How Depreciation Increases the After-Tax Yields of Real Estate Investment Trusts (REITs)

Depreciation is a difficult subject in the area of cost accounting for commercial real estate.

Accountants do strive to make their financial statements accurate, and so they must recognize a fundamental principle of the universe that has troubled philosophers for tens of thousands of years. As George Harrison sang years ago, "All Things Must Pass."

There is nothing permanent in this three-dimensional world of space, time, matter and energy. Just as any Buddhist.

No building will last forever. Even the pyramids of Egypt will someday erode into dust.

Therefore, real estate property owners are allowed to deduct an expense from their gross income, called depreciation, on the theory that every year, the building is being worn down somewhat by the wear and tear of the universe. What physicists call entropy, according to The Third Law of Thermodynamics.

This depreciation expense is often calculated by dividing the total cost of the building by the number of years it's expected to have a useful life.

If you pay one million dollars for a building, and it's expected to last 10 years, that's a straight-line depreciation expense of $100,000 per year.

Notice that $100,000 in cash is not actually paid out of your pocket. Depreciation simply reflects the reality that sooner or later, that building won't be useful, and so the $1,000,000 you paid will be gone.

Although this is not practical, the ideal would be for you to pay someone $100,000 a year for ten years to build you a new, replacement building.

And when you take the depreciation expense, that is also deducted from the building's cost basis. So after 10 years, in the above example, that building is officially worth nothing, even though it may still be in great condition in a prosperous neighborhood. If it's well-maintained and in a good area, it can be useful for an indefinite period.

So one of the big problems is deciding what the useful life span of a commercial building is.

Of course, when we're talking about shopping malls, we're assuming their function is to lease space out to retail stores and restaurants, not to act as tourist attractions. So we can rule out multi-thousand year old spans such as represented by the Coliseum of Rome and the ruins of Angkor Wat -- which attract tourist money even though they've fallen down.

Yet even when we come down the level of commonplace apartment building and shopping strip centers, we just don't know for sure how long they'll last. Sure, there're castles in Europe hundreds of years old -- but also stone farm houses where farming families still live.

So it's entirely possible for a building in a good area to be bought or built, to have the depreciation expense taken on them . . . and 20 or 30 years later they're now worth far more than you originally paid.

So, in a long-term sense, depreciation reflects something real, but it's difficult to know just how much of an expense to take every year -- without a crystal ball.

For example New York City's Empire State Building is nearly 80 years old, but would be worth many millions if sold. The World Trade Center's useful life ended prematurely in a way that couldn't be predicted.

So when a Real Estate Investment Trust calculates its net income, it is required to apply Generally Accepted Accounting Principles. It will figure out its gross revenues, then subtract its operating expenses, then subtract a substantial figure representing depreciation on the buildings it owns -- even though they may in fact have appreciated in value.

Let's say XYZ REIT had gross revenues of $1,000,000 and operating expenses of $$700,000. That leaves $300,000. Then they deduct another $100,000 for depreciation. That leaves $200,000 as their net operating income.

The law requires them to pay at least 90% of this to their shareholders in the form of dividends. So they must mail out $200,000 X .90 = $180,000 to their investors.

But wait -- the $100,000 depreciation expense is a "book entry" only. That is, it's only on paper.

The $700,000 operating expenses represent cash that left the REIT's bank account to pay for salaries, repairs, and other necessary expenditures.

Depreciation does not represent a cash payment to anybody. That $100,000 is still sitting in their bank account.

So why not pay it out to their shareholders also?

That'd be $180,000 plus $100,000 = $280,000 available for dividends for shareholders, making them even happier.

Why not, indeed? That's what many of these companies do -- pay out more in dividends that the law requires.

And receiving some dividend payments that represent depreciation should make the shareholders even happier than usual. Here's why.

The percentage of the dividend checks they receive from real estate investment trusts that represents depreciation is not immediately taxable to shareholders.

Because it represents money that's available only because the company took a depreciation expense, according to the IRS it's officially a "return of capital," not income.

A return of capital is not taxable because it's not income. But it does reduce the cost basis of your REIT shares.

When is the only time you care about the cost basis of your shares of stock?

When you sell them.

If you don't sell them . . . you don't have to ever care.

Let's say you bought 100 shares of XYZ REIT for $10 each. Your cost basis is $1000.

