Real Estate Investment Trust

Real Estate Investment Trust

Concept of REIT
A real estate investment trust (REIT) is a company that buys, develops, manages, and/or sells real estate such as skyscrapers, shopping malls, apartment complexes, office buildings, or housing developments. Rather than investing directly in real estate, investors of REITs invest in a professionally managed portfolio of real estate. REITs trade on the major exchanges, just like stocks. REITs make money from rental income, profits from the sale of the property, and other services provided to tenants. REITs also receive special tax considerations; they do not pay taxes as long as they pay out at least 90 percent of their net income to their investors..
Basic REIT Structure



How does a company qualify as a REIT
In order for a company to qualify as a REIT, it must comply with certain provisions within the Internal Revenue Code. As required by the Tax Code, a REIT must:

• Be structured as corporation, trust, or association
• Be managed by a board of directors or trustees
• Have the shares that are fully transferable
• Be taxable as a domestic corporation
• Not be a financial institution or an insurance company
• Be jointly owned by 100 persons or more
• Pay dividends of at least 90% of the REIT's taxable income
• No more than 50% of the shares can be held by five or fewer individuals during the last half of each taxable year
• At least 75% of total assets must be invested in real estate
• Derive at least 75% of gross income from rents or mortgage interest
• No more than 20% of its assets may consist of stocks in taxable REIT subsidiaries.

Terms used in the context of REIT

1.  Adjusted Funds From Operations (AFFO) - It is a computation made by analysts and investors to measure a real estate company's cash flow generated by operations. It is calculated by subtracting from Funds from Operations (FFO) both recurring expenditures that are capitalized by the REIT and then amortized, but which are necessary to maintain a REIT's properties and its revenue stream (e.g., new carpeting and drapes in apartment units, leasing expenses and tenant improvement allowances) and "straight-lining" of rents. This calculation also is called Cash Available for Distribution (CAD) or Funds Available for Distribution (FAD).
 

2.  Capitalization Rate - The capitalization rate (or "cap" rate) for a property is determined by dividing the property's net operating income by its purchase price. Generally, high cap rates indicate higher returns and greater perceived risk.
 

3.  Cash (or Funds) Available for Distribution - Cash (or Funds) available for distribution (CAD or FAD) is a measure of a REIT's ability to generate cash and to distribute dividends to its shareholders.
 

4.  Cost of Capital - The cost to a company of raising capital in the form of equity or debt. The cost of equity capital generally is considered to include both the dividend rate as well as the expected equity growth either by higher dividends or growth in stock prices. The cost of debt capital is merely the interest expense on the debt incurred.
 

5.  EBITDA - Earnings before interest, taxes, depreciation and amortization. This measure is sometimes referred to as Net Operating Income (NOI).
 

6.  Equity Market Cap - The market value of all outstanding common stock of a company.
 

7.  Funds From Operations (FFO) - The most commonly accepted and reported measure of REIT operating performance. Equal to a REIT's net income, excluding gains or losses from sales of property, and adding back real estate depreciation.
 

8.  Leverage - The amount of debt in relation to either equity capital or total capital.
 

9.  Net Asset Value (NAV) - The net "market value" of all a company's assets, including but not limited to its properties, after subtracting all its liabilities and obligations.
 

10.              Positive Spread Investing (PSI) - The ability to raise funds (both equity and debt) at a cost significantly less than the initial returns that can be obtained on real estate transactions.
 

11.              Securitization - Securitization is the process of financing a pool of similar but unrelated financial assets (usually loans or other debt instruments) by issuing to investors security interests representing claims against the cash flow and other economic benefits generated by the pool of assets.
 

12.              Straight-lining - Real estate companies such as REITs "straight line" rents because generally accepted accounting principles require it. Straight lining averages the tenant's rent payments over the life of the lease.
 

13.              Total Market Cap - The total market value of a REIT's (or other company's) outstanding common stock and indebtedness.
 

