How to Find the Best
REITs: A Way to Invest in
Commercial Real Estate
Real estate investment trusts (REITs) enable individual investors to
participate in large-scale, income-producing real estate investments.
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 its shareholders (for the years 2009/2010, the IRS allowed
to pay 90% of its dividends in stock rather than cash).
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.
Equity REITs vs. Mortgage REITs
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.
Attention to Funds From Operations (FFO)
When analyzing REITs, you need to know that that taxable income
is not necessarily the same as the net income shown in the quarterly or
annual financial statements. In fact, most REITs do not disclose their
taxable income reported to the IRS.
Actually, when it comes to analyzing a REIT's ability to pay dividends,
neither taxable income or financial statement net income means much.
That's because, in both instances, real estate property owners
must deduct non-cash depreciation expenses when they calculate income, even if the property is, in
fact, appreciating in value. Thus, neither the taxable income nor the
financial state numbers tell you anything about the cash available to
For that reason, the REIT trade association created a
measure called funds from operations (FFO), which reflects the actual cash
profits generated by a property REIT's operations. Almost all property
REITs include the funds from operations numbers in their quarterly
No matter how you count it, the federal rules require REITs to pay
out a large chunk of earnings to shareholders, leaving little to fund
expansion. Thus REITs must
raise capital by borrowing or by selling more shares 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
We have divided the
REIT universe into eleven categories:
shopping centers, outlet centers, small neighborhood centers, or
downtown/heavily trafficked retail locations.
owners, but not operators, of healthcare facilities such as nursing
homes, medical office buildings, hospitals, etc.
hotels, motels, and resort properties. Since Lodging REITs are not allowed to
directly manage their hotel operations, most hire nationally known
hotel operators such as Marriot or Westin to run their properties.
Those properties bear the name of the management company, not the
industrial, warehouse, distribution center, or flex properties. Flex
properties, a recent innovation,
are single-story buildings that could be configured as needed to be
used as office, light
manufacturing and/or warehouse space.
office buildings are generally categorized as Class A, Class B, or
Class C, depending on amenities and location. Class A, typically
located in downtown or upscale areas, are the
best. Class B buildings are usually in suburban neighborhoods. Class
C buildings are typically older and in low-rent areas.
Industrial/Office: these REITs own both office and
REITs that invest in existing mortgages, or offer new mortgages or
other types of financing.
apartment and manufactured home community owners.
Computer data centers, telecomm towers operators, and communications
self-storage centers, restaurant property owners, and other REITs
that do not fit into the major categories.
REITs that own properties in multiple categories.
REIT Income Tax Considerations
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%/20%
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 REIT list in the REIT
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