SIC 6798
REAL ESTATE INVESTMENT TRUSTS



This industry covers establishments primarily engaged in closed-end investments in real estate or related mortgage assets operating so that they could meet the requirements of the Real Estate Investment Trust Act of 1960 as amended. Such trusts include mortgage investment trusts, mortgage trusts, realty investment trusts, and realty trusts. This act exempts trusts from corporate income and capital gains taxation, provided they invest primarily in specified assets, pay out most of their income to shareholders, and meet certain requirements regarding the dispersion of trust ownership.

NAICS Code(s)

525930 (Real Estate Investment Trusts)

Industry Snapshot

After coming of age in the early 1990s and flourishing in the mid 1990s, the investor-driven REIT (pronounced "reet") industry languished at decade's end. Dragged down by tightened credit and waning investor interest, publicly-traded REITs coped with falling share prices by selling properties and buying back shares. Despite these measures, total market capitalization of U.S. REITs sank $16 billion between 1997 and 1999, according to statistics published by the National Association of Real Estate Investment Trusts (NAREIT), the industry's leading trade organization. Figures from NAREIT showed that industry market capitalization fell from $141 billion in 1997, the industry's best year, to $124 billion for the 203 REITs on record at year-end 1999.

The industry's troubles stemmed from a few sources. Since REITs depend heavily on investor goodwill to raise capital for real estate acquisitions and development, the industry suffered when investors poured money into Internet and other technology stocks that offered higher returns than REITs. The problems for REITs were only compounded by a mid 1990s run-up in real estate prices, signaling to some investors that REITs were paying too much for their properties and that a downward correction was imminent. Historically the real estate sector has gone through boom cycles with heavy development and escalating prices, followed by bust cycles notorious for over-supply and falling prices. In addition, international economic crises in 1997 and 1998 led to credit tightening at many banks, and as a result, less money available to REITs to finance new growth.

By the beginning of the twenty-first century, some analysts believed that the industry was poised for recovery, arguing that it had hit bottom in 1999. Indeed, by the turn of the century, indices of REIT shares staged somewhat of a comeback, although the average share price was still well below its 1999 peak, let alone historical highs. Still, these analysts were encouraged by the industry's underlying value—REITs' assets were worth more than their market capitalization—and by the overall health in the U.S. real estate market. Other observers remained wary, though, and predicted a round of REIT consolidation and privatization as a remedy for the industry's market woes.

Organization and Structure

REITs are corporations, trusts, or associations that pool investor money to purchase and manage real estate and sometimes related investments such as mortgages. A corporation or trust that qualifies as a REIT generally is not required to pay federal income tax. In most states, REITs are also exempt from state income taxes.

U.S. tax laws specify exacting standards for what qualifies as a REIT. Among other requirements, a REIT must have:

Most REITs issue shares that are traded publicly on an exchange such as the New York Stock Exchange (NYSE), the American Exchange (AMEX), or the NASDAQ. The NYSE is home to about three-quarters of all REITs. These vehicles pool investors' money, using professional managers to supervise a portfolio of properties, mortgages, or both, depending on the business objective. REITs thus provide liquidity to investors wishing to participate in the real estate market, while providing capital for real estate managers and developers to develop new revenue streams from real estate holdings.

REITs characteristically have high dividend yields, which recently have been about the same as yields on 10-year Treasury notes. High yields make REITs interestrate sensitive like utility stocks and other financial companies, since high-yielding equity investments compete with fixed-income securities for investor money.

Types of REITs. There are three basic types of REITs: equity trusts, mortgage trusts, and hybrids. Most REITs belong to the equity category. These REITs invest directly in real property; they receive rental income and lease payments and occasionally realize capital gains from selling properties. Equity trusts are typically organized as blind pools for the purpose of investing in several unspecified rental income-producing properties to be held for an indefinite period to produce cash flow from rents, which could be distributed as dividends to shareowners.

A fully specified REIT invests in properties or in mortgages detailed in its offering statement; these investments do not change over time. As a result, investors can attempt to evaluate the quality of the underlying real estate prior to investing in the REIT. A blind-pool trust, in contrast, raises capital initially and then searches for real estate properties or mortgages in which to invest the proceeds raised from the offering.

