How REITs Work

­REITs are part of an extremely diverse industry. Not only are there different categories of REITs, many different property types and classifications can comprise them.

Let's start with the three REIT categories: equity, mortgage and hybrid.

Equity REITs (EREITs) purchase, own and manage income-producing real estate properties such as apartments, malls and office buildings. Equity REITs are different from typical real estate developers because they purchase or develop real estate to operate it as part of their portfolios instead of developing it for resale. Equity REITs are considered superior for the long-term investing because they earn dividends from rental income as well as capital gains from the sale of properties.

Rather than investing in properties, Mortgage REITs (MREITs) loan money for mortgages to real estate owners or purchase existing mortgages or mortgage-backed securities. Their revenue is generated primarily by the interest that they earn on the mortgage loans. Mortgage REITs react more quickly to changes in interest rates than equity REITs because their dividends come from interest payments. Today, there are close to 40 mortgage REITs. Of these, about 25 invest in residential-mortgage securities and the rest invest in commercial mortgages. Mortgage REITs are considered a good speculative investment if interest rates are expected to drop.

As their name suggests, Hybrid REITs are a combination of equity and mortgage REITs. They both own property and make loans to real estate owners and operators. Hybrid REITs earn money through a combination of rents and interest.

Some REITs are established for a single development project and set up for a specific number of years. At the end of that time period, the REIT is liquidated and the proceeds are distributed to the shareholders.

There are also classifications based on whether or not the REIT can issue additional shares. If the REIT is a Closed-end, it can only issue shares to the public once and can only issue additional shares, which dilutes the stock, if current shareholders approve it. Open-ended REITs can issue new shares and redeem shares at any time.

Although some REITs have a broad focus and invest in a variety of property types in a range of locations, many REITs focus their investments either geographically or by property types. An individual REIT may hold properties only in a specific region, state, or metropolitan area. Or, it may hold properties across broader geographical areas but focus on healthcare facilities, apartments or industrial facilities.

The National Association of Real Estate Investment Trusts (NAREIT) divides REITs into three classifications based on how they can be purchased: private, publicly traded and non-exchange traded.

Private REITs are not registered or traded with the Securities and Exchange Commission (SEC) and raise equity from individuals, trusts, or other entities that are accredited under federal securities laws. Private REITs generally are subject to less regulation, with the exception of guidelines associated with maintaining REIT status. There are almost 800 private REITs in the United States.

There are nearly 200 publicly traded REITs registered with the SEC and traded in major stock exchanges such as the New York Stock Exchange, NASDAQ and the American Stock Exchange. Because they're traded on an exchange each day, publicly traded REITs are simple for investors to buy or sell and offer great liquidity. Total assets of these listed REITs exceed $400 billion.

About 20 non-exchange traded REITs are registered with the SEC but not traded on any of the public exchanges. Instead, they have private sponsors who market them to investors-often those who have been burned elsewhere in the market and seek relative stability. In exchange for easy liquidity, REIT sponsors focus on the benefit of not having to "time the market." They often promote non-exchange traded companies as providing insulation from fluctuations in the market and, in part, as fixed-income investments that offer better returns than bonds, certificates of deposit, money market funds and similar financial instruments.

Next, we'll look at how REITs operate.

Because REITs are required to distribute 90 percent of their taxable income to investors, they must rely upon external funding as their key source of capital. Just like other stock offerings, publicly traded REITs collect funds via an initial public offering (IPO). Those funds are used to buy, develop and manage real estate assets. The IPO works just like other security offerings except that instead of purchasing stock in a single company, the buyer will own a portion of a managed pool of real estate. Income is generated through renting, leasing, or selling the properties and is distributed directly to the REIT holder on a regular basis. When a REIT pays out its dividends, they're equally distributed among shareholders as a percentage of paid-out taxable income.

REITs have a board of directors elected by its shareholders. Typically, these directors are real estate professionals who are highly respected in the field. They are responsible for selecting the REIT's investments and hiring the management team, which then handles day-to-day operations.

REITs earn money from rented space or sales of property. The preferred method for measuring REIT earnings is called funds from operations (FFO). The National Association of Real Estate Investment Trusts (NAREIT) defines FFO as:

Basically, REITs add or deduct from net income (rent and sales computed according to generally accepted accounting principles [GAAP]) any gains or losses due to depreciation, sale of property and unconsolidated partnerships and joint ventures. Essentially, FFO measures a REIT's operating cash flow produced by its properties, less administrative and financing costs.

