Thursday, June 08, 2006
REIT: Real Estate For The Elite
With interest rates on the rise and real estate prices in strategic retreat, syndicates and trusts are going private once again, and managers are out in droves looking for deals.
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While real estate syndicates are formed for a variety of reasons, the typical reason is to create a tax shelter. More specifically, the purpose of a Real Estate Investment Trusts or REIT is to reduce or eliminate corporate income taxes. In the United States, where they are generally more widespread as investment vehicles, REIT pay little or no federal income tax but are subject to a number of special requirements set forth in the Internal Revenue Code, one of which is the requirement to distribute annually at least 90 percent of their taxable income in the form of dividends to shareholders.
The first REIT was introduced in the United States in 1960. The vehicle was designed to facilitate investments in large-scale income-producing real estate by smaller investors. The US model was simple, enabling small investors to acquire equity interests in vehicles holding large-scale commercial property. In order to ensure that REIT are widely held, they must have at least one hundred shareholders, no five or fewer individual shareholders can own more than 50 percent of the equity value of the REIT’s shares, and the REIT must be managed by one or more trustees or directors. At least 75 percent of the gross income of the vehicle must come from real estate related sources, and at least 95 percent of the REIT’s gross income must come from real estate related and other passive income sources.
To maintain competitiveness, many REIT have distributed in recent times among investors all or even more than their annualized earnings, often resulting in dividend yields comparable to bond yields. This is not, however, a practice that can be sustained for long even during times of appreciation of real capital assets and market values, much less when values are dropping. In fact, if an investment company such as a REIT distributes more than its taxable income, the excess distribution is considered "return of capital" for tax purposes, which is taxed to the individual investors as a capital transaction, rather than regular income. The end result is, therefore, that the distribution requirement may hamper a REIT's ability to retain earnings and generate growth.
Because of this, the shift to privatization is driven by the realization that private buyers will pay more for the company than stock market investors will. In addition, rising costs of being publicly-traded companies are another factor enticing REIT to pull out of the stock market. And finally, being private gives Real Estate Investment Trusts a freer hand to reach out for deals in an increasingly competitive market. The reason is that public companies find it very difficult to grow through acquisition, as investors invariably do not justify the risk of development alternatives. The combined power of reduced expenses, consolidated pools of capital and abating real property values are exactly the perfect recipe for making a kill in real estate – and they are doing it!
The inverse relationship between interest rates and prices of REIT’s shares plays a role as well. On average, it is safe to assume that interest rate increases are likely to be met by REIT’s price declines in the Stock Exchange, because increasing rates correspond to a slowdown in the economic growth and less demand. But out of the context of the frantic buy and sell of Wall Street, even slowdown in the market for single-family houses can actually benefit REIT. This is so, because even though real property prices are in decline, it is still cheaper to rent than to own, especially during a period of rising interest rates. And REIT thrive on rentals. No city is a better environment for REIT to operate in than New York City, where some 70 percent of residents rent.
Bottom line is that the privatization trend has taken off this year, and that it is likely to continue for the next foreseeable future. For a list of the Top 100 US REIT, visit http://www.forbes.com/2006/02/15/real-estate-REITS-cz_sf_0215reits.html?partner=msn
Luigi Frascati
Real Estate Chronicle
