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REITs and Conversions

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. They generally collect rent or mortgage interest and 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. Shareholders pay the tax on the dividends, primarily at their ordinary income tax rate rather than the lower qualified dividend rate. 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 retain under the REIT rules, most REITs pay out not just 90 percent, but all of their taxable income to their shareholders in dividends.

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 and timberlands, among others.

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 more than $1 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.
  • Additionally, 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.

Facts About REIT Conversions 

A number of companies have announced recently that they are exploring converting to a REIT.  Why?

There are two primary reasons a company would consider converting to a REIT:

1)   Business model and core competencies – REIT status is available to companies that are primarily real estate companies, the majority of whose revenues and assets come from real estate. They’re choosing to focus on their core real estate business and operate as REITs.

2)   Macro-economic trends – Today’s slow-growth economic environment and the Federal Reserve’s commitment to keep interest rates low for an extended period have produced a global search for yield and strong valuations for income stocks. The requirement that REITs pay out at least 90 percent of their taxable income as dividends makes them especially desirable now as excellent income stocks.

 

Corporate Response to a Slow-Growth, Low-interest Rate Environment

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 refocusing mainly on their real estate business.

An important 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.

Investors in this environment increasingly 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 requirement to pay out at least 90 percent of their taxable income as dividends to shareholders annually.

The fact that a REIT cannot keep the rent it collects or the interest it receives results in a significant dividend payout.  Through the first quarter of 2014, the dividend yield of the FTSE NAREIT All REITs Index was 4.14 percent compared to 2.02 percent for the S&P 500. Over longer holding periods the income return from REITs has accounted for nearly two-thirds of their total return.

REITs income stream provides some characteristics of a fixed income investment but, unlike a fixed income investment, REIT dividends may increase over time.  Additionally, as equities, they offer the opportunity for capital appreciation.

What’s required for a company to convert to a REIT?

The REIT election can be made only by a real estate company, defined 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.

Within the original definition of real estate, the IRS has concluded that property like towers (on which space is leased to telecom companies) and data centers (which lease server space for the “cloud” to Internet companies) are considered real estate and therefore are eligible property. So generally, companies that are today considering converting to a REIT are not redefining the REIT boundaries set originally by Congress in 1960; they are merely acknowledging that their core business is real estate. 

In addition, there are significant 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.

It's also 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.

Is the definition of real estate changing?

No, the definition of real estate remains the same:  land and the improvements on it.  By design, this definition is far-reaching and flexible enough to allow for growth and evolution of the industry.

Would the companies currently exploring REIT status represent new REIT property types?

Most of the companies that have converted or are exploring REIT status appear to represent property types that have been represented in the FTSE NAREIT All REITs index or have been in the past. The FTSE NAREIT All REITs index is an index of all REITs listed on the NASDAQ, NYSE and NYSE Market and was created in 1972.

Tower Companies
Tower companies build permanent structures on land and rent space on them to telecom companies. Tower REITS were first recognized by the IRS in 1964 and have been around publicly since the 1990s.

Data Centers
Data center REITs lease server space to their tenants, and they have been in the index since 2004.

Storage
Storage REITs have been around for decades. There are four self-storage REITs in the index now.

Prisons
Prison REITs first entered the index in the 1990s.

Lodging/ Resorts
There are currently 16 Lodging/Resorts companies in the index. There have been dedicated hotel REITs since 1970.

Infrastructure
There currently is an Infrastructure sector in the FTSE NAREIT All REITs Index. 

Billboards and Gaming
There haven’t been billboard or gaming REITs in the index in the past, but their basic business models, like those of other REITs, involve providing land and the improvements on it for lease to tenants. Additionally, the IRS issued private letter rulings in the 1990s confirming that billboards owned by shopping malls constituted real estate and their rents were income under the REIT rule tests.

What about tax implications?

Congress patterned REITs on mutual funds. REITs and mutual funds are required to pay out their taxable income to their shareholders in the form of dividends and receive a dividends paid tax deduction from their corporate tax computation for each dollar they pay out. REITs and mutual funds cannot pass through losses or tax credits to their shareholders.

REITs must pay at least 90 percent of their taxable income to their shareholders annually. The shareholders are fully taxed on the dividend income they receive – and they are taxed primarily at the ordinary income tax rate.

What is NAREIT’s view of the IRS proposed regulations regarding the definition of real estate for REIT purposes??
 
NAREIT believes the IRS process under way is an appropriate, reasonable and timely undertaking by the agency charged with administering the REIT rules. Our view is that the IRS is working to ensure that its regulations are consistent with long-established regulatory interpretations of longstanding statutory law. Congress enacted REIT legislation more than 50 years ago to ensure that Americans from all walks of life could access the real estate asset class on a collective basis to secure greater investment diversification with the benefit of professional management. NAREIT believes that the IRS has that objective clearly in mind as it conducts its process.