Word-of-the-Week: Real estate investment trust
What is a real estate fund?
Real Estate Investment Trusts (REITs) are the point at which the stock market and real estate market collide. They are a way for individuals to invest in high yielding real estate without having to buy and operate the property themselves. REITs allow investors to diversify into real estate without submitting to property liability and the supervisory duties of real estate management.
A real estate investment in a REIT is not like owning real estate as seen in the real estate market.
In fact, stocks in a REIT have a lot more in common with stocks than real estate in terms of risk and value. At the end of 2020, 30 REITs were represented in the Standard & Poor’s (S&P) 500 stock market index.
For stock market investors, REITs serve as a form of diversification by spreading the risk associated with managing a particular REIT among the broader group of shareholders. Investors appreciate the variety of REIT investments, as each REIT typically owns several properties.
In addition, investing in several different REITs is very similar to acquiring partial ownership of many different properties and property managers.
Real estate holding companies
REITs are different from other forms of syndication better known in the real estate market, such as Limited Liability Company (LLC) and the far riskier transfer for Section 1031 Leases (TICs).
REITs are essentially companies that own real estate. However, unlike publicly traded corporations, they avoid paying income taxes through a tax loophole by giving at least 90% of their profits to investors in the form of Dividends. In both REITs and LLCs, income, profits and losses are passed on to individual members in proportion to their share of ownership of the company.
For real estate syndication purposes, the REIT is similar to an LLC. Both are unincorporated organizations that were set up for group investment primarily in real estate. REITs provide limited investor liability and a disclosure of income for state and state tax reporting to the investor (as do LLCs). The pass-through avoids double taxation of distributed corporate profits. The very different tax results of corporations favor the REIT (or LLC) stock market vehicle. [Calif. Corporations Code §23000; Internal Revenue Code §856]
State tax reporting qualification
To qualify for federal tax reporting as a REIT, the REIT must have at least 100 shareholders. In addition, 75% of the REIT’s business must be limited to investing in:
- Trust letters;
- Cash register; or
- Government bonds.
No such restrictions apply to an LLC. Another difference, a REIT that solicits investors in California must first qualify its investment program by getting approval from California Department of Corporations (DOC). An LLC formed to acquire existing income assets identified and fully disclosed prior to receipt of contributions from investing members in order to own and operate it is not subject to this rule. [IRC §856(c)(4); Corp C §23000(b)]
Critically important to real estate agents and brokers, REITs are similar to a Chapter S corporation. Both show profits without paying taxes and pass any income tax liability on to shareholders. Therefore, real estate agents are prohibited from charging a brokerage fee when selling or buying REIT stock (as opposed to an LLC, which is treated as a limited partnership under California law). [Business and Professions Code §10131.3]
Limited management skills
The bottom line for REITs is a severely limited opportunity for management to receive compensation for almost anything involving fundraising, representation, management fees, or the allocation of assets and cash reserves.
In search of alternative income for their REIT exposure, REIT management members often work as real estate agents to cover the percentage fees their REIT pays on buying or selling large assets. This risky behavior may be good for management, but it has long-term negative implications for REIT investors.
When REITs buy real estate at price-based prices, problems arise with the asset on capitalization rates (cap rates) that deliver low annual returns, say 5%, as it has for over a decade.
While low annual returns are acceptable for stock market investors, they are not acceptable for real estate investors. Stock investors are used to buying and selling company shares at a price-to-earnings (earnings) ratio (multipliers) that reflects pricing, a profit-taking perspective that has never been acceptable to prudent high yield real estate investors as they treat real estate the way they do income-generating collector’s item.
In contrast to companies, which are all comparable with one another, land is unique and its value cannot be easily or quickly assessed by means of comparisons or given formulas. After all, companies can logically grow and remain profitable for centuries. Businesses are not destined to become obsolete, as is the case with real estate improvements. The capital recovery depreciation premium is included in the real estate investment analysis cap rates.
Where do I start with REIT investments
Cautious and uninformed investors prefer to buy bundled stocks of different REITs, thereby reflecting the market as a whole, rather than trying to pick individual REIT winners. This approach requires less research and, by being diversified, reduces the tedious due diligence process associated with purchasing individual REITs. These investors can benefit from historical information and updated reports from the National Association of REITs.
Dedicated investors need to spend more time and effort asking detailed questions about each individual REIT before buying stocks. Does the REIT trade in hotels, self-storage units (as riskier properties) or in apartments (less risky)?
When conducting this research, the most important factors to consider are:
- The REITs administration. Management must have a history of responsibly operating real estate, not just buying and selling for the sake of short-term gains.
- Purchases must be made with no cash involved. to lose fees be burdened by deals at the front end, and property management must be carried out effectively (few vacancies) and efficiently (low cost ratios). Whenever possible, the investor needs to analyze the REIT’s income reports to get a feel for its historical use of cash and real estate.
- The location and Type of property owned by the REIT. This information can be found in the REIT’s operating account. Perhaps most useful for those who want to do the research are the REIT’s annual reports to the US Securities and Exchange Commission.
The SEC requires all REITs to report the number of properties they own, the number under construction, and the amount invested. You must also report details of the types of property held, as well as other information about the REIT’s activities and objectives. The report, which can be over fifty pages long, lists possible risks to the REIT and its investors, describes the degree of insurance of the trust and provides a comprehensive picture of the trust’s market position.
Other questions to consider:
- How has the REIT developed historically?
- Is it currently encumbered with properties that have lost value in the recession but have not been “marked-to-market”?
- Does she have a ton of cash to make new investments in the years to come?
If buyers have learned one thing from the end of the residential and commercial bubble, it is that there are no safe bets on real estate – just more or less risky ones.