While there are four primary benefits to owning real estate, there are many reasons to invest. These reasons will vary widely from one owner to the next, and ownership itself can take many forms depending on the individual or the entity involved. It’s important for real estate managers to thoroughly understand the goals and objectives of the client. To do so, it’s important to first know the process and reasons behind owning property, how the property was financed/acquired, what the owner hopes to accomplish, and the entity that will take ownership. The answers to these items will definitely affect how the income-producing real estate is managed.
Most people aspire to invest in real estate at some point in their lives—people usually buy a home or condominium, but they might not consider it an investment. A new homeowner usually says, “I bought a house,” instead of, “I invested in real property.” But purchasing real property is always an investment—regardless of how the owner uses the property.
Investors purchase property in one of two ways: (1) they buy it outright as an all-cash purchase, or (2) they finance part of the purchase price through a loan. Both purchases have specific advantages and disadvantages for the investor.
All-Cash Purchase. An all-cash buyer is able to keep all of the NOI from a property and yields greater cash return. When a property is financed, the NOI is divided between the owner and the lender in the form of mortgage payments (debt service). Most investors, even if they have substantial amounts of cash available, do not generally pay cash for their real estate investments. This is because the benefits of leverage (use of borrowed funds) can produce a higher return with a smaller cash investment.
On the other hand, real property is considered an illiquid asset. The owner can only convert real estate into cash in two ways: (1) sell or (2) refinance the property. Neither is quick, and both require agreement on the property’s value. For example, selling property can sometimes take years, depending on the type of property and strength of the market. For a six-year period starting in 2008, the real estate market became especially challenging—nearly all forms of real estate assets suffered a huge loss in value, which made both selling and refinancing nearly impossible.
Financing. Borrowing funds to purchase an income-producing property is often necessary or desirable. When a financial institution approves a loan, it drafts numerous instruments often referred to collectively as loan documents. The most significant of such documents are the mortgage and the promissory note. Among other things, the mortgage places a lien on the property in favor of the lender. The borrower pledges the property as collateral to secure the mortgage loan. The lender has the right to foreclose the mortgage, sell the property, and apply the proceeds to the outstanding debt—in the event the borrower defaults on the loan.
The promissory note is the legally binding document that stipulates the loan conditions, including repayment terms, but borrowers and lenders alike commonly use the words mortgage and loan interchangeably. In place of a mortgage, some states use a deed of trust, which pledges the property as collateral—the buyer holds title to the property as a warranty deed, and the financial institution and the buyer execute a note as evidence of the debt.
Mortgage Conditions. Mortgages for all real property loans contain three major conditions: (1) They require the repayment of the principal, or the amount borrowed, (2) they require the payment of interest on the principal, and (3) they require a specific schedule of payments. The debt service, or process of repayment, addresses all three of these conditions. Borrowers usually pay debt service monthly, and the amount of the payment depends on the interest rate for the loan, the duration of the loan, and whether part of the payment is to pay back principal.
When the debtors’ payments gradually reduce the principal with each succeeding payment over the term of the loan to a final payment in which the balance is completely paid off, the loan is a fully amortized loan. When the loan is fully amortized, allocation of the payments between principal and interest are determined by a mathematical formula. In the early years of the loan term, the lender allocates most of the borrower’s monthly debt service payment to interest and applies only a small portion to pay down the principal. However, if the payment amount and interest rate remain the same, the portion the lender allocates to interest gradually decreases as the borrower pays the principal down over time, and the portion the lender allocates to principal slowly increases. The type of loan determines whether the lender uses the debt service payment to amortize the principal, and if so, how much it uses for that purpose. In real estate investment, the best loan is usually the one that has the lowest annual debt service because paying less debt service increases the property’s before tax cash flow.
In addition to monthly payments, most mortgages have start-up costs such as points and application fees. A point is one percent of the total loan amount. If the borrower must pay two points to secure a $100,000 loan, the lender will receive $2,000 at the closing of the purchase, or the beginning of the loan. Because the acquisition of real estate involves more than the purchase price of the property, some owners consider these additional costs as part of their initial investment base. Investors will add additional funds to the investment base if there are initial improvements required to make the newly purchased property operational or to enhance its ability to generate income, such as installation of new appliances to upgrade apartments for achieving higher rental rates.
