Why Do REITs Pay Out 90% of Their Profits As Dividends?
A Real Estate Investment Trust, commonly referred to as a REIT, is an equity product that is built around real estate. With several different types of REIT’s, including mortgage REIT’s, income REIT’s, capital appreciation and growth REIT’s, etc. there are many different advantages to having a REIT in a portfolio, such as high dividends, additional diversification benefits (as Real Estate is often thought of as a way to diversify a portfolio from equity markets), and as a way to take on risk in order to attempt to increase your returns. With all the good however, comes some notable bad, such as the potentially high firm-specific risk that comes with each of these products, the heavy tax burden that excess dividends can have on your bottom line, and a host of other issues. The following work will look into the pros and cons of Real Estate Investment Trusts, will explain what exactly a Real Estate Investment Trust is, and will serve to give my opinion on several of my top REIT products that I would recommend. The following blog post will answer the question of “Why Do REITs Pay out 90% of their profits as dividends?”
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In looking at what a REIT actually is, it’s important to look at a few things that allow a REIT to be classified as such, including how they are different from regular equities, what constitutes a REIT, and how a REIT asset and its dividends is taxed in comparison to those dividends or gains of regular equity securities. First off, from purely a brick and mortar perspective, a REIT is a holding company that operates, owns or finances what is usually income-generating real estate property. Two common examples of REIT company types are REITs that own apartment buildings, and generate rental income from each room, or REITs that own mortgages, and generate income off of payments and interest. REITs, aside from needing to own real estate in order to be classified as such, must adhere to certain financing guidelines in order to maintain their favorable status as a Real Estate Investment Trust. Among these include investing at least 75% of their assets in
Real Estate, get 75% or more of revenue from rents, mortgage income or interest income, and in my opinion the one that gives the most insight into how a REIT operates, pay a minimum of 90% of taxable income in the form of shareholder dividends each year. (Chen 1) In order to hold REIT status, these are among the most important rules, and is the major reason why dividend yields on these stocks are so high. The major drawback that I see with regards to receiving high dividends like this, especially from a REIT, is that REIT’s cannot receive qualified dividends, and as such are subject to less favorable tax rates, this is why I personally would only keep a small percentage of my portfolio in REIT assets.
Here’s Why REIT’s Really Pay Out 90% of Their Profits As Dividends, Tax Breaks and Stock Gains!
Within a well-diversified portfolio however, if choosing between types of REIT’s to add to my investments, I would bring in income-generating, moderate dividend-yield REITs (in order to try and minimize tax implications) that make their revenue from rental property ownership and payments, as these seem to be the most stable REITs (Hicks 2) over the long term (most REITs are equity REITs, and they are already generating regular cash flow off of rental property that they own, which minimizes their risk of defaulting, missing a dividend payment etc.). Even with all this, I would try and maintain about a 3% allocation level to REITs within my portfolio.
My reasoning behind this is that my total allocation within my ideal portfolio, to individual stocks, blue chip or otherwise, will be about 10% once I have the means to do so, with 10% cash from here (bonds, CD’s, Money Market Accounts, etc.), and the other 80% being in a combination of low cost, globally diversified index funds, the S and P 500, or the CRSP-110, in order to have a properly diversified portfolio, almost totally free of firm specific risk or home-country bias, and to minimize the tax implications of excess dividends. I continually bring up the fact that dividends increase your taxes, in that, in the case of REITs, all of their dividends are non-qualified, which means that you will pay ordinary income tax rates on your REITs, as opposed to the more favorable capital gains rates.
What is a Real Estate Investment Trust, and Why I Will Probably Never Own One
Past this however, any stock that pays any dividends at all, even in the case of ETFs that track indices that pay out dividends to ETF shareholders, is actually sucking profits out of your bottom line. My reasoning here, is that if these dividends were reinvested back into the ETF (by the company, by way of their retained earnings, not by the investor) and allowed to flow through to the investor by way of unrealized capital gains, their will be no tax implications from these profits. As soon as a dividend is paid out however, this detracts from the stocks plowback ratio, and the amount that they can grow by reinvesting their earnings, and a tax implication is immediately incurred, as you now have reportable income from your portfolio that you must pay a percentage to the IRS from. In short, this is why I will keep REITs, and individual stocks in general, as a very small portion of my portfolio. In terms of measuring REIT performance, this is one of the most important concepts to keep in mind, the investor should look at their total holding period return on the stock, after all fees, taxes, and expenses are paid, and should look at their net income of gains, in comparison to those of something like a low cost index benchmark, such as the S and P 500, and of how much of their gains they are actually keeping at the end of the day. My opinion on this matter, and that of the leading academic professionals in the field of portfolio management, is that you’d be hard pressed to find a REIT ETF that beats something like an S and P 500 index fund over a 30-year period of time. (Daley 3)
Final Thoughts on REITs, and Why They are Good For a Small Portion of Your Portfolio Only
In short, while I like some of the advantages of REITs, like serving as a liquid way to get real estate exposure into a portfolio, and of how they allow for an automated system of payments on a monthly or quarterly basis (via automatic dividend payouts from the stock into your account, which could function as a sort of annuity if desired), I personally would only weight them as a small percentage of my portfolio, for the myriad of reasons outlined above. REITs are a very interesting product, but I definitely do not think that they should take up an enormous percentage of an investors portfolio or investing strategy, but that they serve as an additional tool for re-allocating anyone’s portfolio into real estate.
Sources:
- Chen, J. (2020, April 8). Real Estate Investment Trust (REIT) Definition. Retrieved from https://www.investopedia.com/terms/r/reit.asp
- https://money.usnews.com/investing/real-estate-investments/articles/the-ultimate-guide-to-reits
- https://www.pwlcapital.com/what-stock-should-i-buy/
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