REITs, like any other business, require capital. An IPO (initial public offering) is how a publicly traded REIT (real estate investment trust) accomplishes this. This is similar to selling any other stock to the general public, who are investing in the company’s income-producing real estate. People who purchase initial public offerings (IPOs) are investing in real estate that is managed similarly to a stock portfolio. These outside cash sources allow the REIT to acquire, develop, and manage real estate in order to generate profits. REITs generate income, and shareholders must get 90 percent of that taxable income on a regular basis. REITs create money by renting, leasing, or selling the assets they purchase. The shareholders elect a board of directors, which is in charge of selecting investments and recruiting a team to oversee them on a daily basis.
FFO stands for funds from operations, which is how most REIT earnings are calculated. FFO is defined by the National Association of Real Estate Investment Trusts (NAREIT) as the net income from rent and/or sales of properties after deducting administrative and financing costs. The NAREIT’s net income computations follow GAAP (generally recognized accounting rules). The issue is that depreciation of assets is presumed to be a predictable given in GAAP calculations, which skews the true measure of a REIT’s revenue in a negative direction because real estate, which is what REITs deal in, retains or even improves in value over time. As a result, depreciation is not included in FFO’s net income.
How do REITs raise money?
Another type of equity financing that REIT managers might pursue is right issues and private placement. This type of funding is fairly common. Given the leverage restriction imposed on REITs, debt borrowing alone will not be adequate to raise capital. As a result, the REIT manager would often strike a balance between stock and debt to fund future asset acquisitions.
- A rights issue is a way for REITs to raise extra capital in exchange for stock. They provide existing shareholders the chance to subscribe to issued shares in proportion to their present holdings rather than going public to acquire additional funds.
- In contrast, a private placement is a process by which REITs issue shares to accredited investors such as investment banks, mutual funds, and other institutions in exchange for capital.
Both right issues and private placements entail the issuance of shares, resulting in share dilution.
Perpetual Securities
The issue of perpetual securities is another avenue for REITs to raise capital. Perpetual securities, like bonds, offered the bearer a fixed interest payment. The main difference is that instead of being considered as debt, they are treated as equity. As a result, the gearing ratio is not increased. Despite the fact that it is recognized as equity, investors should treat it as a debt.
Summary
In essence, there are two common ways for REITs to raise capital: stock and debt financing. Given the nature of REITs, this is a critical procedure for acquisition and asset enhancement initiatives. As investors, we must assess how the REIT manager makes these decisions, as this is a key aspect of every REIT. Constant debt financing leads to over-leveraging, while constant equity financing leads to a larger share base.
Hopefully, the following information will help you understand how REITs raise cash. If you’re just getting started, check out our REIT Guide and REIT Analysis for further information. If you’re unfamiliar with REITs, you can learn more about them here.
How does a REIT grow?
While most individuals buy REITs for the dividend income, they have historically provided strong capital growth. As a result, REIT performance has been remarkable in recent decades, with the sector’s average total yearly returns exceeding those of the S&P 500.
The ability of many REITs to continually grow their dividends has been a key driver of the sector’s high total returns. While dropping interest rates and growing rents have helped enhance REIT revenue, the ability of REITs to create and buy additional cash-flowing properties has been the key driver of dividend growth.
The most successful have achieved this by focusing on a conservative financial profile that comprises a dividend payout ratio of less than 80% of FFO and a strong investment-grade balance sheet with low leverage measures. As a result, the top REITs now have the financial flexibility to focus on investments that will increase their FFO per share.
In recent years, Boston Properties, for example, has done a good job of growing shareholder value by utilizing its financial flexibility. Since 2014, it has completed around $2.6 billion in development projects and has another $3.6 billion in active development projects underway, as well as approximately $2.1 billion in property acquisitions. These investments have increased the company’s FFO from $4.90 per share in 2012 to a forecasted range of $7.45 to $7.65 per share in 2020, allowing it to raise the dividend by 42 percent in three years.
