Chapter 21: REITs and Liquid Real Estate


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Chapter 21 discusses Real Estate Investment Trusts (REITs) and liquid real estate. Changes in U.S. tax law and in lender demands in the early 1990s required real estate investors and developers to discover new equity sources. REITs and publicly-traded real estate companies, called “liquid real estate,” evolved to meet this need.


One of the differences between publicly-traded real estate companies and real estate private equity funds is that private equity funds are much less liquid. Another is that private equity funds generally seek much higher equity returns and are not accessible to smaller investors because of high investment minimums. Lastly, investors in public real estate companies own both the real estate assets and the management team while private equity funds generally have not allowed people to invest in the sponsor/management team.

Real Estate Investment Trusts were created by Congress in 1960 to make investments in income-producing real estate accessible to all investors. REITs were not popular until the early 1990s as the bulk of real estate capital came from banks, insurance companies, tax syndications, and pension funds. When real estate capital was more difficult to find in the early 1990s, real estate transferred from private vehicles to public REITs. The total market capitalization of REITs increased from $12 billion in 1990 to roughly $1 trillion in 2017. There are three REIT categories: equity REITs (own and operate income producing real estate); mortgage REITs (own real estate mortgages and/or real estate debt); and hybrid REITs (a combination thereof).

During the recession of the early 1990s, for many leading real estate operators there were only two viable financing options: filing a Chapter 11 bankruptcy or filing an S-11 IPO prospectus with the SEC. The latter strategy was to sell the majority equity claim in the firm’s assets and use the IPO’s net cash proceeds to pay off maturing debt.

These IPOs worked as follows: Assume someone owned an apartment portfolio worth a theoretical $100M at a 9% cap rate. The actual value was uncertain, as the absence of debt meant that there were very few purchasers available. Additionally, imagine that the owner had $98M in debt on the portfolio and that $56M of that debt matured in the next year, with significant personal guarantees. If the owner declared Chapter 11 bankruptcy, market conditions might improve during the 12- to 24-month process, but the owner would most likely ultimately lose the properties, the management fee streams associated with the properties, and other assets (due to the personal recourse), and may have to pay a large tax bill as a result of the foreclosure. Alternatively, the owner could pursue an IPO through which they could raise equity to pay off the upcoming maturities.

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For example, if the owner raised $60M in an IPO, with the proceeds used to pay off the $56M maturing debt and to cover the $4M (6% of the amount raised) IPO fees, the owner could keep the business afloat. The IPO would dilute their ownership interest substantially, and the management fees would now be shared by all of the investors in the IPO, but the original owner would be left with a sliver of equity of perhaps 2%. The owner would have a healthy company and the opportunity to grow its stake in the company via performance incentives. Lastly, the company now could more easily raise capital in the equity and debt markets given its public nature.

The REIT tax structure offers the possibility of avoiding corporate taxes without generating tax liabilities for owners when there are no concurrent income distributions. This compares favorably to C-corps, which have a double taxation problem (profits are taxed at both the corporate and the shareholder level) The REIT structure is also favorable to partnerships, which do not pay taxes at the corporate level, but instead pass through all tax liabilities directly to the owners, who will be taxed on profits regardless of whether income is distributed. To qualify as a REIT under the tax code, a company must satisfy significant operating restrictions including that the firm’s primary business is owning and operating real estate and that at least 90% of its taxable income is paid out as dividends. Remember that a REIT’s taxable income is usually significantly lower than the cash available for distribution because of depreciation, among other reasons. Consequently, REITs can typically distribute as little as 50 to 70% of its available funds and still comply with the 90% requirement.

As a result of these restrictions, homebuilders and merchant builders do not generally qualify as REITs, as they do not own and operate their properties on a long-term basis. Since a REIT’s primary business must be owning and operating real estate, the REIT structure is not available to most companies. For example, Microsoft may own a lot of real estate but that is not their primary business. Additionally, to qualify as a REIT, the firm cannot be in the business of trading real estate. If a REIT loses its qualified status, the IRS can demand back taxes, interest on those taxes, and other penalties.

