The Vault

January 1994
Coburn Dewees Berry

REITs enjoy a renaissance

The words "Real Estate Investment Trusts" and "REITs" seem to be on the lips of every broker, developer, title officer, banker, and real estate lawyer I run into these days.  Of course, this is understandable, because REITs have been raising large sums of money in the public markets and have been buying properties at a brisk pace.

Given this activity, even if you don't represent a REIT or a REIT underwriter, you  will probably deal with a REIT soon if you haven't already done so.  And when you deal with a REIT you will want to have a general sense of what REITs are and  how they function.  To give such a general sense is my goal here.

I must begin by telling you that real estate investment trusts really have very little to do with real estate law – even though real estate is the product or commodity in which they deal.  What I mean by this is that there are no real estate law issues peculiar to REITs.  Like any real estate business, REITs need ongoing real estate counsel.  Underwriters need real estate legal advice in evaluating leases and title problems, zoning issues, and environmental concerns that are discovered during due diligence.  But the big issues surrounding REITs are tax and securities issues.

Real estate investment trusts are "creatures," if you will, of the federal tax laws.  So any discussion of REITs must begin there.

The provisions of the Internal Revenue Code dealing with REITs, which were first enacted in 1960, make REITs conduits for federal income tax purposes, like partnerships.  Double taxation is eliminated by a deduction for dividends paid.  But unlike partnerships, there is no pass through of losses.

There are many technical requirements in the Internal Revenue Code and its regulations relating to REITs.  In order to qualify as a REIT (which by the way, can be a corporation as well as a trust), an entity must meet certain organizational, income, asset, and distribution requirements under Sections 856 and 857 of the Code.

In order to meet the Code's organizational tests, there must be more than one director or trustee; interests must be freely transferable; the entity must be taxable as a domestic corporation; the entity cannot be a financial institution or insurance company; there must be 100 or more owners; and during the last half of the taxable year, 50% of the entity can't be owned by five or fewer individuals.  To meet the Code's income tests, the entity must derive most of its income from real estate activities.  These income tests are commonly referred to as the "75% of Income Test," "the 90% of Income Test," and the "30% Test."  To meet the Code's asset tests, the entity's assets must be primarily real estate.  These tests are known as the "75% of Assets Test" and the "25% of Assets Test."  To meet the Code's distribution requirements, an entity must – broadly speaking – distribute 95% of its taxable income to its beneficiaries or shareholders.

We speak of real estate investment "trusts," but, as I said, a REIT can also be a corporation.  The original REIT provisions of the Code applied only to trusts.  But the law was amended to add corporations in 1976.  Generally speaking, trusts offer more flexibility (their activities usually are subject to fewer statutory and common law rules and procedures than are the activities of corporation), and trusts may have certain state tax advantages.  Corporations, on the other hand, are more predictable.

It is important to remember that REIT shares, whether they are beneficial interests in trusts or stock in corporations, are securities and that their sale is subject to federal and state securities laws.  A promoter can't just go out and start peddling them.  And not only are REIT shares securities, they often must be registered with the SEC and state securities commissions.  These agencies have special rules applicable to REIT registrations.

Although the market has cooled somewhat in recent months, over the past two years REITs have been among the hottest things on Wall Street.  According to an ABA publication, between January of 1992 and May of 1993, REIT offerings raised over 10 billion dollars.  And the Wall Street Journal reported that 1.8 billion dollars were raised in August of last year alone.

Why have REITs been so popular?  I think there are basically five reasons.  First, there remains a widespread inability to obtain financing for real estate from traditional sources such as banks and insurance companies.  Yet developers still need money to finance expansion and pay down high interest debt.  Second, low interest rates on CDs and money market funds have created a demand for higher yielding investments.  REITs are paying 8% or more, and that looks pretty good right now.  The third reason there has been an appetite for REITs is liquidity.  Pension funds and other institutional investors don't want to risk getting stuck with unproductive real property as they have in the past.  Because there is a viable public market in REIT shares, liquidity is assured.  The fourth reason REITs have been popular is because limited partnerships, the other traditional vehicles for passive real estate investment, are in disfavor.  They have a poor track record, no liquidity, and tax and accounting complications.  (Of course, the passive loss rules of the Tax Reform Act of 1986 ended their usefulness as tax shelters.)  The final reason REITs have been hot is simply that they have performed very well over the last two years.  Generally speaking, they have made money and their shares have increased in value.

REITs last enjoyed a vogue in the early 1970's, but in 1974 and 1975 there was a bloodbath, and most of those REITs failed.  The typical 70's REIT had a collection of investment properties and an outside manager.  Today's REITs, though, are different.

Most of the REITs of the 90's are operating companies, with property management and development capabilities.  They see themselves as ongoing businesses and plan to grow.  They are not just investment funds.  Moreover, new REITs generally have a specific focus, such as a type of business or a geographic area.  For example, Meditrust is a New York stock exchange listed REIT that deals in healthcare properties.  Taubman Centers, Inc. specializes in malls.  And United Dominion out of Richmond focuses on apartment projects in the South Atlantic region.  Finally, today's REITs are run by experienced in-house people.  The market has so far been unwilling to accept REITs promoted by greenhorns or by people who won't be intimately involved with the entity's operations.

One more thing should be mentioned, and that is the Umbrella Partnership REIT, or "UPREIT."  An UPREIT is simply a partnership that has a REIT as its general partner.  Promoters contribute properties to the partnership rather than to the REIT itself.  This has certain tax advantages.  UPREITs are being used more and more frequently, so you will probably be hearing about them.

It is perhaps too soon to ascertain whether REITs will be permanent and widespread additions to the real estate industry landscape.  But the current generation of REITs has to date helped meet the needs of both developers and investors and has helped revitalize some segments of the real estate market.  Let's hope they are with us for a while.

Note:

*  This article is based on introductory remarks by the Editor at a recent Tennessee Land Title Association/Tennessee Bar Association real estate seminar in Nashville.

* Resource materials for this article include the October 1992 issue of The Institutional Real Estate Law Letter; an article by Richard M. Lipton entitled "UPREITs: Fad or Fixture" in the July 1993 issue of Taxes; and materials prepared by James J. Hanks, Jr. and Morris L. Kramer for the program on REITs presented at the American Bar Association annual meeting in New York in August of 1993.