Real Estate Investment Trusts, commonly known in investment circles
as REITs, are more popular than ever. REITs allow investors to position
investment dollars into the real estate market and simultaneously bypass
the inherent difficulties of property management or "active ownership."
A Real Estate Investment
Trust, or 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 a REIT are freely transferable, and are usually traded
on a major stock exchange. A REIT is required to be taxable as a corporation
and usually operates as either a C corporation or a statutory trust,
such as a Massachusetts Trust.
A company that
qualifies as a REIT is permitted to deduct dividends paid to its shareholders
from its corporate tax bill. As a result, most REITs remit one hundred
percent (100%) 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 do not require REITs to pay state income tax. To qualify as a REIT,
a company must distribute at least ninety percent (90%) of its taxable
income to its shareholders annually. However, unlike partnerships and
certain limited liability companies, a REIT cannot pass its tax losses
to its investors.
In order for a
company to qualify as a REIT, it must comply with certain provisions
within the Internal Revenue Code. As required by the Tax Code, beginning
with its second taxable year, 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 the shares held (taking into account
certain rules attributing ownership to related parties) by five or
fewer individuals during the last half of each taxable year;
invest at least 75 percent of the total assets in real estate assets;
derive at least 75 percent of gross income from rents from real
property, or interest on mortgages on real property;
have no more than 20 percent of its assets consist of stock in taxable
REIT subsidiaries;
distribute at least 90 percent of its taxable income annually in
the form of shareholder dividends.
The U.S. Congress
created REITs in 1960 to make investments in large-scale, income-producing
real estate accessible to smaller investors. Congress concluded that an
efficient way for average investors to invest in large-scale commercial
properties was the same way they invest in other industries, through the
purchase of publicly traded stock. In the same way that shareholders benefit
by owning stock of other 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 expert management
by experienced real estate professionals.
Real Estate Investment
Trusts (REITs) are an efficient way for many investors to invest in
commercial and residential real estate businesses. They give an investor
a practical and effective means to include professionally managed real
estate in a diversified investment portfolio.
The shares or trust
certificates of a REIT are registered with the Securities and Exchange
Commission pursuant to the Securities Act of 1933 or when issuing bonds
pursuant to the Trust Debenture Act of 1939, by the filing of a registration
statement.
Although most REITs
trade on an established securities market, there is no requirement that
REITs be publicly traded companies. REITs that are not listed on an
exchange or traded over-the-counter are called "private" REITs.
There are three typical types of private REITs:
REITs targeted to institutional investors that take large financial
positions;
REITs that are syndicated to investors as part of a package of services
offered by a financial consultant (some of these have more than 500
shareholders and must file statements with the Securities and Exchange
Commission just like publicly traded companies); and
"incubator" REITs that are funded by venture capitalists
with the expectation that the REIT will develop a sufficient track
record to launch a public offering in the future.
Funds from Operations
(FFO) are a supplemental measure of a REIT's operating performance.
FFO is different from corporate "earnings" as typically reported
in the financial press. The National Association of Real Estate Investment
Trusts, or NAREIT, defines FFO as net income (computed in accordance
with generally accepted accounting principles) excluding gains or losses
from sales of property or debt restructuring, and adding back depreciation
of real estate.
Historically, commercial
real estate maintains its residual value to a much greater extent than
certain other assets, such as machinery, computers or other personal
property. As a result, the current depreciation used for all of these
assets in normal earnings measures may actually exceed the real depreciation
of commercial real estate, which may in fact appreciate over time. Accordingly,
a REIT with physical assets consisting primarily of commercial real
estate may not require as much cash flow as other companies to maintain
and replace its physical assets. FFO recaptures that cash flow and presents
it as part of a REIT's annual performance.
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. Since rental rates
have historically tended to rise during periods of inflation, REIT dividends
have tended to be protected from the long-term corrosive effect of rising
prices. Because real estate depreciation is such a large non-cash expense
that likely exceeds any real decline in commercial real estate values,
the dividend rate divided by FFO is a more appropriate measure than
taxable income of the REIT's ability to pay dividends.
For REITs, dividend
distributions for tax purposes are allocated as 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.
A return of capital
distribution is that part of the dividend that exceeds the REIT's taxable
income. 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 tax rate, substantial capital distributions
may be especially attractive to investors in high tax brackets.
