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Why So Many REITs?

Real estate investment trusts (or REITs) have been all over the news recently. The value of many traded REITs has increased dramatically as the US housing market has recovered (see, for example, Vanguard's REIT ETF VNQ which is currently trading at or above pre-crisis levels). Many mortgage REITs have been making headlines for their rapid growth and potentially adverse effects on the financial system. And of course, non-traded REITs continue to see criticism for reasons we've highlighted beforehere on the blog and in a working paper.

This past weekend, the Wall Street Journal's Nathaniel Popper hadan excellent story on what has been called the REIT conversion boom -- the phenomenon that many companies, from telecoms to casinos to prison operators, have been converting to REITs instead of traditional tax-paying corporations. At this point, we think it's worth stepping back and thinking about what it means to be a REIT and how the term now incorporates a wide variety of companies and investments.

A REIT is any company that qualifies as a real estate investment trust according to the Internal Revenue Service; therefore, the term 'REIT' is fundamentally a tax designation. The primary motivation for converting to a REIT is to enjoy their special tax status, under which the company would be subject to very little (often zero) corporate taxes. However, to do so, the company must pay out nearly all of its annual income to shareholders in dividends, and must derive 95% of its income from real estate related operations. What counts as real estate operations, however, has become less clear as other firms with substantial real estate holdings pursue the REIT designation.

These recent REIT conversions cloud an already complex landscape. REITs are already divided into several subgroups depending on their line of business, such as residential, retail, industrial, etc. These categories have expanded to include timberland, health care, storage, and other less traditional real estate operations. Mortgage REITs, which have seen total assets rise from"$159 billion in 2009 to $450 billion as of the end of last year" according to the WSJ, invest not in actual properties but in the mortgages that finance them. The term might be stretched even further if crowdfunded real estate becomes popular with retail investors.

Also, there is a very important distinction between REITs based on how shares can be purchased. Traded REITs are listed on major public exchanges, trade like any other publicly listed stock, and have extensive analyst coverage and SEC filings. Non-traded REITs can be purchased through brokers but are not listed on public exchanges. They are required to file periodic statements with the SEC, but have far less transparency and typically far higher transaction and other costs. Private REITs can only be purchased by accredited investors and have no public information whatsoever.

Clearly, the term REIT has come to include a very wide array of business and investors should be very careful to differentiate between them.