Real Estate Investment Trusts and You
The expansion of one’s investment portfolio can be exciting for a physician investor. However, once the realm of stocks and bonds is left behind and physicians are left in the realm of real estate, things can become daunting. The Ambulatory M&A Advisor teams up with CPAs to help explain Real Estate Investment Trusts (REIT) and its involvement in the healthcare industry.
Joseph Eckelkamp, president, E&A CFO Group says that the use of a REIT is usually for somebody who wants predictable income, but isn’t comfortable buying a bond mutual fund.
“There are a couple of different kinds of REITs, but in essence they all do the same thing. They take a pool of money from investors, and use it to buy income producing real estate. It might be commercial office buildings, it might be multi-family residential, but it’s typically income producing property,” Eckelkamp says.
“The reason I say there area couple of different kinds is how they go about buying the real estate. In one case, simply referred to as “the equity REIT,” they only use the cash that is raised from their investors to buy the real estate. They do not use mortgages at all.
The second, which is called a “mortgage REIT”, does exactly the opposite. They will take your money, they will use that money as a down payment and then they will mortgage the property.”
Eckelkamp adds that there is also a third category of REIT called a “hybrid” that is a mix of the two.
“You’ve got several flavors on REITs. You have traded REITs on major stock exchanges, public non-listed REITs and private REITs. The major stock exchange is where the larger REITs tend to populate,” Joseph Brophy, president of Joseph D Brophy CPA, PC says.
“The mortgage REITs and equity REITs also come into play because the equity REITs primarily invest in real estate properties. Mortgage REITs tend to invest in loans secured by real estate.”
Brophy says that concerning REITS there is in fact, a requirement that at least 75 percent of the total assets are committed to real estate.
Eckelkamp says that of the types of REITs, anything that has debt associated with it is going to be a greater risk. In theory, it will produce higher returns, but it will have greater risk for two reasons.
One reason is that if they use variable rate debt to finance the purchase of these properties and interest rates go way up, they may or may not be able to make a profit from the rents, Eckelkamp says.
The other reason is, if the value of the real estate falls dramatically enough, the lender can force a sale. Whereas if you own it outright, there is no lender to enforce anything.
“It’s not tremendously riskier, it’s just a little bit riskier,” Eckelkamp says.
Eckelkamp says that one important thing to know about REITs is that they generate dividends, but unlike dividends on a traditional corporation, that are taxed at a preferential rate, these are taxed at ordinary income rate.
“So, instead of having a maximum tax rate of 15 or 20 percent, they could be taxed as high as 40 percent,” he says.
Eckelkamp goes on to explain the differences between a REIT and a standard Trust.
“A REIT must have a given percentage of their assets that have to be in real estate. In addition, they are obligated to distribute 90 percent of the cash flows of operating the real estate every year,” Eckelkamp says.
“So, if a given group of rental properties generates a million dollars worth of cash flow, they are obligated to send 900,000 dollars of that out to the REIT share holders.”
Any other investment trust can basically own anything at once. Typically it does not have an obligation to pay out a given percentage of cash flow. The trust will specify general rules, but in most investment trusts, the distributions are at the trustees’ discretion, Eckelkamp says.
“A trust really offers more options. You can invest in a trust without a requirement to do 75 percent real estate. In the trust, depending on whether it is a simple or complex trust, you don’t have to distribute 90 percent of its income on an annual basis. If it is a simple trust, the trust is required to distribute all taxable income each year so the beneficiaries pay any tax on simple trust taxable income. But, if it’s a complex trust, you have choices. You have more choices on the trust in ownership and you don’t have to have 100 shareholders, whereas in a REIT you do,” Brophy says.
Brophy explains that REITs are used in most industries and are very prevalent in the healthcare field.
He says that REITs have been used in the medical community for nursing homes, for retirement and medical facilities.
Scott Peters, CEO of Healthcare Trust of America Inc. says that Healthcare REITs focus on 5 key types of assets: Medical Office Buildings (or MOBs), Skilled Nursing Facilities, Senior Housing (Assisted Living or Independent Living), Hospitals, and Laboratory facilities.
“Each of these asset types are related to healthcare and will benefit from strong macro-economic trends including a US population that is getting older and the significant increase in projected healthcare spending over the next 10 years, partially as a result of the Affordable Care Act. Each sector will benefit differently from these trends and all have very different risk and return characteristics,” Peters says.
“MOBs, for example, are traditional real estate that tenants physicians and health systems. They have great long term, steady growth and have limited risk since physicians perform well in all economic environments and tend not to move. Given this, MOBs are considered the most valuable real estate and offer relatively lower current yields. On the other end is Skilled Nursing Facilities. These are operated by 3rd party operators and have a very high component of government reimbursement thru Medicare and Medicaid. Over time, government payors have periodically cut reimbursement rates which have had negative consequences. As a result, SNFs tend to be thought of as more risky but offer higher current yields as a result.”
Speaking of risk, Scott says that any investment has risks, and REITs are no different. Scott says REITs are subject to the same economic forces that impact real estate and the stock market. However, investors can mitigate some of these risks by investing with REITs with strong management teams and a solid track record of performance over different economic cycles.
Both Brophy and Scott say that there are tax implications that come with investing in REITs.
“REITs can be very tax efficient investments. REITs are not taxed at the corporate level, allowing them to pass the majority of income to investors as ordinary income. However, a large portion of REIT dividends are shielded by certain items such as depreciation and amortization. As a result, a large percentage of some REIT dividends are not taxed and classified as “Return of Income,”” Scott says.
Brophy adds that because a REIT is distributing taxable income, the intent in congress when REITs were formed in the 1960s, was for the individual owners to pay tax on the amount distributed.
“Individuals pay tax each year on the income. Now, they have recieved cash, which is the good part of a REIT. In a trust, in theory, you could have income but not see the cash. In a REIT, you are paying tax as individual investors based on the amount distributed. So, if you get cash, you pay the tax. Rarely does the trust leave beneficiaries with that problem. Normally, the trustees are aware of, and are instructed that if there is a tax due at the beneficiary level, it needs to be distributed as tax due at the trust level. Then the trust pays it without the income being distributed and effecting the owner,” Brophy says.
If you would like to learn more about the concepts covered in this article, want to sell your business or discuss how Ambulatory Alliances, LLC might be able to help you out, contact Blayne Rush, (469)-385-7792, or Blayne@ambulatoryalliances.com.
If you have suggestions for future topics, email Blayne@ambulatoryalliances.com.