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Real Estate Investment Trusts

REITs: What You Need to Know

by Harry Domash

REIT Directory    How to Find the Best Property REITs

Real estate investment trusts (REITs) are a special form of corporation that, by law, must invest only in real estate. In return for following that rule, a REIT does not have to pay U.S. federal income tax if it pays out at least 90% of its net income in the form of dividends to their shareholders (for the years 2009/2010, the IRS allowed a REIT to pay 90% of its dividends in stock rather than cash). REITs enable individual investors to participate in large-scale, income-producing real estate investments.

To qualify as a REIT, a company must meet the following requirements:

  • its assets must consist mostly of real estate held for long-term investment,

  • its income must be mainly derived from real estate, and

  • it must pay out at least 90% of its taxable income to shareholders.

There are two major categories of REITs. Equity REITs own physical properties such as apartment houses or shopping centers. By contrast, mortgage REITs do not own real estate properties, instead, they invest in mortgages. Equity REITs may invest in any type of real estate, but most specialize in a particular property type.

Note that taxable income is not necessarily the same as the net income shown in the quarterly or annual financial statements. Also, because real estate property owners must deduct non-cash depreciation expenses, even if the property is, in fact, appreciating in value, neither the taxable or reported income figure accurately reflect the real cash flow generated by the properties. For that reason, the REIT trade association created a measure called funds from operations (FFO), which reflects the cash profits generated by a property REIT's operations.

Because REITs must pay out a large chunk of earnings to shareholders, most property REITs must raise capital by borrowing or by selling more share to fund growth.

Property REITs are allowed to provide the customary management services associated with leasing properties such as apartment buildings, shopping centers and office buildings. But REITs are not allowed to operate real estate that requires a high degree of personal service such as hotels and healthcare facilities. However, property REITs can create affiliated companies that can provide management services. in these sectors.

We have divided the property universe into these categories:

  1. Retail: shopping centers, outlet centers, small neighborhood centers, or downtown/heavily trafficked retail locations.

  2. Healthcare: owners, but not operators, of healthcare facilities such as nursing homes, medical office buildings, hospitals, etc.

  3. Lodging: hotels and resort properties. Lodging REITs are not allowed to directly manage their hotel operations, but many arrange management contracts with affiliated companies. 

  4. Industrial: industrial, warehouse, or distribution center properties. Flex properties are a recent innovation in industrial real estate. These are one-story buildings with high ceilings, rear loading docks, surface parking and generous landscaping. Flex building shells are designed to accommodate companies needing office, light manufacturing and/or warehouse space.

  5. Office: office buildings are generally categorized as Class A, Class B, or Class C, depending on amenities and location, and Class A is the best. Class B buildings are usually in suburban neighborhoods. Class C buildings are usually older and in low-rent areas.

  6. Mixed Industrial/Office: many REITs own both office and industrial/warehouse properties.

  7. Mortgage/Finance: REITs that invest in mortgages, or provide mortgage or other types of financing.

  8. Residential: apartment and manufactured home community owners.

  9. Specialty: self-storage centers, restaurant property owners, and other REITs that do not fit into the major categories.

  10. Diversified: REITs that own properties in multiple categories.

Income Tax Implications
REIT dividends are mostly taxed at ordinary income tax rates. However, after the year-end, a REIT may designate a portion of its prior year's payouts as "qualified dividends," which qualify for the maximum 15% rate.  On average, roughly 20% of annual payouts fall into this category. A REIT may also classify portions of its prior year payouts as return of capital. Return of capital payouts reduce your cost basis and are not taxable until you sell your REIT shares, when they are taxed at the appropriate capital gains rate.

See the complete list in the REIT Directory

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