REITS are a creation of the United States tax code.
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They have some unique features that make them attractive investment vehicles. They also have some fairly onerous operating requirements which, if unfulfilled, could lead to a venture losing its REIT status. This article is a quick summary of REITs. A great resource for learning more is Bruggeman and Fisher's text Real Estate Finance and Investments, 13th Edition. The summary here draws heavily from Bruggeman and Fisher's chapter on REITs, and focuses on Equity REITs.
What is a REIT?
A REIT is a Real Estate Investment Trust; a legal creation that serves as a pass-through vehicle for investors, similar to an LLC. As a legal entity, REITS are not taxed as a corporation. Rather, a REIT simply passes through its earnings to the owners who are then taxed at an individual level. This tax benefit is significant, and led to rampant growth in REITs in the US from the 80s through 2007.
Characteristics of a REIT
• Asset Requirements
- 75% of the REIT's value must be held in real estate assets
- Not more than 5% of the value of the assets may consist of the securities of any one issuer if the securities are not includable under the 75% test above
• Income Requirements
- At least 95% of the REIT's gross income must come from dividends, interest, rent, or gain on asset sales
- 75% of the REIT's gross income has to come from rents, interest on secured mortgages, gain on sale, or investment in other REITs
• Distribution Requirements
- Distributions to REIT shareholders have to meet or exceed 90% of REIT taxable income
Advantages and Disadvantages
One of the main advantages of forming your venture as a REIT comes from the investment structure. If you are looking to attract capital from a wide variety of investors and investment sources, then a REIT provides a great structure for doing that. In addition, the fact that income tax is not paid at a corporate level is great as well.
There are two big disadvantages in using a REIT structure: capital management and accounting requirements including calculating funds from operations (FFO).
The capital management issue is clear from the structure of REITs. If 90% of your income has to be paid out as dividends, then you are unable to reinvest heavily in your operation. This can limit your ability to grow quickly and take advantage of hot markets. As a private LLC you are free to reinvest as heavily as you want. Perhaps this is a reason to move towards becoming a REIT as your organization and portfolio of properties matures.
The other issue with becoming a REIT deals with the accounting complexity. Most developers and smaller property owners will create an LLC for each property they own. Each property has its own balance sheet and income statement. It is easy to follow, and quick to see which properties are performing well.
REITS are complicated as all the assets and cash flows come together. In addition, Net Income is not enough information for REIT investors. You also have to provide a funds from operations (FFO) calculation that accounts for any property sales to help explain what is continuing cash flow from operations and what was just a one-time sale.
Taking these points into account, think about what you want your new company to become. If you plan on attracting investment from outside sources, a REIT structure can be efficient and convenient. On the other hand, if you wish to develop and own properties on a piece-by-piece basis, perhaps sticking with the LLC format is more efficient.