortgage-backed securities

offer an investment opportunity that is very similar to a mortgage REIT

– Limit the amount of borrowing the fund may employ to leverage investments


Investment Planning


Alternatives

• Mortgage-backed pass-through certificates, mortgage-backed bonds, collateralized mortgage obligations (CMOs) and real estate mortgage investment conduit (REMIC) bonds are all investments in pools of mortgages that are similar to mortgage REITs.– They are typically treated as debt for tax purposes– “FREITs”: Finite-life REITs

• Liquidate their holdings by a given date and distribute the proceeds to investors.

• Residual interests in REMICs– Privately placed– If the market for them grows as anticipated, residual interests will

become publicly traded


Investment Planning


Where and How do I get it?

• Listed on the national and regional exchanges• Traded on the over-the-counter market• Stock brokerage firms• Discount brokers• Banks and financial institutions


Investment Planning


What fees or other costs are involved?

• A commission is commonly charged when shares are purchased or sold.– The fee will depend on:

• The amount invested• The number of shares purchased• Whether the shares are purchased through a full-service broker or a discount

broker• The market in which the shares are traded

– Trade in round lots of 100 shares• Odd-lot transactions involve higher commissions

– Regular full-service commissions typically range from 2% to 3% of the dollar value of the shares purchased or sold.

• Discount brokerage fees range from about 15% to 70% of the regular full-service rate

• Typically a minimum fees of about $30


Investment Planning


How do I select the best of its type?

• There are over 300 REITs available to investors, which vary considerably in terms of:– Size– Fees– Management performance– Investment philosophy– Capital structure– Asset characteristics

• When selecting a REIT, the investor should ascertain the type of REIT that best meets the investor’s objectives with regard to income versus growth and tolerance for risk.– Equity REITs: moderate income and opportunities for increasing cash

flows and capital appreciation; considered riskier than mortgage REITs– Mortgage REITs: higher income but less opportunity for growth; in

individual cases, they are often riskier than equity REITs


Investment Planning



• When selecting a REIT, determine whether the management’s investment philosophy is consistent with the investor’s.– The prospectus that accompanies an initial public offering always

includes a section describing the proposed activities of the trust– The annual reports should be analyzed as well, considering:

• The type of assets that the REIT will invest in• Whether leverage will be employed and, if so, whether there are limits on the

amount of debt it can employ• Whether the trust will provide broad diversification or concentrate its

investments in a particular type of real property• Whether the trust will diversify geographically • Whether the trust will limit the placement of assets in any one project• Whether the trust will emphasize income or capital appreciation when

selecting its investments


Investment Planning



• When selecting a REIT, evaluate the historical performance of those REITs that match the investor’s investment objectives and philosophy– Quality of management

• Who’s Who in Business• Who’s Who in America• Dun’s Reference Book of Corporate Managements

– Critical factors• Dividend payout record• Expense ratios• Vacancy rates• Length of time the REIT management has been in business• The quality or value of the properties in which the REIT invests• The percentage of ownership held by the managers of the company

• When selecting a REIT, the investor should project Future Performance.


Investment Planning


Where can I find out more about it?

• National Association of Real Estate Investment Trusts (NAREIT)– Frequently Asked Questions About REITs

• Value Line Investment Survey• Realty Stock Review• Moody’s Handbook of Common Stock• Stock Reports• Wall Street Journal• Financial magazines and journals

Documents

REITs Chapter 21 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? REITs (Real Estate Investment