Real estate investment trusts, or REITs, are a good option for long-term value investments. They provide a stable dividend yield and overall high total returns, as the real estate prices historically are going up.
REIT dividends create a stable income, which is especially important if you are close to retirement. If you have not heard about REITs and want to learn more, let’s dive in. We will explain what REITs are and how to evaluate them for your portfolio.
What Are REITs?
REIT stands for real estate investment trust. These are companies that own, finance, and oftentimes manage various real estate. There are different ways to invest in REITs: through REIT mutual funds, standalone stocks, and exchange-traded funds (ETFs).
Real estate Investment trusts even have their own national association — Nareit — that advocates, represents, and promotes the earning of income through REITs.
Types of REITs
REITs can be listed on a stock exchange, can be public non-listed, or can be private. You can invest in two types of REITs: equity REITs and mortgage REITs.
- Mortgage REITs (or mREITs) invest in mortgage-related securities.
- Equity REITs include various property types: shopping centers, health care facilities, office buildings, hotels, warehouses, and even telecommunication infrastructure. Depending on the properties’ locations, they can be local or global.
How REITs Make Money
Profits from properties through rents or leases are their main source of taxable income. To benefit from the real estate market, there is no need to directly own and manage properties anymore. Rental income will come to private investors in the form of dividends from REITs.
Real estate investment trusts in general have above-average dividend yields, usually starting at 3-5% and higher. For example, W.P. Carey (NYSE:WPC) is a midcap diversified real estate investment trust with commercial properties in the United States and Europe, and its current dividend rate is 6.12%.
REITs with higher dividend yields do not automatically mean higher risk, as there are economic fundamentals behind it. Here are some of the reasons REITs offer good rewards for investors:
- REITs do not pay income tax: Their profits pass through to the shareholders in the form of dividends. As a result, the profits are taxed only once.
- REITs must pay at least 90% of their taxable income: This is given to shareholders in the form of dividends. These high payouts provide individual investors with steady and consistent income.
- Real estate asset prices historically go up: This gives REITs long-term stability. The longer you hold the REIT, the higher its capital appreciation.
- REITs can be a hedge against volatility: They are more stable and do not closely correlate with other assets. By investing in different REIT stocks, ETFs, and mutual funds, you further diversify your portfolio. Selecting between property types (industrial vs. office) and their locations (the United States vs. Europe) helps to spread the investment exposure and minimize risks.
How To Evaluate REIT Stocks
There are several important metrics that you can use to evaluate REIT performance. Individual investors should pay attention to the trajectory of a company’s cash flow, dividends paid, historical stock prices, and macroeconomic trends.
Selecting REITs with strong financial results will help to create a desirable portfolio. These results are reported in the form of the balance sheet, income statement, and cash flow for publicly traded companies.
REITs define the cash flow from operations by using the funds from operations (FFO) metric. FFO is calculated by adding net income, depreciation, and amortization (mortgage payout), and then subtracting gains on sale of property. This metric is one of the key parameters to help determine how risky the investment can be. FFO should be stable or increasing year over year.
Dividend Yield vs. Dividend Rate
Some REITs pay out dividends monthly, while others pay quarterly or even yearly. Monthly dividends allow you to reinvest more often if desired.
The dividend rate is the absolute amount to be paid out per share, or the dollar amount you receive as the investor. The dividend yield is a ratio, or percentage. It is calculated by dividing the dividend rate by the current REIT price.
For example, Simon Property Group (NYSE:SPG) is a REIT that administers and manages malls, outlets, and lifestyle centers. As of February 2021, the REIT’s price was $109.43, and the annual dividend was $5.20. To determine the dividend yield, you would divide $5.20 by $109.43. In this example, SPG’s annual dividend yield was 4.75%.
Dividend yield changes depending on the current REIT price, and it gives you an expected return on investment if you were to buy the stock at that moment. So, a rise in the dividend yield could mean either the dividend rate went up or the price of the REIT went down. That is why you should use the annual dividend rate to estimate how much income you can expect from your investment.
Historical prices and dividend distributions demonstrate how the REIT has been performing and if the dividend rate has been consistent. The stock price trajectory tends to point out the company’s financial well-being and future trend.
Let’s use Digital Realty Trust (NYSE:DLR) as an example. This company owns, develops, and operates data centers in North America, Europe, Latin America, Asia, and Australia. DLR’s price per share went from $12 in 2005 up to $136 in February 2021. Its dividend rate went up from $0.16 to $1.12 per quarter, staying in the 2.8-6.5% dividend yield range. DLR’s example also attests to how REITs create not only a stable dividend yield but also growth overtime.
Changing monetary policy, rising inflation, anti-monopolistic regulations, and technological advancements are among the many factors that impact the stock market. Here are some examples of how trends might influence the REITs you add to your portfolio:
- Global crises: In 2020, the pandemic drove companies to abandon office space, and the stock market plummeted. This caused many REITs to become undervalued even though they still had good balance sheets and high dividends. This made office-building REITs attractive to investors who anticipated that it would only be a short-term disruption for the industry.
- The growth of 5G: 5G may be the biggest breakthrough technology. Built close to each other, short-range 5G towers will enable the new high-speed networks. Many telecom companies are competing to develop the new infrastructure and establish the network ahead of the competition. This influenced many investors to look at telecom infrastructure REITs.
- Online shopping: The pandemic accelerated the shift from retail to online shopping. Many companies decided to focus on fast-growing e-commerce and move their inventory from stores to warehouses. As a result, demand for warehouse space and distribution centers skyrocketed. This led investors to choose warehouse and distribution REITs.
- Economic policies: REIT prices benefited from the Fed’s monetary policies in 2020. The goal of the policies was to provide a powerful support to the U.S. economy. Near-zero interest rates, low Treasury bond yields, and low taxes pushed REIT prices higher. Expansionary fiscal policy through higher government spending, unemployment reduction, and stimulus checks could further benefit REIT investors.
How Are REIT Dividends Taxed?
REIT dividends are usually not considered qualified dividends, so they are taxed at a higher rate:
- If you bought a REIT through a standard brokerage account, it typically will be taxed as ordinary income, depending on your tax bracket. But thanks to the Tax Cuts and Jobs Act (TCJA), 20% of your dividend income from REITs is tax-exempt.
- If the dividends are received as part of a 401(k) retirement plan or various IRA plans, then the dividends are tax-free while they are in the account. The money you withdraw from your 401(k) or IRA will be taxed at the income tax rate.
Diversify Your Portfolio With REITs
Real estate investment trusts are a safer play for individual investors than owning real estate property. REITs historically provide a good long-term payout and offer dividends that are generally higher than most stocks.
REITs can help diversify your investment portfolio, reduce its volatility, and provide a high fixed income. Portfolio diversification is especially important when you are close to retirement.
You have now learned how REITs can augment your portfolio and help you with constant cash flow. To learn which specific dividend stocks to buy and hold to create stable dividend income, subscribe to Investors Alley’s “Dividend Hunter” newsletter.