Investing in Real Estate Investment Trust – Accessible Investing

Established September 14, 1960, the United States real estate investment trust industry is a robust section of the marketplace. A real estate investment trust (REIT) is a special entity that combines real estate investing with traditional stock market trading. The REIT company is set up with special tax considerations. The company is basically in place to manage REIT that produce income. Investing in this type of investment trust is primarily just like investing in the stock market. The investor buys shares of the REIT on the market. In fact, $4 billion in REIT stock is traded each day in the United States.

To qualify for significant tax benefits, the REIT company must keep the vast majority of its assets and income involved in the investing. Ninety percent of the taxable income must be distributed to its shareholders once a year as dividends. The REIT company does not have to count the money paid as dividends to its shareholders when calculating corporate income tax. In the last fifty years, many REIT companies choose to return one hundred percent of corporate income to the investors so they do not have to pay any corporate income tax. Shareholders receiving dividends from investing in REIT companies pay the taxes and capital gains on the money.

REIT structure makes investing in real estate possible for a wider array of people. Traditional investment typically requires a large amount of capital. Investing in REIT companies breaks down the capital cost per individual, making this a more accessible investment vehicle. This method also gives this kind of investing a higher level of liquidity than traditional direct investment structures.

Investing in real REIT can be a great way to get started in this type of investing for beginners and those who want minimal involvement. However, serious investors might consider forming a REIT themselves. The company must be set up in line with governmental regulations in order to receive the corporate tax benefits that make it an attractive company structure. REIT’s can be diversified or specialized. Many specialize in a specific kind of commercial real estate, such as office spaces, apartment buildings, or shopping malls. Leveraging your experiences in real estate investing when choosing a specialty for your real estate investment trust is a smart practice.

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Real Estate Investment Trusts on the Road to Recovery

Real Estate Investment Trusts, or REITs, have been a very risky investment vehicle for the last couple of years, but it appears as they are becoming a more viable investment mode. Many REITs have restructured their balance sheets by selling or forfeiting properties after defaulting on loans or in jeopardy of it. This year has brought much needed easing of credit standards, a rise in total returns, and a rebound in share prices. Analysts believe the bottom for the REIT industry hit on March 6th earlier this year after more than two years of declining.

Even as property values have steadily fallen, REITs have been hit hard by balloon payments coming due on their properties. Many have also faced difficulty remaining liquid as their revenue declined in the struggling economy. Last year, many analysts feared that REITs would be unable to handle the growing debt. Starting in March, however, many of them managed to secure the assets needed and address their short term debt obligations. Last year, REITs raised a total of $8 billion from 81 debt and equity offerings, so far this year, they have raised $31 billion from 119 offerings. In September, FelCor Lodging Trust, Inc. issued $635 million in new secured debt to cover $515 million in payments due in 2011. The REIT is also attempting to get lenders to refinance about $270 million in mortgages to free up cash flow. FelCor has had its cash flow severely impacted by a decline in travel spending affecting the REIT’s 85 hotels. Its cash flow in the first half of this year was a 50 percent drop from 2008.

Other REITs are attempting to get through the crisis by arranging interest rate agreements, purchasing cash flow hedges, or refinancing mortgages. Economists call this the “delay and pray” approach, and it is commonly used by investors when property values are low. Ashford Hospitality Trust Inc., with about 1000 hotels among its assets, is trying to refinance a large portion of its $300 million in debt, most of which is set to mature in 2011, to generate cash flow. The REIT experienced a net cash flow loss of 25 percent for the first half of the year, compared with 2008.

NAREIT’s equity REIT index was up almost ten percent for 2009 through the month of October, compared with a gain of almost 18 percent for the S & P 500 stock index. The MSCI US REIT price index grew nearly 100 percent between early March and the end of October. While prices have recovered substantially since March, they are still below the market highs set in the early part of 2007.As the economy continues on the road to recovery, watch for REITs traded publicly to begin buying new properties. That will be a positive sign for the struggling economy.

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How Depreciation Increases the After-Tax Yields of Real Estate Investment Trusts (REITs)

Depreciation is a difficult subject in the area of cost accounting for commercial real estate.

Accountants do strive to make their financial statements accurate, and so they must recognize a fundamental principle of the universe that has troubled philosophers for tens of thousands of years. As George Harrison sang years ago, “All Things Must Pass.”

There is nothing permanent in this three-dimensional world of space, time, matter and energy. Just as any Buddhist.

No building will last forever. Even the pyramids of Egypt will someday erode into dust.

Therefore, real estate property owners are allowed to deduct an expense from their gross income, called depreciation, on the theory that every year, the building is being worn down somewhat by the wear and tear of the universe. What physicists call entropy, according to The Third Law of Thermodynamics.

This depreciation expense is often calculated by dividing the total cost of the building by the number of years it’s expected to have a useful life.

If you pay one million dollars for a building, and it’s expected to last 10 years, that’s a straight-line depreciation expense of $100,000 per year.