Some equity trusts are organized as specified funds or specified trusts. Sale-leaseback trusts, in contrast to blind-pool trusts, invest in nondepreciable land under-lying buildings and then lease the land back to the sellers from which they were purchased. Because these trusts offered tax advantages to the seller-lessee, they typically attempt to obtain higher rental returns by sharing in the gross receipts of the lessees or the proceeds from refinancing the respective buildings.

Mortgage REITs are established to invest the proceeds from the sale of their shares in mortgages secured by real estate holdings or mortgage-backed pass-through certificates. These trusts are sensitive to the credit quality of the borrower. Some mortgage trusts limit their investments to construction and other short-term mortgages; others invest only in long-term or permanent mortgages, and some invest in both types of mortgages.

Another type of mortgage trust—a dedicated trust—is organized to provide mortgage financing to a particular real estate developer for a given project. Hybrid trusts are organized to invest in both equity properties and mortgages. In recent years, several mortgage trusts have started issuing collateralized mortgage obligations (CMOs) at interest rates below the interest rates received on the mortgages, or the mortgage-backed pass-through certificates, acquired by the REIT and pledged to the respective CMOs. In the late 1980s, REITs were organized to invest in mortgage securities called "CMO residuals"—real estate mortgages offering potentially high risks and yields.

Within these categories, REITs may be classified by other characteristics, such as closed-end or open-end. Under a closed-end REIT, the number of shares issued to the public at the initial offering are limited in order to protect shareholders from future dilution of their equity interests. This practice results in more predictable projected returns and reduces the price volatility of the shares themselves. Open-end REITs, in contrast, create and sell new shares as they discover new opportunities for investment. Although the new shares dilute the interests of existing shareholders, management representatives and shareholders believe that the total value of each share will ultimately be increased by the additional investments.

Term. REITs may also be distinguished on the basis of whether they are finite. A finite life trust is established as a self-liquidating investment vehicle; it must dispose of its assets and distribute the proceeds to shareholders by a specified date. In such cases, properties will be acquired for various periods, usually between 4 and 15 years, after which the properties will be sold and the proceeds distributed to the shareholders when the trust is liquidated. In theory, the advantage of a specified investment lifetime is that REIT's share prices should closely match its current asset values because investors can presumably make fairly accurate estimates of the residual values of the respective properties. Non-finite life REITs have a perpetual life and typically reinvest any sale or financing proceeds in new or existing properties. To retain their status as real estate investment trusts, perpetual REITs must distribute most of the cash flow from rental or interest payments to shareholders.

Leverage. REITs may be further distinguished on the basis of leveraging. When a leveraged REIT acquires properties, it seeks mortgage financing to fund the acquisition. In general, the financing may pay up to 90 percent of the value of the purchased assets. Unleveraged REITs do not utilize debt financing in their acquisitions, but they instead purchase properties for cash or invest their funds in mortgages.

Background and Development

Contemporary REITs are an outgrowth of the so-called Massachusetts Trusts—early business trusts formed by nineteenth-century corporations to avoid certain legal constraints imposed by states on corporate holdings of real estate. Under the standard form of real estate trust organization, investors were permitted to pool their funds and obtain equity interests in real estate with centralized management and the safety of diversification without incurring the personal liability associated with partnership interests. Funds established through the trust form of organization were largely responsible for the development of Boston in the nineteenth and early twentieth century, as well as for the early development of such cities as Detroit, Chicago, Minneapolis, St. Paul, Kansas City, Omaha, Duluth, and Seattle.

From 1913 to 1935, common law business trusts, as distinguished from corporations, were not taxed on trust income distributed to owners. However, in 1935, the U.S. Supreme Court held that business trusts should be taxed as corporations in Morrissey v. Commissioner. In the aftermath of World War II, fueled by large amounts of capital and heavy demand for new construction, real estate syndicates began to expand, primarily in the larger Eastern cities. To reduce the impact of the corporate tax, many of these syndicates were formed as "thin" corporations, whereby the investor would invest as little as 20 percent of funds as capital, with the remaining 20 percent of the total investment being accounted for in bonds or debentures signifying the corporation's debt.

In the decades following the Morrissey v. Commissioner decision, no new substantial REITs were formed as common law business trusts. Instead, pooling of real estate investments was undertaken under either the corporate or partnership form of business organization.