In the first year got a dollar back for each share, of which 25 cents per share was for depreciation. Which means your cost basis is reduced by .25 X 100 = $25.00.

So your cost basis in those 100 shares is now $975 instead of $1000.

You do have to pay taxes on the dividends, but only on $75, not the full $100.

If next year you decide to sell the shares of stock for $11 each, you'd get a total of $1100. You'd owe capital gains taxes on $125 instead of $100.

In effect, you're now paying the taxes on that 25 cents per share depreciation in dividend checks you received the year before.

But let's say you're smarter than that. You don't sell your shares of XYZ. You just keep collecting the dividends for as long as you live.

When do you pay taxes on the depreciation percentage? Never.

The implications of this aren't widely known or understood. Even the best known REIT book writer, Ralph L. Block, doesn't mention this in his book INVESTING IN REITS until the first Appendix.

The percentage of dividend checks that represent return of capital because of depreciation varies from company to company, and can of course vary over time. Historically, it runs 25% to 30%.

The bottom line for real estate trust shareholders is that -- if they never sell their shares -- their effective, net after-tax yields are significantly higher than they think. The exact amount depends on their marginal tax rate.

Let's say that in the above example, your marginal tax rate is 35%.

You'll owe ordinary taxes of .35 X $75 = $26.25.

You received $100, and paid $26.25 in taxes, leaving you with an after-tax net of $73.75.

Your after-tax net yield on your shares is 7.375%.

If this was an ordinary dividend-paying company in some business besides real estate, you'd have to pay taxes on the entire $100 in dividends, for a total tax owed of $35. For a net of $65. For a net after-tax yield of 6.5%.

Therefore, to figure out the true net, after-tax yield of a REIT, you must multiply its stated yield by (one plus the depreciation percentage X your marginal tax rate).

Thus, in the above example, the apparently yield is 10%. (One dollar in dividends for ten dollars worth of stock).

.10 X (1 + ((.25 X .35)) =

.10 X 1.0875 = 10.875% net after tax yield

Purists would argue that you should use the new cost basis, but my argument is that it's irrelevant so long as you never sell the stock. In that case, your "practical" cost basis is what you originally paid for it.

So never sell it.

Depreciation causes must provide depreciation

The life of an asset to a company depends largely on the purpose of acquisition, and secondly on the nature. An item is sold for immediate consumption or purchase of short duration and that the real estate is held for prolonged use, is of long duration, although both have an income. While the first plants to run after a year of acquisition, the assets, which lasts longer. Therefore, spending almost all of an asset is an expense of short and is in current yearRevenue.

But the situation is different, worn with a long-term activity will be written off, or over a long period of time. Consequently, the cost of assets over several years and each year are a fraction of this distribution ends. Simply put, the village, called expired cost or depreciation, in current revenue and pay the rest, said the UN has cost us run is performed on the coming times.

"Depreciation may be defined as the impairment of an assetdue to the use and / or the date of expiry. "Terminology of the Institute of Cost and Management Accountants, England

"Depreciation is the permanent and continuous decline in the quality, quantity or value of the property. Pickles

"Depreciation is a measure of the destruction of the effective life of an asset shall be determined for a cause in a certain period." Spicer and Pegler

"Depreciation is the gradual and permanent decline in the value of an asset for allQuestion. "Carter

Objects include a provision for impairment

In order to achieve the following objectives, the depreciation accounting is a must for every business

(1) The recovery of expenditure on capital goods for the estimated useful life have emerged to keep intact the capital of the owner;

(2) The amount of the replacement value for the transfer of the goods;

(3) includes the amortization of production costs to determine the exact cost of production;

(4)Learn to fix a non-profit for the year;

(5) to see the situation through the proper financial balance.

Causes of depreciation

Depreciation can be two types: --

(1) Interior depreciation occurs in some cases with normal is known that the internal damping. The causes of internal damping are:

(1.1) normal wear and tear of assets by continuous use, such as buildings, equipment,
Machinery, etc. This drop isQuantum for the use of the property. If a plant operates two shifts, instead of being doubled for a single layer, the depreciation of machinery and equipment. It is obvious that this loss is inevitable. An activity can be maintained in good working conditions
with repairs yet, but it can be done continuously, if assets are not suitable for repair when it is most appropriate.

