| Royalty trusts, in Finance, are classic flow-through | | | | rise thus causing yields to drop. On the other |
| investments vehicles. The trust, like a mutual | | | | hand, when interest rates rise, prices of REIT's |
| fund, holds a portfolio of assets, which can be | | | | drop thus causing yields to rise.For example, when |
| anything from producing oil and gas wells to | | | | interest rates were pushed up by both the |
| power generating stations to interests in land. The | | | | Federal Reserve Board and the Bank of Canada |
| net cash flow, i.e. the total cash flow minus | | | | all the way back in 2000, the typical REIT was |
| revenues, is passed on to the unit-holders as | | | | yielding close to 14 percent as prices per share |
| distribution.The purpose of a Real Estate | | | | fell. When interest rates subsequently dropped, |
| Investment Trusts is to reduce or eliminate | | | | yields fell to less than 10 percent as demand for |
| corporate income taxes. In the United States, | | | | REIT's increased thus pushing share prices |
| where they are generally more widespread as | | | | higher.This is a very important consideration to be |
| investment vehicles, Real Estate Investment | | | | kept in mind when investing or otherwise trading |
| Trusts pay little or no federal income tax but are | | | | units involving this type of trusts. If interest rates |
| subject to a number of special requirements set | | | | appear to be poised to rise, investors may want |
| forth in the Internal Revenue Code, one of which | | | | to defer purchases, and those who own this type |
| is the requirement to distribute annually at least | | | | of shares already may consider reducing their |
| 90 percent of their taxable income in the form of | | | | exposure by selling and take in some profit.There |
| dividends to shareholders.Real Estate Investment | | | | are typically two catches with REIT's. The first is |
| Trusts are, therefore, a special type of royalty | | | | that since investors are ‘unit-holders' rather |
| trust. They specialize in real property, anything | | | | than shareholders, they are potentially jointly and |
| from office buildings to long-term care facilities. | | | | severally liable together with all other unit-holders |
| For illiquid assets like real estate, closed-end funds | | | | (plus the trust itself) in the eventuality of |
| of this type make good sense. Open-end or | | | | insolvency. Instead of limited liability, investors rely |
| ‘mutual' real estate funds are subject to | | | | on the REIT's management to have property, |
| new money and redemption problems, entirely | | | | casualty and liability insurance, prudent lending |
| absent in closed-end trusts. The first Real Estate | | | | policies and other reasonable safeguards in place. |
| Investment Trust was introduced in the United | | | | Nevertheless there is always the possibility of a |
| States in 1960. The vehicle was designed to | | | | problem - say a catastrophic fire or a building |
| facilitate investments in large-scale | | | | collapse - that is not covered by insurance. This |
| income-producing real estate by smaller investors. | | | | may have seemed like a very small matter prior |
| The US model was simple, enabling small investors | | | | to the attacks on the World Trade Center in |
| to acquire equity interests in vehicles holding | | | | 2001. Since then, however, it is something that |
| large-scale commercial property.But the birth of | | | | has to be taken seriously.The second problem |
| Real Estate Investments Trusts as a mass | | | | with REIT's is less transparent. All real estate |
| investment vehicle can be traced directly to the | | | | properties depreciate in value over time (not the |
| liquidity crisis encountered by open-end real estate | | | | land, only the buildings). Depreciation can be |
| mutual funds all the way back to 1991-92, during | | | | somewhat slowed down by earmarking at times |
| the slowdown of real estate that characterized | | | | significant amounts of money for maintenance |
| those years. Faced with redemption demands on | | | | and renewal of facilities. Since most of the REIT's |
| the part of unit-holders, real estate mutual funds | | | | income is being distributed and the capital cost |
| were presented with the unpalatable option of | | | | allowance is being allocated to investors, investors |
| selling valuable real properties into a distressed | | | | are factually getting their own capital back over |
| market to raise cash. Many of them, therefore, | | | | time. As such, the book value of the underlying |
| chose to close off redemptions and converted | | | | real properties will be steadily depleting.Obviously, |
| into Real Estate Investment Trusts, since then | | | | if real estate markets are on the upswing the |
| most commonly known as REIT's. Only a few | | | | depreciation factor will not be overly important, |
| open-end real estate mutual funds continue to | | | | since it will be offset by the appreciation of the |
| own real estate directly. Most now invest in | | | | underlying assets. But in essence, the point is that |
| shares of real estate-related companies.The | | | | the long-term income stream is quite variable, |
| typical REIT usually distributes about 85 to 95 | | | | certainly more variable than some managers |
| percent of its income (rental income from | | | | would have investors believe.As stated above, the |
| properties) to the shareholders, usually on a | | | | inverse relationship between interest rates and |
| quarterly basis. This income gets a special tax | | | | prices of REIT's shares plays an important role. |
| break, because REIT's shareholders are entitled to | | | | On average, it is safe to assume that interest |
| a deduction for the pro-rata share of capital cost | | | | rate increases are likely to be met by REIT's |
| allowance (depreciation on the real properties). As | | | | price declines in the Stock Exchange, because |
| a result, a high percentage of the distributions are | | | | increasing rates correspond to a slowdown in the |
| normally tax-deferred. However, the amount will | | | | economic growth and less demand. But out of the |
| vary from year to year and will differ depending | | | | context of the frantic buy and sell of Wall Street, |
| on the particular REIT.As with royalty trust, the | | | | even a slowdown in the market for single-family |
| value of tax-deferred income will reduce the | | | | houses can actually benefit REIT's. This is so, |
| adjusted cost base of the shares owned. For | | | | because even though real property prices are in |
| example, if an investor purchases 1,000 units at | | | | decline, it is still cheaper to rent than to own, |
| $15.50 per unit, receives $3,000 ($3.00 per share) | | | | especially during a period of rising interest rates. |
| in aggregate tax-deferred distribution over time, | | | | And REIT's thrive on rentals. In fact, no city is a |
| and the sells the shares for $17.50 each, the | | | | better environment for REIT's to operate in than |
| capital gain will be calculated as follows:[1,000 x | | | | New York City, where some 70 percent of |
| ($17.50 - $15.50 + $3.00)] = $5,000 before | | | | residents rent.Luigi FrascatiLuigi Frascati is a Real |
| adjustments for commissions. In Canada, this gain | | | | Estate Agent based in Vancouver, British |
| will be subjected to capital gain treatment, so only | | | | Columbia. He holds a Bachelor Degree in |
| 50 percent or $2,500 will be included in income | | | | Economics and maintains a weblog entitled the |
| and taxed accordingly. In fact, Canada allows | | | | Real Estate Chronicle where you can find the full |
| preferential tax treatment to REIT's by making | | | | collection of his articles on Real Estate Economics |
| them RRSP-eligible and by not considering them | | | | and Finance. Luigi is associated with the Sutton |
| foreign property (which would taxed at a higher | | | | Group, the largest real estate organization in |
| rate), so long as the real estate portfolio does not | | | | Canada, and is based with Sutton-Centre Realty in |
| contain non-Canadian property in excess of the | | | | Burnaby, BC.Luigi is very proud to be an |
| allowable limit.REIT's yields and the market price | | | | EzineArticles Platinum Expert Author. Your rating |
| of units tend to be strongly influenced by interest | | | | at the footer of this Article is very much |
| rates movements. As rates drop, prices of REIT's | | | | appreciated. Thank you. |