Over the past decade, the effects of the 2008 financial crisis and the more recent coronavirus pandemic pushed interest rates down to minimal inflation lagging levels. This environment led to retail and institutional investors seeking alternative assets to generate returns. This environment proved to be very conducive to the real estate markets worldwide, especially in Canada, where it has been in a bull run for more than a decade now, as borrowing costs were very low and demand was robust.
What is a REIT?
REITs (Real Estate Investment Trusts) are securities that regular or real-estate businesses can issue. Another way to explain REITs is that it is a vehicle that helps securitize real estate, which means the representation of ownership through liquid and tradable units. Investors are then compensated for their holding from future cash flows from the real estate, such as those from rent and capital appreciation.
The real estate that represents a REIT can be of various sorts. For example, a REIT issued by a real-estate company can represent office buildings, shopping malls, retail outlets, a residential complex, a group of single-family homes, etc.
REITs can also be healthcare or hospitality-focused, but in that case, to be classified as a REIT, they can only rent out properties to operating companies that manage such properties full-time; the REIT cannot be involved in the day to day operations in any commercial assets it owns. In other words, the REIT is limited to being a landlord.
Structure of REITs
There are two types of REITs, private and public, on a broad level. Private REITs are those that are privately held, while public REITs are those that are traded on the stock exchanges.
Private REITs can only be sold to institutional investors, but a key advantage of such a REIT is lower hassles such as more lenient disclosure requirements. Another advantage of private REITs is higher flexibility in terms of operations, for example, unique management and fees structures.
On the other hand, public REITs are more liquid due to being exchange-traded. Still, they involve higher costs and burdens regarding disclosures such as audited financial statements, quarterly reports, etc., to protect the interests of shareholders, particularly smaller retail investors. In addition, a trust must be publicly listed on a recognized exchange to qualify as a REIT in Canada.
REITs are unique because they have to be structured in a certain way to be classified as the same. For starters, REITs are not taxed as corporations, but rather the taxes on proceeds from dividends and capital appreciation are taxed at the shareholder level. To meet this criterion, REITs must payout at least 90% of their taxable income to investors.
To qualify as a REIT, it must comply with specific requirements other than paying out most of its taxable income. For starters, a holding company or trust that holds the real estate assets must meet the requirements of the revenue test.
Under the revenue test, at least 90% of the trust’s total revenue, defined as revenue net of any asset sales, must be derived from rent, interest, dividend, royalty, property management fees or capital gains/losses from sales of assets.
As a second requirement, the revenue from dividends, royalties, or other revenue-generating activities other than rent, interest, or asset sales cannot exceed 25% of reported revenue. In other words, revenues from rent, interest, and real estate sales should make up at least 75% of reported revenue.
After meeting requirements for the revenue test, companies must clear a set of asset tests. Under the first test, at least 90% of the fair market value of the REIT must be in the form of qualified REIT assets. In simple terms, an eligible REIT asset derives 90% of its revenue from qualified activities listed in the above revenue test, meaning that at the very least, 90% of revenue must be from rent, interest, property management fees or asset sales. In other words, each asset in the REIT must comply with the revenue test mentioned above, and at least 90% of the REITs value must be made up of such investments.
Under the second asset test, at least 75% of the REIT’s assets must be in the form of real estate assets, for-sale real estate, cash, bank loan, government loan, deposits. Finally, the last three forms allow the REIT to exist between sales and acquisitions or post a public offering before funds are invested.
Once these criteria are met, the company will get the go-ahead from the Canadian Income Tax office and be forwarded to the provincial office and the securities regulators.
How to Form a Canadian REIT
The first step toward forming a REIT is forming and registering a taxable corporation, which will later be converted into the REIT after all required criteria are met. The company is most commonly formed as a property management company before receiving approvals to convert to REIT.
The second and one of the most crucial steps toward forming a REIT is the drafting of its memorandum prospectus, which outlines essential details about the REIT, such as those of operations, fund payouts, redemption details, the management, targeted market segments, etc.
In the case of a private REIT, Canadian regulators classify them as private mutual funds. As a result, private REITs, as mentioned above, are exempted from a public memorandum prospectus and can only be marketed to accredited investors. In Canada, an accredited investor has a minimum net worth of C$5 million and an annual income of at least C$200,000; the definition of an accredited investor can vary between different Canadian jurisdictions. In addition, private REITs must provide investors with a pre-defined exit or redemption route if one or more of them wants to sell their holdings.
In the case of a public REIT, Canadian regulators require that any units be sold through registered broker-dealers.
Why You Should be Interested in REITs as Business Operator or Investor
Businesses and companies lean toward REITs for several reasons –
- Liquidity – For starters, it gives them an avenue to partially liquidate certain parts of their business, real estate in this case, without having to dilute their core operations. The proceeds from liquidation can be used for various purposes, such as a partial exit. Or, as another example, a hotel company might form a REIT of the land on which its hotel operates and sell the REIT shares to interested investors. The investors are compensated for their investment in the form of cash flows which the company pays for the use of the land.
- Access to Capital – Apart from REITs that businesses can issue for the purpose of liquidity, REITs are also very popular among companies as an avenue to unlock capital to fund expansions, especially in the case of companies that are engaged in real estate as their primary operations. By clubbing real estate assets into a REIT, real-estate companies can add liquidity to certain assets without dilution of equity in the core company to fund acquisitions of more real estate.