(1.2) Depletion Some activities by the appreciation in proportion to the amount ofProduction, mining, etc. career with the extraction of coal, mine, etc., the total number of deposit is progressively reduced and after some time you will be fully utilized. Then the value will be zero.

Due (2) Other affected by some external reasons and external calls
Depreciation.

External causes of depreciation are:

(2.1) overhauled

Some activities, but in good working conditions, could become obsolete. For example, the old one obsoleteThe invention of the machine more expensive and demanding, whose production capacity is generally higher and the cost of production lower. To survive in the competition, the manufacturer must install new machine replaces the old one.

(2.2) over time

Some decline in property value due to the simple passage of time, even if they are used, for example, to lease the property, patents, copyrights, etc.

(2.3) injuries

Activities can beby unusual reasons, such as fires, earthquakes destroyed, floods, etc. can be removed from the destructive activity of the loss in such cases and bought.

Requirement Depreciation

The need for a provision for impairment is apparent from the following reasons:

(1) determine the gain or loss of real depreciation is a loss. So unless it's like all other costs and losses of the actual profit treats / loss can be detected. In other words, the depreciationbe considered in determining actual profit / loss of business.

(2) to determine the actual cost of producing goods are produced with machines and equipment with the devaluation of the manufacturing process. The impairment must, as part of the cost of production of goods. Otherwise, the cost of production would be shown, unless the actual cost. The price is usually determined on the basis of production costs. So if the cost of production is shownIgnoring less depreciation, the purchase price will be set at a low level, causing the loss of the company;

(3) the valuation of assets, reduces the value of the assets to the gradual devaluation. If depreciation is not taken into account, the value of the assets on the books are displayed in an amount greater than its actual value, and then the true financial position of the company will not be disclosed in the balance sheet.

(4) the replacement property after a certain time, a goodis completely, because the appeal are exhausted. New goods are purchased that require a large sum of money. If the entire amount of the profit to be removed from the economy each year, regardless of the loss of depreciation, the amount needed may not be available. the acquisition of new equipment. Be exercised in such cases the money due to the introduction of new capital or obtain loans through the sale of certain other securities. This is in contrast to 0sound & Commercial.

(5) Maintain CapitalIntact Capital has invested in the purchase of a system is gradually being reduced
Account for depreciation. If the loss from depreciation not included in the calculation of earnings used / losses at year-end, the result will be shown again. If the extra profit is removed, the working capital, and after, the company is too weak and reduced its profit without profit
Capacity will decrease.

(6) Legal restrictions under Art. 205 of the Companies Act 1956, no dividend may be declaredDepreciation of capital goods. As required in "cases of renal Corporations fee.

Characteristics of the depreciation, the basic elements for determining depreciation

Features Depreciation

Depreciation has the following characteristics:

(1) Depreciation is charged in the case of fixed assets only, such as construction, equipment and machinery, furniture, etc. "This is not the case, the depreciation of current assets such as inventories, accounts receivable, credits, etc.

(2) Depreciation fall from eternal causes gradual and continuous asset value

(3) Depreciation is calculated to the last day of work asActivities in the life

(4) The attenuation caused by the use of property, in some cases, however, the depreciation can occur even if the goods are not used, for example, land ownership, patent, law-d "author, etc.

(5) Depreciation of the revenue of an accounting period calculated.

(6) depreciation does not depend on fluctuations in the market value of assets

(7) The depreciation charge for a billing period can not be accurately determined, it must be estimated. Insome cases, however, can be precisely determined, for example, land ownership, patent, copyright, etc.

(8), the depreciation of an asset amount not exceeding the cost of capital (cost less scrap value).

Fundamental factors to determine that the depreciation

(1) the cost of capital, the purchase price as costs for transportation and installation;

(2) Estimated cost of repairs during the useful life;

(3) Estimated useful life of assetsafter which it will be rejected;

(4) or the estimated residual scrap;

Investing (5) The return on invested capital, the amount involved was to buy the assets invested in some interest from other investments, which would have earned;

(6) the possibility of obsolescence.

Fixed deposit or acquisition or in a straight line approach, reduction and the amortization method

In this method, depreciation is calculated on the cost of the goods. It is calculated based on the book value. Task.The book value of assets will be made by deducting the amortization of costs. The book value of assets decreased gradually due to the depreciation. As the percent of depreciation is used to reduce the balance of activities. This method is written as depreciation or reduce the payment method or a method of value.

