REAL ESTATE INVESTMENT TRUSTS
An always exciting aspect of the derivatives market is the sudden emergence of a dormant derivative product to the front page of the news. This can be observed by the recent rise in popularity and regulatory concern of Real Estate Investment Trust transactions.
An REIT is composed of either real estate mortgages or the tangible asset—the real estate itself. A few REITs may invest in both. The dominant REIT in the market is the one that is invested in the actual asset (the property). These are known as equity REITs; the other type is referred to as a mortgage REIT. The REIT product gives the general public an opportunity to “own” and participate in the real estate market. The REIT may invest in properties or the mortgages of heath care facilities, shopping malls, apartment complexes, office buildings, hotels, storage facilities, etc.
REITs earn revenue through one of two venues: one method, the equities REITs, obtains the majority of their income from rent on property owned by the REIT. The other method, mortgage REITs, derive their income from interest earned on investments in property mortgages and/or through the acquisition of mortgage-backed securities (this product is covered elsewhere in this book).
Many REITs trade on stock exchanges while others are offered in the over-the-counter market and still others are privately placed. The first two, those that trade on exchanges, such as the New York Stock Exchange, and those that are distributed through the over-the-counter market must be registered with the Securities and Exchange Commission (SEC). Those that are privately placed are not so registered and are primarily offered to institutions and high net worth individuals who are supposed to be sophisticated enough to understand the risk/rewards scenario of the product.
The REITs that trade on exchanges trade as if they were common stock. Their market value is quoted, executions captured and reported to the public through pricing vendors, and transactions are processed from execution to settlement, through the same systems used by regular equity securities. Buyers and sellers trade ownership without any interference from the REIT issuer. SEC-registered REITs that do not trade on exchanges follow a similar type of issuance as open-end mutual funds, with shares issued through a distribution network. The terms for redeeming these shares are on an issuer by issuer basis. In addition, the individual REIT prospectus may contain a mandatory holding period. If at a later time the board of directors should decide that the registered REIT be listed on an exchange, the outstanding shares will become fully tradable once listed. Finally, the acquisition of a non-SEC–registered REIT constitutes a private transaction between the issuer and buyer. These are generally sold in rather large blocks of $100,000 or more and are therefore placed with institutions or high net worth individuals as mentioned previously. A private REIT can be a customized product (one off) or part of a larger block and its duration is set for a predetermined period of time (twelve years, for example). During that period withdrawals generally are not permitted. If an emergency should occur forcing the owner to sell, the share owner would pay a heavy penalty against the value of the REIT. Liquidation of non-SEC–registered REITs is issuer dependent and generally conducted under very limited conditions. One benefit of a private REIT is that it usually pays a higher rate of return than those that are publicly traded.
Owners of REITs can avoid long-term capital gains taxes on principal appreciation that may be due if they were to sell REITs, by using the REITs’ value to invest in a new REIT called an umbrella partnership. Their participation (or contribution) in the new REIT is added to funds raised by an initial public offering of the new REIT. The original REIT owner becomes a limited partner in the new REIT. Along with the limited partnership, the original REIT owner receives put options that permit the limited partnership to be exchanged for cash or shares of the new REIT. The process is known as UPREIT. In a DownREIT, a property owner goes into a partnership with an existing REIT entity and forms a limited partnership. The newly formed limited partnership acts as a joint venture with the limited partnership’s and the original property owner’s acting independently of the original existing REIT. The value of the put options that the limited partners receive is based on joint venture property and not the total property of the limited partnership and the existing REIT.
The SEC–registered REITs that trade on exchanges come under the rules and regulations of that exchange and FINRA (Financial Industry Regulatory Authority). SEC–registered REITs not traded on exchanges answer to the NASAA (North American Securities Administrators Association). NASAA is comprised mainly of state security regulators; non-SEC–registered REITs are not regulated. In addition, some may not be liquid or there may not be any liquidity when an owner may want to sell. BUYER BEWARE.
For diversification investors may acquire REITs through select mutual funds as well as through exchange-traded funds. Using the mutual fund or the exchange-traded fund vehicle allows the investor to own several REITs at one time. Options on REIT products trade on exchanges as well as on over-the-counter markets (mutual funds, exchange-traded funds, and option products are discussed elsewhere in this book).
Under the Internal Revenue Code Section 856, an REIT is any trustor corporation or an association of participants that acts as a single investment agent specializing in real estate and or real estate mortgages. Under subchapter M (sections 856–59), Chapter 1 of the Internal Revenue Code, REITs are entitled to deduct dividends paid to its shareholders or investors from its earnings as an offset to income tax liabilities. Among the requirements for REITs to avoid certain income tax liabilities, they are required to distribute a minimum of 90 percent of their taxable income to the aforementioned participants. This same rule applies to mutual funds covered elsewhere in this book. The income tax owed on the revenue earned by the REIT is paid by the REIT owners. This is unlike the income tax obligations of other entities, such as corporations. In those cases, the entity earning the revenue has a liability to pay income tax on the earnings and the share owners pay income tax on the dividend distribution.
Real estate investment trusts are truly a global product. They are offered in many countries of Africa (Ghana and Nigeria), Asia (Australia, Hong Kong, India, Japan, Pakistan, Philippines, Saudi Arabia, Singapore, and United Arab Emirates), Europe (Bulgaria, Finland, France, Germany, and the United Kingdom), North America (Canada, Mexico, United States), and South America (Brazil). Caution must be taken by the investor as the rules, regulations, and other restrictions differ from one country to another.
The formation of a real estate investment trust must be a fully taxable entity. It is operated through a management contingent who decides on investments and who oversees the day-to-day operation. The management answers to the board of directors or trustees. This senior group in turn answers to the shareholders. There must be at least one hundred shareholders of which no more than 50 percent of its shares are owned by five or fewer individuals. The REIT must have its investments gauges concentrated so that at least 75 percent of the entity’s total invested portfolio is in real estate. The entity must have no more than 20 percent of its assets invested in taxable REIT subsidiaries. Finally, it must earn at least 75 percent of its gross income from real estate–related activities.
Each REIT has its own termination point. In some cases the terms of the trust set the expiration. In some cases termination of the REIT is when the asset(s) is (are) sold or, in the case of mortgages, when the last mortgage is paid off. Any residual is disbursed to the remaining owners.