MLP Units vs REITs

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MLP Units as an Alternative to REITs

by Glenn M Fydenkevez

Income investors appear to be taking a fresh look at real estate stocks. Some Real Estate Investment Trusts (REITs), such as Federal Realty Trust (NYSE: FRT), Boston Properties (NYSE: BXP) and Brandywine Realty (NYSE: BDN), have displayed truly impressive performance during the recent stock market rally.

With the financial crisis and credit squeeze abating, there is reason for cautious optimism.

Many astute real estate investors have discovered a potentially promising opportunity in a somewhat obscure class of securities called Master Limited Partnerships (MLPs).

Although MPL units trade on stock exchanges the same way REIT and common shares do, they distribute income and capital gains differently and have unique tax ramifications. MLPs are not for everyone but they can be rewarding for investors who take the time to understand how they work.

Quite simply, an MLP is a Limited Partnership whose shares - called units - trade on regulated exchanges just like stock of public corporations. Buyers of MLP units simply become limited partners rather than equity shareholders. 

Restrictions in the tax code limit the types of industries that can form and trade partnership units. Most MLPs are energy companies involved in the production and transportation of oil, natural gas and propane. There are also MLPs in the financial sector, natural resources, commodities, and real estate. The primary objective of MLPs is to provide a high, tax advantaged income to unit holders. 

For tax purposes partnerships are not considered separate tax-paying entities. Partnerships are classified as “pass-through” entities. Because of this distinction, taxes are not payable by the company itself. Only the individual partners get taxed, and only on their proportionate share of the income and capital gains. By avoiding double taxation, which public corporations are subject to, MLPs are able to distribute significantly larger payouts.

Partnership earnings are passed through to investors in the form of a quarterly cash distribution. Tax-wise, these distributions are treated more favorably than ordinary dividends from stocks or mutual funds. Instead of considering distributions investment income, the IRS recognizes some of the payout to be, “return of principle”. This can have the effect of reducing the cost basis of the investment. In-other-words, investors don’t pay taxes on these capital distributions until the units are sold or the cost basis is reduced to zero. Income distributions are taxable, but the tax due is usually quite low because an MLP can pass through deductions and depreciation just like it can pass through income.

When properly understood and used correctly MLPs can provide excellent income and have the potential for capital appreciation over time, but it’s important that investors know what they are getting into. 

The dividend yields can seem high, but an investor can’t tell just by viewing a quote if the firm is producing income or returning capital. Further, when units are sold it takes some sophisticated calculations to determine cost basis, capital gains, and income. Also, unit holders receive a K1 form rather than the 1099 form they may be used to.  

New England Realty Associates, LP (NEN), NTS Realty, Ltd (NLP), W.P. Carey & Co. LLC (WPC), America First Tax Exempt Investors (ATAX) and Centerline Holding Company (CLNH.OB) are well established real estate MLPs that are worth researching. When considered as an income vehicle they can be viewed as attractive alternatives to comparable real estate investment trust (REIT)shares.   

Disclosure: The Author holds a significant long position in ATAX. Also, in his capacity as a commercial real estate finance professional, the author has occasion to do business with W.P. Carey & Co. LLC.