Real estate investment trusts, or REITs, invest in properties, allowing investors to enjoy the benefits of ownership without its associated headaches. That includes income in the form of REIT dividends.
"REITs must payout at least 90% of their taxable income to shareholders," says Chris Burbach, co-founder and partner at Phoenix-based Fundamental Income. "Dividends are typically paid on a quarterly basis and some pay monthly."
While earning a dividend payout is tempting, it's not the only reason to consider REIT investing. For example, it can be more accessible than direct ownership, in that many of the best REIT funds have a low minimum to invest. REIT shares can be bought and sold like a stock, making them relatively liquid investments.
Real estate can add diversification to a portfolio, helping to balance risk. In terms of total return, REITs can offer solid performance.
According to a recent analysis from researchers in the Netherlands, real estate investments outpaced stocks by a full percentage point per year on average since 1960.
But there are a few things to keep in mind about earning REIT dividends in an investment portfolio:
-- REIT dividend tax rules.
-- REIT dividends versus dividend-paying stocks.
-- How dividends compare by REIT type.
-- How to invest in REITs for dividend income.
REIT Dividend Tax Rules
There are two sides to the tax coin with REITs: how the REIT itself is taxed and how investors are taxed on dividends and capital gains.
"REITs don't pay taxes at the corporate level," says Robert Johnson, professor of finance, Heider College of Business at Creighton University. "They're treated as pass-through entities like [limited liability corporations], partnerships and S-corporations."
This is the biggest tax advantage of REIT investing, Johnson says. "The earnings of a REIT are not subject to double taxation."
So what does that mean for the REIT investor in plain speak? Simply that REIT dividends are taxed as ordinary income for the end shareholder, no different than any other stock, says Ryan Giannotto, director of research at New York-based GraniteShares.
That's significant for investors who are focused on creating reliable streams of income while maximizing tax efficiency.
REIT Dividends Versus Dividend-Paying Stocks
REITs aren't the only investments that can pay dividends; numerous stocks offer regular dividend payouts to investors. It's important to understand how they differ, both from a tax perspective and in terms of what drives dividend payouts.
"With an ordinary dividend-paying stock, investors are subject to the double taxation phenomenon, where earnings are taxed at the corporate level and again at the individual level," Giannotto says.
REITs are spared one layer of taxation, meaning they can offer relatively higher yields than a regular taxable company.
Burbach says that with dividend-paying stocks, investors should be tuned in to how the company generates cash flow to pay the dividend. That typically comes from selling products or services. On the other hand, REITs use their contractual cash flow generated from leases to pay dividends.
"Investors can look at how long those leases are, how much cash flow is being generated relative to the dividend payment and get a good idea about the security of the dividends being paid," he says.
With a dividend stock, payouts are often tied to the company's overall stability and profitability. If a company experiences a rough path with revenues or is carrying high debt loads, that can affect the amount paid to investors. The exception to the rule may be the dividend aristocrats, a grouping of companies that have consistently paid out an increased dividend to investors year over year for 25 years or more.
Guy Baker, founder of Wealth Teams Alliance in Irvine, California, says investors should be aware of factors that could similarly affect REIT dividend payouts. He says two of the biggest are increased vacancy rates or property issues stemming from foreclosures or defaults.
"REIT dividends should be more predictably certain," he adds.
How Dividends Compare by REIT Type
Another consideration for real estate investors is how the type of REIT can dictate dividend payments.
"There exists a myriad ecosystem of REITs that cover the entire gamut of real estate activity, from mortgage financing to direct real estate ownership, known as an equity REIT," Giannotto says. "REITs may specialize in different types of real estate, from commercial office space to residential apartments and homes, to warehousing and even data centers and towers."
The dividends a REIT pays can be determined by how well the underlying assets in the REIT perform.
According to the National Association of Real Estate Investment Trusts, commonly referred to as Nareit, the dividend yield across all REITs was nearly 4% in November 2019. Among equity REITs, the dividend yield was nearly 3.6%. By comparison, the S&P 500 yield for that same period was 1.9%.
Experts differ in their estimation of which REITs are most reliable when it comes to dividends. Baker likes mortgage REITs as an income source.
"These REITs only loan money to property owners and they're in a first position should the borrower default," he says. "The dividends can be significantly higher than the normal REIT dividends."
Heading into 2020, Burbach says real estate investors should be familiar with the real estate sectors that are poised to offer the strongest performance. He says that while office, industrial and apartment REITs are typically the most popular options they don't always produce the best yields.
The net lease sector, on the other hand, which focuses on properties leased to single tenants that are responsible for paying the rent and property expenses, often flies under the radar but offers competitive yields.
How to Invest in REITs for Dividend Income
Getting started with REIT investing begins with researching various types of REITs. Comparing dividend payouts is a first step but there are other things to consider.
Johnson says investors should consider the overall economic environment and how changes to monetary policy, such as rising or falling interest rates, might affect REIT performance.
According to Johnson's research, equity REITs returned 16.3% annually from 1972 to 2018 during expansive monetary policy periods. When monetary policy became more restrictive, annual returns dropped to 9.5% on average.
Investors should also understand the differences between a traditional REIT and a REIT fund. Both ETFs and mutual funds can offer exposure to a basket of REITs and their underlying assets but it's important to avoid overlap to remain diversified.
Finally, weigh the risks of a specific REIT sector. Office properties, for instance, might be more susceptible to economic fluctuations since they tend to have shorter lease terms, Burbach says.
When investing in REITs for dividends or any other reason, remember the age-old rule for managing risk: Know what you own.
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