Mortgage Types. Lenders offer many types of mortgages. Some of the more common types are (1) fixed-rate, (2) variable-rate, (3) adjustable-rate, and (4) balloon-payment mortgages. The type of loan a borrower will use will be a function of the owner’s goals and of the market availability for mortgage funds. While a basic description of each type of loan follows, the actual loan put in place by a borrower must be analyzed for its ability to help the owner achieve its goals.
A fully amortized loan is characterized by periodic payments that include a portion applied to interest and a portion applied to principal. In the early years of the mortgage, a greater portion of the payment is applied to the interest. As the loan matures, a greater portion of the payment is applied to the principal, and the entire debt obligation is extinguished at the end of the loan term.
Over the course of a fully amortized loan, the borrower builds equity in the property, and the lender gains additional cushioning against loss in the case of default of payment. There are two types of fully amortized loans: (1) fixed-rate and (2) adjustable-rate.
An amortization schedule shows the periodic interest and principal components of each individual payment and the amount of the outstanding loan balance after each scheduled payment. An amortization schedule can be generated for monthly, annual, or any other schedule of periodic payments.
*Source: IREM Educational Course, Investment Real Estate: Financial Tools (FIN 402)
While financing has many advantages, purchasers must understand that their equity in the property will be some amount less than 100 percent of the asset’s value until the principal of the mortgage is fully amortized. To calculate one’s equity, simply find the current market value and subtract from it the current outstanding amount of the loan.
Prior to investing in real estate, one must understand whether liquid or illiquid assets are best suited for their investment needs. Generally, the earnings of liquid investments derive from just a few sources. Growth in the value of precious metals is based on demand and, therefore, investors often buy metals to preserve capital. The value of stock can appreciate from both demand for the stock and increasing value (profitability) of the company. Stocks often pay a periodic dividend as well, while the only earnings from a savings account are periodic interest payments. Bonds purchased at less than face value have a fixed maturity date and accrue interest over the period they are held. While some bonds, such as municipal bonds, are tax free, the income from others may be taxable when the bond matures, when the investor converts it to cash, or throughout the holding period as the interest accrues. Unlike real estate, investors have little to no control over their investment in these liquid assets.
Even though real estate is an illiquid investment, the allure of owning property and the financial rewards of ownership make real estate one of the largest storehouses of wealth. What’s more, real estate provides comfort through physicality in that the assets are typically large and built out—serving greater functional purpose in a space than just an investment vehicle. As previously noted, there are four benefits to owning real estate, including: (1) capital preservation, (2) capital appreciation, (3) periodic return or regular income, and (4) income tax advantage. While a major consideration in real estate investment is financial return, it has nonfinancial considerations as well—it can also be a means of diversifying an extensive investment portfolio.
Capital Preservation. Many people believe that investment in real property is a way to preserve capital. Property values tend to rise with the inflation rate if the property is in a good location and the economic environment of the area is healthy. Land and real property are similar to precious metals because they have an intrinsic value—they are inherently useful. The intrinsic value of a property should increase at least at the same rate as inflation. Investors interested primarily in the safety of their capital look for property with extremely low risk. The following lists the qualities that indicate low risk:
Capital Appreciation. Appreciation is the increase in the value of an asset over time. In real estate investment, capital appreciation is realized when an owner sells a property for more than its original purchase price. Since it does not materialize until the owner sells or refinances the property, capital appreciation can be the ultimate goal of a long-term investment, although appreciation is also possible for a short-term holding. The equity generated by appreciation can also be used to diversify an investor’s real estate holdings. If there is sufficient equity, it can be drawn through a refinance of the property, thereby making cash available for other investments. It’s important to note that depreciation can also occur, cutting cash flow, and increasing debt for the short or long term.
