what is a REIT?

real estate stocks

Many global stock markets contain vibrant real estate sectors.  Real estate investment companies, specializing  in holding either residential, or commercial or office real estate, are the most common.  But a number of markets also feature real estate development firms as important index constituents.  And, of course, hotel companies are almost ubiquitous.

Except for hotels, this hasn’t been the case in the US.

REITs

Real Estate Investment Trusts are a US concept, enabled by the Real Estate Investment Trust Act of 1960.  Since then, they’ve become the most common form of stock market ownership of apartment houses, malls and office buildings.

The REIT Act permits the creation of highly specialized corporations, analogous to mutual funds, that hold real estate.  In general terms, REITs must accept restrictions on the types of activity they can engage in and the requirement that they distribute to shareholders virtually all the profits they generate.  In return, REITs avoid having to pay tax at the corporate level on their earnings.  This means distributable income can be over 50% higher than a regular corporation would have!!

Specifically, to qualify as a REIT, a company must:

–hold at least 75% of its assets in real estate

–generate at least 75% of its income from real estate

–distribute to shareholders virtually all of that income

–maintain a diversified portfolio of assets, in much the same way that mutual funds are required to do

–keep an open share register, in that no one entity can own over 50% of the outstanding shares.

updates to the law

There are two:

The Tax Reform Act of 1986 allows REITs to provide their own property management and leasing services, rather than having to hire third parties to do this for them.

The REIT Modernization Act of 1999 allows REITs to have their own taxable subsidiaries to provide maintenance and other services to the properties they own.

The effect of these two modifications is to make REITs much more like publicly traded real estate investment companies available in Asian or European markets.  But REITs still retain the important advantage that they’re not subject to corporate tax.

appeal widening

The attractiveness of REITs in the US stock market has increased significantly in recent years.  Three main factors:

1.  investor preferences are changing

The aging of the Baby Boom means that this important segment of the investing population is increasingly interested in income generating investments.  REITs are a natural area of interest.

2.  mature companies are turning themselves into REITs

This is partly a response to the growing receptivity of investors to income vehicles.

Part is an intelligent response by corporate managements to the increasing maturity of their businesses.  The more common tack has been for aging companies to plow their cash flow back into new capacity or into acquisitions (both of which invariably generate only losses) in a foolish attempt to regenerate lost youth.  This may make the CEO feel good, but it almost always destroys shareholder value.

Part is also an increasing liberal interpretation by Washington of what constitutes real estate.

examples of “unconventional” REITs

Forest products company Weyerhaeuser and cell tower owner American Tower have already converted themselves into REITs.  Iron Mountain, which stores/disposes of corporate documents is in the process of following suit.

It seems to me the appeal of REIT conversion can only increase, especially since the companies doing so are receiving a strong positive reaction in their stock prices.