REAL ES­TATE IN­VEST­MENT TRUST (REIT): Chal­lenges and Op­por­tu­ni­ties

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The REIT in­dus­try has a di­verse pro­file, which of­fers many al­ter­na­tive in­vest­ment op­por­tu­ni­ties to in­vestors. REITs of­ten are clas­si­fied in one of three cat­e­gories: eq­uity, mort­gage or hy­brid.

The abun­dance of in­vest­ment ve­hi­cles out there cre­ates a chal­lenge for the aver­age in­vestor try­ing to grasp what they’re all about. Stocks are the main­stay of in­vest­ing, bonds have al­ways been the safe place to park your money, op­tions have in­creased lever­age for spec­u­la­tors, and mu­tual funds are con­sid­ered one of the eas­i­est ve­hi­cles for in­vestors. One type of in­vest­ment that doesn’t quite fall into these cat­e­gories and is of­ten over­looked is the real es­tate in­vest­ment trust, or REIT.

So what ex­actly is a REIT? Well, it’s a trust com­pany that ac­cu­mu­lates a pool of money, through an ini­tial pub­lic of­fer­ing (IPO), which iPO is iden­ti­cal to any other se­cu­rity of­fer­ing with many of the sams then used to buy, de­velop, man­age and sell as­sets in real es­tate. The Ie rules re­gard­ing prospec­tuses, reporting re­quire­ments and reg­u­la­tions; how­ever, in­stead of pur­chas­ing stock in a sin­gle com­pany, the owner of one REIT unit is buy­ing a por­tion of a man­aged pool of real es­tate. This pool of real es­tate then gen­er­ates in­come through rent­ing, leas­ing and sell­ing of property and dis­trib­utes it di­rectly to the REIT holder on a reg­u­lar ba­sis REIT – An In­tro­duc­tion: REIT is a real es­tate com­pany that of­fers com­mon shares to the pub­lic. In this way, a REIT stock is sim­i­lar to any other stock that rep­re­sents own­er­ship in an op­er­at­ing busi­ness. But a REIT has two unique fea­tures:

a. Its pri­mary busi­ness is man­ag­ing groups of in­come­pro­duc­ing prop­er­ties.

b. It must dis­trib­ute most of its prof­its as div­i­dends.

Es­sen­tially, REITs are the same as stocks, only the busi­ness they are en­gaged in is dif­fer­ent than what is com­monly re­ferred to as “stocks” by most folks. Com­mon stocks are own­er­ship shares gen­er­ally in man­u­fac­tur­ing or ser­vice businesses. REITs shares on the other hand are the same, just en­gaged in the hold­ing of an as­set for rental, rather than pro­duc­ing a man­u­fac­tured prod­uct. In both cases, though, the share­holder is paid what is left over af­ter busi­ness ex­penses, in­ter­est/prin­ci­pal, and pre­ferred share­hold­ers’ div­i­dends are paid. Com­mon stock­hold­ers are al­ways last in line, and their earn­ings are highly vari­able be­cause of this. Also, be­cause their re­turns are so un­pre­dictable, com­mon share­hold­ers de­mand a higher ex­pected rate of re­turn than lenders (bond­hold­ers). This is why eq­uity fi­nanc­ing is the high­est-cost form of fi­nanc­ing for any cor­po­ra­tion, whether the cor­po­ra­tion be a REIT or man­u­fac­tur­ing firm.

Char­ac­ter­is­tics of an REIT:

To qual­ify as a REIT, the re­quire­ments are dif­fer­ent for dif­fer­ent na­tions.