Notice that $100,000 in cash is not actually paid out of your pocket. Depreciation simply reflects the reality that sooner or later, that building won’t be useful, and so the $1,000,000 you paid will be gone.

Although this is not practical, the ideal would be for you to pay someone $100,000 a year for ten years to build you a new, replacement building.

And when you take the depreciation expense, that is also deducted from the building’s cost basis. So after 10 years, in the above example, that building is officially worth nothing, even though it may still be in great condition in a prosperous neighborhood. If it’s well-maintained and in a good area, it can be useful for an indefinite period.

So one of the big problems is deciding what the useful life span of a commercial building is.

Of course, when we’re talking about shopping malls, we’re assuming their function is to lease space out to retail stores and restaurants, not to act as tourist attractions. So we can rule out multi-thousand year old spans such as represented by the Coliseum of Rome and the ruins of Angkor Wat — which attract tourist money even though they’ve fallen down.

Yet even when we come down the level of commonplace apartment building and shopping strip centers, we just don’t know for sure how long they’ll last. Sure, there’re castles in Europe hundreds of years old — but also stone farm houses where farming families still live.

So it’s entirely possible for a building in a good area to be bought or built, to have the depreciation expense taken on them . . . and 20 or 30 years later they’re now worth far more than you originally paid.

So, in a long-term sense, depreciation reflects something real, but it’s difficult to know just how much of an expense to take every year — without a crystal ball.

For example New York City’s Empire State Building is nearly 80 years old, but would be worth many millions if sold. The World Trade Center’s useful life ended prematurely in a way that couldn’t be predicted.

So when a Real Estate Investment Trust calculates its net income, it is required to apply Generally Accepted Accounting Principles. It will figure out its gross revenues, then subtract its operating expenses, then subtract a substantial figure representing depreciation on the buildings it owns — even though they may in fact have appreciated in value.

Let’s say XYZ REIT had gross revenues of $1,000,000 and operating expenses of $$700,000. That leaves $300,000. Then they deduct another $100,000 for depreciation. That leaves $200,000 as their net operating income.

The law requires them to pay at least 90% of this to their shareholders in the form of dividends. So they must mail out $200,000 X .90 = $180,000 to their investors.

But wait — the $100,000 depreciation expense is a “book entry” only. That is, it’s only on paper.

The $700,000 operating expenses represent cash that left the REIT’s bank account to pay for salaries, repairs, and other necessary expenditures.

Depreciation does not represent a cash payment to anybody. That $100,000 is still sitting in their bank account.

So why not pay it out to their shareholders also?

That’d be $180,000 plus $100,000 = $280,000 available for dividends for shareholders, making them even happier.

Why not, indeed? That’s what many of these companies do — pay out more in dividends that the law requires.

And receiving some dividend payments that represent depreciation should make the shareholders even happier than usual. Here’s why.

The percentage of the dividend checks they receive from real estate investment trusts that represents depreciation is not immediately taxable to shareholders.

Because it represents money that’s available only because the company took a depreciation expense, according to the IRS it’s officially a “return of capital,” not income.

A return of capital is not taxable because it’s not income. But it does reduce the cost basis of your REIT shares.

When is the only time you care about the cost basis of your shares of stock?

When you sell them.

If you don’t sell them . . . you don’t have to ever care.

Let’s say you bought 100 shares of XYZ REIT for $10 each. Your cost basis is $1000.

In the first year got a dollar back for each share, of which 25 cents per share was for depreciation. Which means your cost basis is reduced by .25 X 100 = $25.00.

So your cost basis in those 100 shares is now $975 instead of $1000.

You do have to pay taxes on the dividends, but only on $75, not the full $100.

If next year you decide to sell the shares of stock for $11 each, you’d get a total of $1100. You’d owe capital gains taxes on $125 instead of $100.

In effect, you’re now paying the taxes on that 25 cents per share depreciation in dividend checks you received the year before.

But let’s say you’re smarter than that. You don’t sell your shares of XYZ. You just keep collecting the dividends for as long as you live.

When do you pay taxes on the depreciation percentage? Never.

The implications of this aren’t widely known or understood. Even the best known REIT book writer, Ralph L. Block, doesn’t mention this in his book INVESTING IN REITS until the first Appendix.

The percentage of dividend checks that represent return of capital because of depreciation varies from company to company, and can of course vary over time. Historically, it runs 25% to 30%.

The bottom line for real estate trust shareholders is that — if they never sell their shares — their effective, net after-tax yields are significantly higher than they think. The exact amount depends on their marginal tax rate.

Let’s say that in the above example, your marginal tax rate is 35%.

You’ll owe ordinary taxes of .35 X $75 = $26.25.

You received $100, and paid $26.25 in taxes, leaving you with an after-tax net of $73.75.

Your after-tax net yield on your shares is 7.375%.

If this was an ordinary dividend-paying company in some business besides real estate, you’d have to pay taxes on the entire $100 in dividends, for a total tax owed of $35. For a net of $65. For a net after-tax yield of 6.5%.