14.              Total Return - A stock's dividend income plus capital appreciation, before taxes and commissions.
 

Charactertics of Publically Traded REITS , Non Exchange Traded REITS

Particulars	Publically Traded REITS	Non Exchange Traded REITS	Private REITS
Meaning	REITs that file with the SEC and whose shares trade on national stock exchanges	REITs that file with the SEC but whose shares do not trade on national stock exchanges.	REITs that are not registered with the SEC and whose shares do not trade on national stock exchanges.
Traded	Shares are listed and traded, like any other publicly-traded stock, on major stock exchanges. Most are NYSE listed.	Shares are not traded on public stock exchanges. Redemption for shares vary by company and are limited. Generally a minimum holding period for investment exists.	Shares are not traded on public stock exchanges. Terms of redemption vary by company and are generally limited in nature.
Cost of transaction	Brokerage costs the same as for buying or selling any other publicly-traded stock.	Generally fees of 10-15 % of the investment are charged for broker-dealer commissions & other up-front costs.	Varies by company
Management	Typically self advised and self managed	Typically externally advised and managed.	Typically externally advised and managed
Min. Investment Amount	One share	Typically $1,000 - $2,500.	Typically $1,000 - $25,000; private REITs that are designed for institutional investors require a much higher minimum.
Independent directors	Stock exchange rules require a majority of directors to be independent of management. NYSE and NASDAQ rules call for fully independent audit, nominating and compensation committees. Subject to North American Securities Administrators	Association (NASAA) regulations. NASAA rules require that boards consist of a majority of independent directors. NASAA rules also require that a majority of each board committee consist of independent directors	Not required
Corporate Governance	Specific stock exchange rules on corporate governance.	Subject to state and NASAA regulations	Not required
Disclosures	Required to make regular financial disclosures to the investment community, including quarterly and yearly audited financial results with accompanying filings to the SEC.	Required to make regular SEC disclosures, including quarterly and yearly financial reports.	Not required

Types of REITs

1.  Equity REITs
Equity REITs mostly own and operate income-producing real estate. They increasingly have become real estate operating companies engaged in a wide range of real estate activities, including leasing, maintenance and development of real property and tenant services. One major distinction between REITs and other real estate companies is that a REIT must acquire and develop its properties primarily to operate them as part of its own portfolio rather than to resell them once they are developed.
 

2.  Mortgage REITs
Mortgage REITs mostly lend money directly to real estate owners and operators or extend credit indirectly through the acquisition of loans or mortgage-backed securities. Today’s mortgage REITs generally extend mortgage credit only on existing properties. Many mortgage REITs also manage their interest rate and credit risks using securitized mortgage investments, dynamic hedging techniques and other accepted derivative strategies.
 

3.  Hybrid REITs
As the name suggests, a hybrid REIT both owns properties and makes loans to real estate owners and operators.
 

REIT Vs Mutual Funds

• Mutual Funds invest in securities whereas REITs invest in real estate properties.
   
• The value of the mutual fund units are determined by the value of the underlying securities whereas the value of the units of REIT schemes would be based on the income from / appreciation of the real estate assets
   

Structure of REITS

REITs are typically structured in one of three ways:

1.  Traditional REIT

2.  Umbrella Partnership REIT (UPREIT)

3.  DownREIT.

 

1.  Traditional REIT - A traditional REIT is one that owns its assets directly rather than through an operating partnership.
 

2.  Umbrella Partnership REIT ( UPREIT ) - one or more individuals and/or partnerships owning real estate contribute their holdings to an "umbrella partnership" in exchange for limited partnership units, sometimes called operating partnership units. Contemporaneously, a REIT ' is formed and issues shares to the public. The REIT then contributes the proceeds received from the REIT shareholders to the umbrella partnership in exchange for a general partnership interest. The proceeds are used to reduce debt or acquire additional property or used for any other REIT purposes. The limited partners also receive rights to "put" their partnership interest to the umbrella partnership or to the REIT in exchange for cash or REIT shares. The structure of UPREIT is as under –
 


 
 

3.  Down REIT - a property owner becomes a partner in a limited partnership with the REIT (if no UPREIT exists), the umbrella partnership of an UPREIT, or a wholly-owned subsidiary of the REIT or UPREIT, as the case may be. The newly formed limited partnership owns and operates the property and possibly other income producing property contributed by the other partner (i.e., the REIT, UPREIT or wholly-owned subsidiary thereof.) The structure of Down REIT is as under -
 


 

Strengths of REITS

1.  All REITs are governed by strict regulations
 

o    REITs are generally required to have at least 100 investors, and there are laws that prevent a small number of those investors from owning a majority interest in the REIT.
 

o    At least 75 percent of a REIT's assets must be in real estate, and at least 75 percent of its gross income must be derived from rents, mortgage interest, or gains from the sale of property.
 

o    REITs are required by law to pay out at least 90 percent of annual taxable income (excluding capital gains) to their investors in the form of dividends.
 