Because Boston Properties did not sell any stock to fund expansion, it was able to optimize its per-share growth rate. Instead, it used its strong bank sheet to fund development while selectively selling noncore properties to minimize leverage from spiraling out of control, climbing from 5.7 times in 2014 to 6.8 times in 2018. Since the beginning of 2013, this strategy has enabled the company earn a total return of more than 60%.
Do REITs have capital gains?
Dividend payments are assigned to ordinary income, capital gains, and return of capital for tax reasons for REITs, each of which may be taxed at a different rate. Early in the year, all public firms, including REITs, must furnish shareholders with information indicating how the prior year’s dividends should be allocated for tax purposes. The Industry Data section contains a historical record of the allocation of REIT distributions between regular income, return of capital, and capital gains.
The majority of REIT dividends are taxed as ordinary income up to a maximum rate of 37% (returning to 39.6% in 2026), plus a 3.8 percent surtax on investment income. Through December 31, 2025, taxpayers can deduct 20% of their combined qualifying business income, which includes Qualified REIT Dividends. When the 20% deduction is taken into account, the highest effective tax rate on Qualified REIT Dividends is normally 29.6%.
REIT dividends, on the other hand, will be taxed at a lower rate in the following situations:
- When a REIT makes a capital gains distribution (tax rate of up to 20% plus a 3.8 percent surtax) or a return of capital dividend (tax rate of up to 20% plus a 3.8 percent surtax);
- When a REIT distributes dividends received from a taxable REIT subsidiary or other corporation (20% maximum tax rate plus 3.8 percent surtax); and when a REIT distributes dividends received from a taxable REIT subsidiary or other corporation (20% maximum tax rate plus 3.8 percent surtax); and when a REIT distributes dividends received from
- When allowed, a REIT pays corporation taxes and keeps the profits (20 percent maximum tax rate, plus the 3.8 percent surtax).
Furthermore, the maximum capital gains rate of 20% (plus the 3.8 percent surtax) applies to the sale of REIT stock in general.
The withholding tax rate on REIT ordinary dividends paid to non-US investors is depicted in this graph.
Do REITs have capital appreciation?
REITs are investments that provide a total return. They usually provide significant dividends and have a moderate chance of long-term financial appreciation. REIT stocks have long-term total returns that are comparable to value equities and higher than lower-risk bonds.
Why are REITs a bad investment?
Real estate investment trusts (REITs) are not for everyone. This is the section for you if you’re wondering why REITs are a bad investment for you.
The major disadvantage of REITs is that they don’t provide much in the way of capital appreciation. This is because REITs must return 90 percent of their taxable income to investors, limiting their capacity to reinvest in properties to increase their value or acquire new holdings.
Another disadvantage is that REITs have very expensive management and transaction costs due to their structure.
REITs have also become increasingly connected with the larger stock market over time. As a result, one of the previous advantages has faded in value as your portfolio becomes more vulnerable to market fluctuations.
Is REIT a good investment in 2021?
Three primary causes, in my opinion, are driving investor cash toward REITs.
The S&P 500 yields a pitiful 1.37 percent, which is near to its all-time low. Even corporate bonds have been bid up to the point that they now yield a poor return compared to the risk they pose.
REITs are the last resort for investors looking for a decent yield, and demographics support greater yield-seeking behavior. As people near retirement, they typically begin to desire dividend income, and the same silver tsunami that is expected to raise healthcare demand is also expected to increase dividend demand.
The REIT index’s 2.72 percent yield isn’t as high as it once was, but it’s still far better than the alternatives. A considerably greater dividend yield can be obtained by being choosy about the REITs one purchases, and higher yielding REITs have outperformed in 2021.
Weak Growth
REITs that are publicly listed are required to pay out 90% of their profits in dividends to shareholders right away. This leaves little money to expand the portfolio by purchasing additional properties, which is what drives appreciation.
Private REITs are a good option if you enjoy the idea of REITs but want to get more than just dividends.
No Control Over Returns or Performance
Investors in direct real estate have a lot of control over their profits. They can identify properties with high cash flow, actively promote vacant rentals to renters, properly screen all applications, and use other property management best practices.
Investors in REITs, on the other hand, can only sell their shares if they are unhappy with the company’s performance. Some private REITs won’t even be able to do that, at least for the first several years.
