Real Estate Investment Trusts: Are REITs A Good Investment Now?

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When interest rates are in the cellar, so are effective bond yields – same with preferred stocks. In short, rock-bottom interest rates make it tougher than normal for anyone who is a net lender, rather than a net borrower, to generate a good return on financial assets.

So how do you make money in a low-interest rate environment? Align yourself with the borrowers. And one way to do that is by investing in REITs, or Real Estate Investment Trusts.

See also: Ready to invest in REIT funds right now?  Check out NerdWallet’s favorite online brokerage accounts so you can sign up and get started investing in real estate today.

REIT Basics Explained

REITs are sort of like a mutual fund that invests in real estate projects. You can buy “mortgage REITs” that invest in pools of mortgages, too, but that’s a different scenario. This story will focus on REITs that actually own properties, or companies that own properties, rather than debt instruments. You can also buy mutual funds that just buy REITs – which is handy for spreading your risk around if you aren’t comfortable buying REITs directly.

Congress gives REITs a nice little tax break: Unlike other corporations, REITs don’t have to pay income taxes at the corporate level. Instead, any profits and capital gains ‘flow through’ the REIT to the investor’s individual income tax return. That means that unlike normal C corporations, there’s no double taxation. That’s especially important now that the corporate income tax is back up to 39.6 percent this year.

In exchange for the tax preference, REITs must commit to paying out at least 90 percent of their operating profits in dividend income to investors.  So unless you hold them in a retirement account, you give up the tax deferral in exchange for freedom from the pitfall of double taxation.

Why is this? Normally, C corporations – that is, anything publicly traded, have to pay corporate income tax on profits. Dividends to shareholders are not tax deductible to the corporation. So last year pretty much all of them had to pay 35 percent tax before issuing a single dividend, and this year it’s up a bit more. So they can only pay dividends with what’s left. And then the investor pays income taxes on that. So the same dollar gets taxed twice: first at the corporate level and then at the individual level. So imagine two dollars coursing their way through two identical companies – except one is a REIT and the other isn’t. The REIT shareholder in a 28 percent tax bracket keeps 72 cents on the dollar that his REIT earns. The same shareholder in a non-REIT company this year only keeps $43.49. He had to pay 39.6 cents on the dollar at the corporate level, and then had to pay 28 percent on the amount remaining. In a retirement account, though, it doesn’t matter, because there’s no ongoing dividend tax at the individual level. It’s just income when you take distributions.

The REIT Tailwind

It won’t last forever – but government and federal policy is currently lined up to make things easy on real estate investors. The Federal Reserve is working hard to goose lending by buying up financial assets from banks and providing cash to lend. That means there is plenty of cash available for REITs to fund capital expansion – and at today’s interest rates, it’s cheap.

Meanwhile, the low yields on competing assets tend to drive income-oriented investors to REITs. Where treasuries and investment grade corporate bonds are generating around 3-4 percent, that’s a low-yielding REIT in today’s market.

As of this writing (16 February 2013), the MSCI US REIT Index has returned 5.31 percent YTD, and has a 16.55 trailing 1-year return. Its 3-year return – coming off the difficult times of 2010, is 22.65 percent. And over the last decade, the Index has posted a 12.65 percent annualized compound total return.

Meanwhile, the low yields on competing assets tend to drive income-oriented investors to REITs. Where treasuries and investment grade corporate bonds are generating around 3-4 percent, that’s a low-yielding REIT in today’s market.

But REIT yields aren’t where they once were, either.

Subsectors

While regional malls are doing ok – their anchor stores sign long 10-year+ leases that see malls through tough times – neighborhood retail malls are still struggling, according to Calvin Schure, the Vice President of Research and Industry Information at the National Association of Real Estate Investment Trusts.

Schure is looking to stronger gains in the office REIT category – expecting a ramp-up in hiring over the next year. If the economy recovers, office REITs could do well.

Meanwhile, REITs have a long history of demonstrating dividend growth outpacing inflation. This Morningstar graph shows that REIT dividend growth has outrun inflation for at least 17 of the last 23 years – and that includes 2008 and 2009, the worst years for REITs on record.

The REIT and Demographic Vortex

Some REITs benefit from the twin tailwinds of a favorable environment for REITs in general and demographic changes. For example, the baby boom cohort is now hitting their mid-60s – and will soon enter their peak years for health care consumption. That bodes well for REITs that specialize in hospitals and health care facilities and senior living. Examples include Health Care REIT (HCN), Senior Housing Properties Trust (SNH), Ventas (VTR) and HCP (HCP).

Non-Listed REITs

Not all REITs are publicly traded. You can also buy non-listed REITs, too. These are only for the most sophisticated and experienced REIT hands, though. The reason is that there is so much opaqueness with these balance sheets, and such variance among the quality and reliability of management, that it takes much more due diligence to make an informed decision on whether to invest in these REITs.

Plus, liquidity is a big factor. Transaction costs in this space can run up to 20 percent, and it can take a while before you find a buyer if you want to sell your position in some of these thinly-traded REITs.

Now, the upside is that you get a nice liquidity discount on the share price compared to the income yield. So some use it as an income strategy – but risks are high. There are lots of very compelling options available in the publicly-traded sector where investors get better protection, balance sheets are more transparent, and you can get in and out of your position more cheaply.

REIT Risk

Currently, REITs are not exactly trading near their historic highs, in terms of percentage yield. We get that, because interest rates are low across the board. Income-hungry investors have already bid up asset prices to compress yields.

However, there are some early signs that institutional investors are beginning to take some profits from the sector. The Vanguard REIT fund, for example has been experiencing substantial outflows as its price soars above the 200 day moving average.

 

Real estate image courtesy of TonyV3112 / Shutterstock.com