A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. By law, to avoid corporate income tax, a REIT must distribute at least 95% of its taxable income to shareholders in the form of dividends.
Structure and Requirements
Legal Formation
REITs are created under specific income tax and securities regulations that grant them special tax considerations to promote real estate investment.
Shareholder and Ownership Distribution
A REIT must comply with the following:
- Minimum Number of Shareholders: A REIT must have at least 100 shareholders.
- Widely Dispersed Ownership: No more than 50% of its shares should be held by five or fewer individuals during the last half of the taxable year.
Asset and Income Tests
For a corporation to qualify as a REIT, it must:
- Invest at least 75% of its total assets in real estate, cash, or U.S. Treasuries.
- Derive at least 75% of its gross income from rents, interest on mortgages financing real property, or sales of real estate.
Unique Features
Tax Benefits
Unlike regular corporations, REITs avoid double taxation. They do not pay corporate income tax as long as they meet distribution and asset requirements, although shareholders must pay tax on their dividends.
Accessibility for Small Investors
REITs allow small investors to participate in large real estate ventures, which would otherwise be unattainable due to high capital requirements.
Types of REITs
REITs are categorized based on their investments:
Equity REITs
- Invest in income-producing real estate directly.
- Earn revenue mainly from leasing space and collecting rents.
Mortgage REITs (mREITs)
- Provide financing for income-producing real estate by purchasing or originating a mortgage.
- Earn revenue from the interest on these mortgages.
Hybrid REITs
- Combine the investment strategies of both equity REITs and mortgage REITs.
Special Considerations
Funds from Operations (FFO)
A key performance metric for REITs is Funds from Operations (FFO), which excludes gains or losses from property sales and adds back real estate depreciation. This metric gives a clearer picture of a REIT’s operating performance.
Historical Context
REITs were established by the U.S. Congress in 1960 to enable individual investors to invest in large-scale, income-producing real estate. Before REITs, only large institutions and wealthy individuals had access to such investments.
Applicability
Portfolio Diversification
REITs offer diversification benefits as their performance is generally not correlated with other asset classes like stocks and bonds.
Inflation Hedge
Real estate investments typically provide a hedge against inflation, as property values and rents tend to rise with inflation.
Comparisons
REITs vs. Real Estate Mutual Funds
Unlike mutual funds that invest in stocks of real estate companies, REITs own physical properties or mortgages, leading to differences in risk and income generation.
REITs vs. Direct Real Estate Investment
REITs provide liquidity and low minimum investments, while direct real estate investment requires higher capital but offers potential for greater control and tax benefits.
Related Terms
- Funds from Operations (FFO): Funds from Operations (FFO) is a measure of cash generated by a REIT, widely used to assess the performance of REITs. It adjusts net income for depreciation and gains or losses on sales of property.
- Net Asset Value (NAV): Net Asset Value (NAV) represents the value of an entity’s assets minus its liabilities, often used to value mutual funds and REITs.
FAQs
What is the primary benefit of investing in a REIT?
Do REIT shareholders pay taxes on dividends?
Are REITs liquid investments?
References
- U.S. Securities and Exchange Commission. (n.d.). REITs.
- National Association of Real Estate Investment Trusts (Nareit). (n.d.). REIT Industry Data.
Summary
A Real Estate Investment Trust (REIT) provides a tax-efficient vehicle for individuals to invest in large-scale, income-producing real estate. By combining the benefits of liquidity, diversification, and accessibility, REITs have become a popular investment option, offering unique advantages over direct real estate investments and other financial instruments.
