C H A P T E R Today’s REITs S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 42 I N V E S T I N G I N R E I T S N ow that you have a general sense of what REITs are and how they compare to other investments, let’s take a closer look at the structure of REITs and how they’ve adapted to changing conditions over the years. T H E F I R S T R E I T The REIT was defined and authorized by the U.S. Congress, in the Real Estate Investment Trust Act of 1960, and the first REIT was actually formed in 1963. The legislation was meant to provide indi - vidual investors with the opportunity to participate in the benefits, already available to large institutional investors, of owning and/or financing a diversified portfolio of commercial real estate. The avoidance of “double taxation” is one of the key advan- tages to the REIT structure. A key hallmark of the REIT structure is that the REIT can deduct from its taxable income all dividends paid to its shareholders—thus the REIT pays no corporate taxes if it distributes to shareholders all otherwise taxable income. By law, however, it must pay out at least 90 percent of its net income to its shareholders. The shareholders, of course, must pay income taxes on the dividends, unless the REIT shares are held in an IRA, 401(k), or other tax-deferred account. Often, however, a portion of a REIT’s dividend is not immediately taxable, as we’ll see later. T H E T A X R E F O R M A C T O F 1 9 8 6 The tax reform act of 1986 was a significant milestone in the REIT industry, as it relaxed some of the restrictions historically limiting REIT activities. Originally, management was legally obliged to hire outside companies to provide property leasing and management services, but a REIT is now allowed to perform these essential ser - vices within its own organization. This change was highly significant because imaginative and efficient leasing and property manage - ment are key elements in being a successful and profitable property owner. Most of today’s REITs are fully integrated operating companies that can handle all aspects of real estate operations internally: 43 T O D A Y ’ S R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 ◆ Acquisitions and sales of properties ◆ Property management and leasing ◆ Property rehabilitation and repositioning ◆ Property development U P R E I T A N D D O W N R E I T In studying different REITs, you might come across the terms “UPREIT” and “DownREIT.” These are terms used to describe dif - ferences in the corporate structure of REITs. The UPREIT concept was first implemented in 1992 by creative investment bankers. Its purpose was to enable long-established real estate operating com - panies to bring properties they already own under the umbrella of a REIT structure, without actually having to sell the properties to the REIT, since by such a sale the existing owners would incur sig - nificant capital gains taxes. UPREIT just means “Umbrella Partnership REIT.” Generally, it works like this: The REIT itself might not own any properties direct - ly; what it does own is a controlling interest in a limited partner - ship that, in turn, owns the real estate. The other limited partners often include management and private investors who had indirectly owned the organization’s properties prior to its having become a REIT. The owners of the limited-partnership units have the right U N I Q U E L E G A L C H A R A C T E R I S T I C S O F A R E I T 1 The REIT must distribute at least 90 percent of its annual taxable income, excluding capital gains, as dividends to its shareholders. 2 The REIT must have at least 75 percent of its assets invested in real estate, mortgage loans, shares in other REITs, cash, or government securities. 3 The REIT must derive at least 75 percent of its gross income from rents, mortgage interest, or gains from the sale of real property. And at least 95 percent must come from these sources, together with dividends, interest, and gains from securities sales. 4 The REIT must have at least 100 shareholders and must have less than 50 percent of the outstanding shares concentrated in the hands of five or fewer shareholders. 44 I N V E S T I N G I N R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 to convert them into shares of the REIT, to vote as if they were REIT shareholders, and to receive the same dividends as if they held publicly traded REIT shares. In short, they enjoy virtually the same attributes of ownership as the REIT shareholders. DownREITs are structured similarly but are usually formed after the REIT becomes a public company, and generally do not include members of management among the limited partners in the con - trolled partnership. REITs structured as UPREITs or DownREITs can exchange operat - ing partnership (OP) units for interests in other real estate partner - ships that own properties the REIT wants to acquire. Such an exchange can defer capital gains taxes for the seller. By receiving OP units in a “like-kind” exchange, the sellers can then not only defer the payment of taxes but also gain the advantage of having a more diversified form of investment, that is, an indirect interest in many properties. This gives the UPREIT or DownREIT a competitive edge over a regular REIT when it comes to making a deal with tax-sensitive property sellers. Home Properties, among others, has made very effective use of this tool. Originally conceived