Reits

Since 1950, the Dow Jones Industrial Average has yielded average annual returns of 12.19%. It is an average of 30 large blue-chip corporations and has been in existence since 1896. The index is often considered one of the best performance gauges of the US Stock Market. At the end of October 2002, its value was the same as it had been precisely four years earlier in October 1998 ("Invest" par.2). Since this index serves as one of the best indicators of stock performance in the US, it is fair to state that the average long-term investor would have been better off with their money in their bank account rather than invested in stocks or mutual funds. Most people are content with some level of short-term risk in their investments, while they take comfort in the commonly held belief that the stock market will rise in the long-term. This belief has begun to change for a number of factors. The technology bubble of the late 1990's, the crash of 1987, accounting scandals, and countless other factors have influenced a growing feeling of distrust in the future of the stock market. Even with US interest rates reaching 30 year lows, people are no longer prepared to risk their retirement money on a system that seems to get more volatile with every passing month. In this new era of investment, there is a need, now more than ever, to find new avenues in which investors can diversify their portfolios and minimize their risk. One possible opportunity is through the purchase of real estate, and more specifically Real Estate Investment Trusts or REITs. The following paper will provide some history and background about REITs' origins, outline what REITs are, and demonstrate how REITs operate. The main focus will be on equity REITs, but it will also cover basic information on mortgage and hybrid REITs.

The true origin of REITs can be traced back to the days of the 1880's. In those years, before strong taxation laws were in place, investors could avoid double taxation because trusts were not taxed at the corporate level if income was distributed to beneficiaries. However, in the 1930's the tax advantage investors imposed on the government was reversed. A law was first passed to tax all passive investments at the corporate level and then later as part of an individual's personal income. Stock and bond investment companies were able to overturn this type of taxation rather promptly. However, REITs were unable to secure legislation to overturn the 1930 decision for the next 30 years. Soon after the end of World War II, there was a large surge for real estate funds. President Eisenhower responded to this by signing into law the 1960 Real Estate Investment Trust Tax Provision which reestablished the special tax considerations qualifying REITs as pass through entities (thus eliminating the double taxation) ("Appleton" par.3). Since the law's inception in 1960, it has remained relatively intact with very minor improvements. The plan for this legislation was to make it was easier for smaller investors to invest in large-scale real estate properties. Congress did just this by creating the REIT in 1960. This allowed individual real estate investors to "pool their investments" in order to enjoy the same benefits as direct real estate owners ("History" par.2). It is from the purchase of equity that shareholders can earn a pro-rata share of the economic profits bound through the ownership of commercial real estate.

Initially, REITs were largely ignored due to the fact that the majority of investors preferred to invest in real estate through limited partnerships because the tax laws favored those tax shelters available only to partnerships. Also during this time, REITs were not allowed to manage or operate their real estate, only own it. The Tax Reform Act of 1986, however, eliminated investors' abilities to generate partnership losses to shelter otherwise taxable income, and permitted REITs to operate and manage, in addition to own, most types of income-producing commercial real estate ("Annaly" par. 4). Throughout the mid to late 1980's, the market continued to remain quite stagnant and as a result real estate companies were able to obtain debt financing from their banks and insurance companies. In 1990 however, the market suffered a remarkable downturn and commercial property values dropped making the debt financing for commercial real estate essentially unavailable. During this low point in commercial real estate, private companies started looking for other methods of investing. They thought that the most attractive way was to invest in the stock market through the use of a REIT. Also, interest rates had started to drop and investors were turned to the stock market instead of continuing to invest with certificate of deposits and bonds that only returned a fixed rate. While interest rates continued to fall, REITs began to pick up in popularity, finally emerging as a noteworthy investment tool for real estate development. The rise in the stock market and real estate market over the past five years has continued to stimulate REIT growth.

A REIT is a company that manages all aspects of real estate assets. This often involves the purchase, development, and sale of a number of different forms of real estate. The concept of REITs allows investors to put their money in the care of professional managers specializing in portfolios of real estate properties ("Glett" par.1). REITs are considered pass-through entities, which allow the company to declare dividends to their investors without having to pay corporate level taxes on the profits. In general, these dividends stem from the rental income produced from the properties held in the trust. Managers of REITs make their income in a similar manner as mutual funds by charging commission fees to their clients. REITs allow a number of individual investors to pool their financial resources together to purchase real estate that they could not have on their own. REITs enable investors to hold liquid real estate assets that can be traded on major exchanges rather than purchased through private means. Similar to mutual funds, there are a number of types of REITs with varying focuses ranging from geographical location to the type of properties that are held.

If a corporation is wants to qualify as a REIT and gain the advantages of a pass-through entity free from taxation at the corporate level, it needs to comply with specific requirements set by the Internal Revenue Code. The first rule of a REIT is that it must distribute at least 90 percent of its annual taxable income, excluding capital gains, as dividends to its shareholders. Secondly, a REIT must have at least 75% of its assets invested in real estate, mortgage loans, shares in other REITs, cash, or government securities. A third requirement of REITs is that it must derive at least