Real estate investment trusts (REITs) are companies that own and, in most cases, operate INCOME-producing real estate. Typically owners of apartments, shopping centers, offices, and warehouses, REITs take funds from investors and purchase real-estate ASSETS. REITs were created in 1960 to allow individual investors to participate in realestate INVESTMENT. As of 2001, there were 300 REITs in the United States with approximately $300 billion in assets. There are three general categories of REITs: EQUITY, MORTGAGE, and hybrid. Equity REITs own and operate income-producing real estate. They engage in leasing, or development of property and tenant management. Unlike other real-estate developers, REITs develop and acquire properties, which are then part of their investment portfolio rather than being resold to other investors. From 1960 to 1986, REITs were not allowed to directly manage properties; they could only invest in real estate. The Tax Reform Act of 1986 expanded the power of REITs to include owning and operating real estate. Mortgage REITs purchase mortgage-backed securities and lend MONEY directly to real-estate owners and operators. Most mortgage REITs extend credit on existing properties and do not engage in real-estate development. Hybrid REITs own properties and also make LOANS to real-estate owners. Some REITs own or lend in all areas of real estate, but most REITs specialize in one or two categories of real-estate investment, such as shopping malls, health-care facilities, apartments, etc. Some REITs invest throughout the United States, while others specialize in one region or city. The major advantage of a REIT as a business organization is tax treatment. Unlike CORPORATIONs, REITs are allowed to deduct DIVIDENDs from their corporate tax bill. They are also required to distribute at least 90 percent of their taxable income to SHAREHOLDERS. REITs are thus effectively exempted from corporate taxation. The major disadvantage of REITs is the fact that they are required to distribute almost all of their income to shareholders. Many corporations retain all or most of their taxable income to reinvest in business activities. REITs have to find new investment CAPITAL in order to expand. Unlike PARTNERSHIPs, REITs are not allowed to pass through losses to shareholders, who would then deduct those losses on their personal income-tax return. To qualify as a REIT for the INTERNAL REVENUE SERVICE, a REIT must
• be an entity that is taxable as a corporation
• be managed by a BOARD OF DIRECTORS or trustees
• have shares that are fully transferable
• have a minimum of 100 shareholders
• have no more than 50 percent of shares held by five or fewer individuals
• invest at least 75 percent of total assets in real-estate assets
• derive at least 75 percent of gross income from rents or interest on mortgages on real property.
• have no more than 20 percent of its assets of stocks in taxable REIT subsidiaries
• pay dividends of at least 90 percent of its taxable income in the form of shareholder dividends
REITs are considered relatively conservative, incomeproducing STOCK MARKET investments. REIT stockholders have suffered during periods of real-estate overexpansion but benefited during periods of peak demand for space. Stock-market analysts differ in evaluating the investment performance of REITs. Traditionally they estimated REITs’ funds from operations (FFO) rather than net income. FFO was used because under GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP), a real-estate company must depreciate the value of its properties, even though most real-estate properties appreciate in value. FFO standards, created by the National Association of Real Estate Investment Trusts in 1991, allowed REITs to add back real-estate DEPRECIATION and ignore gains from sales of properties when calculating FFO. Since 1991, some REITs have also excluded losses from investments (particularly, losses from technology and foreigncurrency investments) and included funds for sales of depreciated property. In short, FFO has come to have many meanings among REIT managers and market analysts. In 2001, three WALL STREET firms agreed to review and forecast REITs’ performances based on GAAP standards rather than the industry FFO figures.