Ownership Structures for Financing and Holding Real Estate David E Wish
Chapter 20 Learning Objectives ▪ Understand that the ownership form is defined by legal considerations, but that the choice of ownership form is driven by institutional and economic considerations ▪ Understand the three main determinants of the form in which real estate is held, the federal tax environment, issues of personal liability, and access to equity capital markets ▪ Understand the basic tax regulations and legal considerations that govern each type of ownership form ▪ Understand the risks and returns of various ownership forms
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Ownership Structures for Real Estate Investment Sole Proprietorship C Corporation S Corporation Partnership Trust
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Sole Ownership Simple and inexpensive to create Taxed as individual - no double taxation No access to the capital markets Unlimited liability Loss deductibility subject to passive loss restrictions
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C Corporation Articles of incorporation Separate legal and taxable entity Limited liability to shareholders Losses do not flow through to shareholders Greater access to the capital markets Double taxation of income
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S Corporation ▪ Separate legal but not taxable entity ▪ Taxable income and losses flow through to shareholders ▪ Limited liability ▪ Cannot have more than 75 shareholders ▪ Income and losses allocated based on proportion of ownership
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General Partnership ▪ Income and losses flow through to partners as determined by partnership agreement and not by proportion of ownership ▪ No double taxation ▪ Unlimited liability for all partners ▪ Fairly uncommon in real estate
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Limited Partnership ▪ Personal liability for some partners limited to equity investment ▪ Must have at least one general partner ▪ General partner has management responsibilities ▪ No double taxation ▪ Income and losses flow through per the partnership agreement
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Master Limited Partnerships (MLPs) ▪ Creates one large partnership out of many smaller ones ▪ Increases liquidity and access to the capital markets ▪ MLPs investing in real estate are treated as partnerships and not corporations ▪ Income classified as portfolio income instead of passive income
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Real Estate Investment Trusts (REITs) ▪ Created by the Real Estate Investment Trust Act of 1960 ▪ Played limited role until early 1990s ▪ Since 1992, the REIT marketplace has increased dramatically
▪ Corporations that invest in real estate ▪ Advantages include limited liability, favorable tax treatment, and access to the capital markets
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REIT Requirements ▪ Income Requirements ▪ Distribute at least 90% of its taxable income to its shareholders in the form of dividends ▪ At least 75% of gross income from real-estate-related investments ▪ 95% of income derived from dividends, interest and property income
▪ Asset Requirements ▪ At least 75% of assets in real estate, loans secured by real estate, mortgages, other REITs, cash, or government securities ▪ No more than 25% of assets invested in taxable REIT subsidiaries
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REIT Requirements ▪ Ownership Structure Requirements ▪ Jointly owned by at least 100 shareholders ▪ Issue transferable shares ▪ No more than 50% of shares can be held by five or fewer investors during the last half of each taxable year ▪ Managed by one or more trustees or directors (individuals or corporations) ▪ Use independent advisory and management firms to manage its real estate properties
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REITs – Additional Regulations ▪ Cannot hold real estate property primarily for sale ▪ Sale of property under the following conditions: ▪ Property held at least for 4 years ▪ During the holding period, capital expenditures on the property <=30% of the sales price ▪ Max. 7 properties can be sold during the same year or the FV of properties sold <=10% of FMV of all REIT’s assets as of the beginning of the year ▪ The REIT must have not acquired the property through foreclosure
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▪ Funds from Operations (FFO) provides a more accurate measure of operating performance of REITs ▪ FFO = net income (GAAP) + Depreciation (real property) + Amortization of leasing expenses + Amortization of tenant improvements + Gains (losses) from infrequent or unusual events
▪ Adjusted FFO (AFFO) measures cash flows available to shareholders, also called cash available for distribution (CAD) or funds available for distribution (FAD) ▪ AFFO = FFO minus normalized recurring expenditures and straight-lining of rents
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Measuring Operating Performance of REITs
REIT Types ▪ Equity REITs invest in and operate income-producing properties ▪ Mortgage REITs purchase mortgages ▪ Hybrid REITs invest in both – equity and mortgages ▪ Finite-life or self-liquidating ▪ Open-end REIT funds vs. closed-end REIT funds ▪ UPREIT or DownREIT ▪ All offer diversification and liquidity
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REIT Specialization ▪ Most REITs specialize in certain types of real estate ▪ REITs can focus on properties in a specific geographic region ▪ Some REITs specialize in residential mortgages – purchase FHA and VA insured loans and hold them for investment ▪ Few REITs specialize in derivative mortgage securities such as CMO residuals
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Thank You
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