Real estate managers play an important role in the capital appreciation of the investment by positioning the property to meet its highest and best use, producing as much income as possible, controlling operating costs as much as possible, and maintaining, preserving, and improving the structure itself. This has become even more challenging in recent years because more investors have lost properties to foreclosure or bankruptcy. In turn, new owners or banks have sought out real estate managers with specific skills in turning around troubled properties to bring them back to the market.
With regard to distressed assets or troubled properties, there are seven major factors that contribute to the decline of property value:
The community surrounding the income property can change in many ways that can dramatically affect a property. Increased vacancy leads to reduced rents, which in turn means reduced maintenance, causing building deterioration, which then causes the surrounding area to slip into decline—initiating a domino effect that amplifies the general decline in value. The nearby construction of facilities such as prisons, sewage treatment plants, and airports also contributes to an adverse effect on the location and value of the property. Comparably, the construction of a major highway or intersection includes additional noise and inconveniences that drive tenants away. Basically, if the property is not maintained, the value of the investment in real estate is reduced; this is referred to as economic obsolescence, which is the failure to generate enough income to offset operating expenses because of the physical condition of the property.
With regard to market conditions, there are two main factors that can cause values to go down: (1) overbuilt properties and (2) stringent funds. With the multifamily sector, overbuilt implies that more apartment units are available to rent than there are tenants to rent the units. Simple economic principles of supply and demand tell us that a surplus of supply will not promote rent growth. On the contrary, under-built markets will see demand and pricing increase. Having stringent funds applies to the unavailability of long-term financing options from lenders, which means there will be fewer qualified buyers for rental property.
Despite particular challenges in a down economy, value can still increase for several reasons. If income increases and exceeds any increase in expenses, the property will be more desirable and can sell for a higher price. An improvement in the economy of the area, greater demand for property in the area, rehabilitation of the property, or a change in its use can drive value up as well.
Periodic Return. The relationship between purchase price and cash flow is a consideration for investors who seek regular, periodic income from their property. Before tax cash flow refers to the amount remaining after subtracting operating expenses and debt service from gross receipts. In the same manner that the capital appreciation of the property is enhanced, the amount of periodic income derived from property operations can also be influenced. However, the amount of income a property can generate is subject to prevailing conditions in the market. The investor’s income is usually expressed in dollars, i.e., cash flow, or as a percentage rate of return.
Income Tax Advantage. Federal and state governments in the United States and elsewhere commonly grant tax incentives for real estate investment. Incentives for property ownership help drive the U.S. economy. To increase the amount of housing stock available, federal and state governments allow income tax deductions for mortgage interest, operating expenses, and depreciation of income-producing residential property. Owners of income-producing commercial properties can take the same kinds of deductions—the deductibility of mortgage interest encourages borrowing, which keeps money in circulation. The demand for loans encourages lending institutions to seek savings and investments, which in turn generates additional tax dollars. The deductibility of operating expenses provides an incentive for the owner to reinvest in the property and keep it well maintained.
Depreciation. Depreciation, also called cost recovery for income tax purposes, is particularly enticing because it is a noncash expense that the property owner can take as a deduction from income. The U.S. income tax laws permit an owner to assume that a building has a specific useful life in which it will produce income and to recover the cost of the building over a period of years. The depreciation period (or useful life) varies for different types of properties. In theory, if the depreciation period is 39 years, the property owner can deduct 1/39th of the purchase price of the property, excluding the land, each year for 39 years. However, the calculation of income tax deductions for depreciation is more complicated. The tax law sets the periods of useful life for various classes of property. For real estate investments, the depreciation period depends on the type of property, such as residential or commercial.
The value of an owner’s investment in real estate is equity. An all-cash purchase gives the owner 100 percent equity. If a real estate purchase is financed, the investor’s initial equity is the amount of the cash down payment. When an owner has an amortizing loan and holds a property over time, the owner’s equity increases as the principal of the loan decreases. If the owner then sells the property for more than the original purchase price, the increase in the market price is the result of an appreciation in value, and the amount of appreciation becomes part of the owner’s equity. For example, if an owner pays $10,000 down on a $100,000 real estate purchase and finances the remaining $90,000, the owner’s initial equity is $10,000. If the property sells for $120,000 five years later, the seller’s equity at that time will be at least $30,000 ($10,000 initial equity plus $20,000 in appreciation plus whatever equity—if any—has accumulated through amortization).
