Real Estate Investment Trusts

Royalty trusts, in Finance, are classic flow-throughrise thus causing yields to drop. On the other
investments vehicles. The trust, like a mutualhand, when interest rates rise, prices of REIT's
fund, holds a portfolio of assets, which can bedrop thus causing yields to rise.For example, when
anything from producing oil and gas wells tointerest rates were pushed up by both the
power generating stations to interests in land. TheFederal Reserve Board and the Bank of Canada
net cash flow, i.e. the total cash flow minusall the way back in 2000, the typical REIT was
revenues, is passed on to the unit-holders asyielding close to 14 percent as prices per share
distribution.The purpose of a Real Estatefell. When interest rates subsequently dropped,
Investment Trusts is to reduce or eliminateyields 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 ashigher.This is a very important consideration to be
investment vehicles, Real Estate Investmentkept in mind when investing or otherwise trading
Trusts pay little or no federal income tax but areunits involving this type of trusts. If interest rates
subject to a number of special requirements setappear to be poised to rise, investors may want
forth in the Internal Revenue Code, one of whichto defer purchases, and those who own this type
is the requirement to distribute annually at leastof shares already may consider reducing their
90 percent of their taxable income in the form ofexposure by selling and take in some profit.There
dividends to shareholders.Real Estate Investmentare typically two catches with REIT's. The first is
Trusts are, therefore, a special type of royaltythat since investors are ‘unit-holders' rather
trust. They specialize in real property, anythingthan 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 orinsolvency. Instead of limited liability, investors rely
‘mutual' real estate funds are subject toon the REIT's management to have property,
new money and redemption problems, entirelycasualty and liability insurance, prudent lending
absent in closed-end trusts. The first Real Estatepolicies and other reasonable safeguards in place.
Investment Trust was introduced in the UnitedNevertheless there is always the possibility of a
States in 1960. The vehicle was designed toproblem - say a catastrophic fire or a building
facilitate investments in large-scalecollapse - 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 investorsto the attacks on the World Trade Center in
to acquire equity interests in vehicles holding2001. Since then, however, it is something that
large-scale commercial property.But the birth ofhas to be taken seriously.The second problem
Real Estate Investments Trusts as a masswith REIT's is less transparent. All real estate
investment vehicle can be traced directly to theproperties depreciate in value over time (not the
liquidity crisis encountered by open-end real estateland, only the buildings). Depreciation can be
mutual funds all the way back to 1991-92, duringsomewhat slowed down by earmarking at times
the slowdown of real estate that characterizedsignificant amounts of money for maintenance
those years. Faced with redemption demands onand renewal of facilities. Since most of the REIT's
the part of unit-holders, real estate mutual fundsincome is being distributed and the capital cost
were presented with the unpalatable option ofallowance is being allocated to investors, investors
selling valuable real properties into a distressedare 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 convertedreal properties will be steadily depleting.Obviously,
into Real Estate Investment Trusts, since thenif real estate markets are on the upswing the
most commonly known as REIT's. Only a fewdepreciation factor will not be overly important,
open-end real estate mutual funds continue tosince it will be offset by the appreciation of the
own real estate directly. Most now invest inunderlying assets. But in essence, the point is that
shares of real estate-related companies.Thethe long-term income stream is quite variable,
typical REIT usually distributes about 85 to 95certainly more variable than some managers
percent of its income (rental income fromwould have investors believe.As stated above, the
properties) to the shareholders, usually on ainverse relationship between interest rates and
quarterly basis. This income gets a special taxprices of REIT's shares plays an important role.
break, because REIT's shareholders are entitled toOn average, it is safe to assume that interest
a deduction for the pro-rata share of capital costrate increases are likely to be met by REIT's
allowance (depreciation on the real properties). Asprice declines in the Stock Exchange, because
a result, a high percentage of the distributions areincreasing rates correspond to a slowdown in the
normally tax-deferred. However, the amount willeconomic growth and less demand. But out of the
vary from year to year and will differ dependingcontext of the frantic buy and sell of Wall Street,
on the particular REIT.As with royalty trust, theeven a slowdown in the market for single-family
value of tax-deferred income will reduce thehouses can actually benefit REIT's. This is so,
adjusted cost base of the shares owned. Forbecause even though real property prices are in
example, if an investor purchases 1,000 units atdecline, 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, thebetter environment for REIT's to operate in than
capital gain will be calculated as follows:[1,000 xNew York City, where some 70 percent of
($17.50 - $15.50 + $3.00)] = $5,000 beforeresidents rent.Luigi FrascatiLuigi Frascati is a Real
adjustments for commissions. In Canada, this gainEstate Agent based in Vancouver, British
will be subjected to capital gain treatment, so onlyColumbia. He holds a Bachelor Degree in
50 percent or $2,500 will be included in incomeEconomics and maintains a weblog entitled the
and taxed accordingly. In fact, Canada allowsReal Estate Chronicle where you can find the full
preferential tax treatment to REIT's by makingcollection of his articles on Real Estate Economics
them RRSP-eligible and by not considering themand Finance. Luigi is associated with the Sutton
foreign property (which would taxed at a higherGroup, the largest real estate organization in
rate), so long as the real estate portfolio does notCanada, and is based with Sutton-Centre Realty in
contain non-Canadian property in excess of theBurnaby, BC.Luigi is very proud to be an
allowable limit.REIT's yields and the market priceEzineArticles Platinum Expert Author. Your rating
of units tend to be strongly influenced by interestat the footer of this Article is very much
rates movements. As rates drop, prices of REIT'sappreciated. Thank you.