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The coronavirus pandemic has triggered a paradigm shift in the way the global economy operates. Companies have had to learn how to adapt quickly to new demands and find ways to cut costs in order to stay solvent. The REIT industry isn’t alone in this endeavor, however, they face certain restrictions and difficulties that investors should be aware of before investing.
One of the biggest challenges facing REITs is the SEC requirement to distribute at least 90% of taxable income to investors through dividends and keeping enough liquidity on hand in order to absorb unanticipated economic adversities. While cost-cutting initiatives are being implemented, these companies must still follow compliance regulations in order to keep their protected status as an REIT. Striking a balance between meeting distribution requirements and conserving cash is a top priority for REITs right now.
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REITs have several guidelines they must adhere to when they act as lenders. According to federal income tax law, an REIT must pass an asset test that requires at least 75% of the REIT’s value to be invested in real estate assets, cash, cash receivables, and U.S. government-issued or guaranteed securities.
Interest earned by REITs needs to meet an income test that satisfies the 75% rule as well. For REITs this includes demand deposits, CDs with maturities no greater than 1 year, and money market bank and money market mutual fund accounts. Assets that are not covered under this ruling includes debt holdings, other equity holdings or financial instruments like bankers acceptances and repurchase agreements.
REITs need to be careful not to engage in any prohibited transactions either. For example, some REITs may have plans to assist tenants and renters through capital injections or by equitizing debt obligations but could end up in a position where they violate the “related party rent” rules or crosses over the 20% threshold for how much stock may be held in taxable REIT subsidiaries.
Despite the 90% rule, some REITs have poor payouts. Click here to find out why!
The legislative benefit given to businesses impacted by COVID-19 known as the Coronavirus Aid, Relief, and Economic Security Act (CARES) doesn’t address some of the unique concerns that REITs have regarding taxation and distribution requirements.
Another problem REITs must solve is how to maintain their distribution requirements to investors during this crisis. While rental payments and loan interest payments are delayed, the company may still be in a position of accruing income without having actually received the funds necessary to pay out to shareholders.
The value of real estate holdings may fall relative to an REITs investments in other assets such as stock held in taxable REIT subsidiaries, which could alter the results of an asset test as the value of “good” assets (such as real estate) decline and give greater weight to “bad” assets, putting an REIT’s tax-advantaged status at risk.
Despite the obstacles that REITs are currently presented with, there are still ways for them to navigate the economic current and remain profitable.
Considering how low stock prices have fallen, REITs may loathe to raise capital via secondary stock offerings. Instead, these companies could turn to the debt markets to raise the necessary capital needed. Because debt accumulates interest, this enables REITs to take advantage of interest-related tax deductions.
REITs get a paid deduction on dividends paid out to investors which can essentially reduce its taxable income to zero if it pays out 100% of income to investors. They also have the ability to treat subsequent year dividends as taxable during the current year. This gives them yet another tax-advantaged tool they can wield.
Finally, REITs may utilize deferred dividends that pay out at the end of the year instead of during the quarter — or quarters in which they are normally distributed. They can further extend this deferment at the end of the year by one month. This could give some cash-strapped REITs some room to manage its portfolio and still retain its tax status as a REIT.
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REIT stock prices have fallen precipitously along with many other market sectors which may make them attractive targets for value-oriented investors. These investors should be mindful of avoiding “value traps,” however, where high dividend distributions may be an unsustainable trend.
Income investors need to be especially cautious before investing. REITs may have an obligation to distribute at least 90% of ordinary taxable income, but due to certain accounting methods adopted by concerned REITs, investors may not receive the amount they had planned on getting. Deferred dividends can cause problems for some investors who rely on quarterly distributions.
Don’t forget to check out this article to know the differences between public and private REITs.
Investors that are interested in REITs should keep in mind the issues facing the industry right now. Due diligence is critical in identifying REITs that have the ability to overcome economic obstacles versus those that may not. While signs of the COVID-19 crisis appear to be abating, the long-term impact on REITs has yet to be fully realized. Staying up-to-date on the latest news and monitoring trends in the REIT industry is a must for investors.
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