By Diana Hill, Online Trading Academy Real Estate Investor Instructor
Recently, I had a request from a student that I address REITs in an upcoming article. I appreciate the opportunity to hear from you and hear about the areas of real estate that interest you and that you would like to learn more about.
So what are REITs? How do they work? Is this a good time to invest in them?
REIT stands for Real Estate Investment Trust. A REIT is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income tax. Congress created REITs back in 1960 as a way to give all investors an opportunity to invest in large-scale, income-producing commercial real estate. Before the REIT, these investments were typically limited to only institutions and very wealthy individuals.
An Equity REIT is a company that owns and operates commercial income-producing real estate. The Tax Reform Act of 1986 substantially altered the real estate investment landscape by permitting REITs not only to own, but also to operate and manage most types of income-producing commercial properties. It also stopped real estate "tax shelters" that had attracted capital from investors based on the amount of losses that could be created.
A REIT can also be a company that engages in the financing of commercial and residential real estate. This kind of REIT is classified as a Mortgage REIT. Mortgage REITs dominated the market in the early years but the pendulum has swung toward Equity REITs. Currently, 83% of the 134 publicly traded U.S. REITs are Equity REITs.
REITs can either be publicly or privately held and are also available as an index fund. But more about that later.
In order for a company to qualify as a REIT, it must comply with specific rules as designated by the Internal Revenue Code (IRC). These include: 75% of total assets must be invested in real estate, 75% of gross income must come from either rents of real property or interest paid on mortgages of real property, and 90% of its taxable income must be distributed annually to shareholders in the form of dividends.
Most REITs historically remit 100% of their taxable income to their shareholders and therefore, owe no corporate tax. Shareholders pay tax on the dividends received and any capital gains. A REIT, however, is prohibited from passing any losses through to its investors.
Even though REIT's are required to pay out 90% of their income to shareholders, these companies were allowed to distribute part of their dividends in stock instead of cash in order to conserve capital in the financial crisis of 2009. The government has recently announced that they will allow REIT's to do the same thing in 2010. This has infuriated many investors who count on the cash dividends.
Here are some of the key statistics to look at when analyzing the value of a REIT.
Net Assessed Value (NAV): The net "market value" of all a company's assets including, but not limited to its properties, after subtracting all its liabilities and obligations.
Adjusted Funds From Operations (AFFO): This term refers to a computation made by analysts and investors to measure a real estate company's cash flow generated by operations.
Cash After Debt Service (CADS): Cash (or Funds) available for distribution is a measure of a REITs ability to generate cash and to distribute dividends to its shareholders. Note: If you have taken the Professional Real Estate Investor course at Online Trading Academy, you know that we work with the CADS formula and the importance I have placed on it.
Most financial advisers suggest you should have a good 5% of your portfolio in Real Estate Securities at this time. That's because REIT prices often move in a different direction than stocks. Plus, their hefty dividends – REITs pay out nearly all of their rental income to shareholders – can provide a much-needed cushion in a roller-coaster market. The average yield on Equity REITs recently is 3.9%, but during 1990-2002, the yield averaged 7.4%.
Next week, in the second part of my series on REITs, we'll look at the current REIT market and evaluate where the market is today, and how best to time the market for your goals.
Once again, I really appreciate your suggestions and questions. Keep them coming.
Great Fortune!
- Diana Hill
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