A Brief Primer on REITs
REITs – Real Estate Investment Trusts – are companies that mainly own real estate or invest in real estate mortgages and mortgage securities. Patterned on mutual funds, they were created by Congress in 1960 as a way to provide easy and affordable access to investment in real estate -- a way for people of all income levels and all walks of life to benefit from large-scale, income-producing real estate.
REITs can’t keep the rents they collect or the interest they receive because they are required to pay out at least 90 percent of their taxable income annually to shareholders as dividends. Because REITs cannot retain their income, they receive a “dividends paid deduction” from their corporate tax computation for each dollar they pay out. Since REITs must pay standard corporate tax on any of the 10 percent of taxable income they can retain under the REIT rules, most REITs pay out not just 90 percent, but all of their taxable income to their shareholders in dividends.
Shareholders pay the full tax on the dividend income at the ordinary income tax rates of up to 39.6 percent – significantly higher than the 35 percent corporate income tax rate.
By design, a broad definition of real estate
From its beginning, the REIT approach to real estate investment established by Congress contemplated land and the improvements on it. Congress established a broad definition of real estate because it understood that the role and uses of real estate in the economy would change over time.
Consequently, there are REITs today that own real estate tied to almost all sectors of the economy. The holdings of these REITs take the form of apartments, data centers, hospitals, hotels, industrial facilities, life science buildings, nursing homes, offices, shopping malls, storage centers, senior housing, student housing, telecommunications towers, electrical transmission infrastructure and timberlands, among others. The definition of real estate, however, as land and the improvements on it, has not changed.
Since its inception, NAREIT has supported Congress’s approach to REIT-based real estate investment and the IRS’s authority to administer the REIT rules.
REITs today are a significant and integral part of our economy and a mainstay of individual and institutional investing and retirement planning:
- REITs are all around us. They own and operate more than 40,000 properties in the United States, including many of the malls, hotels, office buildings, apartments and medical facilities we use every day.
- Through their own operations and the businesses that occupy their properties, REITs help support nearly 1 million jobs in the U.S. each year.
- REITs have become a bedrock of investment for everyday Americans – from teachers and firefighters to retirees and executives. More than 40 million Americans have REITs as part of their 401(k) plans. There are more than 200 mutual funds and ETFs dedicated to REITs. And according to one survey, REITs are in 75 percent of target date funds, the fastest-growing retail retirement investment.
- There are more than 200 stock exchange-listed REITs with an equity market capitalization of about $800 billion. This represents $1.5 trillion of underlying real estate and is roughly 15 percent of total commercial real estate. Most of the remaining 85 percent is held by tax-exempt entities like pension funds or pass-through partnerships.
- REITs paid out approximately $34 billion in dividends in 2013. This was taxed at the shareholder level at the higher ordinary rate of up to 39.6 percent, whereas most non-REIT dividends are taxed at the lower qualified rate of up to 20 percent.
- More than 30 countries around the world have adopted REIT laws comparable to the U.S. REIT rules for real estate investment, ranging from developed economies, such as the United Kingdom and Japan, to emerging markets like Singapore and Malaysia.
- REITs are required to operate with a longer-term investment horizon, they bring transparency to real estate investment markets, and they act as a stabilizing force within the real estate sector for financial intermediaries during times of economic turbulence.
Why some companies have converted to REITs
It is important to understand the vast majority of listed REITs today were an outgrowth of partnerships and became REITs through IPOs, not from corporations converting to REITs. However, a small number of companies in the past two years have converted from C corporations to REITs. Companies usually make major strategic decisions, such as adding or dropping different lines of business or electing REIT status, in the context of broader economic and market forces. Such forces are operating today. In the context of an economy that is growing very slowly and limiting corporations’ ability to deliver growth to their shareholders, companies are seeking other ways to deliver shareholder value. Some companies that have amassed very significant real estate assets are choosing to deliver this value by focusing on their real estate business.
A defining characteristic of commercial real estate is its capability to generate a strong, consistent income stream based on the continuing flow of income from rents – an attractive investment attribute in a slow-growth environment, and one in which continuing low interest rates have severely limited the yields and appeal of fixed income investments.
A global search for yield
In this environment, investors around the globe are seeking stocks that deliver income and are rewarding them with higher valuation multiples. REITs provide the income many of these investors are seeking because of their obligation to pay out at least 90 percent of their taxable income as dividends to shareholders annually.
At the end of the second quarter of 2014, the dividend yield of the FTSE NAREIT All REITs Index was 4.03 percent compared to 2.00 percent for the S&P 500. Over longer holding periods, the income return from REITs has accounted for nearly 60 percent of their total return.
Requirements to become a REIT
The REIT election can be made only by a real estate company, required by the Internal Revenue Code to have at least 75 percent of its total assets in real estate and at least 75 percent of its gross income coming from rents from real property or interest on mortgages financing real property. This IRS requirement is very specific and has not changed since REITs were created in 1960. No other type of company can become a REIT.
Over the years, the IRS has concluded that properties like communications towers (on which space is leased to communications companies and which were approved by the IRS in 1964), railroad tracks (which are leased to transporters of freight and passengers and were approved by the IRS in 1969), electrical transmission infrastructure (leased to energy providers and approved by the IRS in 2007), and gas pipelines (leased to natural gas providers and approved by the IRS in 2007) fit within the original definition of real estate and therefore are eligible property.
In addition, there are substantial costs associated with exploring and ultimately making the decision to convert to REIT status. These include distributing to shareholders all accumulated earnings and profits from the years before conversion, paying taxes on any appreciated gain in the company's assets, and the fees and expenses associated with changing a business model, then adopting and operating according to the REIT rules.