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)


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


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


Crowdfunding’s early innings (2:02)

Key Terms

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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.

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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