What Are REITs All About?

Congress created Real Estate Investment Trusts (REITs) in 1960 in order to provide the investing public with a way to invest in large-scale commercial properties. A REIT is a tax-advantaged operating company that specializes in owning and managing commercial property. REITs avoid taxation at the corporate level if they distribute 90 percent of their net income to shareholders annually. REITs thus typically provide a much higher dividend yield relative to most common stocks.

REIT dividends received by individuals are taxed as ordinary income, where federal rates top out at 35 percent. The Jobs and Growth Tax Relief Reconciliation Act of 2003 cut the tax rate on dividends for most common stocks to 15 percent, but REIT dividends, because they avoid taxes at the corporate level, were excluded from this break. For this reason investors should consider holding REITs in tax-deferred accounts if possible, while holding more tax-efficient assets (e.g. common stocks, which provide returns largely through capital appreciation) in taxable accounts.

Many investors have bitter recollections of the commercial real estate market. The REIT market of the 1970s, for example, was dominated by "mortgage REITs." These REITs, which originated, held and marketed mortgage loans, were crushed by skyrocketing interest rates and left investors with significant losses. Real estate limited partnerships bring even darker memories; these structures were touted more for their tax advantages than their economic advantages. When the tax laws changed, these highly illiquid instruments crashed and burned.

Equity REITs, however, are distinct from both of these ill-fated predecessors. Unlike mortgage REITs, equity REITs directly own and manage commercial properties. They also bear very little resemblance to limited-partnerships, which were frequently assembled by brokerage firms and promoters who claimed exaggerated appreciation potential. Those entities charged high fees, typically held only few properties, and were highly illiquid. Raising new capital proved very difficult. Equity REITs, by contrast, trade in a highly liquid market where they are valued based on their ability to grow their earnings and dividends. Capital can be quickly and efficiently accessed by issuing new debt or shares, by reinvesting undistributed dividends, or by selling appreciated properties. Finally, unlike limited partnerships whose general partners frequently had conflicts of interest with the limited partners, the managers of most successful equity REITs hold a significant stake in the business themselves.

The FTSE All REIT Index currently includes 178 REITs. Of these, 134 are equity REITs (the remainder are either mortgage or "hybrid" REITs). Equity REITs invest in shopping centers, malls, apartments, hospitals, nursing homes, office buildings, manufactured home developments, industrial properties, and hotels. Some specialize within these areas, or within a geographic region, while others are diversified. According to the National Association of Real Estate Investment Trusts (NAREIT), the market capitalization of all equity REITs stood at $401 billion at the end of 2006, up from only $118 billion seven years earlier.

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