As someone who has participated and underwrote various transactions in the real estate investment trust (REIT) space, both non-traded and traded REITs. I am often asked at certain real estate and business events about mortgage REITs or other components of REITs and what make this sector of the industry appealing. Of course, anyone who is associated with the REIT world knows about many advantages of a publicly traded REIT, which are quite different than non-traded REITS. Non-traded REIT are not on any exchange, and cannot be bought as a stock like a traded REIT that is listed on an exchange (i.e. New York Stock Exchange NYSE). The main difference is truly about the real estate objective.
I conducted a myriad of in classroom and field projects about many REITs (multifamily, retail, office, industrial, health care) when I attended New York University for my graduate studies in real estate finance and investment. It was a fascinating experience when valuating a REIT based on the type of investors (individuals or institutional) involved in the transactions. Anyhow, this will not be a primer about the history of REIT, although just remember that in the 1960s President Eisenhower and Congress signed in the Real Estate Investment Trust (REIT) Act into law to create publicly traded securities that allowed individual to invest in portfolios of commercial real estate assets. My intention with this very short piece is to share with the reader the 10 commandments of a REIT in an easy way to understand.
REIT 10 COMMANDMENTS
1 – Being a publicly traded REIT is nothing more taking advantage of superior tax benefits. In simple laymen term, there are no preferred federal taxes – meaning REITs are not taxed the same way as a typical traded public company. An individual can also go to an exchange and invest in a REIT due to the Act that Eisenhower and Congress signed. Yes, equity REIT is a form of stock and mutual fund.
2- REITs must pay 90% of their taxable income, taxable net income, as dividends to shareholders every year in the United States. This is very important for a REIT in order to continue qualifying as a real estate investment trust. About 75% of their gross income must be generated from the properties or mortgages, and they must have at least 100 shareholders at the onset of being public.
3- Because of their taxable income rule, a REIT saves very little capital over time on their balance sheet. Due to that reason, a REIT typically has little cash flow to acquire properties and develop their assets. Essentially, debt is a plentiful world for REITs. They are constantly raising equity in the capital market space because they have to pay majority of their earnings as dividends, thereby issuing ton of stocks consistently. Yes, as alluded before, REITs stocks can be purchased on any major stock exchange in the world.
4- REITs are constantly disposing of older properties in their portfolio and acquiring new properties. In fact, sometimes if a REIT cannot issue more debt or equity they may have to liquidate several properties in their portfolio quickly for extra cash flow. Cash flow is king but usually lacking for REITs, so assets liquidation is like gold in this space.
5- REITs by no means are Private Equity, however they sort of operate like private equity firms because of one thing: These players pledge allegiance to aggregate an army of properties continuously, and many times in huge packages. Although, the holding period may differ, nonetheless they splurge on acquisition.
6- REITS are categorized in 3 major groups: Equity, Mortgage and Hybrid.
7- Equity REITs simply invest and sell individual properties. They usually improve the assets through value-add play and reposition them over time. Their revenues are earned from office, retail, and apartment rents, and if it is hotel, revenue is earned from guests paying nightly rates and fees.
8 – Mortgage REITs do not invest in the same assets class like Equity REITs do. Rather, they invest in mortgages that are associated with the properties. Revenue is earned from the interest on the mortgages that it has invested in. Additionally, revenue can be earned from borrowers paying back their mortgages.
9 – Hybrid REITs are a combination of both Equity and Mortgage REITs – They literally do both what the two other REITs do. They have many investment strategies at their disposal.
10 – Unlike other publicly traded companies (i.e. Amazon, Coca Cola, etc.) earnings before interest, taxes, and amortization (EBITA) margins and revenue growth are not the most meaningful metrics for a REIT. The most important and significant metrics for a REIT are: Funds from Operation (FFO), Adjusted Funds from Operation (AFFO), Cash Available for Distribution (CAD), and Net Asset Value (NAV). Additionally, for REITs enterprise value doesn’t matter quite as much, rather it’s the equity value of the that is paramount.
Ultimately, REITs are not like your typical publicly traded companies or real estate companies either. In conclusion, their function maybe similar with other public companies or real estate companies, however from an operational and tax standpoint there are major differences. REITs generally don’t pay corporate taxes, thus, most their dividends (unlike a publicly traded company) will continue to be taxed as ordinary income at a rate of 35%. They are also taxed on long-term capital gain and return on capital as well. Ultimately, REITs are not like your typical publicly traded companies or real estate companies either.
By: Ibsen Alexandre
The opinions expressed herein are those of the author(s) and do not reflect the view of a particular firm, its clients, any respective affiliates nor any Media Platform. This article is for educational general purposes only and is not intended to be and should not be taken as solicitation to lend.