Investment, on the other hand, typically extends for a longer holding period and offers investors fundamental opportunities. For example, an owner/investor may purchase real estate to obtain a steady source of income over a specific time period. The cash flow will provide a rate of return that can be compared to other investments and is enhanced by the tax shelter effects of the real estate, such as depreciation. The strength of a rent roll or market will greatly impact the quality of the cash flow that the owner will receive.
Consider a residential building and a commercial building (placed in service in 1995) that were each bought for $1.3 million. The land is worth $300,000, which gives a recoverable basis of $1 million. For the residential building, straight-line cost recovery over 27.5 years means subtracting 1/27.5 of the recoverable basis each year. For the commercial building, straight-line cost recovery over 39 years means subtracting 1/39 of the recoverable basis each year. The following calculates the adjusted basis of both buildings at the end of the sixth year of ownership.
Capital Improvements. The depreciation deduction also applies to capital improvements—investments in equipment or alterations that last for more than one year and increase the value, productivity, or useful life of the property. The number of years the government allows for depreciation of capital improvements varies, and the deduction may be larger during the early years of the depreciation period—accelerated cost recovery. The IRS also distinguishes between a capital improvement and a repair that preserves the investment in a property but does not lengthen its useful life. For example, adding granite countertops to existing apartments is a capital improvement or added value—fixing a hot water heater is a repair. The cost of a repair is tax deductible as an operating expense for the year in which it is made.
Tax advantages of ownership vary with changes in federal income tax laws. At times, the amount of interest, real estate tax, and depreciation claimed in a given year may result in a taxable loss, which is subject to passive loss limitations and other factors in an individual’s investment portfolio.
Pride of Ownership. In addition to the financial reasons to own income-producing property, investors sometimes own real property because of an inherent pride of possession. Real estate is more tangible than stock certificates or other assets. Property ownership can be a symbol of financial security, wealth, or power. Certain aspects of a property make the owner a contributor to the community—that alone can give an owner satisfaction. In addition, owners sometimes live on the premises, have an office there, or even operate a retail business in the income-producing property they own—an owner’s relationship to the property can have more dimensions than just being a source of income. Sometimes the simple pride that owners exhibit in their properties is likely to increase net income. Especially when the owner gives more attention to maintenance and repairs, the property has more potential to attract tenants and higher rents. Deductibility of maintenance and improvement costs offers tax incentives, and dedicated care makes capital preservation and capital appreciation more likely outcomes.
Investors can own an interest in property in many ways and each form of ownership provides the investor with different capabilities and limitations in making a profit from the property (Exhibit 4.1). No particular form is necessarily ideal—each has certain advantages and disadvantages. Depending on the property and the goals of the investors, one form can be more beneficial than others. Income-property ownership takes five common forms: (1) sole proprietorships, (2) partnerships, (3) corporations, (4) real estate investment trusts (REITs), and (5) joint ventures.
The mainstay among ownership forms is a sole proprietorship, which has total control and unlimited liability. Sole proprietors benefit directly from the profits that the property produces. They are also directly liable for all financial losses and may be able to take deductions for such losses on their personal income tax. However, deductibility rules vary—passive loss limitations apply. Due to this variability, the property manager, along with the owner, should scrutinize tax provisions and seek the guidance of legal or tax advisors regarding the deductibility of losses.
A very common association of individual investors is a partnership, which is an arrangement that allows each partner to participate in the profits and losses of their mutual investment. A partnership distributes all profits and losses to the partners based on the amount of their investments or as stated in their partnership agreement. Although it must report annual information on income, gains, and losses, the partnership itself pays no income tax. The income (or loss) of the partnership affects the tax reporting of the individual partners based on their shares in the investment.
A partnership or other form of multiple ownership may be certified as a legitimate business entity. Depending on state law, a partnership may sue or be sued in the names of the partners or in the firm name. The ownership form does not insulate individual investors from liability. If a partnership is sued and found liable, the general partners would be liable individually and collectively for damages—joint and several liability.