- More Efficient Financing – Given the highly illiquid nature of real estate and the high leverage involved (high debt to fund the acquisition of land/buildings, etc.), the added liquidity from REITs helps companies in numerous ways, such as cheaper debt financing as the financiers (banks, etc.) are lending against a liquid asset, i.e. units of the REIT instead of physical real-estate in the case of a traditional mortgage, which is both very illiquid and involves high selling costs.
Of late, REITs have also become very popular among investors who want to play a certain economic angle; for example, the rise of e-commerce and increasing globalized supply chains has spurred the need for a massive number of warehouses to meet logistical or supply chain needs. Thus, by buying units of warehouse REIT, investors can gain from the increasing demand for the same in the form of dividends and capital appreciation. Such REITs can also trade at a premium compared to the fair value of the assets it holds if the overall business environment of the kind of assets it holds is favourable.
Due to these enormous tailwinds, REITs have gained popularity among businesses and investors. Further, with the onset of the pandemic, global quantitative easing has spurred the problem of record-high inflation, which is being reigned in now by quantitative tightening through the raising of interest rates. The raising of interest rates has massive ramifications for the global financial system. In simple terms, higher interest rates represent higher risk-free returns, which puts downward pressure on equities. In the case of real estate, it increases the cost of borrowing, thus increasing the cost of owning real estate and depressing demand.
However, there is a silver lining for the future of REITs; with the cost of equities and debt both being high and lofty inflation, businesses can simply monetize existing real estate assets with the issuance of REITs.
We hope you liked this article and found it informative.
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A REIT is a real estate investment trust that owns and finances investment properties, generates income and distributes dividends to investors. Under US income tax law, a REIT can be a corporation, trust fund or association that acts as an investment intermediary in real estate or real estate mortgages (Internal Revenue Code Section 856). However, not all REITs are income tax-deductible, as the term “private REIT” is used for trusts that own unlisted real estate and seek investors to participate.
In particular, a private REIT must qualify as an investment fund or trust fund for its shares to be a qualified investment under the ITA Registered Plan. The type of investor a REIT is seeking will dictate its terms and structure, particularly concerning the desired liquidity of units it can hold and whether the investor is a registered plan under the Income Tax Act of Canada (ITA). This factor is essential for retail investors. A REIT reduces the risk for individual investors by allowing them to buy securities in income-generating real estate such as offices, hotels, shopping malls and apartments without purchasing the commercial properties themselves.
Investors can build their real estate empire through a Real Estate Investment Trust (REIT). A REIT allows investors to take part in real estate investments that they would not complete on their own and offers a diverse real estate portfolio. In addition, REITs enable individual investors to buy shares in income-generating commercial real estate without buying them.
Private REITs provide not the same liquidity but are cheaper to establish, minor subject to regulatory reporting requirements, and not limited by the type of real estate activities they can invest in. As a result, setting up a REIT can help business owners reduce cash flow and attract additional investors to grow the company. REITs cannot invest in fixed-income securities, but investors can share in the benefits of a strong Canadian real estate market if they see the yield as attractive enough to generate a cash return paid monthly or quarterly.
How To Set Up a REIT:
Setting up a private REIT is a great way to raise capital from investors while providing flexibility to manage assets to enable you to increase returns for all. How long it takes to get your REIT listed depends heavily on the capital you can raise from investors at the outset and the size of the real estate portfolio you start with. A REIT must pass two annual income tests and quarterly asset tests to ensure that most REIT income and assets come from real estate sources.
At least 75% of a REIT’s gross annual income must be real estate-related income, such as rent on real estate or interest on a mortgage on a property. In addition, to qualify as a REIT, the company conducting the REIT election must file an income tax return on Form 1120 REIT. As a result, qualified REITs are exempt from the new entity-level set for investment flows that reflect the tax-traded income of trusts and partnerships paid before 1 January 2011.
In 2007, real estate investment trusts (REITs) gained legal status under the Canadian Income Tax Act when the Treasury Department introduced the concept of Special Investment flow-through trusts (SIFTs) and partnerships to protect Canada’s corporate tax base. A crowdfunding sponsor of REITs raises money through a special deal (crowdfunding) in which investors receive a portion of the cash flow from the property sold as an investment. Investors provide the sponsor with capital to buy real estate and earn a return on their investment.
In contrast, REIT investors invest in a real estate portfolio. This makes REITs easy for the average investor to ride the Canadian real estate industry that has benefited from massive appreciation in recent decades. In addition, many private Canadian REITS target retail investors in the hope that the assets in the REIT will grow. Finally, they will begin to attract institutional investment because they have uniform returns for unitholders.
While REITs cannot buy the real estate they want, investors are willing to buy stocks or bonds as they grow. Moreover, trading like a REIT provides liquid equities, which means investors can buy and sell REIT shares, for example, just as they invest and sell in retail real estate. In addition, Canadian REITs provide a significant advantage over US investors as distributions are subject to the maximum capital gains tax rate of 15% and not the standard income tax rate for dividends received by UK REITs.
In today’s real estate market, REITs offer the opportunity for long-term business growth and the flexibility to unlock value from static assets. In addition, the availability of tax loopholes such as unit trusts (REITs) and the benefits of viable business concepts such as Sri Lanka has opened up new horizons for entrepreneurs to take the real estate industry to new heights.