2.16 UITs & REITs

Unit Investment Trusts (UITs) & Real Estate Investment Trusts (REITs)

UITs and REITs are two types of pooled investment products that offer unique characteristics compared to mutual funds and ETFs. Understanding their structures, benefits, and limitations is important for the SIE exam.

Unit Investment Trusts (UITs)

A Unit Investment Trust (UIT) is a type of investment company that purchases a fixed portfolio of securities and holds them until a predetermined termination date.

Key UIT Characteristics

Portfolio: Fixed - does not change after creation

Management: Unmanaged - no active buying/selling

Termination date: Predetermined dissolution date

Redeemable: Units can be redeemed at NAV

Board of directors: None

Investment adviser: None during trust life

How UITs Work

1. Sponsor creates trust and selects securities

2. Fixed number of units issued to investors

3. Trust holds securities with little or no change

4. Income distributed to unit holders

5. Trust terminates on predetermined date

6. Assets sold and proceeds distributed

Types of UITs

Equity UITs: Hold stocks, often grouped by theme; Typical Term - 15-24 months

Bond UITs: Hold bonds until maturity; Typical Term - Matches bond maturities

UIT Redemption Options

Investors can:

- Hold to termination: Receive proportional share of liquidation proceeds

- Redeem early: Sell units back to sponsor at current NAV

- Sell in secondary market: Some sponsors maintain a market for units

UITs vs. Mutual Funds

Portfolio: UITs - Fixed; Mutual Funds - Actively managed

Management fees: UITs - Lower (no adviser); Mutual Funds - Higher

Termination: UITs - Yes, specific date; Mutual Funds - No, perpetual

Sales charges: UITs - Front-end; Mutual Funds - Front or back-end

Trading: UITs - Redeemable with sponsor; Mutual Funds - Redeemable at NAV

Key Point: UITs have no investment adviser making decisions after creation. The "buy and hold" approach results in lower management fees but no flexibility.

Real Estate Investment Trusts (REITs)

A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. REITs allow investors to invest in real estate without directly buying property.

REIT Requirements

To qualify as a REIT under the tax code:

Asset test: 75% of assets in real estate

Income test: 75% of income from real estate

Distribution: Must distribute 90% of taxable income

Shareholders: Minimum 100 shareholders

Ownership limit: Five or fewer cannot own more than 50%

Structure: Managed by board of directors

Types of REITs

Equity REITs: Invests In - Physical properties; Income Source - Rent from tenants

Mortgage REITs: Invests In - Mortgages and loans; Income Source - Interest on debt

Hybrid REITs: Invests In - Both properties and mortgages; Income Source - Rent and interest

Equity REITs (Most Common)

- Own and operate commercial real estate

- Properties include: apartments, offices, retail, hotels, healthcare facilities

- Generate income from rent collection

- Can benefit from property appreciation

- Make up approximately 90% of REITs

Mortgage REITs (mREITs)

- Lend money to real estate owners

- Invest in mortgages or mortgage-backed securities

- Generate income from interest payments

- Do NOT benefit from property appreciation

- More sensitive to interest rate changes

REIT Tax Treatment

The conduit tax treatment (Subchapter M):

- REITs distribute 90% of taxable income, avoid corporate-level tax

- Dividends taxed as ordinary income to investors (not qualified dividends)

- Investors may also receive return of capital distributions

Important: REIT dividends are generally taxed as ordinary income, NOT at the lower qualified dividend rate.

REIT Advantages and Disadvantages

Advantages: Real estate exposure without direct ownership; Professional management; Liquidity (publicly traded REITs); Diversification across properties; High dividend yields

Disadvantages: Dividends taxed as ordinary income; Sensitive to interest rates; Market price volatility; Cannot deduct property losses; No control over property decisions

Traded vs. Non-Traded REITs

Publicly traded: Trading - Exchange-listed; Liquidity - High; Pricing - Market price

Non-traded public: Trading - Not exchange-traded; Liquidity - Low; Pricing - Periodic NAV

Private: Trading - Not registered; Liquidity - Very low; Pricing - Appraisal-based

Warning: Non-traded and private REITs have significant liquidity risk - investors may not be able to sell when needed.

UITs vs. REITs Comparison

Investment type: UITs - Stocks or bonds; REITs - Real estate

Structure: UITs - Trust; REITs - Corporation or trust

Termination: UITs - Yes; REITs - No

Pass-through losses: UITs - No; REITs - No

Management: UITs - None; REITs - Active management

Liquidity: UITs - Moderate; REITs - High (if traded)

Key Takeaways

UITs:

- Fixed portfolio with no active management

- Terminate on a predetermined date

- Lower fees but no flexibility

- Redeemable with sponsor at NAV

REITs:

- Invest in real estate properties or mortgages

- Must distribute 90% of income to maintain tax status

- Dividends taxed as ordinary income

- Provide real estate exposure with market liquidity