Advantages and disadvantages.

Accelerated depreciation, is not only fair, depreciation and amortization to income, but also fairly common.the effect of depreciation and repair (ie, an increase in depreciation, but later the heavier repairs over the years.) gains and losses on asset life. The disposal of the majority of the costs in the first years the effects of aging minimized. It is also useful for the management of accelerated depreciation will reduce taxable income and then lowered taxes cash.

Accelerated depreciation methods

The numbers of the year (SYD). This method of depreciationaccelerated depreciation, so that the amount found in the early stages of the life cycle of an asset are higher than those recorded in recent times. The SYD is on the expected useful life of an asset over the years, the allocation of consecutive numbers, then each year and a total of these figures. N For the years
SYD = 1 + 2 + 3 + 4 + ... + N

Annuity

The method is based on the time value (interest) money, and therefore refers to the actual cost of using a long lifethe same amount of assets in this respect and lost interest in the acquisition of real estate investing. Under this method, such as depreciation each year is written off, and falls under the flow of capital account, with interest on the value, stop the activity at the end of his life. Therefore, the amount of depreciation is broken every year the same, but the interest decreases each year.

The annual depreciation is amortized using the method of your pensionfound from the tables of the pension

Method of depreciation or sinking fund method

Under this procedure, a fixed amount is charged as depreciation each year. Strives to provide the needed liquidity to lump sum on the resignation of a long-term activities are charged annually and within easy reach by investing a fixed amount of securities is. These securities bear interest at a fixed rate and fixed the same share reinvested depreciation is allowed to accumulateCompound interest. The method of sinking fund account is therefore likely that the interest arose in determining the annual depreciation and invest the same, because compound interest to the cost of depreciable assets at the end of his life. Obviously, the payment of fixed annual depreciation here is smaller than the linear method. Its size is on the life of the goods and interest rates. In addition to the bow andInterest rate, the lower annual depreciation cost can be depreciated by Rs.

Deficit of depreciation method

Accumulated depreciation method assumes a constant rate of return on all investments in securities identical periods. This is not the case in this dynamic world in which prices vary from time to time. Any change in the yield disrupts the first regular allowance for depreciation and renewal of the same behavior. In addition, rarely the amount realized from the sale of securityconsistent with its cost, due to changes, both irregular and can be significant. It may be necessary to a great divide between the have and in cash.

Insurance Policy Method

This method provides the liquidity necessary efforts for the closure of a given asset in return for a regular contribution (premium). Under the Company adopted a policy of insurance of the CAP, with an insurance company agrees to pay as soon as a certain sum if 'Shopping, pay a fixed amount of premiums after regular intervals. The merchant handles the regular payments of accrued depreciation, amortization and gains and losses. In this case, the depreciation is charged at the end of the year, while the premium is paid at the beginning of the year. At maturity, the insurance pays the political price is usually sufficient to replace the set in their retirement years. Usually, the result for the amount of back pay less than the sum of the premiums for the policyInterest.

Method of revaluation

With this system, each year the asset is assessed and the value is compared with the beginning of the year. The case is regarded as the depreciation. Let us assume that if the value of the instruments was the beginning of the year, Rs 8000, the year worth of instruments of RS. 6000 have been purchased, and at the end of the year at this assessment, which amounted to 11,000 Rs. Amortization for the year: 8,000 + 6,000-11,000 = rs. 3000th This method isUseful for the collection of amortization of animals and tools in bulk.

Method of exhaustion

Natural resources are physical activity, such as deposits of minerals, oil and gas and timber. These natural resources are exhausted by the operation. In some cases, the reduction of deposits of natural growth or development of additional deposits were to be compensated.

The cost of natural resources is the price of the purchase price plus amounts paid for the development of this property paid toon cleaner production.

Exhaustion better not regularly calculated by year. Instead, it is better to calculate the cost per unit, then multiply the unit cost of units produced in that year.

Machine at a price

According to this method is estimated the total number of hours in a car of the actual length, then the cost of the machine is divided by the expected number of hours of life, which gives the velocityfor now. The annual depreciation is calculated this percentage multiplied by the number of hours the machine actually works in a year.