In 1960, President Eisenhower signed into law the Real Estate Investment Trust Act of 1960, which granted special tax concessions to REITs and qualified REITs for tax-exempt status. The law limited the tax benefits of REITs to common law business trusts; corporations could not qualify. It sought to extend to REIT owners substantially the same type of tax treatment they would receive if they invested directly in the real estate equities and mortgages held by the trust.

The law also aimed to encourage the growth of such investment trusts and to increase the funds available for financing real estate developments. This equated the treatment of investors in REITs with that accorded investors in regulated investment companies (such as mutual funds). In both REITs and investment companies, small investors can enjoy advantages that before were available only to institutions or the wealthy. These advantages include spreading the risk of loss by the greater pooling of investments, sharing the opportunity to obtain the benefits of management by real estate experts, and sharing in projects that the investors could not undertake individually. The special tax status provided by the law was intended to be limited to passive investors in real estate, not to entities that actively operated a real estate business.

After a few other technical changes to the tax code, REITs grew rapidly in the late 1960s, raising through public offerings significantly more capital than did traditional sources of real estate financing. However, as the volume of capital increased, REIT managers found it increasingly difficult to find real estate projects in which to invest those funds. According to analyst Menachem Rosenberg, as the supply of funds began to exceed the number of quality projects available, property prices increased dramatically, and many REITs paid too much for projects, particularly development projects. A number of REITs invested their funds into high-risk construction and development loans, and REITs that specialized in mortgage lending tended to become careless in their underwriting practices. For 24 consecutive months beginning in April 1973, REITs posted negative total returns.

When the 1974–75 recession caused many real estate projects to fail, the REIT industry suffered a severe downturn. In 1975, provisions were amended to provide for the treatment of property acquired by a REIT through foreclosure on a mortgage or as a result of a default on a lease, and in 1976 the requirements for qualifying as a REIT were modified and penalties in lieu of disqualification were enacted. In 1978, safe harbor rules for determining when sales of property of a REIT would not be taxed as a "prohibited transaction" were added, and the grace period on foreclosure property was extended. The Tax Reform Act of 1986, as amended by the Technical and Miscellaneous Revenue Act of 1986, made further changes to federal tax law affecting REITs.

During the 1980s, equity REITs outperformed the Standard & Poor's 500—with fewer vicissitudes in returns. In 1985, investors began to take a renewed interest in REITs when it appeared as though the limited partnerships would lose most of their tax shelter under proposed tax reforms. The Tax Reform Act of 1986 significantly limited the tax advantages associated with real estate limited partnerships, providing a boost to the REIT industry. Overall, 33 REITs were established in 1985.

During the 1980s, the rapid increase in the supply of new commercial real estate space greatly exceeded the growth of aggregate space demand. This, in turn, resulted in market imbalances and downward pressure on rental rates and real estate asset values. As a result, real estate developers came under significant financial pressures.

Major changes were also occurring in the real estate capital structure. Previously, real estate investment was dominated by institutional investors such as banks, savings and loans, insurance companies, pension funds, and foreign investors that supplied private capital for both equity and mortgage investments. Around 1990, these institutional investors faced higher costs of capital, more conservative investment guidelines, and reductions in portfolio allocations to real estate. The result was a vacuum in the capital market, which could potentially be filled by real estate investment trusts.

However, the U.S. tax code still made it difficult for large investors like pension funds to participate in REITs. The law, designed to prevent individuals from sheltering private real estate holdings under a corporation to avoid taxes, meant that a large investment by a U.S. pension fund could force a REIT to pay corporate taxes. This, in turn, would diminish investors' returns and make the REIT a less efficient and less profitable investment channel. The problem was solved in 1992 by the creation of the Umbrella Partnership REIT (UPREIT) structure. In an UPREIT, the investors don't own the REIT's properties directly. Instead, they hold shares in the umbrella partnership, which in turn owns the company's real estate.

During the mid 1990s, investors poured money into REITs at an unprecedented pace. Based on NAREIT statistics, REIT market capitalization soared from less than $16 billion in 1992 to more than $140 billion by the end of 1997. The number of REITs tracked by NAREIT also surged nearly 50 percent, from 142 to 211. REITs achieved such growth in part because of strong interest in REITs as lower-risk, higher-yield investments in the traditionally volatile real estate sector. Investors' perceptions of REITs were also boosted by favorable market trends in real estate, including rising property values and relatively high occupancy rates.