as a tax-deferral device, the UPREIT struc- ture has also become an attractive acquisition tool for the REIT. One negative aspect of the UPREIT structure, however, is that it creates an opportunity for conflicts of interest. Management often owns units in the UPREIT’s partnership rather than, or in addition to, shares in the REIT, and their OP units will usually have a low cost basis. Since the sale of a property could trigger taxable income to the holders of the UPREIT’s units but not to the shareholders of the REIT, management might be reluctant to sell a property, or even the REIT itself—even if, for instance, the property is a disappointment or the third-party offer is a gener - ous one. Investors should watch how management handles the conflict issues. There is less concern, of course, in a DownREIT structure where management owns no OP units. UPREITs and DownREITs simply allow existing property owners to “REITize” their existing property without incurring immediate capital gains taxes. 45 T O D A Y ’ S R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 R E I T M O D E R N I Z A T I O N A C T In December 1999, President C linton signed into law the REIT Modernization Act (RMA). The most important feature of this new legislation enables every REIT organization to form and own a “taxable REIT subsidiary” (TRS). The legislation enables a REIT, through ownership of up to 100 percent of a TRS, to provide sub - stantial services to its tenants, as well as others, without jeopardizing the REIT’s legal standing; this had been a major issue in the past. The new law also greatly expands the nature and extent of services that a REIT may offer or engage in, which may now include such activities as concierge services to apartment tenants, “merchant” development, offering discount buying of supplies and services to office tenants, and engaging in a variety of real estate–related busi - nesses; the TRS may also engage in joint ventures with other parties to provide additional services. Furthermore, even noncustomary services may now be offered by a REIT without having to use a third- party independent contractor. However, certain limitations do apply. For example, the TRS cannot exceed certain size limitations (no more than 20 percent of a REIT’s gross assets may consist of securities of a TRS). Loan U P R E I T C O R P O R A T E A N D P R O P E R T Y S T R U C T U R E Typical Corporate and Property Structure of an UPREIT REITs 03.2 b/w “ch3 upreit” Public Stockholders Limited Partnership Property 2 Property 3Property 1 UPREIT Controlling Interest Private Investors Management 46 I N V E S T I N G I N R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 and rental transactions between a REIT and its TRS are limited, and a substantial excise tax is imposed on transactions not conduct - ed on an arm’s-length basis. Furthermore, while restrictions upon hotel and health care REITs have been relaxed, such REITs may not operate or manage hotels or health care facilities (but a hotel TRS may lease lodging facilities from its related REIT if operated independently). The National Association of Real Estate Investment Trusts (NAREIT) has suggested several potential benefits to REIT organi - zations arising from the RMA. These include the ability to provide new services to tenants (thus remaining competitive with non-REIT property owners), better quality control over the services offered (which may now be delivered directly by the REIT’s controlled subsidiary), and the prospects of earning substantial nonrental revenues for the REIT and its shareholders. However, there is still substantial disagreement over the extent to which the RMA (and the TRS) will generate significant additional revenues for the REIT and its shareholders, and whether the added risks will offset the extra rewards. Milton Cooper, the widely respected founding CEO of Kimco Realty, has referred to the RMA as “The REIT Liberation Act,” while industry leader Sam Zell has stated that the opportunities provided by the TRS could eventually produce up to 50 percent of total rev - enues for his REITs in future years (though this presumably includes higher rent levels resulting from additional services provided to tenants under the RMA). On the other hand, such well-known and highly successful REIT executives as Boston Properties’ Ed Linde and Vornado Realty’s Steve Roth have been much less sanguine about the significance of future revenue contributions via the TRS. The bottom line for REIT investors is that it’s too soon to know whether the TRS vehicle will lead to major benefits for REIT share - holders in the years ahead. Many early TRS ventures, particularly with respect to technology and Internet investments, have been failures. However, more recently a significant number of REITs have successfully implemented TRS strategies that will generate substantial additional revenue and allow these companies to com - pete very favorably with their peers. Some, of course, will be more successful than others. The net result of the RMA is that it is clearly 47 T O D A Y ’ S R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 a very positive development for the REIT industry, but the extent of its importance will not be known for a number of years. T H E I N F A M O U S L I M I T E D P A R T N E R S H I P S O F Y E S T E R Y E A R We cannot talk about the REIT structure without also discussing