We learn a business can be classified in one of three ways depending on its ownership: as a sole proprietorship, a partnership or a corporation.  For the purpose of this article, we will not consider the LLC’s and LLP organizations covered by the IRS “check the box” rule. There is another unique business form used in the real estate industry called the real estate investment trust (“REIT”).  REITs became part of the business landscape in 1960 when they were authorized by Congress.  The real estate markets were booming, and it was Congress’ intention to allow everyone to benefit from  ownership of income-producing  real property assets through this new investment vehicle.

REITs operate in a manner comparable to mutual funds.  They own a portfolio of real estate properties.  Investors buy shares of a REIT, taking advantage of the diversification of the portfolio.  Instead of owning one property, the investors now own a piece of many different properties.  This diversification reduces the riskiness of their investment.

There are two major types of REITs, the equity REIT and the mortgage REIT.   An equity REIT purchases and  owns a wide variety of real property.  Equity REITs depend mainly on rental income for its cash flow.  A mortgage REIT  invests in mortgages collateralized by real estate. Mortgage REITs depend on interest income from their mortgage investments to sustain  operations. REITs can also be classified by the type of properties they specialize  in.  Common REIT classifications are retail REITs; residential REITs; office REITs; and healthcare REITs

How are REITs formed?  Usually, a professional management group  drafts an operating agreement for the REIT and then identifies properties for acquisition.  Funds to buy the identified assets will be raising by  selling  trust shares to the public. The REIT is then managed by the management company under the supervision of a board of directors or trustees.

The public has generally reacted well to the sale of REIT shares for several reasons.  The real estate market has tended to appreciate over time, providing  the possibility of gains on the eventual sale of the properties.  An appreciating real estate market  also means reduced risk for  investors.   REIT shares are classified as dividend paying stocks, meaning there is current income for the investor.  Therefore, investors seeking current income with lower risk  from their portfolio are typical REIT owners.  Finally,  many REIT shares are publicly traded, providing  increased liquidity to the investment.  It is much easier to sell shares of a publicly traded REIT than to sell individual real estate properties, which may be highly illiquid.

A major advantage of investing in real estate through a  REIT is there is NO federal taxable income if all income of the REIT is distributed.    The REIT can therefore avoid the double taxation required of  other publicly traded entities.

What are the major requirements for being a REIT?

  1. There must be a minimum of one hundred (100) shareholders.
  2. No more than 50% of the outstanding shares can be owned by 5 or fewer individuals or entities.  Once can clearly see Congress’ intention  REIT ownership be widely distributed, opening the benefits of real estate ownership to everyone.
  3. 75% of income must be from real estate related assets.
  4. 75% of assets must be real estate related assets, cash or U.S. Treasury securities.
  5. 90% of taxable  income must be distributed to the owners as a dividend.
  6. REITs must own the real estate assets as long-term investments.  In other words, Congress does not want REITs to be a trading entity.  This requirement prevents REITS from buying real estate assets only to flip them for a short-term gain.
  7. 95% of the income of the REIT must be passive income. In other words,  a REIT can’t operate a business from one of the real estate properties it owns.

REITs have been part of the real estate world for sixty years now.  They will not be going away soon.  Knowing about this form of real estate investment is important for all financial professionals.