The REIT Stuff

REITs were originally established by Congress in 1960 to give smaller investors an opportunity to participate in the commercial real estate market. However, it took nearly thirty years before changes in tax law made REITs attractive to institutional investors. This change, combined with low commercial property values, gave REITs plenty of capital and lots of attractive buying opportunities in the 1990s. The resulting spending spree made equity REITs among the nation’s largest property owners.

The main attraction of REITs is that, like mutual funds, they pay no corporate taxes, assuming they meet certain requirements. Instead, taxes are passed through to the individual investors. To maintain this tax status, REITs must meet a variety of requirements, including:

• A minimum of 100 shareholders;
• No more than 50 percent of the shares held by five or fewer individuals (depending on the REIT structure);
• At least 75 percent of total assets in real estate;
• At least 75 percent of gross income derived from rents or mortgage interest;
• Disbursement of at least 95 percent of their taxable income as dividends each year (decreasing to 90 percent as of January 1, 2001).

For many property owners, REITs represent an attractive way to turn an illiquid property investment into an easily-tradable security. Owners are often reluctant to sell their property to a REIT outright, however, because of the immediate capital gains taxes resulting from the transfer of the property. To combat this tax problem, a new form of REIT known as an UPREIT ("umbrella partnership REIT") emerged in 1992 and has since proved to be the structure for the majority of newly-formed REITs.

In an UPREIT, the property owners form a new operating partnership with a REIT. In return for contributing the property into the new partnership, the owners receive interests or "units" (often referred to as OP Units) in the operating partnership. Through this arrangement, the owners defer capital gains taxes on the appreciated value of the property. Depending on the size of the REIT, owners may also be able to negotiate other benefits, such as protections against the sale of the property, seats on the board, or other controls over the management of the partnership assets.

After a designated lock-up period (usually one or two years), the owners may convert their OP Units either into cash or shares of the REIT, depending on how the agreement is structured. The tax liability is payable as units are converted, allowing owners to spread out the tax liability over several years. Or, if the owners hold their units until death, their beneficiaries may convert the units without paying income taxes.

Owners who consider rolling their property into an UPREIT usually do so for one reason: taxes. In addition to the tax deferral on capital gains, the REIT itself does not pay any corporate taxes on income paid out to investors.

But there are other potential advantages, too:

Liquidity. Rather than an owner, with equity tied up in a physical facility, you become an investor, with an eventual ability to more easily convert some or all of your assets into cash.

Share Growth. While REIT investors may still be leery after two years of losses, REITs have started beating the market again. And new legislation that takes affect in 2001 will allow REITs to establish special taxable subsidiaries to generate more income from ancillary activities without jeopardizing their REIT tax status. With the ability to market everything from telecommunications services to landscaping to their tenants, REITs will be better able to compete with non-REIT real estate companies, generate income, and hopefully increase share value.

Freedom. For property owners weary of the hassles of daily management, REITs can get them out of the property management business. Most REITs will either retain existing teams or bring in experienced managers. (The question of who will run the facility is usually part of the partnership negotiation.)

Security. When dealing with a publicly-held REIT, owners have the protection of knowing that the REIT is covered by strict SEC regulations and must make broad public disclosures of financial and management information.

But there are disadvantages, too. The roller-coaster ride of the past decade is ample evidence that REITs aren’t a sure-fire investment opportunity. Before plunging ahead, owners also need to consider the downside:

Loss of Control. Suddenly, you’re not necessarily the one calling the shots. After owning and managing a property for a long time, it can be frustrating to realize that you have only as much authority as allowed in the partnership agreement.

Loss of Flexibility. REITs have to follow the strict rules set up in the Internal Revenue Code. The financial flexibility available to owners for managing income and assets goes away when the property is put into the REIT.

Lock-Ups. You can’t generally convert your partnership units immediately. So, for one to two years, you don’t have ready access to the capital. While your liquidity is greater in the long run, your investment may actually be less liquid in the short run.

Tax Liability. If the REIT sells the property that you contributed, then all of the capital gains flow directly back to you. If you haven’t negotiated protections against sale in the partnership agreement, then you could be at risk for an unexpected tax bill. In the late 1990s, as share prices dove and their ability to raise new capital was cut off, many REITs began shedding properties in order to raise money and focus on their core markets.

Future of REITs. In an unstable market, REITs could just as easily go south again. While REIT dividends are a reliable source of cash flow, investors may be frustrated to emerge from a lock-up period to discover that their investment has declined in value – even though the value of the underlying property may have increased.

Owners also need to consider the size and strength of the REIT in thinking about a deal. While a smaller REIT, or even a start-up, may give owners much more control in the partnership, it may also be less able to weather financial or market setbacks. In contrast, a strong, established REIT may provide a better investment opportunity, but may also be much more limiting in terms of operational flexibility or tax protections (such as when the property may be sold).

REITs are no longer the easy answer they appeared to be in the early 1990s. While the dark days appear to be over for now, REITs as investments will probably continue to seesaw, as economic factors affect both the real estate market and the public markets. That means owners have to take a close look at the pros and cons of moving into a REIT.