Real Estate Investment Trusts.

REIT Directory • How to Find the Best Property REITs

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 a REIT to pay 90% of its dividends in stock rather than cash).

To 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

There 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.

REITs: Pay 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 pay dividends.

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 reports.

More About REITs

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 these sectors.

REIT Categories

We have divided the REIT universe into eleven categories:

Retail: shopping centers, outlet centers, small neighborhood centers, or downtown/heavily trafficked retail locations.
Healthcare: owners, but not operators, of healthcare facilities such as nursing homes, medical office buildings, hospitals, etc.
Lodging: 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 property owner.
Industrial: 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: 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.
Mixed Industrial/Office: these REITs own both office and industrial/warehouse properties.
Mortgage/Finance: REITs that invest in existing mortgages, or offer new mortgages or other types of financing.
Residential: apartment and manufactured home community owners.
Digital Infrastructure: Computer data centers, telecomm towers operators, and communications networks.
Specialty: self-storage centers, restaurant property owners, and other REITs that do not fit into the major categories.
Diversified: 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 Directory

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