Therefore, to figure out the true net, after-tax yield of a REIT, you must multiply its stated yield by (one plus the depreciation percentage X your marginal tax rate).

Thus, in the above example, the apparently yield is 10%. (One dollar in dividends for ten dollars worth of stock).

.10 X (1 + ((.25 X .35)) =

.10 X 1.0875 = 10.875% net after tax yield

Purists would argue that you should use the new cost basis, but my argument is that it’s irrelevant so long as you never sell the stock. In that case, your “practical” cost basis is what you originally paid for it.

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Understanding Real Estate Investment Trusts (REITs)

A Real Estate Investment Trust (REIT) works as an investment company that controls the possession and management of revenue generation of real estate properties. Investing through REITs will allow you to claim several tax benefits and thus obtain a higher income from your real estate investments.

The following are the different types of REITs based on the type of real estate investment.

Equity REITs

These are trusts that own properties and generate their income from the rent paid for the property.

Mortgage REITs

These are the trusts that provide loans to property owners in return for a mortgage on a property. Mortgage REITs also buy mortgages and mortgage-backed securities, and get their revenue from the interest collected on mortgage loans.

Hybrid REITs

Hybrid REITs are trusts that generate their revenue from rent, like equity REITs, as well as interest on mortgages, like mortgage REITs.

Retail REITs

These are investment trusts that own and operate commercial ventures like shopping malls and industries. They earn their revenue by leasing out these properties to retail tenants.

Health Care REITs

These are trusts that invest in health care centres like hospitals, nursing homes, and retirement homes. Most health care REITs lease their properties to third-party managers who, in turn, pay them a fixed rent along with operational and maintenance costs.

Office REITs

Office REITs lease out buildings for official purposes, generally for a long time. They generate long-term revenue from the rent paid by these offices.

How Does a REIT Function?

A Real Estate Investment Trust needs to invest more than 75% of its total assets in real estate. For a REIT to be legal, it must have at least 100 investors. At least 90% of the profits earned by a REIT in its real estate ventures must be distributed among the investors. The REIT also cannot sell more than 50% of its stocks to 5 or less investors during the first half of a taxable year.

REIT is merely a pass-through entity which allows investors to purchase equity and transfer the profits to the shareholders. Since it is a pass-through entity, REIT is not taxable under federal or income tax laws. It is considered the duty of the shareholders to pay the taxes for their profits, as this is a source of income for them.

How to Invest in a REIT?

Anyone can invest in property through REITs without actually being a property owner. REIT shares offer liquidity, which means they can be sold and purchased easily. A REIT functions as a public sector market for investments in real estate.

Investing in REITs is similar to investing in any other venture or business. You invest by buying stocks or shares of a particular company and then receive a percentage of the profit earned by that company. The money that comes in from the different investors is used by the REIT to invest in a lucrative real estate deal. The profit that it earns from that venture is then distributed between the investors.

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Equity Real Estate Investment Trusts

Equity real estate investment trusts invest in and at the same time own properties themselves. Their revenues come mainly from the rents of their properties. These trusts are different from the mortgage property investment firms, which provide mortgage loans to the buyers. They don’t buy existing mortgages and mortgage backed securities. It buys and owns properties rather than investing in the mortgages. The properties are then given on a rent from where they get the principal amount as revenue. If you are investing in an equity real estate investment trust then you will get dividend income from the income earned by the investment trusts from their properties.

Unlike the usual REIT’s who invest in mortgage loans, equity real estate investment trusts invest directly in the physical property. In the regular investment trusts, they invest in mortgage loans i.e. they provide loans to people who are willing to invest in the property. They will be repaid back the money along with interest, which becomes their profit. They will carefully select the right people who deserve a qualified mortgage loan and invest on them who in turn buy property and pay back the money to the REIT along with interest.

But when it comes to investment trusts, they don’t invest in the mortgage loans and make money. In turn they invest the money in buying the property themselves and giving it for rent. They make profit from the rent that they get and their principal revenue is the rent that they get. One can invest in the equity real estate trusts and help them buy more property. From the rent that they get from the property they bought, you will earn a dividend share of it. The equity real estate trusts buy the property by investing their own money along with the investor’s money that is ready to invest in the properties.

Most of the time equity investment trusts are viewed as partial substitutes for the conventional property investments. The actual correlation between the equity real estate investment trusts and traditional property returns are insignificant. The primary focus on profits of the equity investment firms is through the acquisition and management of the direct physical property. Whereas for the conventional investment trusts the prime focus of profits is from the interest paid for the mortgage loans. In equity investment trust there is direct ownership on the property, whereas in the conventional REIT there is no ownership existing.

The risk involving in the investment in REIT depends on the type you choose. When it comes to investing in equity real estate investment firms there is a potential for investment returns because of- appreciations in the value of the owned property, inflations resulting in the driving up of rents unlike in stable mortgage returns, healthy dividend payments which increase over time, and there are profits whether it is from sale or buying of the properties. When it comes to the profits earned by the REIT’s, which give mortgage loans, they do produce significant returns but they carry added risks as they hold only debt instruments and not property.

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