Partnerships usually take one of two forms: (1) general partnership or (2) limited partnership. The following sections also discuss two special types of partnerships: (1) syndicates and (2) limited liability companies.
General Partnership. A general partnership involves two or more investors who agree to be associated for business purposes. Title to property is held in the name of the partnership. All partners share in the rights, duties, obligations, and financial rewards to the extent of their own participation—or in accordance with the partnership agreement. However, the partners’ personal liability for the debts of the partnership is unlimited. Any general partner can commit the other partners to a financial obligation without their consent or knowledge—provided the partner makes the contract for the service or material on behalf of the partnership and not on behalf of the individual. A small number of investors who know each other well and are reasonably certain they can work together cooperatively sometimes enter into a general partnership. Because general partners are personally and fully liable for the property, they can lose personal assets along with their investment in the partnership if the property faces bankruptcy or a lawsuit.
As the name implies, limited liability general partnerships (LLGPs) actually do limit the liability of the general partners. Depending on state laws and the partnership agreement, a general partnership may dissolve if one partner chooses to remove their interest. Even if dissolution is not mandatory, it may be unavoidable because selling a partial interest in an established partnership is difficult.
Successfully managing a property for a general partnership can be difficult if all the partners do not agree on an issue, and if they do not have a general partnership agreement that defines a decision process. Even among the most cooperative partners, occasional differences of opinion are inevitable. Although the partners may agree that they must take a vote on certain actions and that those who own the majority of the investment must agree to enact a change, one dissenting general partner among five may have equal authority over the property.
The real estate manager is usually in a good position to reconcile any differing points of view, but that consumes time that could be spent more productively. If the real estate manager reports to more than one person, then multiple reports need to be distributed, which also uses more time and resources. To avoid financial harm to the property because of, or during a dispute, the partners can name one of their members as a managing partner with whom the real estate manager will work exclusively. Such action centralizes the management control and places the obligation for settling differences where it belongs—among the partners.
Limited Partnership. A more popular form of partnership is the limited partnership (LP), which consists of one or more general partners who supervise the investment, plus a number of limited partners who participate in the arrangement—only to the extent of their financial investment. As in a general partnership, the liability of the general partners is unlimited. The limited partners assume no liability beyond their capital investment. It’s important to note that a partnership can organize as a limited liability limited partnership (LLLP), which limits the liability of the general partners.
Two forms of limited partnerships exist: (1) private limited partnerships and (2) public limited partnerships. Private limited partnerships have 35 or fewer investors and usually do not have to register with the Securities and Exchange Commission (SEC)—although they may have to file a certificate with state authorities. Public limited partnerships have an unlimited number of participants and must register with the SEC when the number of partners and the value of their assets reach certain levels.
Individual investment in a limited partnership does not necessarily require a large amount of capital, so this type of partnership is attractive to an investor with limited resources who wants to participate in a large venture. As in a general partnership, the tax benefits and obligations pass through to the individual partners based on the provisions in the partnership agreement.
Limited partners have no say in management policies, and they may consider that a disadvantage. The decisions made by the general partners in a limited partnership affect more than their personal investments—the potential exists for all of the partners to lose their investments. If the property requires additional funds because of adverse economic conditions, the general partners are obligated to invest additional capital, but the limited partners are not. Limited partners may make additional contributions to protect their original investment—but they typically do not do so.
The challenges to management of a limited partnership are about the same as those of a general partnership. However, if some limited partners become frustrated with the general partners’ decisions, they may try to appeal directly to the real estate manager. If a limited partner is permitted to have direct influence on the management of the property, the Internal Revenue Service (IRS) can reclassify the partnership as an association that is taxable as a corporation. The IRS could also reclassify the limited partner as a general partner, and that person would lose the liability protection extended to limited partners.
