Ups and downs: a REIT dilemma.

• Author: Jordan, Brian K.
• Position: Real estate investment trusts

Investors, professional property managers, and real property owners can pool their resources in a REIT, each enjoying the benefit of the others' contributions.

A publicly traded real estate investment trust (REIT) offers investors the opportunity to indirectly own professionally managed equity or mortgage interests in real property by purchasing shares or certificates of beneficial interest in the REIT. A REIT can be thought of as a mutual fund for real estate because many investors are pooling their capital in a professionally managed endeavor. Under the Internal Revenue Code of 1986 as amended (the "Code" or "I.R.C."), a REIT is not generally subject to federal income taxes.[1] Public corporations and certain publicly traded partnerships, on the other hand, generally are subject to two tiers of U.S. taxation. A REIT also offers the owners of equity or mortgage interests in real property the means to achieve their goals of liquidity, growth, and development through the capital infusions received by the REIT from the public. For purposes of this discussion, we will assume that the owners are actually partners in existing real property partnerships.

The formation of a REIT can bring together owner, professional property manager, and investor, all of whom enjoy the rewards of the property and services each contributes to the venture. This article focuses on certain of the more important issues which the investors, the property managers, and the existing real estate partnerships and its partners face when entering the public capital markets.

Organizational and Operational Basics

Organizational Basics. I.R.C. [subsections] 856 through 859 lay out an intricate organizational framework for a REIT. In order to qualify as a REIT, an entity must meet eight organizational requirements. The entity 1) must be a corporation, trust, or association; 2) which is not an insurance company or financial institution; 3) which would be taxable as a domestic corporation if it were not a REIT; 4) which elects to be taxed as a REIT; 5) which has centralized management by trustees or directors; 6) in which at least 100 persons; 7) own transferable shares or certificates; and 8) in which less than six individuals do not own more than 50 percent of the value of the equity.[2]

Further, at the end of each quarter of the tax year, the REIT's assets must meet four tests which prove that its assets are in the nature of real estate. Annually, its sources of income are similarly tested: It must meet three source-of-income tests. Finally, detailed distribution (the REIT generally cannot retain its earnings) and recordkeeping rules must be met. A REIT which meets the above tests receives conduit tax treatment (i.e., "flow through" treatment much like a partnership) so that only the shareholder is taxed because the REIT is allowed to deduct the dividends it pays to shareholders.[3]

Operational Basics and the Commercial Real Estate Market. There are several types of REITs, such as the equity REIT, the externally advised REIT, the hybrid REIT (which owns equity and mortgage interests in real property), the mortgage REIT, the self-administered REIT, the self-managed REIT, and the umbrella partnership or UPREIT (and the "DOWNREIT").[4]

Commercial real estate in the United States consists of five major types of property (hotels, offices, apartments, industrial, and retail) and has recently been valued at approximately $4 trillion. REITs own only approximately three percent of this market.[5] Given the preferred tax treatment enjoyed by the REIT and the ease of access into the public market (even the "average" investor can afford to invest), it generally makes sense that the REIT industry has an excellent opportunity to expand its real estate ownership position. The recent dividend yield of equity REITs, at 6.1 percent, is greater than the 30-year Treasury bond yield and almost four times that of the S&P 500.[6]

A REIT generally must remain passive in its investments and its income must come from these passive-investment sources. Thus, the REIT generally owns and operates commercial real estate such as office buildings, shopping centers, apartments, warehouses, and hotels which produces income (and provides much-needed cash flow).

The REIT generally must obtain capital from outside sources in addition to its internally generated earnings because only a small portion of its earnings may be retained. In order to obtain this capital, the REIT may issue shares or certificates of different classes, preferences, and/or participations. Similarly, the REIT may issue debt obligations (secured and unsecured).

Today's REIT investor perceives that he or she will receive distributions of the REIT's cash flow because the Code requires certain distributions; however, the investor must similarly realize that, in order for the REIT to grow (by the acquisition of new property or improvement of existing property), and since the REIT must distribute its funds, the REIT must have the "ability to readily tap the public debt and equity markets at attractive rates."[7]

Even though, with respect to a REIT, the terminology of financial analysis differs slightly when compared to a public non-REIT corporation, the actual financial analysis of such items as performance and growth of the REIT turns on the same basic concepts but with certain modifications and nuances. For example, earnings are generally measured, not by net income, but by such items as "funds from operations" (or FFO, which is essentially earnings before interest expense, taxes, depreciation and amortization expense or "EBITDA" less its interest expense) or "funds available for distribution" (or FAD, also referred to as "cash available for distribution" or CAD because it adjusts FFO for recurring capital expenditures).[8] As another example, the "net asset value" (or NAV) per share places a "current value" on the assets of the REIT and divides that value by the number of outstanding shares. This NAV concept is common to mutual funds in general and, similarly, the valuation process of the net assets normally turns on discounting projected "net operating income" (NOI) streams or on "capitalizing" the NOI,[9] in much the same fashion as an analyst could value any other income-producing property.

Before investing in a REIT, investors should look at several indicators such as the financial strength as evidenced by the REIT's balance sheet and its cash flows...