Word-of-the-Week: Real estate investment trust

What is a real estate investment trust?

Real estate investment trusts (REITs) are the point at which the stock market and real estate market collide. They are one way for individuals to invest in income-producing real estate, without purchasing and operating the property themselves. REITs allow investors to diversify into real estate without subjecting themselves to the liabilities of ownership and the oversight burdens of property management.

An ownership investment in a REIT does not resemble real estate ownership as known in the real estate market.

In fact, shares in a REIT have much more in common with stocks than with property in terms of risk and merit. As of the end of 2020, 30 REITs were featured in the Standard & Poor’s (S&P) 500 stock market index.

For stock market investors, REITs serve as a form of diversification, spreading the risk inherent in the management of a particular REIT among the broad pool of its shareholders. Investors appreciate the diversity of REIT investments, since each REIT typically owns multiple properties.

Also, an investment in several different REITs is closely equivalent to the purchase of fractional ownership interests in numerous different properties and property management.

Property owning corporations

REITs differ from other forms of syndication better known to the real estate market, such as the limited liability company (LLC) and the far more risky vesting for §1031 tenancies-in-common (TICs).

REITs are essentially property owning corporations. Unlike publicly-held corporations, however, they avoid paying income taxes through a tax loophole by passing a minimum of 90% of their earnings to investors in the form of dividends. In both REITs and LLCs, income, profits and losses are passed through to the individual members according to their share of the ownership of the entity.

For real estate syndication purposes, the REIT resembles an LLC. Both are unincorporated organizations formed for the purpose of group investment primarily in real estate. REITs provide limited liability for investors and pass-through of income for state and federal tax reporting to the investor (as do LLCs). The pass-through avoids the double taxation of distributed corporate earnings. The very different tax results of corporations favor the stock market vehicle of the REIT (or LLC). [Calif. Corporations Code §23000; Internal Revenue Code §856]

Federal tax reporting qualification

To qualify for federal tax reporting as a REIT, the REIT needs to have at least 100 shareholders. Also, 75% of the REIT’s business activities need to be restricted to investments in:

real estate;
trust deed notes;
cash; or
government securities.

No such restrictions apply to an LLC. Another difference: a REIT soliciting investors in California needs to first qualify its investment program by obtaining a permit issued by California Department of Corporations (DOC). An LLC formed to purchase an existing income property, identified and fully disclosed prior to receipt of contributions by investing members, to own and operate it is not subject to this rule. [IRC §856(c)(4); Corp C §23000(b)]

Of crucial important to real estate brokers and agents, REITs resemble a Chapter S Corporation. Both report profits without the payment of taxes while passing any income tax liability on to shareholders. Real estate brokers are thus barred from taking a broker fee on the sale or purchase of REIT shares (unlike an LLC, which is treated as a limited partnership under California state law). [Business and Professions Code §10131.3]

Restricted management ability

The end result for REITs is a greatly restricted ability for management to receive compensation for just about anything involving fundraising, representations, management fees or allocation of assets and cash reserves.

In search of alternative income for their REIT involvement, members of REIT management often work as real estate brokers to take the front-end percentage fees paid when their REIT purchases or sells large assets. This risky behavior may be good for management, but it produces negative long-term ramifications for REIT investors.

Problems of asset value arise when REITs buy property at prices based on capitalization rates (cap rates) that deliver low annual returns, say 5%, as has been the case for over a decade.

While low annual returns are acceptable to stock market investors, they are not acceptable to real estate investors. Stock investors are accustomed to buying and selling business shares at price-to-earnings (P/E) ratios (multipliers) which reflect pricing, a profit taking point of view that never have been acceptable to prudent income property investors since they treat property like an income generating collectible.

Unlike businesses, which are all comparable to one another, parcels of real estate are unique, and their value cannot easily or quickly be judged by comparison or pre-set formulas. After all, businesses can logically grow and remain profitable for centuries. Businesses are not destined for eventual obsolescence as property improvements are, the depreciation premium of capital recapture built into cap rates for real estate income property investment analysis.

Where to start with REIT investments

Cautious and uninformed investors prefer to purchase bundled shares of assorted REITs, thus mirroring the market as a whole instead of attempting to pick individual REIT winners. This approach requires less research, and by its diversification reduces the cumbersome due diligence investigation associated with purchasing any individual REIT. These investors may benefit from the historical information and timely reports available from the National Association of REITs.

More dedicated investors need to put in a greater amount of time and effort asking detailed questions about any individual REIT before purchasing shares. Does the REIT deal in hotels, self-storage units (considered riskier properties), or in apartments (less risky)?

When undertaking this research the most important factors to consider are:

The REIT’s management. Management needs to have a history of operating property responsibly, not just buying and selling for the sake of short-term gains.

Purchases need to be accomplished without losing cash capital to fees loaded on the front end of deals, and property management needs to be accomplished in an effective (few vacancies) and efficient manner (low-cost ratios). If possible, the investor needs to analyze the REIT’s income reports to get a feel for its historic use of cash and property.
The location and type of property owned by the REIT. This information can be had on the REIT’s operating statements. Perhaps most useful, for those willing to do the research, are the REIT’s annual reports made to the U.S. Securities and Exchange Commission (SEC).

The SEC requires all REITs to report the number of properties they own, the number under construction and the amount invested. They also need to report details about the types of properties held, as well as other information about the REIT’s activities and objectives. The report, which may run over fifty pages, lists potential risks to the REIT and its investors, details the trust’s level of insurance, and provides a broad picture of the trust’s position in the market.