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Wharton Emeritus Professor Dr. Peter Linneman explains.
BRUCE KIRSCH: The Real Estate Investment Trust, or REIT, is a type of legal entity that allows for the creation and sale of equity shares in the company itself. It also avoids the dreaded double taxation and the taxation of owners in instances where earnings are generated, but distributions are not made. So being a REIT allows a company to raise capital repeatedly, through the issuance of new shares.
One of the big misconceptions though, is that if a company is a REIT in terms of its legal entity status, it’s therefore, also a public company. Why do people think that’s the case? And if you are REIT, is it better to be private or public?
PETER LINNEMAN: I think the misperception arises because the media says Simon Property is a REIT, and it’s a publicly traded company. And they create the impression that they’re synonymous. But private REITs have been around a long time. There are lots of them. And there are several real estate companies that are public that are not REITs. For example, Forest City is a very good real estate company that’s not a REIT, because they’ve decided that they don’t want to live within the strictures that get put on you as an operating manner of REIT.
So you can be a private company that is a REIT. You can be a public company that’s a REIT. You can be a private company that’s not a REIT. Or you can be a public company that’s not a REIT. It’s a tax selection, not a corporate organization.
Why is it that most public companies in the real estate space are REITs. And the reason is that they’re primarily low-leveraged, income-generating entities. And as such because of low leverage and because of high cash flows, they have a lot of taxable income exposure. And as a result of having the taxable income exposure, not having double taxation becomes very valuable.
If on the other hand, you’re a private company, and your investors are willing to be highly leveraged and to take that risk, you can see your taxable income starts disappearing because of the high leverage. And in so doing, the incentive to be a REIT goes down. Similarly, if you’re doing a lot of negative cash flow stuff, like developing. Developing, as we’ve talked about, is a negative cash flow business in the beginning.
Well, if I’m a developer, I’m not generating positive cash flows for some time. I have no income to shelter from the double taxation. So why would I take on any of these restrictions in how I can operate, and the extra reporting costs and legal costs associated with being a REIT? So when you tend to find, you tend to find large, income asset-owning, not doing a lot of development, and low debt entities, would tend to be public. Smaller companies, development-oriented companies, higher risk companies will tend to not be public or REITs.
A small company is not public. I mean, I have a company that’s worth maybe 200 million. Why am I not public? Well, come on, what’s the liquidity going to be in a $200 million company? So I could go through all the brain damage. And I have to do Sarbanes-Oxley. And I have to have a board of directors. And we have to meet four times a year. And I have to hire one of the big four accounting firms and run up 2 million of extra overhead it just doesn’t support it.
If I’m a $5 billion company, a $3 billion company, it could be worth it, because I get my money a little cheaper. So it’s a trade off. The biggest problem that keeps entities from being re-qualified is the so-called 5 and 50 rule. And the REIT law says that you cannot take the tax election to be a REIT if any five shareholders, owners, own in combination, more than 50% of the company, 5, 0% of the company.
Well, that eliminates a lot of the real estate entrepreneur stuff. Because as an entrepreneur, you went out, and you put up 10% of the money. You got two other investors or three other investors to put up the rest of the money. And the three, four, five of you own 100% of it. Well, automatically, you cannot qualify as a REIT. No five owners in combination, can own more than 50%. And so for the more entrepreneurial smaller stuff, the concentration of ownership generally speaking, makes being a REIT not possible.