real estate limited partnerships. The real estate limited partnerships so popular in the 1980s were designed for the purpose of buying and owning commercial properties and generating positive cash flows for their limited partner investors; however, in many cases, the properties did not live up to expectations. What investors really bought was the tax shelter these properties offered, along with the hope of capital appreciation. In a rapidly rising real estate market, simply holding the property for six months or a year, even if it was operating at a loss, would mean that investors could enjoy a nice capital gain. When, however, the tax laws were changed in 1986, followed by a cooling off in the real estate markets, the arrange - ment no longer worked. Investors were unwilling to continue suf - fering losses for any length of time when upside was limited and the loss was no longer a good tax shelter. Excessive debt made the problems worse, and there was an epidemic of bankruptcies. Today’s REITs are an entirely different animal from the notori- ous real estate limited partnerships of the late 1980s. Let’s compare the two different real estate investment vehicles point by point: Limited partnerships were marketed mostly as tax shelters, rather than investments that generated substantial cash flow. When investors were buying a tax shelter, many of the partnerships, even though operationally unprofitable, made sense. But once the properties were rendered useless as a tax shelter, the bottom line suddenly became significant. As a tax shelter, the partnership investment could afford high management fees and high interest payments but not when the tax shelter benefits vanished. Today’s REITs are not tax shelters. What they focus on is strong total returns, consisting of both current income and capi - tal appreciation. The REIT’s success is measured by its ability 48 I N V E S T I N G I N R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 to increase its free cash flow and its dividend payments to its shareholders. The limited partnership had a built-in recipe for trouble: the man - agement’s fee system. Usually, outside advisers were hired and paid on the basis of the volume of the properties owned. This gave them a strong incentive to add properties that would generate increased fees, but these properties were not always well-located or did not offer rent growth poten - tial, and excessive prices were often paid for them. Often only caretaker managers were hired who had no incentives to manage the properties efficiently. Today’s REITs are allowed to manage their properties internally, and the management of well-regarded REITs is comprised of expe - rienced executives who generally have a significant stake in the company, which often comprises most of their net worth. With the limited-partnership structure, the only chance for growth was through increasing rental revenues and thereby increasing the prop - erties’ values, since property prices are generally determined on the basis of multiples of revenues or operating income. However, for tax-shelter investors, operating cash flow growth was not the primary goal. Today’s well-run REIT is a dynamic business. It achieves growth by increasing the operating income on the properties it owns and by raising capital for acquisitions and new property development. Good REIT managements are frequently able to raise such capital and find attractive opportunities. Limited partnerships were not liquid investments. Since most of the lim- ited partnerships were creatures of syndicators, the partnership interests could not be easily traded in public markets. If you wanted out of the investment, you were out of luck. Narrow trading markets eventually were created, but the bid/ask spreads were large enough to make a pawnbroker blush. Today’s REIT shares, on the other hand, can be bought or sold quickly, several thousand shares at a time, in organized markets such as the New York Stock Exchange. Limited partnerships were promoted by brokers as having high yields, and many did pay 9 or 10 percent with, they claimed, “appreciation 49 T O D A Y ’ S R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 potential.” This rate sounds good now, but remember, in 1989, the prime rate was as high as 11.5 percent. A 10 percent yield wasn’t extraordinary in that interest-rate climate, and, as far as the potential for income growth went, it was quite often only that—potential. Today’s REITs offer very good yields in today’s lower-interest- rate climate, and, what is more, they deliver on dividend growth rates, many of them growing in the vicinity of 3–4 percent or more a year. Limited partnerships, when it came to capital appreciation, presented two very different pictures. Those who came early to the party, when real estate inflation was still spiraling upward, enjoyed reasonably good capi - tal appreciation, but the late arrivals were lucky to get out with their shirts on their backs. Most of today’s REITs have been able to generate steadily increas - ing cash flows, which, coupled with their high dividends, provide double-digit total return potential, yet in a low-risk investment. reits and the traditional real estate limited partnerships have almost nothing in common except the nature of their underlying assets, but, until the last few years, REITs have suffered from an undeserved guilt by association. L E