Adjusted Funds
From Operations (AFFO) - In part to cope with the limitations associated
with the calculation of FFO, many portfolio managers and analysts calculate
adjusted funds from operations, or AFFO. Some analysts, companies, and
portfolio managers prefer the terms cash available for distribution
(CAD), or funds available (FAD) to AFFO. More important than which acronym
you adopt is how you get from FFO to AFFO. Though there is some debate,
most industry veterans derive AFFO by adjusting FFO for the straightlining
of rents, as well as after establishing a reserve for costs which, though
necessary and routine, aren't costs that can be recovered from tenants.
This includes certain maintenance costs and leasing costs.
Adjusted Funds
From Operations (AFFO) Multiple - A company's AFFO yield and its
AFFO multiple are reciprocals of one another. So, both are valuation
measures. For a variety of reasons - including P/AFFO multiples are
roughly equivalent to P/E ratios - AFFO multiples are more often cited
as a valuation measure than AFFO yields. Some portfolio managers contend
that comparing AFFO multiples to growth rates is a useful valuation
screen. If a company's growth rate is equal to or exceeds its AFFO multiple,
the company isn't overpriced. Most portfolio managers modify this screen
by factoring into the equation an appropriate "discount rate."
Adjusted Funds
from Operations (AFFO) Payout Ratio - This is the single best measure
of a company's dividend paying ability. It is calculated by dividing
a company's per-share annual dividend by the current year's per share
AFFO estimate.
Adjusted Funds
from Operations (AFFO) Yield - In addition to being one measure
of valuation, AFFO yield is often used as a proxy for a company's nominal
cost of capital. It is calculated by dividing a company's per-share
AFFO estimate by its stock price. If a company with an AFFO yield of
6.5% buys a property at a going-in stabilized return of 7.5%, it has
acquired the property at a 100 basis point (or one percentage point)
positive spread to its nominal cost of capital.
Capitalization
Rate - A "cap rate" is determined by dividing the property's
net operating income by its purchase price.
Cost of Capital
- Variously defined as the weighted average of the cost of equity
and debt capital employed by a REIT. Unfortunately, an incorrect definition
of this term is often commonly used, which equates the cost of equity
capital to the REIT's current dividend yield or FFO yield. A company's
"true" cost of capital is the investor's expected rate of
return on his/her investment.
Dividend Reinvestment
Program (DRIP) - Most, though not all, REITs offer these.
DownREIT
- A side benefit of the UPREIT structure is that operating partnership
units can be used as currency to acquire properties from owners who
would like to defer taxes that would come due if the property(ies) were
sold or swapped for stock. In response to this advantage of the UPREIT
structure, a number of non-UPREITs have created so-called downREITs.
This makes it possible for them to buy properties using downREIT partnership
units. The effect is the same, however; the downREIT is subordinate
to the REIT itself, hence the name.
EBITDA -
Earnings before interest, taxes, depreciation, and amortization. Funds
From Operations (FFO) - Equal to a REIT's net income after the addback
of real estate depreciation and amortization (not including the amortization
of deferred financing costs). This is the measure of REIT operating
performance most commonly accepted and reported by REITs, conceptually
analogous to net income of non-real estate companies. The principal
reason for the addbacks is that real estate assets tend to appreciate,
making an income statement that includes GAAP historical cost depreciation
a misleading indicator of REIT profitability.
Implicit 12-Month
Total Return - This is calculated by adding the company's year-over-year
growth rate and its current stated annual dividend. This is a "guesstimate"
of total return potential that is widely used. Some industry veterans
criticize this guesstimate of total return because, among other things,
it fails to take into account potential changes in multiples. As long
as investors recognize its potential shortcomings, implicit 12-month
total returns can serve as a useful screening tool when assembling a
REIT portfolio.
Implied Cap
Rate - Net operating income (NOI) divided by a REIT's total market
capitalization (the sum of its equity market capitalization and its
total outstanding debt).
Interest Coverage
Ratio - Simplify referred to as the company's coverage ratio, it's
the ratio of EBITDA to interest expense. This practice is increasingly
viewed as the best means of comparing and assessing REITs' financial
leverage.
Multiple to
Growth Ratio - This measure is calculated by dividing a company's
price to FFO multiple by its FFO growth rate. Investors use this measure
to determine how much the market is willing to pay per unity of growth.
Companies with P/FFO multiples less than their growth rates are often
considered undervalued.