The re­quire­ment to qual­ify as a REIT in USA is:

a. A com­pany must dis­trib­ute at least 90 per­cent of its tax­able in­come to its share­hold­ers an­nu­ally. A com­pany that qual­i­fies as a REIT is per­mit­ted to deduct div­i­dends paid to its share­hold­ers from its cor­po­rate tax­able in­come.

b. By hav­ing REIT sta­tus, a com­pany avoids cor­po­rate in­come tax. A reg­u­lar cor­po­ra­tion makes a profit and pays taxes on the en­tire prof­its, and then de­cides how to al­lo­cate its af­ter­tax prof­its be­tween div­i­dends and rein­vest­ment; but a REIT sim­ply dis­trib­utes all or al­most all of its prof­its and gets to skip the taxation. Types of REITs : The REIT in­dus­try has a di­verse pro­file, which of­fers many al­ter­na­tive in­vest­ment op­por­tu­ni­ties to in­vestors. REITs of­ten are clas­si­fied in one of three cat­e­gories: eq­uity, mort­gage or hy­brid. a. Eq­uity REIT Eq­uity REITs own and op­er­ate in­come-pro­duc­ing real es­tate. Eq­uity REITs in­creas­ingly have be­come pri­mar­ily real es­tate op­er­at­ing com­pa­nies that en­gage in a wide range of real es­tate ac­tiv­i­ties, in­clud­ing leas­ing, de­vel­op­ment of real property and ten­ant ser­vices. One ma­jor distinc­tion be­tween REITs and other real es­tate com­pa­nies is that a REIT must ac­quire and de­velop its prop­er­ties pri­mar­ily to op­er­ate them as part of its own port­fo­lio rather than to re­sell them once they are de­vel­oped. b. Mort­gage REIT Mort­gage REITs lend money di­rectly to real es­tate own­ers and oper­a­tors or ex­tend credit in­di­rectly through the ac­qui­si­tion of loans or mort­gage-backed se­cu­ri­ties. To­day’s mort­gage REITs gen­er­ally ex­tend mort­gage credit only on ex­ist­ing prop­er­ties. Many mod­ern mort­gage REITs also man­age their in­ter­est rate risk us­ing se­cu­ri­tized mort­gage in­vest­ments and dy­namic hedg­ing tech­niques. c. Hy­brid REIT As the name sug­gests, a hy­brid REIT both owns prop­er­ties and makes loans to real es­tate own­ers and oper­a­tors. Struc­ture of REITs REITs are typ­i­cally struc­tured in one of three ways: Tradi- tional, UPREIT and DownREIT. A tra­di­tional REIT is one that owns its as­sets di­rectly rather than through an op­er­at­ing part­ner­ship.

In the typ­i­cal UPREIT, the part­ners of an Ex­ist­ing Part­ner­ship and REIT be­come part­ners in a new part­ner­ship termed the Op­er­at­ing Part­ner­ship. For their re­spec­tive in­ter­ests in the Op­er­at­ing Part­ner­ship (“Units”), the part­ners con­trib­ute the prop­er­ties from the Ex­ist­ing Part­ner­ship and the REIT con­trib­utes the cash. The REIT typ­i­cally is the gen­eral part­ner and the ma­jor­ity owner of the Op­er­at­ing Part­ner­ship Units.

Af­ter a pe­riod of time (of­ten one year), the part­ners may en­joy the same liq­uid­ity of the REIT share­hold­ers by ten­der­ing their Units for ei­ther cash or REIT shares (at the op­tion of the REIT or Op­er­at­ing Part­ner­ship). This con­ver­sion may re­sult in the part­ners in­cur­ring the tax de­ferred at the UPREIT’s for­ma­tion. The Unit hold­ers may ten­der their Units over a pe­riod of time, thereby spread­ing out such tax. In ad­di­tion, when a part­ner holds the Units un­til death, the es­tate tax rules op­er­ate in such a way as to pro­vide that the ben­e­fi­cia­ries may ten­der the Units for cash or REIT shares with­out pay­ing in­come taxes.

