R305: Chapter 17 Practice Questions
Compare the tax advantages and disadvantages of holding income-producing property in the form of a REIT to the tax advantaged and disadvantages of holding property in the form of a real estate limited partnership. Does either form dominate from a tax perspective?
A REIT is a C corporation and but, unlike the standard C corporation, does not pay income tax at the entity level if it adheres to a set of conditions outlined in the Internal Revenue Code. A disadvantage of the REIT ownership form is that tax losses do not pass through to shareholders. Real estate limited partnerships are not subject to double taxation because income tax is not assessed at the entity level. Limited partnerships may allocate tax losses to partners, but the ability of limited partners to use tax losses is potentially limited by passive activity loss restrictions. In practice and from a tax perspective, pass through entities such as limited partnerships and limited liability companies are the dominant form of ownership structures used to invest in real estate assets. However, REITs are also able to avoid double taxation and are favored as a form of ownership by some investors.
What are the major restrictions that a REIT must meet on an ongoing basis in order to avoid taxation at the entity level?
A REIT must have at least 100 shareholders and 50 percent or more of the REIT's shares cannot be owned by five or fewer investors. A REIT is required to distribute at least 90 percent of its taxable income to shareholders in the form of dividends. A REIT is required to have at least 75 percent of its assets invested in real estate assets, cash, and government securities. Additionally, 75 percent of a REIT's gross income must be derived from real estate assets.
Of the more than $3.2 trillion in outstanding commercial real estate debt, what percent is traded in public markets? What percent is traded in private markets? What institutions or entities are the long-term holders of private commercial real estate debt?
Approximately 24 percent of commercial real estate debt is traded in public markets and the remaining 74 percent is privately held by institutional and individual investors. Commercial banks, savings institutions, and life insurance companies are the long-term holders of private commercial real estate debt.
How have equity REITs, measured in terms of total returns, performed in recent years relative to alternative stock investments?
As a sector, equity REITs produced an average annual return of 22.9 percent from 2000-2006. The corresponding average return on the S&P 500 and Russell 2000 were 2.5 percent and 9.6 percent, respectively. In 2007 and 2008, however, equity REITs provided returns of -15.7 percent and -37.7 percent, respectively. This two-year total return of -59 percent was even worse than the -34 percent two-year return produced by the S&P 500. Over the three-year period from April 2009 through March of 2012, equity REITs returned 42.2 percent annually. The corresponding S&P 500 and Russell 2000 returns were 23.4 percent and 26.9 percent, respectively.
Double taxation of the income produced by the underlying real estate is most likely to occur if the commercial properties are held in the form of a(n):
C Corporation
Explain what is meant by the double taxation of income.
Double taxation refers to the taxation of income at both the entity and investor level. For example, a C corporation pays tax on its income, which reduces the amount available to be distributed to shareholders by the amount of the entity-level tax. Shareholders are then taxed on the income distributed to them in the form of dividends, resulting in the double taxation of the income generated by the corporation.
There are two primary considerations that affect the ownership form selected by equity investors to hold commercial real estate. List each and explain how they affect the choice of ownership form.
Federal income taxation rules, and the avoidance of personal liability for debts and obligations affect the form in which investors choose to hold commercial real estate. Federal income taxation is a critical factor in the determination of which ownership form to use in real estate investment. The income produced by properties owned by C corporations is potentially subject to double taxation because tax is assessed at both the corporate and investor level. S corporations, limited liability companies, general partnerships, and limited partnerships are pass-through entities and avoid double taxation. A limited partnership has the added benefit of permitting special allocations of cash distributions and taxable income. Investors prefer ownership structures that provide limited liability. C corporations, S corporations, limited partnerships, and limited liability companies shield investors from any personal liability; liability is restricted to the amount of capital invested. General partnerships require at least one general partner who has unlimited liability for the debts of the partnership.
For what debt in a general partnership is each of the general partners liable?
