If you are seeking a career in real estate private equity, you will need to have a basic understanding of REITs. Once you land your first real estate private equity jobs, you’ll gain even more understanding and experience with REITs because they make up one of the largest real estate ownership types in the world.
Part One described REITs, who invests in them, and why. It also discussed the types of REITs and the three primary structures that REITs use. In Part Two, we will look at three key characteristics of REITs: dividends, liquidity, and capital retention.
Knowing that the purpose of a REIT is to own real estate and generate a return for investors, the question becomes what to do with the cash that the real estate investments generate. The two options are, generally speaking, pay dividends to the shareholders, or retain the cash. REITs are required by law to distribute 90% of their taxable income as dividends. This doesn’t mean, however, that 90% of their net operating income is distributed back to shareholders.
One of the attractive features of real estate investing is the depreciation expense, which helps defer much of the tax liability into the future. For a REIT, the NOI (which is pre-tax, and is very similar to the REIT term “Funds From Operations”, or “FFO”) can be allocated to dividends in compliance with tax laws, and still have funds available to achieve the long term goals of the company.
Investors like the combination of dividends and deferred tax liability. This combination has attracted an abundance of investor capital to REIT stocks, fueling the growth and popularity of REITs.
Not all of the available cash flow can be distributed, however. Fund-level liquidity is important to a REIT for a variety of reasons. Many expenses are seasonal (like property taxes) and require a larger outlay once or twice per year. Investors like steady dividends, so maintaining enough cash to ensure regular dividend payments in spite of normal ups and downs in the business are crucial to investor satisfaction. Depending on the investment strategy, the REIT may acquire properties with all cash, requiring plenty of liquidity to meet investment and reinvestment goals.
Since REITs invest in multiple properties (often hundreds, depending on the size of the REIT), there are occasions where a specific asset may be sold. This could be due to portfolio realignment, shedding an underperforming asset, or harvesting a gain that is unlikely to be available in the future. This sale results in a large inflow of cash.
Management will usually prefer to recycle the capital rather than distribute it. This means acquiring a new property to replace the sold one. In order to avoid the taxable gain on sale (which would require 90% of that taxable gain to be distributed to shareholders), REITs can use a 1031 exchange to exchange the tax basis in the sold property into the acquired property. (A future article will discuss 1031 exchanges in more detail!) By using this tax-free exchange, the REIT is able to retain and reinvest (recycling) the proceeds from the asset sale.
REITs are the dominant player in commercial real estate, and if you don’t work for one during your career in real estate private equity, you will likely work with one on multiple transactions. REITs are an attractive investment option for small investors, providing exposure to the real estate asset class that would otherwise be unattainable. They also provide reduced tax liability and stable dividends. And for your benefit, REITs also provide a gateway to real estate private equity jobs!