Mileage Method

This method is only for those whose lives are used to the fact that the number of miles have been driven out, for example, buses, cars, trucks and vehicles, etc.

Global Method

Under this method, the value of the property, regardless of its type and has the depreciation is charged at an average rateSet on the total value.

The choice of method

Depreciation methods shown above, is absolutely no better or worse than each method has its advantages and disadvantages. The appropriateness of each method is relative and depends on several factors. More important are the type of activity and purpose of depreciation.
Especially suitable method is suitable for buildings and homes, etc.. Reduction method of payment is wasted in plant and machinery, etc. and the method of exhaustionActivities such as mining. Career, etc. However, the basic objective of the fundamental factors for the attractiveness of a depreciation method. Objective important to understand the relationship of accounting, tax benefits, the comparative cost of the products, financial flexibility, replacement and expansion investments, for example, etc.. Fund expects that the method set aside the depreciation charge for the write-off of the company must be invested in certain securities. Even with the methods of insurance, the amount asPreliminary data to the insurance company. If a company has problems working capital on the appropriateness of these methods is questionable.

Among the above methods (1) set the date and (2) Reduce to mention the payment methods that are used most often.

Distinction between fixed payments and payment method, reducing method

Down payment

1. The speed and amount of depreciation remains the same every year.

2. Percent depreciation ratecalculates the cost of goods each year.

3. At the end of his life, the value of the asset is reduced to zero or the value of scrap metal.

4. The oldest active, plus the cost of the repair. But the amount of depreciation remains the same every year. Therefore, increasing the total depreciation and repairs per year. This reduces the annual earnings over time.

5. Depreciation, relatively easy and simple.

Reduce payment method

1. This rate remains the same, butthe amount of depreciation gradually.

2. Depreciation rate is calculated as a percentage of book value of assets.

3. Capital value is never reduced to zero by the end of his life.

4. The amount of depreciation gradually decreased, while the cost of repairs increases.
Thus, the total depreciation and repairs is more or less the same every year. "Therefore, it causes little or no change in annual profits / losses.

5. Depreciation can be calculated withoutDifficulties, but not so easy and simple.

How Depreciation Increases the after-tax returns of real estate investment trusts (REITs)

Depreciation is a difficult issue in its computation of the cost of real estate companies.

Accountants do not try to correct their financial statements, and you need a basic principle of the universe, which recognize troubled philosophers for thousands of years. As George Harrison sang years ago, "All Things Must Pass."

There is nothing permanent in this world in three dimensions of space, time, matter and energy. Like anyBuddhist.

N. Construction will continue forever. Even the pyramids in Egypt eventually undermine the dust.

Therefore the owners are entitled to their their gross income to deduct as depreciation, on the theory that every year, the building a little "worn by abrasion of the universe. What physicists call entropy, according to the third law of thermodynamics.

This impairment is often, by calculating the total costBuilding for the number of years, is expected to have a useful life.

If you pay one million U.S. dollars for a building, and it is expected that in the past 10 years, a straight-line depreciation of $ 100,000 per year.

Note that U.S. $ 100,000 not in cash, actually pay out of pocket. Amortization simply reflects the reality that sooner or later, this building is not useful, and thus the 1000000 dollars has been paid you off.

Although it is not practical, it would be ideal,You pay someone $ 100,000 per year for ten years to build a new building parts.

And if the depreciation that is deducted from the base cost of the building. So, after 10 years in the example above, this building is officially worth nothing, although it may still be in an ideal state in an affluent neighborhood. If she cared for properly and in good condition, can be useful for an indefinite period.

So one of the major problems is the determination of theLife expectancy of an office building.

Of course, when it comes to shopping, we assume that their function is to lease a space for shops and restaurants, not to act as tourist attractions. So we can rule out multi-span thousands of years, including the Colosseum and the ruins of Angkor Wat represent - that the tourists for money to win, even if they are successful.

But even if it drops to the level of construction and banalShopping centers, but do not know with certainty how long it takes. Of course there are castles in Europe are living hundreds of years - but also houses of stone farmhouse, where farming families still.

It is therefore quite possible that were prepared to buy a building in a nice neighborhood, or who have taken the burden of depreciation on them. . . and after 20 or 30 years are now worth much more than originally paid.

