REIT Investing Benefits
1. Lack of Corporate Tax
To qualify as a REIT, companies must meet certain criteria. They must invest three-quarters of assets they own into real estate and they must distribute ninety percent of their taxable income to shareholders in the form of dividends. If these qualifications are meet, REITs can avoid paying corporate taxes, which is a huge tax advantage relative to most companies.
The majority of dividend stocks are double taxed. Once at the corporate level and once on an individual level (in which they are paid out as dividends). REITs avoid this double taxation.
2. High Yield REITs
Because REITS pay 90% of their taxable income over to shareholders, REITs offer high yields. It isn’t uncommon for mid to small cap REITs offering 5%+ dividend yields. By contrast, the average S&P 500 stock yields sub 2% as of today.
Therefore, high yield REITs (prudently screened for risk) are an excellent option for income investors or growth investors that want to reinvesting dividends (allowing gains to compound).
3. Potential for Total Returns
REITs also offer investors capital appreciation potential as its underlying asset values grow. Property values tend to increase over time, which enables REITs to increase funds from operations (FFO), which enables them to increase their dividend. REITs stock prices appreciate along with FFO growth.
REITs can utilize a number of different strategies to produce more value. Their growth tools are:
- Increase revenues via rent increases
- Decrease expenses through scale benefits
- Expand properties through redevelopment
- Large portfolio acquisitions (of smaller operators)
- Issue more shares when their stock price is overvalued relative to the private market.
- Sell non-critical assets and redeploy proceeds into higher return assets
- Sell properties when their share price is low compared to private market value of their assets (arbitrage)
This toolkit is powerful in the hands of skilled management and is still fairly potent in mediocre management teams. This is why REITs have produced total returns that have surpassed the S&P 500 since REITs became an accepted asset class in 1972.
Diversification of Portfolios
While REITs are stocks, they are unique relative to most publicly traded securities. Properties with modest levels of debt are generally more reliable and easier to operate than most businesses. REITs have high profit margins and fewer existential threats relative to most companies. While similar properties compete for tenants, it would be rare for a new property entrant to wipe out the existing competition. However, this happens often in other industries (think Blockbuster and Netflix), where disruption is a constant, lurking concern for many CEOs.
To support this assertion, only one publicly traded REIT filed for bankruptcy during the Great Financial Crisis of 2009. This was one of the worst times in history to be a landlord, yet REITs not only survived, but flourished shortly after the downturn subsided.
Purchasing and selling real estate doesn't happen overnight. Conversely, REITs are liquid investments. You can purchase or sell REITs instantly – all it takes is click of the mouse. Life is unpredictable. The ability to exit an investment quickly if needed is compelling compared to private real estate, which could take months or years to sell at a fair price.
REIT Investing Drawbacks
There is no such thing as a perfect investment. Consider the following drawbacks before adding REITs to your portfolio:
As mentioned, REITs generally have dividends that are above average. These dividends are not taxed at the corporate level. This is great. However, because of this, REIT dividends are not considered “qualified dividends”. Qualified dividends are taxed at lower rates in comparison to regular income. Although since they are pass-through entities, REITs are eligible for the recent 20% deduction.
Still, investors should plan accordingly if they intend to hold REITs in a taxable account. While still attractive for all investors, this tax wrinkle makes REITs especially useful for non-taxable retirement accounts, where their large dividends are tax free.
A Long-Term Investment
REITs function best as long-term investments. Besides fluctuations in interest rates, several factors can impact REIT prices over short time periods. Reason being: lengthier time horizons lead to more positive outcomes. Time is favorable to real estate holdings (properties appreciate, loan balances are paid down and rents increase over time).
Although REITs increase portfolio diversification, you must be mindful that a majority of REITs focus on one sector. In other words, they tend to pursue one investment strategy (ex: apartments). Consequently, REIT investors should to pick several firms, ideally with varying degrees of sensitivity to economic cycles.
We believe the benefits of REITs vastly outweigh their limited downsides. Primarily, REITs offer investors liquid real estate without the hassles of direct ownership.