Real Estate Investment Trusts: A Growing Trend

To qualify as a REIT, a real estate company must distribute to its shareholders annually at least 90% of its taxable income, and must meet other requirements of the US Internal Revenue Code relating to distributions, organization, ownership, income and assets. In particular, a qualifying REIT is an entity that has properly elected to be treated as a REIT, and must:

• Be a corporation, or a trust or association taxable as a corporation (other than certain financial institutions and insurance companies);
• Be managed by a board of directors or trustees;
• Have fully transferable shares;
• Have no more than 50% of its shares held by five or fewer individuals during the last half of each taxable year;
• Have at least 100 shareholders;
• Have at least 75% of its total investment in real estate assets, and derive at least 75% of its gross income from rents (or other income) from real property or interest on real property mortgages;
• Derive 95% of its gross income from dividends, interest, rents from real property, gains from the sale of stocks, securities and real property, real property tax refunds and abatements, and certain fee income relating to mortgage loans or real property sales or leases; and
• Have no more than 20% of its assets consist of stocks in taxable REIT subsidiaries.

The Evolution of REITs

The early history of REITS was marred by the failure of a number of Mortgage REITs during the high-interest-rate environment of the late 1970s and early 1980s. The modern REIT era began in 1991 with the successful public offering of Kimco Realty Corporation as a REIT. The industry then grew rapidly from a market capitalization (price of shares multiplied by the number of shares outstanding) of $13 billion in 1991 to $89 billion in 1996 (National Association of Real Estate Investment Trusts (NAREIT). The principal trade association for the US REIT industry, NAREIT is the source of all US REIT statistics cited in this section).

Today, there are approximately 173 publicly traded REITs registered with the Securities and Exchange Commission, with a market capitalization of $245. As a percentage of Equity REIT market capitalization, 6.9% of REITS are Mortgage REITs, which engage in real estate mortgage lending; 2.3% are “Hybrid REITs,” whose assets consist of both mortgage loans and income-producing real estate; 90.9% are “Equity REITs,” which own and operate (and in many cases, develop) real estate assets.

Equity REITs tend to specialize in a particular asset class, of which the largest (as a percentage of Equity REIT market capitalization) are:

• Office/industrial: 29.7% (made up of office, 17.6%, industrial, 7.31%, and mixed, 4.88%).
• Retail (shopping centers, regional malls and free-standing): 28.7%.
• Residential (apartments and manufactured homes): 16.13%.
• The rest of the Equity REIT sector (25.38% of Equity REIT market capitalization) consists of Equity REITs, which focus on lodging and resorts, health care, self storage, and certain specialized types of real estate, such as golf courses.

Since 1991, REITs have become the main form of organization for publicly traded real estate companies. This is due to a variety of factors relating to tax transparency, dividend yield, liquidity, diversification, professional management, low leverage or gearing ratios, and tax-free acquisitions.

Advantages of REITS

Tax Transparency

The main advantage of the REIT regime is the tax transparency and efficiency achieved by the avoidance of tax at the entity level. Income and capital gains flow through directly to a REIT's shareholders, essentially putting them in the same tax position as they would be if they had invested directly in real estate.

Dividend Yield

The mandatory distribution rules applicable to REITs (at least 90% of taxable income) make them attractive to investors interested in yield. The NAREIT Equity REIT Index yielded 5.52% in 2003, and has produced a dividend yield of 5.12% to date this year.

Liquidity

Unlike partnerships and other traditional real estate investment vehicles, shares of publicly held REITs are traded on the major stock exchanges.

Diversification

REITs allow investors to minimize risks by allowing them to invest in a property portfolio that can be widely diversified by geographic markets, asset classes, and other measures.

Professional Management

The properties in a REIT's portfolio are managed by experienced real estate professionals.

Low Leverage or Gearing Ratios

Historically, the real estate industry in the US employed very high leverage or gearing ratios. Properties were often financed with debt equal to 80% or 90% of value, and sometimes even higher. The real estate recession of the early 1990s and the financial discipline imposed on REITs by the public markets have resulted in much lower gearing ratios. Today, the debt ratio in REITs generally does not exceed 50% (an average of 43.4% in Equity REITs, according to NAREIT).

