UNDERSTANDING REITs

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The History of REITs

Congress created REITs in 1960 to enable small investors to make investments in large-scale, income-producing real estate (Equity REITs) and to participate in the financing of real estate (Mortgage REITs). For years, commercial real estate was almost entirely owned by private investors, including partnerships, pension funds and wealthy individuals. In addition, most properties were financed primarily with debt, which traditionally came from pension funds, insurance companies, commercial banks and savings and loan institutions. Congress decided that the only way for the average investor to access investments in significant commercial properties was through pooling arrangements. As a result, they 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 or through the financing of real estate properties.

What can REITs do?

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 (like United Mortgage Trust) 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 

Benefits to Shareholders

Property and loans are more liquid REITs have helped turn real estate liquid. Through the public REIT marketplace, investors can buy and sell interests in diversified portfolios of properties or mortgages- as well as the management associated with them – on an instantaneous basis. Illiquidity, the bane of real estate investors is gone.

Lower Risk Assets

Because real property and mortgage loans generally have a long life during which they have the potential to produce income investors always have viewed this as an investment option with security. Now, through REITs, small investors have an added level of security never available before in real estate investment. Investors look to high dividend paying stocks both to provide income and to reduce the month-to-month changes in the value of their investment portfolios that come from more volatile assets.

Portfolio Diversification

Investing in REITs and other publicly traded real estate companies also provides diversification benefits because correlation of REIT returns with returns of other market sectors is relatively low.

Required Distributions

REITs are required by law to distribute each year to their shareholders at least 90 percent of their taxable income, putting REITs among those companies paying the highest dividends. Individual investors that are retired or approaching retirement often seek investments that provide appreciable and dependable sources of income. Younger investors also may seek income-producing investments as part of their strategy for reducing the volatility and protecting the value of their portfolios. REIT dividends help to stabilize the value of individual stock portfolios because the contractual rental income or mortgage payment from their assets is similar to the interest payment on bonds.