1. Chapter 20 Ownership Structures for Financing and Holding Real Estate © OnCourse Learning

2. 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 © OnCourse Learning 2

3. Ownership Structures for Real Estate Investment  Sole Proprietorship  C Corporation  S Corporation  Partnership  Trust © OnCourse Learning 3

4. 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 © OnCourse Learning 4

5. 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 © OnCourse Learning 5

6. 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 © OnCourse Learning 6

7. 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 © OnCourse Learning 7

8. 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 © OnCourse Learning 8

9. 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 © OnCourse Learning 9

10. 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 © OnCourse Learning 10

11. 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 © OnCourse Learning 11

12. 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 12 © OnCourse Learning

13. 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 13 © OnCourse Learning

14. 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 14 © OnCourse Learning

15. 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 © OnCourse Learning 15

16. 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 16 © OnCourse Learning

17. 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 17 © OnCourse Learning

18. Factors Determining Ownership Form  Amount of depreciation  Holding period  Amount of retained earnings  Tax credits  Use of debt financing  Passive loss limitations © OnCourse Learning 18

19. 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 19 © OnCourse Learning

20. 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 20 © OnCourse Learning