Tax-free Acquisitions

For REIT operators and parties interested in forming or converting to one, REITs offer:

• Access to the public equity markets; and
• The ability to make tax-free exchanges (available to property owners selling their assets to a REIT) through the use of an Umbrella Partnership Real Estate Investment Trust (UPREIT).

The UPREIT

The UPREIT was originally developed to allow property owners forming a REIT to avoid a taxable gain on the contribution of their assets to a REIT. Nearly 75% of all new US REITs formed since 1993 have been formed as UPREITs (Frankel MG, Needles TT: Real Estate Investment Trusts: A Guide to their History, Formation and Taxation. Practicing Law Institute, Fourth Annual Real Estate Tax Forum, 2002).

Under the UPREIT structure, a sponsor contributes properties to an “Operating Partnership” in exchange for a limited partnership interest in the Operating Partnership. Simultaneously, a newly formed REIT contributes the proceeds of a public offering to the Operating Partnership in exchange for a general partnership interest. Tax on the sponsor's gain will be deferred until the sponsor's limited partnership interest in the Operating Partnership is converted into REIT shares or cash, which often does not take place until the death of the sponsor or its principals.

The UPREIT has also proven to be an extremely effective tool for the acquisition of properties by REITs. In exchange for selling its property to a REIT, a seller receives partnership units that may be made liquid by conversion into REIT shares. Tax on the seller's gain is deferred until conversion, and in the meantime the seller has exchanged its single real-estate asset or portfolio of assets for partnership interests in the REIT's broader and more diverse portfolio.

REITs were invented in the US by legislation enacted in 1960 to enable small investors to make equity investments in large-scale commercial real estate in the same way they invested in large corporations in other industries. This chapter examines:

• The requirements than an entity must satisfy to qualify as a REIT;
• The development of REITS; and
• The advantages of REITs.

What Is a REIT?

A REIT is a company that owns and leases income-producing real estate such as apartments, offices and shopping centers. (Some so-called “Mortgage REITs” generate income by financing real estate.)

The distinctive characteristic of the REIT structure, and the primary reason for its increasing use, is its “pass-through” treatment for US federal income tax and capital gains tax purposes. A REIT may deduct from its taxable income dividends paid to its shareholders, effectively eliminating any tax at the REIT level.

To qualify as a REIT, a real estate company must distribute to its shareholders annually at least 90% of its taxable income, and must meet other requirements of the US Internal Revenue Code relating to distributions, organization, ownership, income and assets. In particular, a qualifying REIT is an entity that has properly elected to be treated as a REIT, and must:

• Be a corporation, or a trust or association taxable as a corporation (other than certain financial institutions and insurance companies);
• Be managed by a board of directors or trustees;
• Have fully transferable shares;
• Have no more than 50% of its shares held by five or fewer individuals during the last half of each taxable year;
• Have at least 100 shareholders;
• Have at least 75% of its total investment in real estate assets, and derive at least 75% of its gross income from rents (or other income) from real property or interest on real property mortgages;
• Derive 95% of its gross income from dividends, interest, rents from real property, gains from the sale of stocks, securities and real property, real property tax refunds and abatements, and certain fee income relating to mortgage loans or real property sales or leases; and
• Have no more than 20% of its assets consist of stocks in taxable REIT subsidiaries.

The Evolution of REITs

The early history of REITS was marred by the failure of a number of Mortgage REITs during the high-interest-rate environment of the late 1970s and early 1980s. The modern REIT era began in 1991 with the successful public offering of Kimco Realty Corporation as a REIT. The industry then grew rapidly from a market capitalization (price of shares multiplied by the number of shares outstanding) of $13 billion in 1991 to $89 billion in 1996 (National Association of Real Estate Investment Trusts (NAREIT). The principal trade association for the US REIT industry, NAREIT is the source of all US REIT statistics cited in this section).