Becoming a REIT is simply a tax status election. Publicly-traded REITs are governed by the same SEC and listing rules as other public companies. REITs do not have to be public companies. Many are private. The REIT decision revolves around the gains from single taxation, which are estimated at 3 to 5% of the value of the assets. One reason why there are fewer private REITs is that a REIT must have 100 shareholders and no five shareholders taken together may control 50% or more of the equity. Therefore, large concentrated private real estate owners would need to dilute their ownership interest substantially to qualify as a REIT.

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The decision to go public depends on a firm’s desire to access large anonymous capital versus the tradeoffs of adhering to the rules imposed on public companies. The rules imposed on public companies include reporting executive salaries, providing detailed, audited financials; disclosing material information, such as planned financings; and paying lawyers and accountants to create SEC filings. All of this is expensive and time consuming and provides information that competitors can use against you. Additionally, an IPO will cost about 10% of the equity raised (with an investment bank taking 6 to 7% for themselves). The IPO decision really relates to your goals as a company and whether large pools of capital are necessary. That said, there may be large economies of scale enjoyed for larger companies. It also should be noted that how real estate has been “liquefied” has increased market transparency significantly. Therefore, companies should see their stock price negatively impacted upon the announcement of ill-conceived projects. It is hoped that such a reaction would discourage others from pursuing similar projects.

In order not to handicap the REIT structure from offering real estate-related amenity services, REITs can offer ancillary services, as long as they do not become the company’s primary business, and as long as the REIT carves out the income from such services into a taxable subsidiary. Simply stated, “non real-estate” income cannot be sheltered from taxes by REIT status. That said, there is room for manipulation, but the subsidiary should enjoy market agreements with the parent company.

An UPREIT structure is simply designed to allow a REIT to acquire buildings from partnerships without triggering capital gains taxes for the sellers. The UPREIT structure essentially creates a tax-sheltered master “umbrella” partnership between the selling partnership and the purchasing REIT, where the REIT owns the master partnership and exchanges ownership units in this new partnership for the seller’s partnership interests. There are many legal nuances, but when the acquisition is set up this way, it is viewed by the IRS as a like-kind exchange.

It is important to note the distinction between return on capital and return of capital. While money is fungible and the money received by an investor is not earmarked as one or the other (except for tax and accounting purposes), the distinction highlights how REITs differ from real estate private equity funds. REITs are focused on return on capital because the individual investor controls the timing of return of capital through their decision of when to sell the stock. As a result, REITs are focused on providing a healthy dividend yield. This contrasts with real estate private equity funds which generally place a focus on the return of investor capital, as investors in such non-traded investments generally do not control the exit decision.


These are the types of questions you’ll be able to answer after studying the full chapter.

1. Does an REIT have to be a private company?

2. What are the pros and cons of the REIT structure vs C-corps and partnerships?

3. What is a taxable REIT subsidiary and how would someone try to shelter income from taxes with such a subsidiary?

4. What is an UPREIT?

5. Explain why REITs are focused on return on capital and why real estate private equity funds are focused on return of capital.

Audio Interviews

The biggest misconception about REITs (5:32)


BRUCE KIRSCH: The Real Estate Investment Trust, or REIT, is a type of legal entity that allows for the creation and sale of equity shares in the company itself. It also avoids the dreaded double taxation and the taxation of owners in instances where earnings are generated, but distributions are not made. So being a REIT allows a company to raise capital repeatedly, through the issuance of new shares.

One of the big misconceptions though is that if a company is a REIT in terms of its legal entity status, it’s therefore, also a public company. Why do people think that’s the case? And if you are REIT, is it better to be private or public?

PETER LINNEMAN: I think the misperception arises because the media says Simon Property is a REIT, and it’s a publicly-traded company. And they create the impression that they’re synonymous. But private REITs have been around a long time. There are lots of them. And there are several real estate companies that are public that are not REITs. For example, Forest City is a very good real estate company that’s not a REIT, because they’ve decided that they don’t want to live within the strictures that get put on you as an operating manner of REIT.

