A real estate investment trust (REIT) is a company that owns and manages income-producing real estate. REITs were created by an act of Congress in 1960 to enable large and small investors alike to enjoy the rental income from commercial property. REITs are governed by many regulations, the most important being that they must distribute at least 90% of their taxable income to shareholders each year as dividends; the REIT is permitted to deduct dividends paid to shareholders from its taxable income. Other important regulations include:

• Asset requirements: at least 75% of assets must be real estate, cash, and government securities.
• Income requirements: at least 75% of gross income must come from rents, interest from mortgages, or other real estate investments.
• Stock ownership requirements: shares in the REIT must be held by a minimum of 100 shareholders.

REITs specialize by property type. They invest in most major property types with nearly two thirds of investment being in offices, apartments, shopping centers, regional malls, and industrial facilities. The rest is divided among hotels, self-storage facilities, health-care properties, and some specialty REITs that own anything from prisons, theatres, and golf courses to timberlands.

Some benefits of REITs include:

High Yields. For many investors, the main attraction of REITs is their dividend yield. The average long-term (15-year) dividend yield for REITs is about 8%, well more than the yield of the S&P 500 Index. Also, REIT dividends are secured by stable rents from long-term leases, and many REIT managers employ conservative leverage on the balance sheet. 

Simple Tax Treatment. Unlike most partnerships, tax issues for REIT investors are fairly straightforward. Each year, REITs send Form 1099-DIV to their shareholders, containing a breakdown of the dividend distributions. For tax purposes, dividends are allocated to ordinary income, capital gains, and return of capital. As REITs do not pay taxes at the corporate level, investors are taxed at their individual tax rate for the ordinary income portion of the dividend. The portion of the dividend taxed as capital gains arises if the REIT sells assets. Return of capital, or net distributions in excess of the REIT's earnings and profits, are not taxed as ordinary income, but instead applied to reduce the shareholder's cost basis in the stock. When the shares are eventually sold, the difference between the share price and reduced tax basis is taxed as a capital gain.    

Liquidity of REIT Shares. REIT shares are bought and sold on a stock exchange. By contrast, buying and selling property directly involves higher expenses and requires a great deal of effort.

Diversification. Studies have shown that adding REITs to a diversified investment portfolio increases returns and reduces risk since REITs have little correlation with the S&P 500. 

Drawbacks of REITs

 REITs also have some drawbacks, including:

Sensitive to Demand for Other High-Yield Assets. Generally, rising interest rates could make Treasury securities more attractive, drawing funds away from REITs and lowering their share prices.

Property Taxes. REITs must pay property taxes, which can make up as much as 25% of total operating expenses. State and municipal authorities could increase property taxes to make up for budget shortfalls, reducing cash flows to shareholders.

Tax Rates. One of the downsides to the high yield of REITs is that the taxes due on distributions are typically higher than the 15% most dividends are currently taxed at. This is because a large chunk of a REIT's distributions (typically about three quarters, though it varies widely by REIT) is considered ordinary income, which is usually taxed at a higher rate, up to 33% currently.

REITs were quite cheap until recently. They suffered greatly during the financial crisis as a proxy for the financial business. REITs as a class hit their lows in early March 2009. Since that time, the average REIT is up 50%, so much of the opportunity for REITs has passed. Still, the average REIT is offering a 6% distribution, which compared with short term interest rates around Zero, is very attractive.

There may be more shoes to drop as commercial RE looks challenged for the next two years. Commercial RE lags the general economy because of the longer term nature of their revenue structure in the form of leases. As leases expire, they will be renegotiated at lower levels than previously. In the area of retail RE, there may be too much space after the economic contraction led by a reduction in consumer spending. This will result in a contraction of lease revenue which will affect RE profits.

AN ALTERNATIVE : RESIDENTIAL HOUSING ETF

An alternative to the REIT is the new Residential ETFs "UMM" and "DMM". This ETF is a zero-sum wager on both sides of the housing market index sponsored and managed by Case-Shiller.  It makes possible a positive or negative wager on the performance of the private  residential real estate market and sidesteps the problems of commercial RE.

The Case-Shiller product is described as follows:  The investment seeks to replicate, net of expenses of the return of the Composite-10 Home Price Index. The index is a value-weighted average and tracks the price path of typical single-family homes located in each metropolitan area: New York City, Los Angeles, San Francisco, Chicago, Washington D.C., Boston, San Diego, Miami, Denver and Las Vegas.

A good strategic use of the housing ETFs: to replace the asset value of a home in an investor's portfolio once sold. It might make sense for a person in transition and not in need of a permanent home, to use the housing ETF to replace that asset class in a diversified portfolio. This is especially true with residential RE near a long-term bottom and with much appreciation potential over the next 15-20 years.

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