REITS

Introduction to REITS

Investing in income-generating real estate can be a great way to increase your net worth. But for many people, investing in real estate, particularly commercial real estate, is simply out of reach financially. But what if you could pool your resources with other small investors and invest in large-scale commercial real estate as a group? REITs allow you to do just that.

REIT stands for real estate investment trust and is sometimes called "real estate stock." Essentially, REITs are corporations that own and manage a portfolio of real estate properties and mortgages. Anyone can buy shares in a publicly traded REIT. They offer the benefits of real estate ownership without the headaches or expense of being a landlord.

Investing in some types of REITs also provides the important advantages of liquidity and diversity. Unlike actual real estate property, these shares can be quickly and easily sold. And because you're investing in a portfolio of properties rather than a single building, you face less financial risk.

REITs came about in 1960, when Congress decided that smaller investors should also be able to invest in large-scale, income-producing real estate. It determined that the best way to do this was the follow the model of investing in other industries -- the purchase of equity.

A company must distribute at least 90 percent of its taxable income to its shareholders each year to qualify as a REIT. Most REITs pay out 100 percent of their taxable income. In order to maintain its status as a pass-through entity, a REIT deducts these dividends from its corporate taxable income. A pass-through entity does not have to pay corporate federal or state income tax -- it passes the responsibility of paying these taxes onto its shareholders. REITs cannot pass tax losses through to investors, however.

From the 1880s to the 1930s, a similar provision was in place that allowed investors to avoid double taxation -- paying taxes on both the corporate and individual level -- because trusts were not taxed at the corporate level if income was distributed to beneficiaries. This was reversed in the 1930s, when passive investments were taxed at both the corporate level and as part of individual income tax. REIT proponents were unable to persuade legislation to overturn this decision for 30 years. Because of the high demand for real estate funds, President Eisenhower signed the 1960 real estate investment trust tax provision qualifying REITs as pass-through entities.

A corporation must meet several other requirements to qualify as a REIT and gain pass-through entity status. They must:

-- Be structured as corporation, business trust, or similar association
-- Be managed by a board of directors or trustees
-- Offer fully transferable shares
-- Have at least 100 shareholders
-- Pay dividends of at least 90 percent of the REIT's taxable income
-- Have no more than 50 percent of its shares held by five or fewer individuals during the last half of each taxable year
-- Hold at least 75 percent of total investment assets in real estate
-- Have no more than 20 percent of its assets consist of stocks in taxable REIT subsidiaries
-- Derive at least 75 percent of gross income from rents or mortgage interest

At least 95 percent of a REIT's gross income must come from financial investments (in other words, it must pass the 95-percent income test). These include include rents, dividends, interest and capital gains. In addition, at least 75 percent of its income must come from certain real estate sources (the 75-percent income test), including rents from real property, gains from the sale or other disposition of real property, and income and gain derived from foreclosure of property.

In Singapore, characteristics also include:
- at least 70% of assets invested in real estate.
- 75% or more of income comes from rents.
- debts of less than 35% of deposited property.

REITs are relatively new to the Singapore market. The first Reit, CapitalMall Trust, was launched in 2001.

How REITs Operate

Because REITs are required to distribute 90 percent of their taxable income to investors, they must rely upon external funding as their key source of capital. Just like other stock offerings, publicly traded REITs collect funds via an initial public offering (IPO). Those funds are used to buy, develop and manage real estate assets. The IPO works just like other security offerings except that instead of purchasing stock in a single company, the buyer will own a portion of a managed pool of real estate. Income is generated through renting, leasing, or selling the properties and is distributed directly to the REIT holder on a regular basis. When a REIT pays out its dividends, they're equally distributed among shareholders as a percentage of paid-out taxable income.

REITs have a board of directors elected by its shareholders. Typically, these directors are real estate professionals who are highly respected in the field. They are responsible for selecting the REIT's investments and hiring the management team, which then handles day-to-day operations.

REITs earn money from rented space or sales of property. The preferred method for measuring REIT earnings is called funds from operations (FFO). The National Association of Real Estate Investment Trusts (NAREIT) defines FFO as:

Net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis.

Basically, REITs add or deduct from net income (rent and sales computed according to generally accepted accounting principles [GAAP]) any gains or losses due to depreciation, sale of property and unconsolidated partnerships and joint ventures. Essentially, FFO measures a REIT's operating cash flow produced by its properties, less administrative and financing costs.

Under generally accepted accounting principles, net income typically assumes that the value of assets goes down over time -- somewhat predictably. Real estate generally retains or even increases in value. On the balance sheet under GAAP, however, land remains at its historical cost and buildings gradually depreciate to zero. Since a REIT's primary business involves real estate, the depreciation charges negatively skewed the company's true profitability. FFO was adopted to address that problem by excluding depreciation costs from the net income figure.

FFO is not a foolproof measure, however. Not all REITs calculate it according to the NAREIT definition and items such as maintenance, repairs and other recurring capital expenses are missing from the formula. In order to get a true FFO, investors must often read a company's quarterly report, and any supplemental disclosures.

Investing in REITs

Because many REITs are publicly traded, they offer investors a powerful tool for portfolio balancing and diversification. They also provide investors with ongoing dividend income, while offering the potential for long-term capital gains through share price appreciation.

REITs have an advantage over other types of stocks. Because of their pass-through taxation, REITs have greater profits from which to pay shareholder dividends than similar sized corporations. As long as a REIT maintains its tax-qualified status by paying out 90 percent of its net income to common shareholders, it doesn't have to pay federal income taxes. Without a tax bite to reduce profits, shareholders get more of the REIT's earnings.

REIT investors receive value in the form of dividend income and potential share value appreciation. Because REIT income often comes from commercial properties with long lease periods, REITs can offer a relatively predictable revenue stream. They also are somewhat resistant to inflation. Unlike bonds with pre-determined rates of interest, which lose relative value in times of high inflation, REITs with rental incomes adjust themselves in line with the cost of living. This makes them less vulnerable to inflation-related devaluation.

In the Singapore context, unlike common stocks REITs are only taxed on individual basis. The Singapore listed REITs are not subject to corporate tax and distribute close to 100% of net income. Whereas some stockholders suffer from ‘double taxation’ of income. Secondly, one of the most prominent features of REITs is high dividend yield as compared to most common securities. Not a very surprising feature if one recalls that REITs pay out almost all their net rental income to shareholders.