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Your REIT Cheat Sheet

Your REIT Cheat Sheet

Grab a seat and meet your neat REIT cheat sheet — playful rhyming aside, many real estate professionals have serious questions regarding the definition, function and rules governing the complex entities known as REITs. To address some common misconceptions, we consulted Baker Tilly partner Randy Barrus, who walked us through the fundamentals and fine points.

What is a REIT?

REITs have been around since the 1960s. Barrus said the initial legislation was drafted to lower the cost barrier for the average investor interested in diversifying his or her portfolio with the addition of real estate.

Developers were provided with a new vehicle for raising capital, which allowed them to expand operations and fuel activity in the sector.

A REIT is simply a company that owns or finances income-producing real estate and conforms to a number of rules. There are equity REITs, mortgage REITs and hybrid REITs. The majority are equity.

“They generally operate income-producing assets or properties,” Barrus said. “This often includes office buildings, apartments, lodging facilities, malls and assisted living rather than condos or raw land. REITs can also invest in mortgages.”

REITs are not for the fast-moving opportunistic investor looking to capture gains quickly through the buying, improving and resale of properties. Instead, REITs seek stability and long-term capital appreciation.

What makes REITs attractive to investors?

The operating profits of REITs are distributed pro rata to investors, and since REITs are not taxed at the corporate level, investors generally pay taxes at ordinary income rates on dividends from operations. Capital gains from the sale of real estate pass to the REIT investors and are taxed at lower rates. Also, some REIT distributions are insulated from the tax burden they would otherwise incur by depreciation and other deductions. As a result, REIT investors often get return of capital distributions even though the REIT has positive cash flow.

Barrus said REITs are also ideal for portfolio diversification, as they offer accessibility to the real estate sector and operate a variety of properties.

What differentiates REITs?

From an investor's perspective, REITs share some similarities and differences with private equity real estate, mutual funds and non-REIT real estate stocks.

Private equity real estate funds, like REITs, generally do not pay federal or state taxes. Unlike a REIT, however, PE funds are able to pass their losses to their investors. Thus, real estate private equity is often more tax efficient than REITs.

There are limitations, however, with investing in PE real estate. The minimum investment is usually high, restricting access to all but high-net-worth individuals and institutional investors. Also, these types of funds often engage in higher-risk/higher-reward transactions.

Mutual funds, which served as the model for REITs, are not real estate-specific, but do provide the potential for capital appreciation. They are generally organized as regulated investment companies, or RICs, and have asset, income and distribution requirements similar to REITs.

Non-REIT real estate companies are not able to eliminate federal and state taxes like a REIT; however, their dividend is generally taxed to the individual shareholder at capital gains rates instead of ordinary rates.

Why would a company want REIT status?

With the restrictions on REITs, REIT status may seem cumbersome. The tax benefits REITs enjoy are significant, and, according to Barrus, enough to justify surmounting the regulatory hurdles to setting them up and running them. They also are a very popular way for developers to raise capital.

REIT profits are generally exempt from federal and state income tax. This helps REITs raise money and increase investors’ returns. REITs are also popular with foreign investors who may be able to escape U.S. tax on the sale of their REIT stock. Tax-exempt investors also benefit from REITs since they generally do not pay tax on REIT dividends, but would pay income tax if they held levered real estate directly.

What is new with REITs?

Barrus said the impact of the 2015 PATH Act, which encourages qualified foreign pension funds to invest in REITs but avoid U.S. tax on exit, has triggered a new influx of foreign capital.

Also significant was that REITs were given their own classification in indexes. REITs now make up around 3% of the Standare & Poor's 500, Barrus said. “REITs have certainly come a long way and are here to stay.”

What does the future hold for REITs?

The Trump administration’s proposal to slash the corporate tax rate may make investing in regular corporations instead of REITs more attractive. Potential tax law changes regarding expensing of assets and limiting interest expense may hurt the REIT industry since REITs generally cannot use net operating losses, but need interest expense to reduce distribution requirements.

A lot of media attention has been paid to eREITs, which are erected with the crowdfunding model, but Barrus said there are only a handful of players, and their footprint is relatively small.

Barrus thinks eREITs could be difficult to administer because they take a large number of investors with small contributions.

REITs’ success depends on the vision and leadership at the top of the organization, and their valuations reflect this and their underlying real estate assets. “Although they are expensive and complex to form and operate, the tax benefits and ability to raise capital far outweigh cost,” Barrus said.

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