REITs 101: Introducing REITs to Real Estate Sponsors

A Brief History of REITs

REITs were created in the United States in 1960 under President Dwight D. Eisenhower as part of the Cigar Excise Tax Extension of 1960. The law was implemented to allow all investors to invest in large-scale, diversified portfolios of income-producing real estate in the same way that they typically invested in other asset classes – through the purchase and sale of liquid securities. This funnel for pooled investments was also designed with the intent of helping communities grow, thrive, and revitalize through the economic activity generated via large scale real estate investments.

Before REITs, investment-grade real estate properties were primarily accessible to wealthy individuals and large institutions. Since the establishment of the first Real Estate Investment Trust, this investment vehicle has experienced significant growth and is now a cornerstone of the real estate investment landscape globally, with REIT regimes established in over 30 countries.

What is a REIT?

A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs offer investors, of all types, the opportunity to own fractional interests in real estate, earn dividends, and hold their investments in through liquid markets for long-term appreciation.

While typical real estate firms concentrate on selling properties once they are developed, a Real Estate Investment Trust differentiates itself by primarily acquiring real estate assets to be operated and managed as long-term investments within their portfolios.

“Today, U.S. REITs own nearly $4.5 trillion of gross real estate with public REITs owning $3 trillion in assets. U.S. listed REITs have an equity market capitalization of more than $1.3 trillion. In 2021, REITs paid an estimated $92.3 billion in dividends to shareholders.” [source]

REITs allow anyone to invest in portfolios of real estate assets in the same way they invest in other industries – through the purchase of individual company stock or a mutual fund or exchange-traded fund (ETF). The stockholders of a REIT earn a share of the income produced through real estate investment in the form of shareholder dividends – without actually having to go out and buy, manage, or finance property in the private real estate market.

"An estimated 150 million Americans have made investments in REITs through a range of financial instruments including 401(k) accounts, IRAs, pension plans, REIT ETFs, and other investment funds." [source]

REITs, by design, avoid corporate income tax. But to do so, REITs have to navigate a labyrinth of strict eligibility requirements such as distribution of at least 90% of their taxable income in the form of shareholder dividends, and deriving at least 75% of their gross income from rents from real property. As a REIT can deduct these dividends from its taxable income, hence, most REITs aim to distribute at least 100% of its taxable income to avoid entity-level tax.

What is an Operating Partnership? What are OP Units?

An Operating Partnership (OP) is a key component of the UPREIT (Umbrella Partnership REIT) structure that is often used by REITs to acquire properties. In an UPREIT, the REIT is the general partner and shareholder of the OP, and the remaining OP units are held by limited partners.

When a property owner contributes their asset to the OP, they receive OP units, which are economically equivalent to REIT shares and can often be converted into REIT shares. However, unlike a direct contribution to a REIT, this structure often allows the property owner to defer the capital gains tax that would typically arise from the sale of the property.

REIT ADVISOR

The REIT advisor serves as the guiding compass for the REIT's investment and management decisions. A REIT advisor is an external entity, typically a separate company, which is appointed by the REIT to provide strategic advice, perform asset management duties, and assist with other operational responsibilities.

The scope of the advisor's role typically extends across a broad spectrum of activities - acquisitions, divestments, capital raise, and portfolio management, to name a few. A well-qualified REIT advisor brings with it the wealth of real estate investment expertise and industry relationships that enable the REIT to fully unlock its capital and real estate markets potential.

REITs can have an external or an internalized advisor.

External Advisor

In an externally advised REIT structure, the REIT contracts an outside advisor for services. The advisor is usually compensated through a fee structure that may include base management fees, incentive fees tied to the REIT's performance, and transaction fees for property financing, acquisitions, or sales. This arrangement allows the REIT to tap into the advisor's expertise without the need to maintain an extensive internal staff. However, it can also create potential conflicts of interest - for example, the advisor's compensation may incentivize transactional activity rather than long-term value creation.

Internalization of the Advisor

Internalization refers to the process of transitioning from an externally advised structure to an internally managed one, whereby the REIT brings the management and advisory functions in-house. This usually occurs through the REIT buying out the external advisor through the REIT’s stock or cash, and hiring its management team.

Internalization may eliminate potential conflicts of interest by more closely aligning the interests of its management with those of its stakeholders. However, it involves significant upfront costs and requires the REIT to build internal management capabilities.

Choosing between an externally advised and internally managed structure depends on the specific circumstances of the REIT, including its size, growth stage, and the capabilities of the potential advisor or internal management team. A careful evaluation of these factors can help ensure that the chosen structure supports the REIT's strategic objectives and stakeholders’ interests. We are happy to help you make this decision.

Types of REITs: Equity, Mortgage, Hybrid

Equity REITs: Equity REITs invest in and own income-producing real estate properties. Such REITs pay (or distribute) at least 90% of their portfolio’s income to their shareholders in the form of dividends. Most REITs are equity REITs. Equity REITs may own and operate diversified (by sector and geography) portfolios of properties, or focus on a particular sector such as hotels or shopping malls. For example, Equity Residential is an equity REIT specializing in multifamily apartments.

