REITs : A New way for Investment in Real Estate

A Real Estate Investment Trust (REIT) is a corporation or a trust that pools the capital of many investors to purchase property. REITs are eligible for corporate income tax exemptions and in return , REITs are required to distribute 90% of their income. This may be taxable in the hands of investors. The REIT structure was designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks.

REIT - Investment in Real Estate

Types of REITs

Equity REITs

The term equity REITs refers to corporate entity that is engaged in the acquisition, management, building, renovation, and sale of real estate. This type of real estate investment trust offers the greatest potential of rewards and as such tends to be favored by professional money managers.  Examples include:

Residential REITs

This type of REIT specializes in apartment building and/or residential properties leased to individuals. The biggest danger for residential REITs is over construction within a particular geographical area during a declining economic environment

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.

Hybrid REITs

A REIT is referred to as a hybrid when it has both equity and mortgage components. Although not as heavily favored by investment advisors as pure equity REITs, they are still attractive investment alternative.

Structure of REITs

A quick snapshot of the REIT structure as contemplated under the Draft Regulations.

Structure of REIT

REITs in India are required to be set up as private trusts under the purview of the Indian Trusts Act, 1882.

  1. Parties: The parties in the REIT include the sponsor, the manager, the trustee, the principal valuer and the investors / unit holders. Sponsor sets up the REIT, which is managed by the manager. The trustee holds the property in its name on behalf of the investors. The roles, responsibilities, minimum eligibility criteria and qualification requirements for each of the abovementioned parties are detailed in the Draft Regulations. Sponsors are required to hold a minimum of 15% (25% for the first 3 years) of the total outstanding units of the REIT at all times to demonstrate skin-in-the-game.
  2. Use of SPV: REITs may hold assets directly or through an SPV. All entities in which REITs control majority interest qualify as an SPV for the purpose of the Draft Regulations.
  3. Investment and Listing: Units of a REIT are compulsorily required to be listed on a recognized stock exchange.
  4. Potential income streams: REITs are principally expected to invest in completed assets. Income would consist of rental income, interest income or capital gains arising from sale of real assets / shares of SPV.
  5. Distribution: 90% of net distributable income after tax of the REIT is required to be distributed to unit holders within 15 days of declaration.

The illustration below gives the typical REIT structure:

Advantages of REITs

High Yields. For many investors, the main attraction of REITs has been their dividend yield. The average dividend yield for REITs was about 4.3% in September 2012, well more than the yield of the S&P.

Liquidity of REIT Shares. REIT shares are bought and sold on a stock exchange. By contrast, buying and selling property directly involves higher expenses and requires a great deal of effort.

Portfolio Diversification. Studies have shown that adding REITs to a diversified investment portfolio increases returns and reduces risk since REITs have little correlation with the S&P 500. Adding REITs to a portfolio with exposure to stocks and bonds has improved returns and decreased risk.

REITs Risks

Sensitive to Demand for Other High-Yield Assets. Generally, rising interest rates could make Treasury securities more attractive, drawing funds away from REITs and lowering their share prices.

Property Taxes. REITs must pay property taxes, which can make up as much as 25% of total operating expenses. State and municipal authorities could increase property taxes to make up for budget shortfalls, reducing cash flows to shareholders.

Taxation of REITs

There are a few extra rules for REITs beyond the rules for other unit investment trusts. They are:

  1. Rental income is treated as business income to REITs because the government considers rent to be the business of REITs. This means that all expenses related to rental activities can be deducted the same as business expenses can be written off by a corporation.
  2. Furthermore, current income that is distributed to unit holders is not taxed to the REIT, but if the income is distributed to a non-resident beneficiary, then that income must be subject to a 30% withholding tax for ordinary dividends and a 35% rate for capital gains, unless the rate is lower by treaty.

For all practical purposes, REITs are generally exempt from taxation at the trust level as long they distribute at least 90% of their income to their unit holders. However, even REITs that adhere to this rule still face corporate taxation on any retained income.

The dividend payments made out by the REIT are taxed to the unitholder as ordinary income – unless they are considered to be “qualified dividends,” which are taxed as capital gains. Otherwise, the dividend will be taxed at the unitholder’s top marginal tax rate.

Also, a portion of the dividend paid by REITs may constitute a non-taxable return of capital, which not only reduces the unit holder’s taxable income in the year the dividend is received, but also defers taxes on that portion until the capital asset is sold. These payments also reduce the cost basis for the unit holder. The nontaxable portions are then taxed as either long- or short-term capital gains/losses.

Because REITs are seldom taxed at the trust level, they can offer relatively higher yields than stocks, whose issuers must pay taxes at the corporate level before computing dividend payout.

Analyzing REITs Performance

There are a few things to keep in mind when assessing any REIT. They include the following:

  1. REITs are true total-return investments. They provide high dividend yields along with moderate long-term capital appreciation. Look for companies that have done a good job historically at providing both.
  2. Unlike traditional real estate, many REITs are traded on stock exchanges. You get the diversification real estate provides, without being locked in long term. Liquidity matters.
  3. Depreciation tends to overstate an investment’s decline in property value. Thus, instead of using the payout ratio (what dividend investors use) to assess a REIT, look at its funds from operations (FFO) instead. This is defined as net income less the sale of any property in a given year and depreciation. Simply take the dividend per share and divide by the FFO per share. The higher the yield the better.
  4. Strong management makes a difference. Look for companies that have been around for a while or at least possess a management team with loads of experience.
  5. Quality counts. Only invest in REITs with great properties and tenants.
  6. Consider buying a mutual fund or ETF that invests in REITs and leave the research work to the mutual fund companies.

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