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Real Estate Investment Trusts: Understanding Why REITs Pay High Yields

Tom Taulli

When it comes to real estate investment trusts, the dividend yields often are quite attractive. It’s not uncommon to see them 3% to 5% or so. Just look at companies like Simon Property Group (NYSE:SPG), Ventas (NYSE:VTR) and Brandywine Realty Trust (NYSE:BDN).

OK then, so why is this so? Well, there are a couple major reasons. First of all, real estate companies usually generate strong cash flows. This could be from rents or even payments from mortgage securities.

The cash flows also are bolstered by special tax benefits like depreciation. This means a company can take deductions over time for purchases of properties. And given the size of the transactions, these tax savings can add up.

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Next, it is important to keep in mind that real estate investment trusts are essentially the creation of the U.S. government. This happened back in 1960 when Congress wanted to develop a structure to help spur more investment in the industry and make it easier for retail investors to get exposure to real estate. Some of the main rules include:

  • At least 75% of the assets must be in qualifying real estate.
  • At least 75% of the income must come from rents or mortgage interest.

But perhaps the most important rule is: If a real estate investment trust distributes a minimum of 90% of its income as dividends, there will be no federal taxes owed.

Yes, this is a juicy tax perk – and it means that much of the cash flows return to the shareholders.

The recent tax reform bill has meant even more benefits. When you receive dividends from real estate investment trusts, you will owe taxes that are based your ordinary rates. However, now there is a 20% pass-through deduction for this. So if you are at the top rate of 37%, then the rate on dividends will be 27%. This is the case even if you take the standard deduction.

Special Aspects of Real Estate Investment Trusts

Real estate investment trusts have their own unique way of measuring earnings. It’s a metric called FFO (funds from operations), which is the net income plus the depreciation. This generally provides a more accurate reflection of the health of a real estate investment trust.

There are still some drawbacks with a high dividend yield. For the most part, it means fewer resources to expand. Instead, a real estate investment trust will issue more equity – which is dilutive – or take on more debt for growth initiatives.

And yes, there are some other risk factors. For example, a real estate investment trust may be focused on a certain industry or region. In other words, if there is a downturn, the cash flows will suffer. We’ve seen this with the retail sector due to the disruption from ecommerce operators like Amazon.com (NASDAQ:AMZN).

Another risk is interest rates. When they increase, this makes it more expensive to operate a real estate investment trust since there is usually a large amount of debt. There might also be less demand for the shares as interest on bonds will be more attractive.

To help with the risks, one approach is to invest in a mutual fund or exchange-traded fund that holds a portfolio of real estate investment trusts, which will provide more diversification. And some funds to consider include Schwab U.S. REIT ETF (NYSEARCA:SCHH) and Vanguard Real Estate ETF (NYSEARCA:VNQ).

Tom Taulli is the author of High-Profit IPO StrategiesAll About Commodities and All About Short SellingFollow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.

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