The real estate manager might be obligated to report to all investors in a limited partnership, but such reporting is potentially expensive. To avoid this reporting requirement, include in the management agreement a clause that clearly explains the form, frequency, and recipients of reports. To minimize or discourage conferences between the real estate manager and anyone other than the general partners, the agreement should also state an hourly fee for discussion with limited partners, their attorneys, accountants, heirs, executors, or anyone else. In turn, the partnership agreement should provide that the individual who requires special services must pay the charges for them. (Chapter 5 provides more details about the management agreement.)
Syndicate. A real estate syndicate is a special type of partnership formed by any combination of owners who purchase an interest in a property together. The investor may be an individual, a general or limited partnership, a joint venture, an unincorporated association, a corporation, or a group of corporations. Syndication is a way to pool both capital and experience for a property’s success. Another advantage of syndication is that people of differing backgrounds can make a formal agreement to accomplish one specific goal. The flexibility of investment is another advantage—the purpose of a syndicate can be to purchase a particular property or to rely on the experience of a syndicator to acquire property that appears promising. If more funds are necessary, the syndicate can sell additional partnership interests.
Limited Liability Company. A limited liability company (LLC) is another form of ownership that allows multiple owners to invest in real estate. Its owners are called members, and the managing entity may be a participating investor (manager member) or a nonparticipant appointed by the members. An LLC is created by state statute, and most states have adopted such laws—although the rules and fiduciary responsibilities vary. For federal income tax purposes, the IRS classifies an LLC as a partnership. Unlike the general partners in a partnership, however, all LLC members enjoy limited liability—no one member may be held liable for debts or other obligations of the company. In addition, LLCs have lesser tax reporting requirements than do C or S corporations described below.
The difference between a corporation and any other association of investors in the United States is its recognition by federal and state governments. A corporation is chartered by a state, and it is considered to have a legal life of its own. It is an independent legal entity—it can sue and be sued. If a corporation goes bankrupt or loses a lawsuit, the liability of the corporate owners, or the stockholders, is limited to the amount of their investment. As an independent legal body, a corporation must pay local, state, and federal income taxes—it cannot transfer its tax deductions to its shareholders. Depending on the structure of the corporation, corporate profits may be subject to double taxation—at the corporate level and again at the individual shareholder level when dividend distributions are made. Income tax law in the United States recognizes two types of corporations for tax purposes: (1) C corporations and (2) S corporations.
C Corporations. The government legally defines most corporations as C corporations. These entities pay income tax and have no restrictions on the number of shareholders they have or the types of stock they issue. The obligation of a C corporation to pay income tax is the main limitation on its ownership of real estate as a primary business endeavor. Even so, the attraction of limited liability for all participants (directors as well as shareholders) is a positive feature for some real estate investors.
S Corporations. Unlike a C corporation, an S corporation combines the ownership features of a corporation with those of a partnership. It does not pay federal income tax, so it does not incur double taxation—profits (and losses) pass directly to the shareholders. Because the investors are shareholders and not partners, their individual liability is limited to the value of the stock they own. Stock ownership inherently provides the election of a board of directors, a factor that ensures centralized management. In addition, ownership of the investment is more easily transferred through stock shares than it is in a limited or general partnership.
The eligibility requirements for classification as an S corporation are strict. To be eligible, the corporation must have no more than 75 shareholders, and it can offer only one class of stock. All shareholders must be individuals or estates; other corporations or business ventures cannot hold stock in an S corporation. Classification as an S corporation is by choice—otherwise, a corporation is classified as a C corporation. Some states may not recognize S corporation status and may impose state corporate taxes in spite of the designation.
Working for a corporation may involve more administrative procedures than working for a sole proprietor or a partnership because the corporation must report to the government, its directors, and its shareholders. The board of directors may be the authority for management decisions, although the contact may be someone other than a board member whose primary responsibility is unrelated to real estate. Decisions involving the property may require formal documentation and board approval. Budgets and financial statements for the property may have to conform to the accounting standards of the corporation-even though such standards may not be suited to real estate management. The corporation may require one budget for the calendar year and another for the fiscal year if the two are different, and it may require both cash- and accrual-basis accounting. Duties may include annual audits and filings with the SEC. Because working with a corporation can create the potential for uncomfortable compromises between confidentiality and mandatory public disclosure, all information must be maintained in the strictest confidence-only the corporation should release its information.