Under generally accepted accounting principles, net income typically assumes that the value of assets goes down over time -- somewhat predictably. Real estate generally retains or even increases in value. On the balance sheet under GAAP, however, land remains at its historical cost and buildings gradually depreciate to zero. Since a REIT's primary business involves real estate, the depreciation charges negatively skewed the company's true profitability. FFO was adopted to address that problem by excluding depreciation costs from the net income figure.

FFO is not a foolproof measure, however. Not all REITs calculate it according to the NAREIT definition and items such as maintenance, repairs and other recurring capital expenses are missing from the formula. In order to get a true FFO, investors must often read a company's quarterly report, and any supplemental disclosures.

Next, we'll look at what you need to know before you invest in a REIT.

Because many REITs are publicly traded, they offer investors a powerful tool for portfolio balancing and diversification. They also provide investors with ongoing dividend income, while offering the potential for long-term capital gains through share price appreciation.

REITs have an advantage over other types of stocks. Because of their pass-through taxation, REITs have greater profits from which to pay shareholder dividends than similar sized corporations. As long as a REIT maintains its tax-qualified status by paying out 90 percent of its net income to common shareholders, it doesn't have to pay federal income taxes. Without a tax bite to reduce profits, shareholders get more of the REIT's earnings.

REIT investors receive value in the form of dividend income and potential share value appreciation. Because REIT income often comes from commercial properties with long lease periods, REITs can offer a relatively predictable revenue stream. They also are somewhat resistant to inflation. Unlike bonds with pre-determined rates of interest, which lose relative value in times of high inflation, REITs with rental incomes adjust themselves in line with the cost of living. This makes them less vulnerable to inflation-related devaluation.

Another benefit is the potential for a nontaxable return of capital. Depending on the REITs distribution policy and annual earnings, a portion of the dividend may be deemed a nontaxable return of capital. Not only does the investor not have to pay taxes on that part of the dividend in the year it is distributed, that amount is also not taxable until the stock is sold. So the return of capital defers taxes as well as lowers an investor's taxable income during the time the REIT stock is held, increasing the after-tax dividend yield.

REITs do have some disadvantages. Because their distributions to shareholders bypass corporate taxation, their dividends aren't eligible for the 15 percent dividend tax rate that was put into place in 2003. That means investors usually pay taxes at their higher ordinary income rates, which can run as high as 35 percent. Nontaxable distributions are taxed as capital gains (currently 15 percent for shares held for more than a year) when shares are sold.

Unfortunately, it is difficult for investors to predict what category of income a REIT will pay out in a given year (dividends or return of capital). According to NAREIT, however, the proportion of distributions that qualifies for the lower tax rate has risen every year since 1998.

So how do you go about choosing a REIT? Even though REITs are somewhat diversified by definition, it is still important to determine whether or not a specific REIT focuses on one type of commercial development or one geographic area that could leave it vulnerable to a downturn. For this reason, many investors invest in more than one REIT. Consider demographic information such as population growth, employment growth and the level of economic activity for the particular area or industry. These will have a direct impact on rent levels and occupancy rates -- which in turn affect cash flow and dividends.

Most investors know that past performance is no guarantee of future performance. With REITs, however, you should look at past dividend payments. Be wary of high yields. If there have been excessive capital gain distributions, this can be a sign that the income is coming from nonrecurring events and will not continue for long. Make sure the REIT is not selling off properties to provide income, because future rental income will be affected.

Evaluate your own needs. REITs can provide both current income and long-term appreciation. Depending on what you're looking for, examine how the REIT management and trustees are compensated. If compensation is based on the value of the REIT's assets, management is usually concentrating on investing in additional properties for capital appreciation. If the basis for determining compensation includes dividends or current earnings, the REIT's management may be motivated to increase dividend yield, possibly at the expense of long-term appreciation.

Study the REIT's management. Before investing, make sure the management has a personal stake in the company. This information should be available in their latest prospectus. There is often a REIT option in most 401(k) plans.

If you want to invest in income-generating real estate, a REIT might be the way to go. For more information on REITs and related topics, check out the links on the next page.