But by 1998, the REIT industry's fortunes reversed. Investors worried that REITs were bidding up real estate prices too fast, potentially setting the stage for a downturn. Currency and debt crises in Asia, Russia, and Latin America left major international banks reeling from bad loans and caused many to tighten their lending policies, making it harder and more expensive for REITs to borrow. Meanwhile, skyrocketing technology stocks lured investors away from real estate. To make matters worse, a glut of new REIT shares were issued in late 1997 and the first half of 1998. As these pressures converged, investors began to pull out of REITs and share prices tumbled. By the end of 1998, REITs had collectively shed 18 percent of their share value for the year. In 1999 the picture was largely the same, although average declines weren't as bad as in the year before.

Current Conditions

Although, by the turn of the twenty-first century, REITs were worth $122 billion in market capitalization, they held less than 10 percent of all commercial real estate in the United States. The largest REIT segment at that point was office and industrial properties, representing nearly a third of the industry in terms of market capitalization. Second were retail REITs (ones that own shopping centers), which accounted for more than one-fifth of REIT capitalization. Other large segments included residential REITs, which mostly own apartment buildings, and diversified REITs, which have significant holdings in multiple segments.

In spite of REITs' poor showing in the late 1990s and early 2000s, a number of analysts believed that the under-lying picture wasn't as bleak as it seemed. Unlike during the 1980s, they argued, there was no building spree creating an overabundance of commercial real estate. Indeed, the economic fundamentals of the real estate business appeared quite sound with a growing economy, low inflation, moderate interest rates, and high occupancy rates. Moreover, with REIT shares trading so low, in many cases the trusts' properties were worth more than their capitalization reflected. In other words, if a typical REIT sold all of its assets, the proceeds would be worth more than its stock valuation. Uncommon in other stock investments, this hidden value could make REITs attractive to investors seeking quality.

At the turn of the twenty-first century, the most vulnerable REIT segment was hotels and resorts. Among other troubles, the lodging business suffered from over-supply and tepid revenue growth. However, the 15 U.S. hotel REITs amounted to just 5 to 6 percent of the industry in terms of market capitalization.

Industry Leaders

The largest U.S. REIT is Equity Office Properties Trust. In 2000, this Chicago-based trust owned some 291 office buildings totaling 76.6 million square feet. Headed by billionaire real estate tycoon Sam Zell, Equity Office owns property in most major U.S. metropolitan areas and, as of January 2000, had a market capitalization of $6.4 billion. Early in the twenty-first century, the firm announced plans to acquire Cornerstone Properties Inc., a New York-based REIT, in a transaction that would add 90 properties and almost 20 million square feet to Equity Office's portfolio. The merger was seen by some as a precursor to further consolidation among REITs. Equity Office's sister company, Equity Residential Properties Trust, also controlled by Zell, is one of the largest owners and lessors of apartments, with more than 1,000 properties throughout the country.

Another leading REIT is Simon Property Group, Inc. The largest of the retail REITs, Simon Property specializes in regional malls and other types of shopping centers primarily in suburban settings. The Indianapolis-headquartered REIT has a 50 percent interest in Minneapolis' Mall of America, one of its best-known holdings. All together, in 1999 the company had an interest in 259 sites with 184 million square feet of gross leasable area. Its market capitalization in January, 2000 stood at $4.2 billion.

Further Reading

Brody, Michael J., and David S. Raab. "A Primer on Real Estate Investment Trusts and Umbrella Partnership Real Estate Investment Trusts." Real Estate Finance Journal, winter 1994.

Hamilton, Kathryn. "REITs: No Need to Abandon Hope." Buildings, March 1999.

Morrissey, Janet. "REITs Battle Investor Tide in 2000." Wall Street Journal, 10 December 1999.

National Association of Real Estate Investment Trusts. "Real Time Index." NAREIT Online. Washington: February 2000. Available from http://www.nareit.org .

Rich, Motoko, and Peter Grant. "For Commercial Real Estate, It Was a Year of Joy—and of Discontent." Wall Street Journal, 29 December 1999.



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