Real estate investment trusts (REITs) are a popular investment vehicle for those who are interested in the potential benefits that come with real estate without actually having to buy and manage the property.
Alternative REIT structures emerged to allow for different types of investors. One of these structures is known as an umbrella partnership real estate investment trust (UPREIT). How do REITs and UPREITs compare? We’ll cover the basics of each as well as their benefits and drawbacks.
What is a REIT?
A real estate investment trust can be thought of as a portfolio of real estate. A REIT is a type of company that owns, operates, or finances real estate that seeks to produce income. This allows investors to pool money to invest in these properties. Major property types are apartments, office, retail, industrial, and hotels
Because of REITs, smaller investors that otherwise wouldn’t have been able to invest in commercial real estate now have access to high-priced commercial property portfolios.
What is an UPREIT?
An umbrella partnership real estate investment trust is a partnership between the owner of appreciated real estate and a REIT where the owner of the appreciated real estate contributes real estate assets in exchange for operating partnership units (OP Units) in a tax-deferred exchange.
This is also known as a Section 721 exchange with similar benefits as a 1031 exchange. Capital gains are realized when the exchanger sells the OP Units, converts the OP Units to REIT shares, or the acquiring operating partnership sells the contributed property.
UPREITs can also be considered a wealth management tool for private real estate owners who don't want to manage their taxes. REITs allow individual investors to access commercial real estate.
REIT Advantages and Disadvantages
There are many potential benefits to investing in REITs, such as:
- Potential for high dividend yields: REITs offer some of the highest dividends, with 90% of taxable income going to shareholder dividends. Dividends are paid through an income stream.
- No corporate taxes: REITs pay zero corporate tax as long as they pay at least 90% of taxable income in the form of shareholder dividends each year.
- Liquidity: Shares in REITs are easier to buy and sell than traditional ownership in commercial real estate, as most REITs trade on major stock exchanges.
- Return potential: Because REITs have the potential for capital appreciation as assets grow, investors can benefit from a potential high total return.
- Portfolio diversification: REITs provide another alternative to diversify your portfolio. They’re treated as stocks but represent real estate assets.
- Access to commercial real estate: This is why REITs were created in the first place. Smaller investors now have the opportunity to invest in real estate assets.
Disadvantages of REITs include:
- Tax burden: REIT tax structures can be complex. Dividends don’t meet the IRS definition of qualified dividends, which are taxed at lower rates. Unless these dividends are collected in a tax-advantaged account, dividends are taxed as ordinary income.
- Debt: REITs typically use leverage to fund their growth which could result in higher interest and lower earnings. Interest rates are sensitive to fluctuations, which is bad for REIT stock prices.
- Low growth: With 90% of taxable income going to dividends, REITs must raise cash by issuing new bonds and shares. This doesn’t mean they will be bought up by investors right away.
- Property-specific risks: Certain types of property are more sensitive to the state of the economy than others. Investing in one type of REIT property could increase risk exposure.
UPREIT Advantages and Disadvantages
UPREITs have many benefits including:
- Liquidity: Although this creates a taxable gain, an UPREIT investor can take advantage of its liquidity by converting OP Units into shares of a REIT which can then be sold.
- Passive investing: Without the responsibility of property management, investors are free to focus on other priorities.
- Tax benefits: Capital gains tax liability can be avoided when appreciated real estate is sold.
- Income: Dividends are typically paid to the investor through income instead of fluctuating cash flow through traditional investments in rental property.
- Diversification: Investors can diversify and balance their investment portfolios.
- Consider estate planning: OP Units can be transferred to heirs or beneficiaries upon death on a stepped-up basis. Heirs can benefit from continued dividends and the elimination of capital gains tax unless the units are converted into REIT shares.
Here are a few drawbacks of UPREITs:
- Limited voting rights: Voting rights are limited but could apply to situations that affect the rights of the holders such as distributions, redemptions, and tax allocations.
- Less control: Although this is also considered an advantage, others may dislike the lack of control and instead may prefer the duties that come with direct ownership.
- Federal and state tax filing requirements: The filing requirements can be hefty. OP unitholders are required to file taxes in each state in which the operating partnership transacts business.
- Unpredictable stock market: Shares are subject to fluctuations in the stock market, although no investment is impervious to volatility.
An UPREIT is any REIT that allows for Section 721 exchanges within the REIT. It’s a strategy that investors use to contribute real estate property in exchange for OP Units which can be converted to REIT shares. This transaction also allows property owners to defer capital gains tax liability similar to a 1031 exchange.
Even if you’re a small investor, you can invest a couple of hundred dollars as a starting point in REITs or avoid capital gains tax liability in an UPREIT or 721 exchange.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