So you can be a private company that is a REIT. You can be a public company that’s a REIT. You can be a private company that’s not a REIT. Or you can be a public company that’s not a REIT. It’s a tax selection, not a corporate organization.

Why is it that most public companies in the real estate space are REITs. And the reason is that they’re primarily low-leveraged, income-generating entities. And as such because of low leverage and because of high cash flows, they have a lot of taxable income exposure. And as a result of having the taxable income exposure, not having double taxation becomes very valuable.

If on the other hand, you’re a private company, and your investors are willing to be highly leveraged and to take that risk, you can see your taxable income starts disappearing because of the high leverage. And in so doing, the incentive to be a REIT goes down. Similarly, if you’re doing a lot of negative cash flow stuff, like developing. Developing, as we’ve talked about, is a negative cash flow business in the beginning.

Well, if I’m a developer, I’m not generating positive cash flows for some time. I have no income to shelter from the double taxation. So why would I take on any of these restrictions in how I can operate, and the extra reporting costs and legal costs associated with being a REIT? So when you tend to find, you tend to find large, income asset-owning, not doing a lot of development, and low debt entities would tend to be public. Smaller companies, development-oriented companies, higher-risk companies will tend to not be public or REITs.

A small company is not public. I mean, I have a company that’s worth maybe 200 million. Why am I not public? Well, come on, what’s the liquidity going to be in a $200 million company? So I could go through all the brain damage. And I have to do Sarbanes-Oxley. And I have to have a board of directors. And we have to meet four times a year. And I have to hire one of the big four accounting firms and run up 2 million of extra overhead it just doesn’t support it.

If I’m a $5 billion company, a $3 billion company, it could be worth it, because I get my money a little cheaper. So it’s a trade-off. The biggest problem that keeps entities from being re-qualified is the so-called 5 and 50 rule. And the REIT law says that you cannot take the tax election to be a REIT if any five shareholders, owners, own in combination, more than 50% of the company, 5, 0% of the company.

Well, that eliminates a lot of the real estate entrepreneur stuff. Because as an entrepreneur, you went out, and you put up 10% of the money. You got two other investors or three other investors to put up the rest of the money. And the three, four, five of you own 100% of it. Well, automatically, you cannot qualify as a REIT. No five owners in combination can own more than 50%. And so for the more entrepreneurial smaller stuff, the concentration of ownership, generally speaking, makes being a REIT not possible.

How REITs improved the real estate business (2:32)


BRUCE KIRSCH: REITs came on to the scene in around 1960. Is the real estate business in the US better off for the existence of REITs?

DR PETER LINNEMAN: Oh, I think it’s massively better off, in two ways. One it has provided an alternative source of capital, and as we’ve talked about, and the book talks about, real estate’s a capital intensive business. And therefore even just getting your capital a little bit cheaper goes a long way. It’s just like if you’re in the manufacturing of steel products. Shaving a little penny off of every ton you produce adds up if you’re doing tens of billions of tons a year. Real estate’s about mounds and mounds of capital, and having REITs has opened up an extra source because of its tax transparency. You add to that the public market side of it, and if you said, is real estate better off for having public companies, the answer is by far. Yes, you’ve gotten cheaper capital access.

The other thing is, back to what we’re talking about a while back on private equity, the public companies, most of which are REIT, have just set a different standard on transparency. And transparency is a funny thing, the industry benefits from it far more than any single company benefits from their own transparency. In that if you’re in a business where things are transparent, people are more willing to put capital in, they’re more willing to trust, they’re more willing. And the thing that the public market has done, in the last 20 years especially, is bring a high level of answerability and transparency to a large amount of the capital going to real estate. And it’s not just brought accountability for the money that’s in those REITs, it’s brought it to the industry as a whole because private equity has to compete with REITs to get money. Private REITs have to compete with public REITs to get money, and it just goes on and on. And therefore, the transparency, as well as the extra pool of capital have greatly benefited the industry.

The future of single-family home REITs (3:37)

BRUCE KIRSCH: We’ve seen recently some REITs come onto the scene that are operating single family homes as their business model.

