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Real Estate Investment Trusts (REITs)

July 18, 2011

John Jastremski Presents:

Real Estate Investment Trusts (REITs)

What is it?

A real estate investment trust (REIT) is a company that buys, develops, manages, and/or sells real estate such as skyscrapers, shopping malls, apartment complexes, office buildings, or housing developments. Rather than investing directly, investors in REITs put their money into a professionally managed portfolio of real estate. REITs trade on the major exchanges, just like stocks. REITs make money from rental income, profits from the sale of the property, and other services provided to tenants. REITs also receive special tax considerations; they do not pay taxes as long as they pay out at least 90 percent of their net income to their investors. Thus, successful REITs can offer investors high yields, current income, and moderate growth.

There are several types of REITs. An equity REIT’s main business is buying, renovating, managing, maintaining, and selling real estate. This is by far the most common type of REIT available today. An equity REIT may invest broadly, or may be dominated by a particular segment of the market–for example, retail space or apartment buildings. Mortgage REITs make loans or invest in existing mortgages. Hybrid REITs combine the characteristics of equity and mortgage REITs. Additional corporate structures (e.g., the UPREIT and Down REIT) were developed in the early 1990s; these REITs typically focus on providing tax benefits to their shareholders.

What are the strengths?

All REITs are governed by strict regulations

REITs are generally required to have at least 100 investors, and there are laws that prevent a small number of those investors from owning a majority interest in the REIT. At least 75 percent of a REIT’s assets must be in real estate, and at least 75 percent of its gross income must be derived from rents, mortgage interest, or gains from the sale of property. Also, REITs are required by law to pay out at least 90 percent of annual taxable income (excluding capital gains) to their investors in the form of dividends. This restriction, however, limits a REIT’s ability to use internal cash flow for growth purposes.

REIT shares are more liquid than a direct investment in real estate
If you need cash in a hurry, it is much easier to liquidate shares of a REIT than it is to sell rental property, office buildings, or other real estate. Part of the reason for this liquidity is that REIT shares are typically traded on major exchanges, making it easier to buy and sell REIT shares than to buy and sell properties in the private market.

Professional management




REITs can provide current income

Because REITs are required to pay out 90 percent of their annual income in the form of dividends, you can expect to receive income from your REIT investment.

What are the tradeoffs?
Supply/demand imbalance


Rising interest rates


Other factors

REITs are also subject to the risks associated with the general real estate market, including possible declines in the value of real estate, possible declines in economic conditions, and possible lack of availability of mortgage funds.




Use as a tax shelter is limited

Unlike other forms of real estate ownership, REITs are not allowed to pass losses through to their investors. Thus, if your REIT investment loses money, you will not be able to use this loss to offset other investment gains. Depending on your reasons for investing, not having this tax break could be a significant disadvantage.

Investing in a REIT
Find the right REIT

Because they are publicly-traded companies, investors can evaluate REITs just as they would evaluate stocks. Among other things, investors should look at the company’s earnings–both past performance and the potential for future growth–dividend yield, payout ratio, and price-earnings ratio. However, bear in mind that past performance is no guarantee of future results.

Monitor your investment

By keeping an eye on the real estate market, you may be able to detect subtle signs that suggest a change to your investment strategy. For example, overbuilding in a certain sector may be a sign that it’s time to decrease your holdings in that area, perhaps by moving your money to a REIT that has a different focus.

What are the tax considerations?
REITs are typically not useful as a tax shelter

REITs are not allowed to pass losses through to their investors. Thus, their use as tax shelters is extremely limited.

Dividends are typically taxable income



For tax years beginning on or after January 1, 2003 and before January 1, 2013, qualifying dividends paid to individual shareholders from domestic corporations (and qualified foreign corporations) are taxed at long-term capital gains tax rates. For tax years prior to January 1, 2003, however, stock dividends were taxed at ordinary income tax rates, generally resulting in significantly more tax due.

Caution: Absent further legislative action, stock dividends will again be taxed as ordinary income beginning in 2013.

Generally, however, REIT dividends will not qualify for taxation at capital gains rates. Instead, REIT dividends will generally continue to be taxed at ordinary income tax rates. This is because most REIT dividends are comprised of rents or other earnings that are being passed through to shareholders. To the extent that a REIT dividend represents qualified corporate dividends being passed through to REIT shareholders, though, the dividend will qualify for taxation at capital gains rates.



You may be required to pay capital gains tax when you sell your REIT shares, if you sell them for more than you paid for them. If this gain cannot be offset by capital losses, you will have to pay capital gains tax on this amount.





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