The Special Structure of Real Estate Investment Trusts

What does investment in real estate have to do with tax on cigars?

The two areas are obviously different.

But legislation creating a real estate investment vehicle was signed in the extension of excise tax on cigars.

Back in 1960, US Congress wanted to give individual investors the opportunity to invest in large-scale, diversified property portfolios. This would give them access to the income that real estate investments generate.

The initial federal tax legislation authorising real estate investment trusts (REITs) was signed into law by President Dwight D Eisenhower within the Cigar Excise Tax Extension Act (1960).

An efficient way of investing in a diversified portfolio of stocks

The new tax laws were intentionally modelled on regulated investment companies called mutual funds. This type of investment structure was created 20 years earlier. It gave the public an efficient way of investing in a diversified portfolio of stocks.

The primary intention of Congress in authorising REITs was to provide small investors with advantages that are normally only available to people with larger resources.

According to the US Securities and Exchange Commission (SEC), companies must operate within certain guidelines to qualify as a REIT.

They must acquire and develop properties to operate them as part of investment portfolios rather than reselling them after they’ve been developed. This means properties must be developed to generate ongoing income instead of capital gains from quickly flipping them.

REITs need to have the bulk of their assets and income connected to investments in real estate.

They must invest at least 75% of total assets in real estate and cash. They need to derive 75% of gross income from sources related to real estate, including rent. They must have no more than 25% of assets in non-qualifying securities or shares in taxable REIT subsidiaries.

They must also distribute at least 90% of taxable income annually to shareholders in the form of dividends.

In addition to other rules regarding the structure, these qualifications enable REITs to remain exempt from paying tax at the trust level. Instead of passing through profits, they distribute cash flow income directly to shareholders. The tax burden is shifted from the REIT to the individual.

Within a year of the legislation in 1960, six REITs were established in the US. Out of these, three of them still exist today.

The Netherlands became the first European country to pass legislation on REITs in 1969. European REITs expanded with legislation in France in 2003, while Germany and the UK passed laws in 2007.

The first property trust in Australia was listed on the ASX as the General Property Trust in 1971. It was launched and managed by Lendlease Group to give retail investors access to a portfolio of commercial property assets.

In 2005, shareholders were offered a proposal for management of the trust to be internalised. After approval, the trust separated from Lendlease and became GPT Group [ASX:GPT], as it’s still known today.

A look at the last 30 years

Let’s take a look at the monthly chart over the last 30 years:

Money Morning

Source: Optuma
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The GFC dealt a savage blow. During the crisis, the share price fell from a high of $19.08 to a low of 96 cents.

It’s easy to get caught up in the emotion of the crash and dismiss stocks like these.

Now let’s zero in on the weekly chart over the last 10 years or so:

Money Morning

Source: Optuma
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The share price has recovered and is up more than sixfold from its low during the GFC.

The chart shows you the value of maintaining long-term charts. You can see examples marked by arrows where lows come in at prior highs. This is a valuable technique that can often pinpoint areas where support can come in.

GPT put in a series of higher lows in the last year. There was not much fallout during the sell-off last October and the share price made an even higher low during December. The stock showed relative strength when the broader market sank to lower levels.

This was a set-up for a breakout to new multi-year highs. The REITs are in a sector that’s performing well.

The majority of REITs are stapled securities. They’re commonly an investment in a property trust that owns properties. This is stapled to shares in the company that manages the properties. The two securities are contractually bound together and cannot be traded separately.

Like most companies in the sector, GPT distributes most of its earnings to shareholders.

In addition to reporting net profit, GPT reports adjusted funds from operations (AFFO). In the full year to 31 December 2018, AFFO came in at $460.5 million, and distributions to shareholders came in at $459.5 million or 25.46 cents per share. This is a payout ratio of 99.8% and is typical of the industry.

My colleague Phil Anderson at Cycles, Trends & Forecasts understands the real estate cycle better than anyone I know.

This type of understanding can help you learn where we currently stand in the cycle and what to expect in the years ahead.

Regards,

Terence Duffy,
Editor, Money Morning Trader


Terence Duffy is an analyst and chartist, specialising in researching economic trends and cycles.  His primary focus is housing and land affordability. But you can also depend on him to offer his unique analysis of stock market charts. As Terence will show you, the charts often forecast, well in advance, the good or bad news to come — which he details in Cycles, Trends & Forecasts.


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