Today, there are approximately 173 publicly traded REITs registered with the Securities and Exchange Commission, with a market capitalization of $245. As a percentage of Equity REIT market capitalization, 6.9% of REITS are Mortgage REITs, which engage in real estate mortgage lending; 2.3% are “Hybrid REITs,” whose assets consist of both mortgage loans and income-producing real estate; 90.9% are “Equity REITs,” which own and operate (and in many cases, develop) real estate assets.

Equity REITs tend to specialize in a particular asset class, of which the largest (as a percentage of Equity REIT market capitalization) are:

• Office/industrial: 29.7% (made up of office, 17.6%, industrial, 7.31%, and mixed, 4.88%).
• Retail (shopping centers, regional malls and free-standing): 28.7%.
• Residential (apartments and manufactured homes): 16.13%.
• The rest of the Equity REIT sector (25.38% of Equity REIT market capitalization) consists of Equity REITs, which focus on lodging and resorts, health care, self storage, and certain specialized types of real estate, such as golf courses.

Since 1991, REITs have become the main form of organization for publicly traded real estate companies. This is due to a variety of factors relating to tax transparency, dividend yield, liquidity, diversification, professional management, low leverage or gearing ratios, and tax-free acquisitions.

Advantages of REITS

Tax Transparency

The main advantage of the REIT regime is the tax transparency and efficiency achieved by the avoidance of tax at the entity level. Income and capital gains flow through directly to a REIT's shareholders, essentially putting them in the same tax position as they would be if they had invested directly in real estate.

Dividend Yield

The mandatory distribution rules applicable to REITs (at least 90% of taxable income) make them attractive to investors interested in yield. The NAREIT Equity REIT Index yielded 5.52% in 2003, and has produced a dividend yield of 5.12% to date this year.

Liquidity

Unlike partnerships and other traditional real estate investment vehicles, shares of publicly held REITs are traded on the major stock exchanges.

Diversification

REITs allow investors to minimize risks by allowing them to invest in a property portfolio that can be widely diversified by geographic markets, asset classes, and other measures.

Professional Management

The properties in a REIT's portfolio are managed by experienced real estate professionals.

Low Leverage or Gearing Ratios

Historically, the real estate industry in the US employed very high leverage or gearing ratios. Properties were often financed with debt equal to 80% or 90% of value, and sometimes even higher. The real estate recession of the early 1990s and the financial discipline imposed on REITs by the public markets have resulted in much lower gearing ratios. Today, the debt ratio in REITs generally does not exceed 50% (an average of 43.4% in Equity REITs, according to NAREIT).

Tax-free Acquisitions

For REIT operators and parties interested in forming or converting to one, REITs offer:

• Access to the public equity markets; and
• The ability to make tax-free exchanges (available to property owners selling their assets to a REIT) through the use of an Umbrella Partnership Real Estate Investment Trust (UPREIT).

The UPREIT

The UPREIT was originally developed to allow property owners forming a REIT to avoid a taxable gain on the contribution of their assets to a REIT. Nearly 75% of all new US REITs formed since 1993 have been formed as UPREITs (Frankel MG, Needles TT: Real Estate Investment Trusts: A Guide to their History, Formation and Taxation. Practicing Law Institute, Fourth Annual Real Estate Tax Forum, 2002).

Under the UPREIT structure, a sponsor contributes properties to an “Operating Partnership” in exchange for a limited partnership interest in the Operating Partnership. Simultaneously, a newly formed REIT contributes the proceeds of a public offering to the Operating Partnership in exchange for a general partnership interest. Tax on the sponsor's gain will be deferred until the sponsor's limited partnership interest in the Operating Partnership is converted into REIT shares or cash, which often does not take place until the death of the sponsor or its principals.

The UPREIT has also proven to be an extremely effective tool for the acquisition of properties by REITs. In exchange for selling its property to a REIT, a seller receives partnership units that may be made liquid by conversion into REIT shares. Tax on the seller's gain is deferred until conversion, and in the meantime the seller has exchanged its single real-estate asset or portfolio of assets for partnership interests in the REIT's broader and more diverse portfolio.