REAL ESTATE INVESTMENT TRUSTS (REITs) were created by Congress in 1960. For more than three decades, they played a very limited role in real estate investment. Since 1992, however, the REIT marketplace has grown dramatically. Why is this happening, and what does it mean?
WHAT IS A REIT?
Simply stated, a REIT is a company dedicated to owning and, in most cases, operating income-producing real estate, such as apartments, shopping centers, offices and warehouses. Some REITs also are engaged in financing real estate. Most importantly, to be a REIT a company is legally required to pay virtually all of its taxable income (90 percent) to its shareholders every year.
In short, a REIT may deduct the dividends paid to the shareholders from its corporate tax bill so long as —
the company’s assets are primarily composed of real estate held for the long term,
the company’s income is mainly derived from real estate, and
the company pays out at least 90 percent of its taxable income to shareholders.
The main benefit of being a REIT: one level of taxation.
The main limitation of being a REIT: a restriction on earnings retained by the company.
For a REIT to grow, capital must come from money raised in the investment marketplace as well as money generated internally. REITs, like other stocks, are carefully monitored by others, including the SEC, each REIT’s independent directors, and independent auditors.
WHY DID CONGRESS CREATE REITs?
Congress created REITs in 1960 to enable small investors to make investments in large-scale, income-producing real estate. Congress decided that the only way for the average investor to access investments in significant commercial properties was through pooling arrangements. As a result, Congress designed REITs to unite the capital of many into a single economic enterprise. That enterprise is geared to the production of income through commercial real estate ownership and finance. REITs played a limited role in real estate investment for more than 30 years. In the beginning, REITs were constrained because they were permitted only to own real estate, not operate or manage it. This meant that REITs needed to find third parties, whose economic interests might diverge from those of the REITs’ owners, to operate and manage the properties. The investment marketplace did not readily accept this arrangement.
During these years, provisions of the tax code also distorted the real estate marketplace by making real estate investment tax shelter-oriented. By using high debt levels and aggressive depreciation schedules, a taxpayer could take interest and depreciation deductions that significantly reduced his or her taxable income. In many cases these deductions led to so-called “paper losses” that were used to shelter a taxpayer’s other income.
By contrast, Congress designed REITs specifically to create taxable income on a regular basis, and did not permit REITs to pass losses through to shareholders. Therefore, for many years the REIT industry could not compete effectively for capital against tax shelters.