The Basics of Real Estate Investment Trusts (REITs)

Investing in real estate, whether in good times or bad, is never easy. One of the most difficult aspects of real estate investing is the fact that it can require a lot of money to build a quality portfolio of income-generating properties, money that most people simply do not have.

Enter the real estate investment trust, commonly known as a REIT. REITs were created as a means of making real estate investment more accessible to a greater number of investors (which of course in turn fuels the real estate development market). A REIT is essentially a corporation which owns a portfolio of real estate. The advantages of ownership of shares in a REIT as opposed to direct ownership of a particular property are several. First, the shares of a REIT are more easily traded than a piece of property, and a REIT allows for diversification of investment across a number of properties instead of an investor having to put all eggs in the one basket (thereby minimizing risk).

Generally speaking, owning real estate within a corporation is not recommend given the double taxation structure of the traditional “C” corporation. With a REIT, however, if the corporation meets certain requirements, the corporation benefits from the pass-through tax status more commonly associated with limited liability companies and “S” corporations.

In order for a corporation to qualify as a REIT and gain the advantages of being a pass-through entity free from corporate level income tax, it must comply with the following provisions of the Internal Revenue Code:

  • It must be structured as a corporation, business trust or similar association (note: “similar association” does not include a limited liability company (LLC), although an LLC can be converted into a REIT if it elects to be taxed as a corporation and so long as it meets the other REIT guidelines);

  • It must be managed by a board of directors or trustees;

  • It must have at least 100 shareholders;

  • Shares in the corporation must be freely transferable;

  • It must pay dividends of at least 90 percent of its taxable income;

  • No more than 50 percent of the corporation’s shares can be held by five or fewer individuals during the last half of each taxable year;

  • At least 75 percent of the corporation’s total investment assets must be in real estate;

  • It must derive at least 75 percent of gross income from rents or mortgage interest; and

  • It must have no more than 20 percent of its assets consist of stocks in taxable REIT subsidiaries.

REITs can be divided into three general categories: (i) equity; (ii) mortgage; and (iii) hybrid. An equity REIT purchases, owns and manages income-producing real estate properties such as apartments, malls and office buildings. Equity REITs differ from real estate developers in that they develop properties to operate themselves rather than developing a property for sale. Equity REITs earn dividends from rental income and capital gains from the sale of the properties.

Mortgage REITs, by contrast, loan money for mortgages to real estate owners or purchase existing mortgages or mortgage-backed securities. The revenue derived by a mortgage REIT comes from interest earned on the mortgage loans.

Hybrid REITs are, not surprisingly, a combination of equity REITs and mortgage REITs. Hybrid REITs purchase own and manage properties and they loan money for mortgages or purchase mortgages and/or mortgage-backed securities.

With regards to the shares of a REIT, REITs are either “closed-end” (meaning that the REIT can only issue shares to the public once and can only issue additional shares and dilute existing shareholders with the consent of such shareholders) or “open-ended” (meaning that the REIT can issue new shares and redeem shares at any time). Some REITs have their shares publicly traded, some are 100% private and others are registered with the Securities and Exchange Commission (SEC) but not publicly traded.

For investors who have an interest in real estate investment but who lack the necessary funds to purchase properties in their own name and/or lack the time necessary to operate and manage properties on their own, a REIT could be an attractive vehicle to enter into the real estate market.