Can REITs Invest in Government Securities?

A Real Estate Investment Trust, commonly known as a REIT, operates as a company that owns, operates, or finances income-producing real estate across various property sectors. These entities allow individual investors to gain exposure to large-scale real estate portfolios without directly purchasing or managing properties. To maintain their tax-advantaged status, REITs must distribute at least 90% of their taxable income to shareholders as dividends.

Government securities are debt instruments issued by a national government to raise funds for its expenditures. These include U.S. Treasury bills, notes, and bonds, which are regarded as low-risk investments due to the backing of the issuing government. The central question for REITs is whether they can incorporate these assets into their portfolios while adhering to their specific regulatory framework. This article explores the rules governing REIT investments and the role government securities play within these guidelines.

Core Investment Requirements for REITs

To qualify as a REIT and benefit from tax advantages, an entity must satisfy ongoing requirements established by the Internal Revenue Service (IRS). These regulations ensure that REITs remain primarily invested in real estate and derive most of their income from real estate-related activities. Two main categories of tests govern these aspects: the asset tests and the income tests.

The asset tests dictate the composition of a REIT’s portfolio, and these are assessed quarterly. A fundamental requirement is the 75% asset test, which mandates that at least 75% of the value of a REIT’s total assets must consist of real estate assets, cash, cash items, and government securities. Real estate assets broadly include real property, interests in real property mortgages, and shares in other REITs.

Beyond the 75% asset test, REITs also face diversification requirements for their remaining assets. A REIT cannot hold more than 5% of its total assets in the securities of any one issuer. Additionally, it cannot own more than 10% of the voting securities or 10% of the total value of the outstanding securities of any one issuer.

In addition to asset composition, REITs must pass two income tests annually, focusing on the sources of their gross income. The 75% gross income test requires that at least 75% of a REIT’s gross income must be derived from real estate-related sources. This includes rents from real property, interest on obligations secured by mortgages on real property, and gains from the sale of real property.

The second income requirement is the 95% gross income test, which is broader than the 75% test. Under this rule, at least 95% of a REIT’s gross income must come from sources qualifying for the 75% test, or from other passive income sources. These additional sources include dividends, interest from any source, and gains from the sale of stock or other securities.

Government Securities as Qualifying REIT Assets

Government securities play a defined role within the regulatory framework for REITs, particularly concerning the asset tests. For the 75% asset test, government securities are specifically listed alongside real estate assets, cash, and cash items as qualifying assets. This means a REIT can hold U.S. Treasury bills, notes, and bonds, and these holdings count towards satisfying the 75% asset requirement.

While government securities are qualifying assets, the interest income they generate typically qualifies for the 95% gross income test but not the stricter 75% gross income test. Interest income from U.S. Treasury securities, for instance, is considered passive income and thus contributes to the 95% gross income threshold. However, this interest does not generally fall under the definition of real estate-related income required for the 75% test. A REIT must carefully manage its income streams to ensure it meets both percentage requirements without relying on government security interest for the more stringent 75% real estate income rule.

Types of government securities considered for these purposes include those issued by the U.S. Treasury, such as Treasury bills, notes, and bonds. Additionally, certain agency securities, like those issued by Government National Mortgage Association (Ginnie Mae), are often considered real estate assets for REIT purposes, particularly for mortgage REITs, due to their underlying collateral.

Practical Considerations for REITs Holding Government Securities

Holding government securities offers REITs practical advantages beyond simply meeting regulatory requirements. These low-risk instruments serve as an effective tool for liquidity management. A REIT may hold a portion of its capital in government securities to maintain readily available funds for upcoming real estate acquisitions, property developments, or operational expenses. This allows for temporary cash reserves to earn a modest return while awaiting deployment into less liquid real estate investments.

For certain types of REITs, particularly mortgage REITs (mREITs), government securities or government-backed securities play an even more integrated role. Mortgage REITs typically generate income by investing in mortgages and mortgage-backed securities (MBS). Many of the mortgage-backed securities held by mREITs are issued or guaranteed by government-sponsored entities like Fannie Mae, Freddie Mac, or Ginnie Mae. These agency MBS are considered real estate assets for the 75% asset test and carry limited credit risk.

While equity REITs primarily generate income from rents by owning and operating physical properties, they also utilize government securities for strategic purposes. For an equity REIT with a substantial cash balance, or one that has recently sold a property and is awaiting reinvestment opportunities, holding government securities helps ensure compliance with the 75% asset test. This prevents the REIT from inadvertently falling below the required real estate asset threshold due to an accumulation of uninvested cash.

The decision to hold government securities involves balancing various factors, including liquidity needs, risk tolerance, and the generation of qualifying income. While government securities provide stability and regulatory compliance for the asset test, their interest income only broadly qualifies for the 95% income test, not the 75% real estate-specific income test. Therefore, REITs must carefully manage their overall portfolio to ensure that the majority of their income continues to be derived from real estate-related activities.