Net Asset Value
(NAV) - When evaluating public companies, investors generally focus
on price-to-book ratios as one valuation measure. Unfortunately, price-to-book
ratios are inappropriate for REITs insofar as a company's book value,
which is based on historic cost figures, may not accurately reflect
the earnings capacity of otherwise well-maintained assets. Also, the
balance sheet consolidations accompanying IPOs were often pursued using
different accounting conventions, resulting in an apples-to-oranges
comparison between companies. Thus, many analysts prefer to use net
asset value as a surrogate for book value, which is appropriate insofar
as book value is meant to represent an entity's liquidation value.
Positive Spread
Investing - Defined as when a REIT buys a property that has a higher
initial yield than the current yield on the REIT's capital. For example,
a REIT buys a property yielding 11% (property net operating income divided
by the all-in cost of the property) at a time that its debt is borrowed
at 8% interest and its equity is trading at an FFO yield (inverse of
its FFO multiple) of 10%. If the REIT is funded half with equity and
half with debt, it realizes a 200 basis point (11% minus 9%) positive
spread.
Real Estate
Investment Trust (REIT) - A real estate investment trust is a private
or public corporation (or trust) that enjoys a special status under
the U.S. tax code that allows it to pay no corporate income tax so long
as its activities meet statutory tests that restrict its business to
certain commercial real estate activities. Most states honor this federal
treatment and do not require REITs to pay state income tax. By law,
REITs must pay out 95% of their taxable income.
Return of Capital
- The portion of a REIT's dividend in excess of taxable income. Because
REIT dividends are often higher than taxable income, principally due
to depreciation, the amount by which the dividend exceeds taxable income
is a return of capital to a shareholder, meaning that - for a taxpaying
shareholder - it does not create currently taxable ordinary income,
but instead reduces the shareholder's tax basis. At the final sale of
the shares, the difference between tax basis and final net sales price
is recognizable as a capital gain. To the extent the final capital gains
rate is lower than interim ordinary income tax rates, REITs provide
a tax shelter function for certain taxpaying investors, by allowing
the deferral of tax on current cash received as dividends and taxing
it at a lower rate upon disposition of the shares.
Straightlining
- REITs straightline rents because generally accepted accounting principles,
or GAAP, require it. Typically, a tenant's monthly rent will increase
over the life of a lease; this applies to commercial properties, not
usually residential properties. Straightlining averages the tenant's
rent payments over the Lease's life. In other words, rental revenues
are overestimated in the early years and underestimated in the later
years.
Total Debt and
Total Market Capitalization - Together, these measures have been
used to provide an assessment of leverage. Debt-to-Total Market Cap
was the most often cited measure of leverage early on in the current
REIT underwriting cycle (circa 1993). There are a number of problems
associated with using it for that purpose, however. Chief among those
is that it doesn't provide meaningful information regarding a company's
ability to service its debt.
Umbrella Partnership
REIT (UPREIT)
- A REIT structure in which the REIT does not own a direct interest
in properties, but rather in an umbrella partnership that owns interests
in properties. For this reason, this umbrella partnership is generally
referred to as the operating partnership. It is also common for an operating
partnership in an UPREIT structure to own interests in joint ventures
in addition to properties. The UPREIT has been the structure of choice
in most REIT initial public offerings over the past several years, owing
to the tax deferral benefits this structure offers to the company's
principals.
In summary, the
UPREIT structure allows the principals, who are transferring their properties
from private ownership to public ownership via an IPO, to maintain their
historical cost basis by transferring the properties to the operating
partnership rather than directly to the REIT.
The REIT, in turn,
is the general partner of, and owns a majority interest in, the operating
partnership. If the properties were transferred directly to the REIT,
it would result in a stepped-up cost basis in the properties for the
new public entity and trigger a taxable event for the transferring principals.
By transferring the properties to the operating partnership in exchange
for operating partnership (OP) units, the principal's historical cost
basis is maintained.
The 0P units are
exchangeable on a one-for-one basis into REIT common shares and, over
time, the principals can convert OP units to REIT common shares (triggering
a taxable event), giving the principals the option to incur their tax
liability in smaller increments.
By getting to know
your company thoroughly, Legal & Compliance, LLC can prepare all
the essential documents required for a variety of private equity transactions
including REIT's. Over the years the firm has also developed an extensive
network of key professionals in the securities industry. These accomplished
investment bankers and consultants can provide access to investors as
well as perform feasibility studies to discern how well a REIT may be
received by the investment public. In other cases our consultants will
offer advice pertaining to the creation of business plans as well as
compensation packages in order to maximize the effectiveness of the
REIT without "giving away the house" in the process.
