Real Estate Investment Trusts

These mutual funds can help investors diversity into real estate, with some plusses and minuses.

A real estate investment trust (REIT) is a corporation or a business trust that combines the capital of many investors to acquire (or provide financing for) various real estate assets. Appearing first in the 1960s, there are now over 300 REITs in the United States -- about 65% of which trade on national stock exchanges.

REITs have enjoyed tremendous popularity over the past two years; during 1996, equity REITs on average outperformed the S&P 500. This success was driven by a strong real estate market, favorable interest rates, and a vibrant commercial rental market. Current REIT performance generally does not move in tandem with the stock market. The following table compares the annualized total returns on equity REITs to those of the S&P 500 (data is for noted periods ending Dec. 31, 1996).

	1 year	3 year	5 year	10 year	20 year
Equity REITs	35.27%	17.17%	17.14%	11.67%	16.13%
S&P 500	22.96%	19.63%	15.18%	15.27%	14.55%
Source: National Association of Real Estate Investment Trusts.

Individuals, pension funds, endowment funds, insurance companies, bank trust departments, and mutual funds can invest in REITs. Individuals have been attracted to REITs because (1) a minimum investment is not required (in most cases), and (2) REITs provide the opportunity to participate in the ownership of commercial property and/or mortgage lending. Institutional investors have been attracted by returns on REIT investments, and their liquidity (real estate traditionally is an illiquid investment, but equity REITs are relatively liquid).

Qualifications: The Internal Revenue Code includes many qualifications that a REIT must meet. Among these qualifications, the entity must be organized as a corporation, trust, or similar association, and managed by a board of directors or trustees. Board members are elected by the REIT’s shareholders, and the directors are responsible to shareholders (similar to a corporate board of directors). The directors appoint the REIT’s management personnel.

A minimum of 100 shareholders (of which no five can own 50% or more of the REIT) are required, and shares must be fully transferable. The REIT must invest at least 75% of its funds in real estate assets, and receive 75% of its gross income from rent on real property, interest from mortgages, or other real estate related income. Proceeds from the sale of securities held less than one year, or from the sale of property held less than four years, cannot provide more than 30% of the REIT’s gross income. Ninety-five percent of the entity’s net income must be distributed to shareholders.

There are three different investment approaches for REITs -- equity, mortgage, and hybrid. Equity REITs are the most common (approximately 89% of the industry).

Equity REITs: In these investment vehicles, revenues are generated primarily from rental/lease income from owned properties. Investors have a relatively steady dividend payout, and the real estate often provides capital appreciation.

Traditional investments include office buildings, apartments, hotels, and shopping centers, but some equity REITs have made nontraditional real estate investments (for example, golf courses). Approximately 64% of equity REIT investments are in retail, residential, or industrial/office properties. Investment philosophy varies; some REITs invest nationally in all types of property, but many specialize in specific property types, regions, or metropolitan areas. A REIT’s level of diversification will impact an investor’s exposure to market (systematic) risk.

Many of the new equity REITs are formed with existing properties and/or real estate partnerships through an Umbrella Partnership Real Estate Investment Trust (UPREIT). This entity differs from a traditional REIT because a limited partnership structure is utilized, with the REIT functioning as general partner. The arrangement allows existing partnerships (or property holders) to contribute their property in exchange for a limited partnership interest in the new REIT operating partnership. After a period of time (usually one year) limited partners who contributed property can exchange some or all of their interest for cash or REIT shares. This will cause tax to be due on appreciation that occurred in the contributing partnership (although by selling their units over a period of time, the partnership unit-holders may spread any tax over several years).

Both holders of real estate partnership interest and REITs can benefit from the UPREIT. Real estate partnership unit-holders transform their illiquid partnership interest into the more liquid REIT shareholder status. The REIT benefits by acquiring real property without having to generate capital to purchase the property.

Mortgage REITs: These REITs use investors’ money and other borrowed funds to make loans to real estate owners. Revenues are derived from interest earned on mortgage loans. Mortgage REITs generally do not own property, and income can be affected by fluctuations in interest rates and/or loan defaults.

Hybrid REITs: A combination of equity and mortgage REITs, hybrid REITs own property and also loan funds to owners of real estate.

Tax Considerations: A corporation or a trust that qualifies as a REIT generally does not pay federal income tax; however, REITs are not allowed to pass tax losses to shareholders. Dividends are paid during the year, and income from the REIT is reported to investors on IRS Form 1099 (which indicates the amount and type of income). REIT income usually is taxable only in the state of the shareholder’s residence (unlike partnerships which can be taxed in the state where property resides).

Other Considerations: Unlike partnerships, the financial media and other independent analysts and reporting services monitor the performance of publicly traded REITs (a practice which increases the accountability of REIT management).

The budget legislation currently being considered by Congress includes several provisions that would benefit REITs and their shareholders. If passed, the law would expand both the type of income a REIT can earn, and the pass-through benefits shareholders receive. (Search Tax News & Views for more information.)

These are some thoughts to consider about REITs. A Deloitte & Touche LLP financial advisor can provide additional information and should be consulted before any action is taken.

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	Understanding REITs Personal Finance Advisor by Deloitte & Touche OnLine July 21, 1997