In a way, in the long run, reflects the amortization something real, but it is difficultexactly know how much effort to be made each year - without a crystal ball.

For example, New York is the Empire State Building nearly 80 years, but millions of euros would be different if sold. The useful life of the World Trade Center was stopped prematurely in a way that could not be predicted.

Thus, if a Real Estate Investment Trust calculates its net profit, you must apply generally accepted accounting principles. He determines the gross income, then subtract theOperating expenses, then subtract a number that represents the depreciation of the buildings they have - even if they have, in fact, a value obtained.

Suppose XYZ REIT had gross revenues of $ 1,000,000 and expenditures in the amount of 700,000 U.S. dollars. This is $ 300,000. While keeping 100,000 U.S. dollars for the depreciation. This leaves $ 200,000 that its operating revenues.

The law requires them to pay at least 90% of these assets to shareholders as a dividend. Thenmail must to 200,000 X $ 90 = $ 180,000 for investors.

But wait - the cost of depreciation of U.S. $ 100,000 is an entry for "book" only. In other words, it is only on paper.

The $ 700,000 in operational costs amount to money that the REIT account has left to pay salaries, repairs and other necessary expenses.

Depreciation is not a cash payment to third parties. The $ 100,000 is still sitting in their bank account.

So pay, why not to the shareholdersmuch?

The $ 180,000 plus $ 100,000 = 280,000 $ A provision for dividends for shareholders, they would be even happier.

Why not? This is to pay what many of these companies - from dividends, rather than the law requires.

And you get some payments of dividends, which may represent the depreciation of the stockholders, it even happier than usual. Why.

The control rate on dividends, which it is real estate investment trusts, which represents the impairmentNot immediately taxable to the shareholders.

Why is the money that is available because the company's costs in the amount of depreciation to the IRS officially a "return of capital," no income.

A return of capital is not passive, because it is not income. But it reduces the cost basis of your shares of REITs.

What is the time when you care about the cost basis of your shares?

If you sell them.

If you do not sell. . . notCare ever.

Suppose you have 100 shares of XYZ REIT for $ 10 each. Your cost basis is $ 1,000.

In the first year return on a dollar for each share, 25 cents per share, the depreciation. This means that the cost is reduced from, 25 x 100 = $ 25.00.

So your cost basis of these 100 shares is now $ 975 instead of $ 1000

You have to pay taxes on dividends, but only $ 75, not the total amount of 100

If next year you will decide to sell the shares at $ 11each, you get a total of $ 1100 You have capital gains tax on $ 125 instead of $ 100.

In fact, now pay taxes, 25 cents per share dividend from the depreciation of checks that the past year.

But to say that you are smarter than that. Do you sell your shares of XYZ. Dividends, as long as you continue to live, to obtain.

If you do not pay taxes on the deposition? Ever.

The impact of this little-known orunderstood. Even the well-known book writer REITs, Ralph L. Block does not mention in his book, "Investing in REITs until the first plant.

The control rate of dividend represents a return of capital because of depreciation differs from company to company, and of course, vary over time. Historically, runs 25% to 30%.

The bottom line is for the shareholders of the estate of the confidence that - well, they never sell their shares - their effectiveness, the net return after taxthan they think. The exact amount depends on the marginal tax rates.

Say the above example is the marginal tax rate of 35%.

Enter the ordinary income of 35 x $ 75 = $ 26.25.

You will receive $ 100 and paid $ 26.25 in taxes, so that a net after-tax $ 73.75.

Your network is after tax on your shares 7.375%.

If there is to pay an ordinary dividend in any commercial enterprise outside the property, you have to pay taxes on $ 100 in allDividends, for a total amount of tax due of $ 35. For a net-65 U.S. dollars. A network of after-tax of 6.5%.

So is the true net after tax returns of a REIT to be calculated, it is necessary to multiply the benefits of (one plus the removal of X given marginal tax rate) to.

Thus in the example above, the yield 10%, apparently. (One dollar in dividends for ten dollars) in the camp.

, 10 X (1 + ((.25 X .35)) =

, 10 x 1.0875 = 10.875% net after tax

Purists sayYou need is the cost method again, but my argument is that it does not matter as long as you never sell the shares. In this case, your "practice" approach that costs reimbursed.

So do not sell forever.