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The following frequently asked questions, and related answers,
are supplied by or excerpted from materials prepared by the
National Association of Real Estate Investment Trusts, or NAREIT.
1. What is a REIT?
A REIT is a company that owns, and in most cases, operates income-producing
real estate such as apartments, shopping centers, offices, hotels
and warehouses. Some REITs also engage in financing real estate.
The shares of many but not all REITs are freely traded, usually
on a major stock exchange. Some REITs, which are believed to
comprise a small percentage of the total based on real estate
asset value, are private.
To qualify as a REIT, a company must distribute at least 90
percent of its taxable income to its shareholders annually.
A company that qualifies as a REIT is permitted to deduct
dividends paid to its shareholders from its corporate taxable
income. As a result, most REITs remit at least 100 percent
of their taxable income to their shareholders and therefore
owe no corporate tax. Taxes are paid by shareholders on the
dividends received and any capital gains. Most states honor
this federal treatment and also do not require REITs to pay
state income tax. Like other businesses, but unlike partnerships,
a REIT cannot pass any tax losses through to its investors.
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2. Why were REITs Created?
The U.S. Congress created REITs in 1960 to make investments
in large-scale, income-producing real estate accessible to
smaller investors. Congress decided that a way for average
investors to invest in large scale commercial properties was
the same way they invest in other industries, through the
purchase of equity. In the same way as shareholders benefit
by owning stocks of non-real estate focused corporations,
the stockholders of a REIT earn a pro-rata share of the economic
benefits that are derived from the production of income through
commercial real estate ownership. REITs offer distinct advantages
for investors: greater diversification through investing in
a portfolio of properties rather than a single building and
management by experienced real estate professionals.
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3. How Does a Company Qualify as a REIT?
In order for a company to qualify as a REIT, a real estate
investment company must comply with certain provisions within
the Internal Revenue Code. As required by the Tax Code, a
REIT must:
• Be an entity that is taxable as a corporation
• Be managed by a board of directors or trustees
• Have shares that are fully transferable
• Have a minimum of 100 shareholders
• Have no more than 50 percent of its shares held by
five or fewer individuals during the last half of the taxable
year
• Invest at least 75 percent of its total assets in
real estate assets
• Derive at least 75 percent of its gross income from
rents from real estate property or interest on mortgages on
real property
• Have no more than 20 percent of its assets consist
of stocks in taxable REIT subsidiaries
• Pay annually at least 90 percent of its taxable income
in the form of shareholder dividends
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4. How Many REITs are There?
There are believed to be fewer than 200 REITs registered with
the Securities and Exchange Commission in the United States
that trade on one of the major stock exchanges, with the majority
listed on the New York Stock Exchange. NAREIT indicates that
the total assets of these listed REITs are believed to exceed
$400 billion.
About 20 REITs are registered with the SEC but are not publicly
traded. Approximately 800 REITs are not registered with the
SEC and are not traded on a stock exchange
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5. What Types of REITs are There?
The REIT industry has a diverse profile, which offers many
alternative investment opportunities to investors. REITs often
are classified in one of three categories: equity, mortgage
or hybrid.
Equity REITs: Equity REITs own and operate income-producing
real estate. Equity REITs increasingly have become primarily
real estate operating companies that engage in a wide range
of real estate activities, including leasing, development
of real property and tenant services. One major distinction
between REITs and other real estate companies is that a REIT
must acquire and develop its properties primarily to operate
them as part of its own portfolio rather than to resell them
once they are developed.
Mortgage REITs: Mortgage REITs lend money directly to real
estate owners and operators or extend credit indirectly through
the acquisition of loans or mortgage-backed securities. Currently,
mortgage REITs generally extend mortgage credit only on existing
properties. Many modern mortgage REITs also manage their interest
rate risk using securitized mortgage investments and dynamic
hedging techniques.
Hybrid REITs: As the name suggests, a hybrid REIT both owns
properties and makes loans to real estate owners and operators.
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6. How are REITs Structured?
REITs are typically structured in one of three ways: Traditional,
UPREIT and DownREIT. A traditional REIT is one that owns its
assets directly rather than through an operating partnership.
In the typical UPREIT, the partners of an Existing Partnership
and a REIT become partners in a new partnership termed the
Operating Partnership. For their respective interests in the
Operating Partnership (“Units”), the partners
contribute the properties from the Existing Partnership and
the REIT contributes the cash. The REIT typically is the general
partner and the majority owner of the Operating Partnership
Units.