Mortgage REITs (mREITs): Mortgage REITs hold investments in real estate backed debt securities that are either bought directly from lenders or organically generated through loans originated by the mREIT to owners, operators, and developers. mREITs may also extend credit indirectly through the acquisition of loans or mortgage-backed securities.

The income of mREITs generally comprises of interest payments from mortgage loans. Examples of the kinds of assets that can be found in a mortgage REIT include residential mortgages, commercial mortgages, securities backed by residential mortgages, securities backed by commercial mortgages, or a combination of securities backed by both residential and commercial mortgages.

Arbor Realty Trust (ABR) is an example of an mREIT that stands out as one of the best mREITs given its six straight quarters of dividend hikes and strong performance.

Hybrid REITs: Hybrid REITs are a combination of equity and mortgage REITs. They own and invest in properties and debt instruments, and in some cases, also make out loans against properties.

An example of a hybrid REIT is W.P. Carey Inc. While the company primarily earns its Adjusted Funds from Operations from its real estate portfolio, the company has an investment management business that provides customized financing solutions to commercial real estate owners and operators.

Private vs. Public REITs

Private REITs: Private REITs use various securities registration exemptions of the Securities and Exchange Commission (SEC) to raise capital from accredited and institutional investors, however, REITs must comply with certain eligibility standards to continue maintaining the REIT status. This means that private REITs are subject to a rigorous version of the Internal Revenue Code and a scaled version of SEC regulations. A Private REIT's shares are not listed on public exchanges and are, therefore, not liquid. Private REITs can use securities exemptions to raise capital. Private REIT holdings can range from single-asset to multi-asset to a diversified portfolio with the asset(s) in one or more real estate sectors or geographies.

Public REITs: Public REITs are registered with the SEC and, typically, their shares are traded on national stock exchanges, which makes them the most accessible type of REIT investment for individual investors. Public REITs are governed by strict SEC reporting and disclosure standards and hence are required to adhere to the highest level of financial and operational transparency. For example, they are required to publish periodic audited financial statements through SEC Edgar. However, this added level of scrutiny comes with the ability to raise capital from a wider investor base, including the general public.

"U.S. public REITs own an estimated 535,000 properties and 15 million acres of timberland across the U.S. which add up to $3 trillion in assets."

What is a Public Non-Traded REIT?

A public non-traded REIT is a type of Public REIT that is registered with the SEC but does not trade on national stock exchanges. As a result, while they share the capital raising abilities of a Public REIT, they do not offer their investors the liquidity of the public markets.

Non-traded REITs are less correlated to the traditional equity markets as there is no real-time exchange pricing of a REIT's stock. Therefore, public non-traded REITs are not vulnerable to the pricing and volatility risks of the public markets, however, by the same token, there is no real-time indicator of a REITs value, and hence valuing public non-traded REITs is a complex exercise. As a result, non-traded REITs are better positioned to weather out strenuous economic circumstances and limit their risk exposure to those of the real estate markets. Typically, investors rely on periodic portfolio appraisals and precedent capital raise transactions to ascertain the value of such REITs.

Sectors in which REITs Operate

REITs operate in diverse sectors, each with unique characteristics and market dynamics. Here's an overview of the major sectors:

How is a REIT Structured?

The structure of a Real Estate Investment Trust revolves around the central principle of distributing a substantial part of its income to shareholders, thus avoiding corporate income tax. A typical REIT structure works like this:

• The REIT sponsor is typically the founding team or principles of the REIT, who either invested capital or contributed assets to the REIT.
• A REIT is organized as a corporation or trust.
• The REIT's Board of Directors oversees the operations and regulatory compliance requirements of a REIT.
• A REIT's assets are primarily composed of real estate properties that are housed under a separate legal entity called an Operating Partnership. Other assets may include real estate-related securities, such as mortgages, or taxable REIT subsidiaries (TRS), which are essentially businesses that provide services - for example, landscaping - to the REIT for its real assets. Please note TRS are taxed as corporations, not as REITs.
• A REIT is typically the general partner to the Operating Partnership.
• A REIT Advisor typically provides strategic advice, asset management, and administrative services. It is common for the advisor and general partner to be legally separate entities. In some cases, an advisor does not exist, in which case, the REIT is internally managed by its own management and board.
• The Advisor is typically the general partner of the REIT and is contracted by the REIT.

How CIEL Can Help

REITs are phenomenal but complex capital markets vehicles that are regulated by various agencies. REITs can be daunting, especially when negotiating with them. Given CIEL has been on both sides of the table, real estate owner/developer and REIT sponsor and manager, we understand and appreciate the nuances.

From drafting and filing a registration statement or filing Form 1120-REIT to implementing corporate governance practices to preempting and mitigating for any regulatory or compliance risks, CIEL can help you not only fully understand but also navigate the challenging but substantial opportunity that REITs present.

About CIEL

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