N D I N G R E I T S V E R S U S O W N E R S H I P R E I T S We discussed earlier what the statutory requirements were for a REIT. According to those requirements, there is nothing in the legislation requiring a REIT to own real properties. It is within the boundaries of the legal definition for the REIT merely to lend funds on the strength of the collateral value of real estate by originating, acquiring, and holding real estate mortgages and related loans. These mortgages might be secured by residential or commercial properties. As of the end of 2004, there were thirty-three mortgage REITs. Hybrid REITs both own properties and hold mortgages on properties. They were popular some years ago, but, except for certain health care REITs, are not widely prevalent in today’s REIT industry. In the late 1960s and early 1970s, lending REITs were the most popular type of REIT, as many large regional and “money-center” [...]... pronounced during periods of low mortgage rates “Condomania” hurt apartment owners from 62 I N V E S T I N G I N R E I T S 20 03 through 20 05, but rental growth had again commenced by early 20 05 Apartment REIT investors need to be mindful of certain risks Even if the national economy is doing fine, the regional or local economy can drop into a recession, or worse, causing occupancy rates to decline and rents... mall REITs) over the last several years, but these opportunities appear to be waning as REITs become the dominant owners of this property type So, must REITs rely primarily upon internal growth, that is, revenue improvements within each mall through increases in tenants’ rents, increasing occupancy rates, and “specialty retailing” via kiosks at the malls, in order to create substantial increases in cash... own REITs Almost sixty new REITs were formed back then, all lending funds to property developers at high interest rates However, in 1973, interest rates rose substantially, new developments couldn’t be sold or leased, nonperforming loans spiraled way out of control, and most of these REITs crashed and burned, leaving investors holding the bag A decade later, a number of REITs sprang up to invest in. .. allows today’s REITs to form taxable subsidiar- SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS TRACK 50 ies that enable them to engage in various real estate–related businesses ◆ The vast majority of today’s REITs are in the business of owning, managing, and even developing real property rather than making real estate loans ◆ Mortgage REITs can, at times, provide good returns to the careful investor, but must... factor for apartment owners is the rate of construction of new units in the local area Such competing properties, if built when demand for apartment space is slowing, can force the owners of existing units to reduce rents or to offer concessions, and often result in lower occupancy rates Inflation also determines an apartment owner’s economic fortunes, since inflation can cause higher operating expenses... refer to REITs that own real estate in one sector or another EXPANSION OF REIT PROPERTY SECTOR OFFERINGS In Chapter 1, we briefly mentioned some of the different sectors in which today’s REITs own properties This, too, is a story that has evolved over time In the beginning and until 1993, REITs owned SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS TRACK 50 50 T O D A Y ’ S R E I T S 51 properties in a limited... reduce demand for single-family housing Apartment owners in most areas should be able to get, over time, average annual rent increases of 2 3 percent, while expenses generally rise with inflation If management is capable, apartment ownership and operation will continue to be a good, steady business RETAIL SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS TRACK 50 The various retail-sector REITs behave somewhat... children moving in with parents or leaving for greener pastures elsewhere As the number of households declined, apartment vacancy rates rose and office and industrial space went begging Conversely, when the Olympic Committee decided to hold the summer games in Atlanta, or when Michelin Tires decided to build a plant in Greenville, South Carolina, the entire local economy SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS... be over-emphasized SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS TRACK 50 The 1993–94 REIT-IPO boom changed the REIT industry forever Today’s investor has a choice of many well-managed REITs in many different sectors Each property sector, which we’ll discuss in the next chapter, has its own set of investment characteristics, including its individual economic cycles and particular risk factors, competition threats,... sensitive to interest rates than equity REITs, and a general increase in interest rates (or even a significant change in the spread between short-term and long-term interest rates) can impact earnings substantially Finally, as they do not own real estate whose values can be estimated, the shares of mortgage REITs can be very difficult to value Thus, mortgage REITs are best viewed as trading vehicles, . limited partners in the con - trolled partnership. REITs structured as UPREITs or DownREITs can exchange operat - ing partnership (OP) units for interests in. controlling interest in a limited partner - ship that, in turn, owns the real estate. The other limited partners often include management and private investors