In 1960, Congress authorized the establishment of Real Estate Investment Trusts (REIT) for small investors to participate in real estate investments, providing them with good liquidity and high current yields. To qualify as a REIT, the Trust must distribute 95% of its taxable income to the shareholders.

In addition, REITs were never allowed to use accelerated depreciation methods for tax purposes. For this, REITs are able to avoid double taxation since dividends paid are taxed only once at the personal taxpayer level.

THE INCOME PASS-THROUGH

REITs pay no corporate taxes as opposed to a corporation. Taxes are paid only by the individual investor when the corporation declares a dividend.

Under the tax laws, current income is now worth more due to the elimination of the capital gains exclusion and the lower ordinary income tax rates. This makes the high current income streams from REITs attractive.

The current tax law has also eliminated personal holdings of real estate as a tax shelter. The Economic Recovery Tax Act of 1981 favored investments in real estate for tax purposes.

Because more investors were previously in higher tax brackets (Bracket Creep), it became advantageous to seek tax shelters. The current oversupply of office buildings and hotels in certain sectors of the market is due in part to the tax shelter benefits.

THE IMPORTANCE OF INCOME

The essence of tax laws is to restore economic reality to investing. Real estate investments will now be considered for sound economic reasons, rather than tax reasons or the availability of loanable funds. This will slow the supply of new real estate projects and enhance the current valuations of real estate projects founded for strong economic reasons.

REITs live and die by their dividend. The more a REIT can increase cash flow by selecting excellent property locations, attracting quality tenants and negotiating good leases, the more the REIT can increase its dividend. The more the dividend grows, the more the REIT’s stock will appreciate.

MANAGEMENT

Because real estate is a regional business, the management of most REITs usually gear efforts to specific regional areas as opposed to the entire country. This regional focus provides management niche opportunities and skills very difficult to duplicate. The managers of REITs are often known as good negotiators.

Equity oriented REITs are generally considered to have the least amount of risk. Perhaps one might consider that one of the best ways to participate in real estate is through a professionally managed REIT fund designed around holding a diversified portfolio of real estate by property type, geographic location and management style.

Source: Investment Performance Digest, 2000