After a period of time (often one year), the partners may
enjoy the same liquidity of the REIT shareholders by tendering
their Units for either cash or REIT shares (at the option
of the REIT or Operating Partnership). This conversion may
result in the partners incurring the tax deferred at the UPREIT’s
formation. The Unitholders may tender their Units over a period
of time, thereby spreading out such tax. In addition, when
a partner holds the Units until death, the estate tax rules
operate in such a way as to provide that the beneficiaries
may tender the Units for cash or REIT shares without paying
income taxes.
A DownREIT is structured much like an UPREIT, but the REIT owns
and operates properties other than its interest in a controlled
partnership that owns and operates separate properties.
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7. What Types of Properties do REITs Invest in?
American Automotive Trust is focused on vehicle retailing
and service related real property. However, REITs in general
invest in a variety of property types including shopping centers,
apartments, warehouses, office buildings, hotels, and others.
Most REITs specialize in one property type only, such as shopping
malls, self-storage facilities or factory outlet stores. Health
care REITs specialize in health care facilities, including
acute care, rehabilitation and psychiatric hospitals, medical
office buildings, nursing homes and assisted living centers.
Some REITs invest throughout the country or in certain other
countries. Others specialize in one region only, or even a
single metropolitan area.
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8. How do Shareholders Treat REIT Distributions for Tax Purposes?
REITs are required by law to distribute each year to their
shareholders at least 90 percent of their taxable income.
Thus, as investments, REITs tend to be among those companies
paying the highest dividends. The dividends come primarily
from the relatively stable and predictable stream of contractual
rents paid by the tenants who occupy the REIT’s properties.
For REITs, dividend distributions for tax purposes are allocated
to ordinary income, capital gains and return of capital, each
of which may be taxed at a different rate. All public companies,
including REITs, are required to provide their shareholders
early in the year with information clarifying how the prior
year’s dividends should be allocated for tax purposes.
This information is distributed by each company to its list
of shareholders on IRS Form 1099-DIV.
An historical record of the allocation of REIT distributions
between ordinary income, return of capital and capital gains
can be found at NAREIT’s web site. A return of capital
distribution is defined as that part of the dividend that
exceeds the REIT’s taxable income. Because real estate
depreciation is usually such a large non-cash expense that
may overstate any decline in property values, the dividend
rate divided by Funds From Operations (FFO), which is referred
to as the Adjusted Funds From Operations (AFFO), is a frequently
used measure of a particular REIT’s ability to pay dividends.
A return of capital distribution is not taxed as ordinary
income. Rather, the investor’s cost basis in the stock
is reduced by the amount of the distribution. When shares
are sold, the excess of the net sales price over the reduced
tax basis is treated as a capital gain for tax purposes. So
long as the appropriate capital gains rate is less than the
investor’s marginal ordinary income tax rate, a high
return of capital distribution may be especially attractive
to investors in higher tax brackets.
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9. Are REIT Dividends Subject to the 15 Percent Maximum
Tax Rate?
In May 2003, the U.S. Congress passed the Jobs and Growth
Tax Relief Reconciliation Act, which decreased income tax
rates on most dividends and capital gains to a 15 percent
maximum. Because REITs generally do not pay corporate taxes,
the majority of REIT dividends continue to be taxed as ordinary
income at the maximum rate of 35 percent (down from 38.6 percent)
under the May 2003 Tax Relief Act.
However, REIT dividends will qualify for a lower tax rate
in the following instances:
• When the individual taxpayer is subject to a lower
scheduled income tax rate;
• When a REIT makes a capital gains distribution (15
percent maximum tax rate);
• When a REIT distributes dividends received from a
taxable REIT subsidiary or other corporation (15 percent maximum
tax rate); and
• When permitted, a REIT pays corporate taxes and retains
earnings (15 percent maximum tax rate).
In addition, the maximum 15 percent capital gains rate applies
generally to the sale of REIT stock.
According to the National Association of Real Estate Investment
Trusts, available data indicate that about one-third of REIT
dividends qualified for the lower 15 percent captial gains
rate in 2003. Of this amount, 54 percent represented captial
gain distributions and 46 percent represented return of capital,
which is taxed at a capital gain rate when the stock is sold.
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10. How are REIT Stocks Valued?