Yield Taxed as Regular Income
Dividends are taxed at the (higher) regular income tax rate, despite the fact that profits on investments held longer than a year are taxed at the lower capital gains tax rate.
And because REITs provide a large portion of their returns in the form of dividends, investors may face a greater tax bill than they would with more appreciation-oriented assets.
Potential for High Risk and Fees
Just because an investment is regulated by the SEC does not mean it is low-risk. Before investing, do your homework and think about all aspects of the real estate market, including property valuations, interest rates, debt, geography, and changing tax regulations.
Fees should also be factored into the due diligence process. High management and transaction fees are charged by some REITs, resulting in smaller returns to shareholders. Those fees are frequently buried in the fine print of investment offerings, so be prepared to dig through the fine print to find out what they pay themselves for property management, acquisition fees, and so on.
What are the tax advantages of a REIT?
REIT shareholders’ income tax obligations might be complicated. Each distribution, or dividend payout, received by taxable account holders is made up of a mix of cash obtained by the REIT from a variety of sources and classifications, each with its own set of tax implications.
REIT dividends are frequently made up of the company’s operating earnings. As a proportional owner of the REIT firm, this profit is passed through to the shareholder as ordinary income and is taxed as nonqualified dividends at the investor’s marginal tax rate.
REIT dividends may, on occasion, comprise a portion of operational earnings that was previously tax-free due to depreciation of real estate assets. A nontaxable return of capital, often known as the ROC, is a portion of the dividend that is not taxed. While it lowers the dividend’s tax burden, it also lowers the investor’s per-share cost basis. The tax liability of current income generated by REIT dividends will not be affected by a fall in cost basis, but it will increase taxes due when the REIT shares are eventually sold. This provision may give income planning options for persons with higher taxable income in the near future, such as the potential to smooth income over numerous years.
Capital gains may make up a component of REIT dividends. This occurs when a firm makes a profit on one of its real estate properties. The length of time the REIT business had that particular asset before selling it determines whether the capital gains are considered short-term or long-term. The shareholder’s short-term capital gains liability is equal to their marginal tax rate if the asset was held for less than a year. Long-term capital gains rates apply if the REIT holds the property for more than a year; investors in the 10% or 15% tax brackets pay no long-term capital gains taxes, while those in all but the highest income group pay 15%. Long-term capital gains will be taxed at 20% for shareholders in the highest income tax level, which is now 37%.
Tax benefits of REITs
Through the end of 2025, current federal tax regulations provide for a 20% deduction on pass-through income. Individual REIT owners are allowed to deduct 20% of their taxable REIT dividend income (but not for dividends that qualify for the capital gains rates). There is no deduction limit, no minimum wage requirement, and itemized deductions are not required to enjoy this benefit. For a person in the highest tax band, this provision (qualified business income) effectively lowers the federal tax rate on ordinary REIT dividends from 37 percent to 29.6 percent.
A word on current tax reform
On April 28, the Biden administration proposed a $1.5 trillion increase in individual taxes to assist defray the costs of a huge family and economic infrastructure investment. Many of the tax plans are similar to hikes in tax rates for high-income earners that were proposed during the campaign.
Congress is currently debating infrastructure initiatives and negotiating potential legislation’s structure and text. This procedure will take up a significant portion of the closing months of 2021, and if passed, it will very certainly affect the tax rates of high-income individuals.
Closing thoughts
When looking into the world of REITs, it’s critical to grasp the potential rewards and requirements. The regulations of REIT taxes are unique, and depending on the situation, shareholders may incur different tax rates. As usual, you should seek advice from your own tax, legal, and investment professionals, as each person’s situation is unique.
Are REIT dividends taxable if reinvested?
The tax rules that govern REITs encourage the distribution of earnings to shareholders in the form of dividends. The same requirements apply to dividends, which means that even if they are reinvested in more REIT shares, investors must pay taxes on them.
Do REITs pass-through losses?
Finally, a real estate investment trust (REIT) is not a pass-through corporation. This means that, unlike a partnership, a REIT is unable to pass on any tax losses to its shareholders.
