REAL ESTATE INVESTMENT TRUSTS
(REIT)

A real estate investment trust (REIT), is a corporation or trust that combines the capital of many investors to acquire or provide financing for forms of real estate. A corporation or trust that qualifies as a REIT generally does not pay corporate income tax to the Internal Revenue Service; most states, in turn, honor this federal treatment and do not require REITs to pay state income tax either. This means that nearly all of a REIT's income is distributed to shareholders, without double taxation on the income. Unlike a partnership, a REIT cannot pass its tax losses onto its investors.

President Dwight D. Eisenhower signed the Real Estate Investment Trust Act of 1960, creating an industry that grew over the next 40 years to more than 215 REITs with a combined $160 billion market capitalization. The basic provisions of the law have changed little since it was enacted, although several modifications have been made. REITs were created to provide investors with the opportunity to participate in the benefits of ownership of larger-scale commercial real estate or mortgage lending and receive an enhanced return, since the income is not taxed at the REIT level.

In order for a corporation or trust to qualify as a REIT, it must comply with certain provisions within the Internal Revenue Code. As required by the tax code, a REIT must: be a corporation, business trust, or similar association; be managed by a board of directors or board of trustees; have shares that are fully transferable; have a minimum of 100 shareholders; have no more than 50 percent of the shares held by five or fewer individuals during the last half of each taxable year; invest at least 75 percent of the total assets in real estate; derive at least 75 percent of gross income from rents generated from either real property or interest on mortgages on real property; derive no more than 30 percent of gross income from the sale of real property held for less than four years, securities held for less than one year, or certain prohibited transactions; and pay dividends of at least 95 percent of REIT taxable income.

This last criteria has drawn criticism from industry players, who state that such a high rate of payment makes it difficult to retain the earnings necessary to pay for capital improvements. Legislation to mitigate this predicament was introduced in the House of Representatives in 1997, but stalled in committee.

The REIT industry started off slowly, following its 1960 inception. By 1968, industry assets totaled only $1 billion. By 1974, however, total assets exceeded $20 billion. But rising interest rates, a national recession, and an overbuilt real estate market affected the performance of the early REITs, and the industry experienced its first general shakeout. Exacerbating the problem, REITs were prohibited from operating or managing real estate; they could only own it. This forced REITs to work through third-party managers who were likely to have independent and, sometimes, conflicting interests, an arrangement investors were reluctant to buy into.

A restructuring and stabilization period followed. The Tax Reform Act of 1986 reduced tax-shelter opportunities in the real estate market, making competitive, tax-motivated real estate syndications less attractive and ensuring that real estate investment would become more income oriented. The reforms resulted in renewed growth in REITs. In addition, the law permitted the management of properties directly by the REIT.

In the late 1980s, however, competitors to REITs, such as banks and insurance companies, maintained a high level of real estate financing. The recession of the early 1990s, both in the broader economy and in the real estate market in particular (largely a result of excess construction in the 1980s) increased the appeal of the more conservative REITs to investors. As a result, REITs boomed through the mid-1990s.

Mergers, historically unattractive to REITs due to family-oriented ownership structures and asset-holdings restrictions, became popular as a part of this expansion. REIT managers in search of critical mass, geographical diversification, and long-term shareholder value have focused increasingly on consolidation. In turn, many mid-size and small REITs are being swallowed up by larger competitors or forced out of the market. Those larger firms with diversified, stable assets are more capable of drawing investors and commanding market share.

Industry analysts classify REITs by three investment categories: equity REITs, mortgage REITs, and hybrid REITs. Equity REITs own real estate, and their revenue principally derives from rent. Mortgage REITs lend money to real estate owners, and their revenue primarily springs from interest earned on mortgage loans. Some mortgage REITs also invest in residuals of mortgage-backed securities. Hybrid REITs combine the investment strategies of both equity REITs and mortgage REITs. The overwhelming majority of REITs (191) currently in operation are equity REITs.

Pension funds, endowment funds, insurance companies, bank trust departments, mutual funds, and investors—both U.S.-based as well as non-U.S.-based—own shares of REITs. An individual who chooses to invest in a REIT seeks to achieve current income distributions and long-term stock appreciation potential. REIT shares typically are purchased for $2 to $40 each, with no minimum purchase required.

Over 80 percent of the REITs operating in the United States in 1999 were traded on the national stock exchanges, including the New York Stock Exchange, the American Stock Exchange, and the NASDAQ National Market System. Dozens of REITs, however, are not traded on a stock exchange.

Analyzing the performance and current value of a REIT is not an easy task. Asset values may be derived using different rent multipliers and capitalization rates; but these values are derived from appraisal reports, which do not always reflect the same standards.

Rather than using asset values to analyze performance, the following elements are recommended for scrutiny: (1) management (prospective investors in a particular REIT should carefully examine the experience level of the management team); and (2) future growth (which is contingent on the future income from the REIT's holdings). Income, in turn, depends on rent, which is influenced by vacancy levels, regional economic growth, and units available in an area; and to some degree on the sales level of the REIT's properties.