For REITs which are public companies, REIT shares are priced
every day in the market and give investors an opportunity
to value their portfolios daily. To assess the investment
value of REIT shares, typical analysis includes but should
not be limited to some or all of the following criteria:
• Anticipated total return from the stock, estimated
from the expected price change and the prevailing dividend
yield
• Current dividend yields relative to other yield-oriented
investments (e.g. bonds, utility stocks and other high-income
investments)
• Dividend payout ratios as a percent of REIT funds
from operations (FFOs)
• Anticipated growth in earnings per share
• Underlying asset values of the real estate and/or
mortgages, and other assets.
• Management quality and corporate structure
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11. Who Invests in REITs?
Tens of thousands of individual investors, both U.S. and non-U.S.,
own shares of REITs. Other investors in REITs include pension
funds, endowment funds and foundations, insurance companies,
bank trust departments and mutual funds. Investors typically
are attracted to REITs for their high levels of current income
and the opportunity for moderate long-term growth. These are
the basic characteristics of real estate. In addition, investors
looking for ways to diversify their investment portfolios
beyond other common stocks as well as bonds are attracted
to the unique characteristics of REITs.
Today, a broad range of investors are using REITs to help
achieve their investment goals, from large pension funds seeking
diversification to the retired school teacher seeking a high-quality
income investment.
Listed REIT shares may be purchased on the open market, with
no minimum purchase required. Many investors also are choosing
to own REITs through mutual funds or exchange traded funds
that specialize in public real estate companies.
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12. What Potential Advantages Do REITs offer as an
Investment?
REITs are total return investments. They typically provide
high dividends plus the potential for moderate, long-term
capital appreciation. Long-term total returns of REIT stocks
are likely to be somewhat less than the returns of higher
risk high-growth stocks and somewhat more than the returns
of lower risk bonds. Because most REITs also have a small-to-medium
equity market capitalization, their returns should be comparable
to other small to mid-sized companies.
There is a relatively low correlation between listed REIT
stock returns and the returns of other market sectors. Thus,
including listed REITs in an investment program helps build
a diversified portfolio.
REITs offer investors:
• Current, stable dividend income
• High dividend yields
• Dividend growth that has consistently exceeded the
rate of consumer price inflation
• Liquidity: shares of publicly traded REITs are readily
converted into cash because they are traded on the major stock
exchanges
• Professional management: REIT managers tend to be
skilled, experienced real estate professionals
• Portfolio diversification, which reduces risk
• Disclosure obligations: REITs whose securities are
registered with the SEC are required to make regular SEC disclosures,
including quarterly and yearly financial reports.
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13. How are REITs Different from Real Estate Limited Partnerships?
REITs are not partnerships, although, as is the case with
other corporations, REITs use partnerships to engage in joint
ventures. There are important organizational and operational
differences between REITs and limited partnerships.
One of the major differences between REITs and limited partnerships
is how annual tax information is reported to investors. Each
year, an investor in a REIT receives a traditional IRS Form
1099 from the REIT, indicating the amount and type of income
received during the prior tax year. However, an investor in
a partnership receives a more complicated IRS Schedule K-1
which must be furnished to taxpayers later in the year than
a 1099. Also, a REIT investor must file fewer state tax returns
than required by a partnership investment.
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14. Can Real Estate be Exchanged for REIT Stock as
Part of a "Section 1031 Like Kind Exchange?
Section 1031 of the Internal Revenue Code generally permits
tax deferral when investment property or property used in
a trade or business is exchanged for "like kind"
property as long as the exchange is completed within 180 days
of the transfer of the exchanged property. Non-simultaneous
exchanges are also permissible under section 1031 if certain
criteria are met. These exchanges are known as "like
kind exchanges." An example of a like kind exchange would
be an exchange of an apartment buidling in Baltimore for an
apartment building in San Diego. REIT stock does not qualify
as investment property, and, accordingly, it is not possible
to effect a like kind exchange of real estate for REIT stock.
Although REIT stock cannot qualify for like kind exchange
treatment, another provision of U.S. tax law (Section 721
of the Internal Revenue Code) does permit owners of real property
to exchange their property for partnership interests on a
tax-deferred basis if certain conditions are met. Relying
on this provision, many REITs own the majority, if not all,
of their properties through an operating partnership ("OP")
in which they hold the majority interests. The operating partnership
most often pertains to an "umbrella partnership REIT"
or "UPREIT," but also may pertain to a "DownREIT."
From time to time, real estate owners may transfer properties
on a tax-deferred basis to an OP in exchange for OP units.
The OP units ultimately are exchangeable into REIT stock or
cash in a taxable transaction, and they allow their owners
to receive partnership distributions typically similar to
the REIT distributions they would receive had they converted
the OP units into REIT stock.
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