Prior to 1960, only wealthy individuals and corporations had the financial resources necessary to invest in significant real estate projects such as shopping malls, corporate parks and health care facilities. In response, Congress passed the Real Estate Investment Trust Act of 1960. The legislation exempted these special-purpose companies from corporate income tax if certain criterion were met. It was hoped that the financial incentive would cause investors to pool their resources together to form companies with significant real estate assets, providing the same opportunities to the average American as were available to the elite. Three years later, the first REIT was formed.
The original legislation had some significant drawbacks, however, in that it required the executives in charge of the business to hire third parties to provide management and property leasing services. These restrictions were lifted in the Tax Reform Act of 1986. Thirteen years later, in 1999, the REIT Modernization Act was passed. The law allows REITs to form taxable subsidiaries in order to provide specialized services to tenants that normally fall outside the purview of real estate investing. Although the law still has some limitations as to the types of services that can be offered, it is expected that the quality of service at REIT-managed properties will improve significantly as a result of its passage.
Requirements for REIT statusAccording to Ralph Block in Investing in REITs: Real Estate Investment Trusts, every REIT must pass these four tests annually in order to retain its special tax status:
- The REIT must distribute at least 90 percent of its annual taxable income, excluding capital gains, as dividends to its shareholders.
- The REIT must have at least 75 percent of its assets invested in real estate, mortgage loans, shares in other REITs, cash, or government securities.
- The REIT must derive at least 75 percent of its gross income from rents, mortgage interest, or gains from the sale of real property. And at least 95 percent must come from these sources, together with dividends, interest and gains from securities sales.
- The REIT must have at least 100 shareholders and must have less than 50 percent of the outstanding shares concentrated in the hands of five or fewer shareholders.
In addition to the prevention of double-taxation, REITs offer numerous other benefits which include:
Professional managementIn most cases, the investor that buys a rental property is left to her own devises. REITs allow the investor the opportunity to have her properties managed by a professional real estate team that knows the industry, understands the business and can take advantage of opportunities thanks to its ability to raise funds from the capital markets. The benefits are not limited to the financial prowess of the management team. Owners of REITs arent going to receive phone calls at three a.m. to fix an overflowing toilet.
Limitation of personal riskREITs can significantly limit personal risk. How? If an investor wanted to acquire real estate, it is likely he will take on debt by borrowing money from friends, family, or a bank. Often, he will be required to personally guarantee the funds. This can leave him exposed to a potentially devastating liability in the event the project is unsuccessful. The alternative is to come up with significant amounts of capital by reallocating his other assets such as stocks, bonds, mutual funds, and life insurance policies. Neither alternative is likely to be ideal.
Purchasing a REIT, on the other hand, can be done with only a few hundred dollars as share prices are often as low, if not lower, than equities. An investor that wants to invest $3,000 in real estate will reap the same rewards on a pro-rated basis as those who want to invest $100,000; in the past, it simply wasnt possible to get this kind of diversification in the real estate asset class without taking on partners or using leverage.