And we know that there are significant restrictions on operations. And the operation of real estate is, being your business model as a requirement to maintaining REIT status.

What do you think about these new REITs that own single family homes and essentially run them as physically separated apartments? And do you think this is going to continue?

DR. PETER LINNEMAN: Well, the operating restriction of not being able to actively manage your properties as a REIT, those have pretty much fallen by the wayside over the last five, seven years through a series of tax decisions.

So you can actively manage your property. So that part isn’t the challenge for single family. By the way, the reason home builders have not been REITs in the past is because there are prohibitions of being a trader. And you can think about what a home builder is is they build a home and trade it. They build a home and trade it. They build a home and trade it. And as a result, they’re viewed as in the trading business and they cannot qualify.

The business of buying single family homes and renting them is a rental business. It’s the same– in concept– the same kind of business as renting any other piece of real estate subject to short term leases. How do you operate it, how do you do this, and how you do that?

I happen to believe you’re going to see from this year three, four, or five notable public companies who will evolve as operators of single family rental. The jury’s out on that. I mean we’re in the early innings.

I think it’s like Public Storage, where most Public Storage in the United States is owned by private operators. But there are several large publicly-traded companies that choose to be REITs because they have the income and low debt.

Similarly, I remember in the late ’80s I made a comment that, someday there’ll be large apartment companies that own thousands of apartments all across the country and will be public. And people thought I was nuts. And you know, no one thought you could do it. You can do it.

And so I think you’re going to see a couple come out of this– single-family. They’ll figure out how to do it. There’ll be some that stumble along the way and won’t figure out how to do it. Their costs will be too high. But I think you will see some public companies.

And in fact, I would not be at all surprised if one of the things you see is that as some of the public companies evolve to rent single-family homes.

That at some point you wouldn’t see them consolidated inside of a large apartment company. And sort of absorb them as once they get to a sufficient scale have them absorbed into a residential rental company with two divisions– an apartment component and a single-family home component, depending on the nature of the tenants.

Crowdfunding’s early innings (2:02)

BRUCE KIRSCH: So we’ve seen lots of changes in the real estate finance landscape. We’ve seen REITs. We’ve seen private equity funds. We’ve seen CMBS. And now we’re seeing something relatively new again, which is this crowdfunding of individual investors putting in as little as $100, in some cases, into investments over the internet. What do you think about this, and do you think it’s going to be around, or is it just a blip?

PETER LINNEMAN: You know, it’s interesting. I’m an old guy, and I remain unconvinced that this is really here to stay. Time will tell.

But I have seen too many instances of quick and easy money-raising in small amounts, which crowd-raised has as a key component, that end up being used by con artists. Doesn’t mean everybody who uses it is a con artist. It means that it is disproportionately used by con artists, and you get a scandal and it kills it.

And I think it’s too early to declare it successful. I think what– I just have in my gut that sooner or later, there is going to be a big scandal that’s going to shut it down. And I don’t say that from a technological point of view, I say it from the point of view that small, fast raise without high transparency has usually led, in my lifetime, to a big scandal. And the big scandal punishes the honest as well as the dishonest. And that, to me, remains the big unknown.

Key Terms


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Text for accomplishing cushion.

To view the definition, click or press on the term. Repeat to hide the definition.

When income is only taxed at a single level, i.e., just at the corporate level, or just at the individual shareholder level.

Sale of equity shares after the IPO.

When income is taxed at both the corporate and individual shareholder levels.

Business model of developing a property and selling it upon stabilization.

A special REIT structure that is designed to allow a REIT to acquire buildings from partnerships without triggering capital gains taxes for the seller.

Chapter Headings

  • History of REITs
  • REIT IPO Basics
  • REIT Income Tax Advantages and Operating Restrictions
  • REIT Versus Publicly Traded Real Estate Company
  • Public Versus Private and Large Versus Small
  • Taxable REIT Subsidiary
  • UPREIT Structure
  • Return on Capital Versus Return of Capital

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