Clauretie Sirmans Chapter 20 - OnCourse Learning Publishing
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Transcript Clauretie Sirmans Chapter 20 - OnCourse Learning Publishing
Chapter 20
Ownership Structures for
Financing and Holding Real
Estate
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Chapter 20 Learning Objectives
Understand that the ownership form is defined by legal
considerations, but that the choice of ownership form is
driven by institutional and economic considerations
Understand the three main determinants of the form in
which real estate is held, the federal tax environment,
issues of personal liability, and access to equity capital
markets
Understand the basic tax regulations and legal
considerations that govern each type of ownership form
Understand the risks and returns of various ownership
forms
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Ownership Structures for Real Estate
Investment
Sole Proprietorship
C Corporation
S Corporation
Partnership
Trust
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Sole Ownership
Simple and inexpensive to create
Taxed as individual - no double taxation
No access to the capital markets
Unlimited liability
Loss deductibility subject to passive loss restrictions
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C Corporation
Articles of incorporation
Separate legal and taxable entity
Limited liability to shareholders
Losses do not flow through to shareholders
Greater access to the capital markets
Double taxation of income
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S Corporation
Separate legal but not taxable entity
Taxable income and losses flow through to
shareholders
Limited liability
Cannot have more than 75 shareholders
Income and losses allocated based on proportion of
ownership
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General Partnership
Income and losses flow through to partners as
determined by partnership agreement and not by
proportion of ownership
No double taxation
Unlimited liability for all partners
Fairly uncommon in real estate
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Limited Partnership
Personal liability for some partners limited to equity
investment
Must have at least one general partner
General partner has management responsibilities
No double taxation
Income and losses flow through per the partnership
agreement
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Master Limited Partnerships (MLPs)
Creates one large partnership out of many smaller
ones
Increases liquidity and access to the capital markets
MLPs investing in real estate are treated as
partnerships and not corporations
Income classified as portfolio income instead of
passive income
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Real Estate Investment Trusts (REITs)
Created by the Real Estate Investment Trust Act of
1960
Played limited role until early 1990s
Since 1992, the REIT marketplace has increased dramatically
Corporations that invest in real estate
Advantages include limited liability, favorable tax
treatment, and access to the capital markets
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REIT Requirements
Income Requirements
Distribute at least 90% of its taxable income to its shareholders in
the form of dividends
At least 75% of gross income from real-estate-related investments
95% of income derived from dividends, interest and property
income
Asset Requirements
At least 75% of assets in real estate, loans secured by real estate,
mortgages, other REITs, cash, or government securities
No more than 25% of assets invested in taxable REIT subsidiaries
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REIT Requirements
Ownership Structure Requirements
Jointly owned by at least 100 shareholders
Issue transferable shares
No more than 50% of shares can be held by five or fewer
investors during the last half of each taxable year
Managed by one or more trustees or directors (individuals
or corporations)
Use independent advisory and management firms to
manage its real estate properties
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REITs – Additional Regulations
Cannot hold real estate property primarily for sale
Sale of property under the following conditions:
Property held at least for 4 years
During the holding period, capital expenditures on the
property <=30% of the sales price
Max. 7 properties can be sold during the same year or the
FV of properties sold <=10% of FMV of all REIT’s assets as of
the beginning of the year
The REIT must have not acquired the property through
foreclosure
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Measuring Operating Performance of REITs
Funds from Operations (FFO) provides a more accurate measure
of operating performance of REITs
FFO = net income (GAAP)
+ Depreciation (real property)
+ Amortization of leasing expenses
+ Amortization of tenant improvements
+ Gains (losses) from infrequent or unusual events
Adjusted FFO (AFFO) measures cash flows available to
shareholders, also called cash available for distribution (CAD) or
funds available for distribution (FAD)
AFFO = FFO minus normalized recurring expenditures and straight-lining of
rents
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REIT Types
Equity REITs invest in and operate income-producing
properties
Mortgage REITs purchase mortgages
Hybrid REITs invest in both – equity and mortgages
Finite-life or self-liquidating
Open-end REIT funds vs. closed-end REIT funds
UPREIT or DownREIT
All offer diversification and liquidity
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REIT Specialization
Most REITs specialize in certain types of real estate
REITs can focus on properties in a specific geographic
region
Some REITs specialize in residential mortgages –
purchase FHA and VA insured loans and hold them for
investment
Few REITs specialize in derivative mortgage securities
such as CMO residuals
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REITs – A Laboratory for Analyzing
Capital Structure Decisions
REITs’ main sources of capital: equity and debt
REITs are not taxed at the entity level – no benefit from tax
deductibility of interest
Interesting case – opportunity to view the effect of leverage in a
“no-tax world”
Arguments for use of leverage
Personal tax – if personal tax on equity is lower than that on debt
interest more equity will be used
Real estate good collateral for debt; if managers believe that
equity is undervalued they will issue debt
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Factors Determining Ownership Form
Amount of depreciation
Holding period
Amount of retained earnings
Tax credits
Use of debt financing
Passive loss limitations
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Factors Favoring Corporate Ownership
Large depreciable basis
Long holding period
Need to retain cash flows
No tax credits available
Financed by debt
No passive income available
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Factors Favoring Partnership Ownership
Small depreciable basis
Short holding period
Need to distribute cash flows
Tax credits available
Financed by equity
Passive income available to be offset by passive losses
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