While a group of investors may form a corporation specifically to purchase and operate one or more income-producing properties, corporations created for purposes other than real estate investment also become real estate owners.
Such a corporation may own the building in which it conducts its business and derive additional income from the property by leasing any excess space. For example, one of the major department stores that holds a shopping mall may own all or part of the mall. A manufacturing company may develop land around its factory into an industrial park. A bank, advertising firm, or other service company may build or purchase a premier office building for its business operations and rent out the space it does not use.
This type of rental income is generally secondary to the income generated by the main business operation of the corporation, such as retail sales and manufacturing. A real estate manager for corporate-owned real estate will have broad responsibilities that include acquisition and disposition in addition to real estate management specifics, such as property maintenance, record keeping, and reporting.
Another vehicle that permits small investors to engage in large real estate ventures is a real estate investment trust (REIT), which is a specialized trust fund that invests exclusively in real estate. Dealing with a REIT can take one of three paths: (1) direct investment, (2) investment through mortgage lending, or (3) both. A REIT issues shares of beneficial interest that can be traded publicly, and its passive losses cannot exceed the cash distributions to the trust beneficiaries. For a REIT to avoid double taxation, it must distribute at least 95 percent of its taxable income to the shareholders—if a REIT has any retained income, corporate taxation rules may apply—and it must meet several requirements to ensure that most of its income is derived from real estate. Investors in a REIT are liable only to the extent of their investment.
Because REITs operate through shares, they offer greater security than limited partnerships because they diversify their assets among properties in several locations—provided the trust is astutely managed and the REIT is significantly large. If shares of the REIT are publicly traded, the beneficiaries have two distinct advantages: (1) they profit from real estate investment and (2) their funds remain liquid. However, REITs must distribute most of their earnings, and adequate reserves may not be available for capital improvements to or additional investments in a property owned by a REIT. Likewise, a REIT has few options for preserving its capital. If the real estate market becomes unfavorable, most owners of real property can liquidate their assets, possibly taking a one-time loss, and invest the remaining capital in something else. A REIT, by definition, must keep its money in real estate.
Investors can use any combination of ownership forms to establish a joint venture—the purpose is to share the risks and the rewards jointly by contributing the appropriate knowledge, skill, or asset. The advantages, disadvantages, and tax obligations depend on the type of business entity selected for the joint venture. Some of the most common joint venture relationships are between a developer and an institutional investor—or a lender who undertakes a new project. The lender invests capital, land, or both, and the developer contributes knowledge to make the project succeed. Foreign capital is often invested in real property in the United States via joint ventures. In that case, a domestic entity nurtures the development and the foreign investor provides the capital.
The challenges of managing real estate owned by a joint venture depend on the type of business entity the joint venture chooses.
Investors can purchase real estate with cash or a combination of cash and financing. Mortgage loans commonly have a fixed maturity and interest rate, but some mortgages have flexible terms that take advantage of market fluctuations. The terms of the loan can have a profound impact on the property’s success based on changes in the property’s income, the overall economy, and the owner’s expectations from the investment. The reasons for owning real estate include capital preservation, capital appreciation, periodic return (cash flow), income tax advantages, and pride of ownership. Any of these reasons alone may be sufficient for an investor to purchase a property. However, the investor usually considers a combination of these factors before making a purchase.
A comparison of investment options reveals that real estate is highly illiquid when compared to stocks, bonds, and other investment vehicles that an investor can convert to cash relatively quickly and easily. However, the various forms of real estate ownership and the many advantages of that ownership sustain real estate’s popularity as an investment.
The principal forms of property ownership are sole proprietorships, partnerships (including limited liability companies), corporations, real estate investment trusts (REITs), and joint ventures. Each ownership form has advantages and disadvantages, and no single form is necessarily ideal. Each has different effects on income from the property, payment to the investor, tax obligations, and the relationship between the owner and the manager. Understanding the subtleties of the owner’s reasons for investing in a property and knowing the form of ownership gives the real estate manager the basis for determining how to manage the property and how to improve its productivity.