A DownREIT is struc­tured much like an UPREIT, but the REIT owns and op­er­ates prop- er­ties other than its in­ter­est in a con­trolled part­ner­ship that owns and op­er­ates sep­a­rate prop­er­ties. Ad­van­tages of REIT: a. Cre­ates a safety net for the In­vestors: When you buy a share of a REIT, you are es­sen­tially buy­ing a phys­i­cal as­set with a long ex­pected life span and po­ten­tial for in­come through rent and property ap­pre­ci­a­tion. This con­trasts com­mon stocks where in­vestors are buy­ing the right to par­tic­i­pate in the prof­itabil­ity of the com­pany through own­er­ship. When pur­chas­ing a REIT, one is not only tak­ing a real stake in the own­er­ship of property via in­creases and de­creases in value, but one is also par­tic­i­pat­ing in the in­come gen­er­ated by the property. This cre­ates a bit of a safety net for in­vestors as they will al­ways have rights to the property un­der­ly­ing the trust while en­joy­ing the ben­e­fits of their in­come.

b. An­other ad­van­tage that this prod­uct pro­vides to the aver­age in­vestor is the abil­ity to in­vest in real es­tate with­out the nor­mally as­so­ci­ated large cap­i­tal and la­bor re­quire­ments. When buy­ing a REIT, the cap­i­tal in­vest­ment is limited to the price of the unit, the amount of la­bor in­vested is con­strained to the amount of re­search needed to make the right in­vest­ment, and the shares are liq­uid on reg­u­lar stock ex­changes.

c. Fur­ther­more, as the funds of this trust are pooled to­gether, a greater amount of di­ver­si­fi­ca­tion is gen­er­ated as the trust com­pa­nies are able to buy nu­mer­ous prop­er­ties and re­duce the neg­a­tive ef­fects of prob­lems with a sin­gle as­set. Sta­tus of REITs in In­dia: REITs are not presently op­er­at­ing in In­dia but are ex­pected to come into force soon. SEBI had in­vited sug­ges­tions and ob­jec­tion and one can have on their web­site. Im­ple­ment­ing REITs would re­quire a num­ber of sub- stan­tial mea­sures on the in­dus­try side as well as on the fis­cal side. Some of the de­ci­sions pend­ing on REITs in In­dia are:

1. Own­er­ship: The per­sons who can form REIT’s

2. The type of scheme: Open ended or close ended

3. Le­gal Is­sues: Is­sues re­lat­ing uni­form stamp duty, clear ti­tles etc. 4. Val­u­a­tions of Property With the govern­ment over the years hav­ing shown a keen de­sire to pro­pel growth in the real es­tate sec­tor by of­fer­ing sev­eral tax and other fis­cal ben­e­fits to de­vel­op­ers and end users, we be­lieve that such eas­ing of re­stric­tions and, more­over, in­creas­ing reg­u­la­tory ac­cep­tance can be taken as an in­di­ca­tion of REITS see­ing the light of day in In­dia. Ex­pec­ta­tions from Gov

ern­ment’s Side: To be­gin, with an exclusive stock ex­change could be set up un­der Se­cu­ri­ties and Ex­change Board of In­dia (SEBI) guide­lines for trad­ing real es­tate stocks. The Govern­ment should per­mit the set­ting up of a Real Es­tate In­vest­ment Trust (REIT) which should be reg­u­lated by SEBI in or­der to open the in­vest­ment flood­gate for the real es­tate sec­tor. The REIT would op­er­ate like a mu­tual fund, where in­vest­ments of in­di­vid­ual in­vestors are con­sol­i­dated to in­vest in real es­tate, rather than stocks of com­pa­nies. It would pro­vide a higher level of liq­uid­ity as well as pro­fes­sional ad­vice for price dis­cov­ery, as the in­vestor would be in­vest­ing through an as­set man­age­ment com­pany. It also pro­vides as­sured re­turns in the form of div­i­dends to its in­vestors from rental in­come earned on real es­tate as­sets. The es­sen­tial dif­fer­ence be­tween a REIT and a mu­tual fund is that in­vest­ments made in REIT are traded in real es­tate stocks and not in­vested in stock of com­pa­nies. Fur­ther the swings in this mar­ket are in the range of 5-10 per cent, which an aver­age in­vestor is in a bet­ter po­si­tion to ab­sorb than the 6090 per cent swings on the stock mar­ket.

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