General partners have unlimited liability and are liable for all debts of the partnership. This includes contractual debts and debts resulting from tort actions against the partnership. General partners are also jointly and severally liable for wrongful acts committed by other partners in the course of the partnership's business. Therefore, the personal assets of the general partners are subject to the claims of the partnership's creditors.
What are the potential advantages of investing in commercial real estate through intermediaries instead of direct investment? What are the potential disadvantages?
Investing through intermediaries avoids some of the cons of direct investment because the required expertise (including better information) is supplied by the sponsor of the intermediary. Investing through intermediaries may also provide more liquidity and allow the investor to more fully diversify and share risk. On the other hand, using an intermediary typically involves another layer of costs—the investor has to pay for expertise, for example—and shifts more control from the investor to the intermediary. Investing through intermediaries may also create principal-agent conflicts. Purchasing properties directly in the private market gives investors complete control of the asset: who leases it, who manages it, how much debt financing is used, and when it is sold. This control is largely given up when assets are purchased through intermediaries.
Small to medium size real estate syndicates that develop or acquire property in a local market are most typically organized most frequently as:
Limited liability companies
Special allocations of income or loss are available if the form of ownership is a(n):
Limited liability company
With regard to double taxation, distributions, and the treatment of the losses, general partnerships are most like:
Limited partnerships
Which of the following forms of ownership involve both limited and unlimited liability?
limited partnerships
Distinguish between equity REITs and mortgage REITs.
Equity REITs invest in and operate commercial properties. Mortgage REITs purchase mortgage obligations (typically commercial) and thus become, effectively, real estate lenders.
Which of these loans is a life insurance company most likely to invest in?
Large office building loan (nonconstruction)
Briefly explain a commingled real estate fund. Who are the investors in these funds and why do these investors use commingled funds for their purchases?
A commingled fund is a means for pension funds that do not possess sufficient in-house real estate expertise to invest in real estate. Pension funds contribute funds to a real estate fund manager who pools, or commingles, these funds with finds from other pension funds to purchase real estate assets.
Which of these lenders is most likely to provide a construction loan?
Commercial bank
Define funds from operations (FFO) and explain why this measure is often used instead of GAAP net income to quantify the income-producing ability of a real estate investment trust.
GAAP accounting includes non-cash deductions, such as deprecation and amortization of certain financial and fixed assets. Therefore, if a REIT has significant depreciable assets, which result in non-cash expense deductions for depreciation, GAAP net income may not reflect the net cash flow available to distribute to investors. Funds from operations (FFO) is an alternative earnings measure that adds back deprecation and amortization expenses to GAP income. Additionally, FFO adjusts GAAP income for gains and losses from infrequent and unusual events. Formally, FFO is defined as:FFO = Net income (GAAP) + Depreciation (real property) + Amortization of leasing expenses + Amortization of tenant improvements - Gains/losses from infrequent and unusual events
Discuss the role life insurance companies play in financing commercial real estate.
Given the long-term nature of their liabilities, life insurance companies prefer to invest in assets on a long-term basis. They are a major source of commercial real estate capital and are heavily involved in the long-term commercial mortgage market.
Which of these financial firms is the least likely to invest in a large, long-term mortgage loan on a shopping center?
Mortgage broker
A real estate investment trust generally:
None of the above: Must have fewer than a 100 shareholders, can only invest directly in income producing properties, cass pass tax losses through to shareholders
Which statement is false concerning the limited partnership form of ownership?
The limited partners cannot enjoy tax deduction benefits but the general partners can.
Approximately 88 percent of private commercial real estate equity (on a value- weighted basis) is owned by "noninstitutional" investors. Who are these investors?
These "noninstitutional" investors include both individual investors and groups of private investors who pool their capital via several types of ownership structures, including C corporations, S corporations, general partnerships, limited partnerships, and limited liability companies, to purchase real estate assets. Pooled investments comprise the bulk of the market value of real estate held by "noninstitutional" investors. Individual investors, or investors who own property jointly with other family members, comprise a small fraction of these "noninstitutional" investors.
