As investors clamor for income solutions in the face of the Federal Reserve’s low interest rate policies, many have honed in on the dividend opportunities in real estate investment trusts (REITs). In order to qualify for the tax structure, REITs must derive at least 75% of their revenue from rents and other direct real-estate activities and distribute at least 90% of their taxable income in the form of dividends. As such, the sector has a much higher average yield - currently around 4% - than their traditional corporate cousins.
Desperate for income, investors can't get enough high-yielding REITs and Wall Street is rushing to supply them. However, that supply growth isn’t coming from traditional apartment building or office park owners. It’s coming from firms in businesses such as the ownership of billboards, cell-phone towers and data centers, making the conversion to REIT status through IRS private letter rulings.
For investors, the surge in new REIT activity is providing some pretty interesting dividend opportunities.
Making the Leap
Investment bank Barclays currently counts at least 15 firms actively considering a partial or total conversion to a real estate investment trust structure within the next few years. The primary driver behind the conversions is simple: investors need reliable income and corporations need to save money on rising taxes. As a result, the market has shown REITs considerable preferential treatment because of their reliable income streams. The companies cite the potential for tax savings, increased dividends and higher stock valuations. This duality on the investor and corporate levels has pushed many companies to expand upon the definition of “real property” and make the conversion into a REIT; however, getting there isn’t so simple.
The first test is determining whether or not the business owns a sufficient amount of real property that can generate rental income. Remember, 75% of a REIT’s income must come from rent or interest. While that is easy for a company planning on owning shopping malls, it gets difficult under the IRS’s vague rules on the definition of “real property” for, say, a firm owning salt caverns for document storage.
That requires private letter rulings from Uncle Sam, particularly in sectors where there are no or few examples of REIT conversion. Following the OK from the IRS comes a complicated process of different tax reporting standards, potentially selling-off divisions as well as purging a company’s cash hoard.
Firms and shareholders that make the conversion successfully can be rewarded, however. In 2011, American Tower (NYSE:AMT) converted to a REIT after the IRS agreed to classify cell towers as real property. Shares could be had for around $45. Today, AMT can be had at $77 a share. Likewise, timber firm Weyerhaeuser (NYSE:WY) upon its conversion paid a $5.6 billion special dividend to shareholders in 2010.
Conversions don’t always go right. When REITs were first created back in the 1990s, non-traditional real estate types like prisons, cell towers and golf courses were turned into REITs; however, some of those firms produced terrible results, with some cases producing losses of 90% or more. For example, prison owner and current REIT conversion Corrections Corp (NYSE:CXW) did try the REIT conversion once before. By 2000, the stock was below $1 and the conversion was reversed. Likewise, debt ratings often suffer in the wake of a REIT conversion.
Still Worth Your Portfolio's Time
Despite the risks, there is still a lot to like about the growth in REIT conversion for regular retail investors. REITs can reduce the risks of a traditional stock/bond portfolio and protect against the ravages of inflation as they own real properties whose values don't move in sync. Then there are those juicy dividends to consider. All in all, betting on those firms making the switch could be worth it in the long run. These include Cincinnati Bell's (NYSE:CBB) date center subsidiary CyrusOne, cell phone tower operators Crown Castle International (NYSE:CCI) and SBA Communications (Nasdaq:SBAC), document storage firm Iron Mountain (NYSE:IRM) and billboard owner Lamar Advertising (Nasdaq:LAMR).
A Continued Surge
While the leap to gain REIT tax status has been going on for a few years, it really has accelerated in the last year or so. Given that the hunt for higher income and lower corporate taxes is still on, investors can continue to see the trend play out in the years ahead. Overall, that should make them smile and provide them with lots of new dividend choices.
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