The REIT Story

Although Congress created real estate investment trusts (REITs) in 1960, REITs played a relatively limited role in real estate investment for more than three decades. Since 1992, however, the REIT marketplace has grown dramatically. Why is this happening, and what does it mean for investors and the economy?

What is a REIT?

Simply stated, 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 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 (95 percent) to its shareholders every year.

In short, 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 95 percent of its taxable income to shareholders,

a REIT may deduct the dividends paid to the shareholders from its corporate tax bill.

The net benefit of being a REIT: one level of taxation.
The net cost of being a REIT: little or no retained earnings generated to expand the business.

Capital for growth must come principally from new money raised in the investment marketplace from investors who have confidence in the REIT's future prospects and business plan.

Why did Congress create REITs in 1960?

Congress created REITs in 1960 to enable small investors to make investments in large-scale, significant income-producing real estate. Drawing in part from the example of mutual funds, Congress decided that the only way for the average investor to access investments in larger-scale commercial properties was through pooling arrangements. As a result, Congress 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 and finance.

Why did REITs play a limited role for over 30 years?

At the beginning, REITs were handcuffed. They were permitted only to own real estate, not to operate or manage it. This meant that REITs needed to find third parties, whose economic interests might diverge from those of the REITs' owners, to operate and manage the properties. The investment marketplace did not accept this arrangement readily.

Second, during these years, provisions of the tax code distorted the real estate marketplace by making real estate investment tax shelter-oriented. By using high debt levels and aggressive depreciation schedules, a taxpayer could take interest and depreciation deductions that significantly reduced his or her taxable income. In many cases these deductions led to so-called "paper losses" that were used to shelter a taxpayer's other income.

By contrast, a REIT is designed specifically to create "taxable" income on a regular basis, and a REIT is not permitted to pass "losses" through to shareholders. Therefore, the REIT industry could not compete effectively for capital against tax shelters.

What changed?

The Tax Reform Act of 1986 radically changed the real estate investment landscape in two important ways. First, the Act drastically reduced the potential for real estate investment to generate tax shelter opportunities. It did so by limiting the deductibility of interest, lengthening depreciation periods and restricting the use of "passive losses." This meant that real estate investment had to be more economic and income-oriented.

Second, as part of the Act, Congress took the handcuffs off REITs. The Act permitted REITs not only to own, but also to operate and manage, most types of income-producing commercial properties. They could do so by providing 'customary' services associated with real estate ownership. Finally, for most types of real estate (other than hotels, health care facilities and some other activities that consist of a higher degree of personal services relative to rent), the economic interests of the REIT's owners could be merged with those of the REIT's operators and managers.

If Congress changed the law in 1986, why didn't the REIT renaissance really begin until 1992?

Change takes time. During the late 1980s, banks and insurance companies kept up a fast pace of real estate lending. Foreign investment, particularly from Japan, also helped buoy the marketplace. But by 1990, the combined impact of the savings and loan crisis, the Tax Reform Act of 1986, overbuilding during the 1980s and regulatory pressures on bank and insurance lenders, led to a depression in the real estate industry. During the early 1990s, commercial property values dropped between 30 and 50 percent. Credit and capital for commercial real estate became largely unavailable.

What happened in 1992?

Against this backdrop, many private real estate companies decided that the best and most efficient way to access capital was through the public marketplace using REITs. At the same time, many investors decided that it was a good time to invest in commercial real estate on terms favorable to them. After all, they believed recovering real estate markets were just over the horizon. They were right.

Why are REITs growing so fast now?

Investor interest has sparked REIT growth. The real estate cycle has been on the upswing for the past five years, and investors want to be part of it. In addition:

Since REITs must be widely held, they are ideal candidates to be public companies.
Because REITs must distribute almost all their taxable income as dividends to shareholders, they instill confidence in a marketplace somewhat skeptical about real estate investment in the wake of the early 1990s.
Because the managers of a modern REIT also have a meaningful ownership stake in the company, investors are increasingly comfortable with the structure.

Are REITs here to stay?

Yes, because smaller real estate investors are offered three important qualities through the modern REITs that previously were never accessible and available to them before: liquidity, security and performance.

Liquidity. REITs have helped turn real estate liquid. Through the public REIT marketplace of over 200 real estate companies, investors can buy and sell interests in diversified portfolios of properties - as well as the management associated with them - on an instantaneous basis. Illiquidity, the bane of real estate investors, is gone.

Security. Because real estate is a physical asset with a long life during which it has the potential to produce income, investors always have viewed real estate as an investment option with security. Now, through REITs, small investors have an added level of security never available before in real estate investment. Low levels of debt practiced by REITs also mean greater security for the financial system as a whole.

Today's security also comes from information. The advent of the public REIT industry (which is governed by SEC-mandated information disclosure and reporting) has made available to the public a flow of available information about:

the company and its properties,
the management and its business plan, and
the property markets and their prospects.

Performance. Since their inception, REITs have provided competitive investment performance. Whether over the past two years, or the past 20 years, REIT market performance has been roughly comparable to that of the Standard & Poor's 500 Index and has exceeded returns on fixed debt instruments or direct investment in real estate. Because REITs annually pay out almost all their taxable income, a significant component of total return reliably comes from dividends.

REITs work. Just as Congress intended when it created REITs, small investors today have easy access to large-scale, income-producing real estate on a basis competitive with wealthy entrepreneurs and large institutions.

The growth of REITs in the 1990s has been unprecedented, and their increasing ownership position in commercial real property markets will continue to reshape real estate investment, finance, operation and development into the next century.