Click here for "The Investor's Guide to Real Estate Investment Trusts (REITs)" from the National Association of Real Estate Investment Trusts. More on Investing in REITs. Glossary of REIT Terms. FAQs about REITs.

Real Estate Investment Trusts (REITs) were created by Congress in 1960 but played a very limited role in real estate investment for more than three decades. Since 1992, however, the REIT marketplace has grown dramatically. Why is this happening, and what does it mean?

WHAT IS A REIT?
Simply stated, a REIT is a company dedicated to owning and, in most cases, operating income-producing real estate, such as apartments, shopping centers, offices and warehouses. Some REITs also are engaged in financing real estate. Most importantly,

to be a REIT a company is legally required to pay virtually all of its taxable income (90 percent) to its shareholders every year.

In short, a REIT may deduct the dividends paid to the shareholders from its corporate tax bill so long as the company's assets are primarily composed of real estate held for the long term, the company's income is mainly derived from real estate, and the company pays out at least 90 percent of its taxable income to shareholders.

The main benefit of being a REIT: one level of taxation.

The main limitation of being a REIT: a restriction on earnings retained by the company.

For a REIT to grow, capital must come from money raised in the investment marketplace as well as money generated internally. REITs, like other stocks, are carefully monitored by others, including the SEC, each REIT's independent directors, independent auditors, and the business and financial media. REITs directly support their local communities through the payment of property and other taxes.

WHY DID CONGRESS CREATE REITs?
Congress created REITs in 1960 to enable small investors to make investments in large-scale, income-producing real estate. Congress decided that the only way for the average investor to access investments in significant commercial properties was through pooling arrangements. As a result, Congress designed REITs to unite the capital of many into a single economic enterprise. That enterprise is geared to the production of income through commercial real estate ownership and finance.

REITs played a limited role in real estate investment for more than 30 years. In the beginning, REITs were constrained because they were permitted only to own real estate, not operate or manage it. This meant that REITs needed to find third parties, whose economic interests might diverge from those of the REITs' owners, to operate and manage the properties. The investment marketplace did not readily accept this arrangement

During these years, provisions of the tax code also distorted the real estate marketplace by making real estate investment tax shelter-oriented. By using high debt levels and aggressive depreciation schedules, a taxpayer could take interest and depreciation deductions that significantly reduced his or her taxable income. In many cases these deductions led to so-called "paper losses" that were used to shelter a taxpayer's other income.

By contrast, Congress designed REITs specifically to create taxable income on a regular basis, and did not permit REITs to pass losses through to shareholders. Therefore, for many years the REIT industry could not compete effectively for capital against tax shelters.

HOW HAVE REITS EVOLVED?
The Tax Reform Act of 1986 radically changed the real estate investment landscape in two important ways. First, the Act drastically reduced the potential for real estate investment to generate tax shelter opportunities. It did so by limiting the deductibility of interest, lengthening depreciation periods and restricting the use of "passive losses." This meant that real estate investment had to be economic and income-oriented.

Second, as part of the Act, Congress empowered REITs. The Act permitted REITs not only to own, but also to operate and manage, most types of income-producing commercial properties. They could do so by providing "customary" services associated with real

estate ownership. Finally, for most types of real estate (other than hotels, health care facilities and some other activities that require a higher degree of personal services relative to rent), the economic interests of the REIT's owners could be merged with those of the REIT's operators and managers.

"The REIT story is an economic success story. REITs are doing exactly what the Congress intended when it created them in 1960. They have made accessibility to income-producing commercial real estate a reality for all investors. And their liquidity enables investors to buy or sell shares of diversified portfolios of properties - from shopping malls to apartment complexes."

– U.S. Representative Ben Cardin (D-MD)

Even with these changes, REITs did not flourish right away. During the late 1980s, banks, insurance companies and pension funds kept up a fast pace of real estate financing. Foreign investment, particularly from Japan, also helped buoy the marketplace. But by 1990, the combined impact of the savings and loan crisis, the Tax Reform Act of 1986, overbuilding during the 1980s and regulatory pressures on bank and insurance leaders, led to a depression in the real estate industry. During the early 1990s, commercial property values dropped between 30 and 50 percent. Credit and capital for commercial real estate became largely unavailable.

Against this backdrop, many private real estate companies decided that the best and most efficient way to access capital was through the public marketplace using REITs. At the same time, many investors decided that it was a good time to invest in commercial real estate on terms favorable to them. After all, they believed recovering real estate markets were just over the horizon. They were right.

"With the expansion of REITs in recent years, real estate investment increasingly is in public hands. This is a healthy development for the marketplace because it ensures that more and more real estate investment will be equity-oriented, transparent and taxable at the investor level."

– Jon A. Fosheim, Principal, Green Street Advisors

WHY HAVE REITS BEEN GROWING?
Investor interest has sparked REIT growth. The real estate cycle has been on the upswing for the past five years, and investors want to be a part of it. In addition: Since REITs must be widely held, they are ideal candidates to be public companies. Because REITs must distribute almost all their taxable income as dividends to shareholders, they instill confidence in the marketplace.

Because the managers of a modern REIT also have a meaningful ownership stake in the company, investors are increasingly comfortable with the structure. Currently, REITs operate properties in nearly every metropolitan area across the country and in several international locations.

ARE REITS HERE TO STAY?
Yes, because real estate investors are offered three important qualities through modern REITs that were never accessible or available to them before: liquidity, security and performance.

LIQUIDITY.
REITs have helped turn real estate liquid. Through the public REIT marketplace of over 200 real estate companies, investors can buy and sell interests in diversified portfolios of properties - as well as the management associated with them - on an instantaneous basis. Illiquidity, the bane of real estate investors is gone.

SECURITY.
Because real estate is a physical asset with a long life during which it has the potential to produce income, investors always have viewed real estate as an investment option with security. Now, through REITs, small investors have an added level of security never available before in real estate investment. Low levels of debt practiced by REITs also mean greater security for the financial system as a whole. Today's security also comes from information. The advent of the public REIT industry (which is governed by SEC-mandated information disclosure and reporting) has made available to the public a flow of available information about:

The company and its properties, the management and its business plan, and the property markets and their prospects.

PERFORMANCE.
Since their inception, REITs have provided competitive investment performance. In recent years and over the long-term, REIT market performance has been roughly comparable to that of the Russell 2000 Index and has exceeded returns on fixed debt instruments or direct investments in real estate. Because REITs annually pay out almost all their taxable income, a significant component of total return reliably comes from dividends.

The growth of REITs in the 1990s has been unprecedented, and their increasing ownership position will continue to reshape real estate investment, finance and operation into the next century.