2.  REIT shares are more liquid than investing directly in real estate
It is much easier to liquidate shares of a REIT than it is to sell rental property, office buildings, or other real estate, because REIT shares are traded on major exchanges, making it easier to buy and sell shares than to buy and sell properties in the private market.
 

3.  Professionally managed
 

4.  REITs open up investment opportunities that might not be available to individual investors
As the money is pooled with the funds of many other investors, the initial cash outlay is much less than for other types of real estate investments. This makes REIT investing accessible for many people who can't afford to buy office buildings and apartments on their own.And as the money is pooled with that of other investors, the personal exposure to risk is reduced as compared to the risk of investing directly in real estate.
 

5.  REITs can provide current income
As the REITs are required to pay out 90 percent of their annual income in the form of dividends, income from REIT investment can be expected on a comfortable level
 

Negatives about REIT

1.  Supply/demand imbalance
REITs depend on an adequate supply of tenants and/or buyers to occupy their properties. During certain periods the supply of available space may exceed the demand by a significant margin, leaving REITs with property that is vacant or less than fully occupied. During these periods, it may also be difficult to make profits on rents because the excess supply of rental property will drive rental prices down. These factors can negatively impact a REIT's profitability.
 

2.  Rising interest rates
When interest rates increase, a REIT's borrowing costs increase. This can negatively impact a REIT's bottom line. In addition, increasing interest rates can foreshadow a weakening economy, which in turn can reduce the demand for space.
 

3.  Other factors
 

o    REITs are also subject to the risks associated with the general real estate market including possible declines in the value of real estate, possible declines in economic conditions, and possible lack of availability of mortgage funds.
 

o    Recessions can impact REITs in the retail sector, while health−care reforms may have an effect on REITs that invest in hospitals and assisted−living facilities.
 

o    REITs are also subject to risks associated with the underlying REIT properties. These risks include - increases in property taxes, changes in zoning laws, changes in neighborhood values, and the possibility of a natural disaster. These risks may be more significant to the extent that the REIT's investments are concentrated in a particular geographic region.
 

o    Loss of management credibility can be devastating to any REIT
 

4.  Use as a tax shelter is limited
Unlike other forms of real estate ownership, REITs are not allowed to pass losses through to their investors. Thus, if an investor’s REIT investment loses money, he shall not be able to use this loss to offset other investment gains.
 

Who are the Investors in REITS ??

Individual investors of all ages, both in the U.S. and worldwide, invest in REITs directly or through REIT mutual funds. Other typical buyers of REITs are exchange traded funds, pension funds, endowments, foundations, insurance companies and bank trust departments. Investors typically are attracted to REITs for their high levels of continuing current income and the opportunity for long-term growth. A broad range of investors are using REITs to help achieve the investment goals of diversification, dividends, liquidity, performance and transparency.

How is the investment done in REIT??

• An individual may invest in a publicly traded REIT, which is listed on a major stock exchange, by purchasing shares through a securities dealer. As with other publicly traded securities, investors may purchase common stock, preferred stock or debt securities.
   
• An investor can enlist the services of a broker, investment advisor or financial planner to help analyze his or her financial objectives.
   
• These professionals may be able to recommend appropriate REIT investments for the investor.
   
• An investor may also contact a REIT directly for a copy of the company’s annual report, prospectus and other financial information. Much of this information is available on a company’s web site. The web site www.investinreits.com also lists all publicly traded REITs with their exchange symbols.
   
• Many financial web sites and local libraries offer a wide range of investment research and information on REITs.
   
• Another alternative is to diversify your investment further by buying shares in a REIT mutual fund or exchange traded fund.
   

Judging REIT’s ability to pay dividend

• Many investors often look at the payout ratio as the measure of a REIT’s ability to pay its current dividends. Because real estate depreciation is a large non-cash expense that likely overstates any decline in property values, dividend per share divided by net income per share likewise understates a REIT’s ability to sustain dividend payments.
   
• Therefore, the payout ratio, calculated as dividend per share divided by Funds From Operations (FFO) per share, or as dividend per share divided by Adjusted Funds From Operations (AFFO) per share, is