When it comes to income, I’m a fan of real estate investment trusts (REITs).
After all, what’s not to like? This sector was almost custom-made for dividend investors.
It’s still a relatively young asset class, with main legislative documents regulating its functioning only signed in 1960. The general idea: allow individuals with smaller capital an opportunity to invest in commercial real estate and benefit from its income generation and other opportunities without actually buying properties.
This income has the potential to grow — as does the value of the properties. By law, REITs are required to pay out at least 90% of their annual taxable income to investors. This too is attractive, especially today, as bond yields continue to slide.
REITs are also excellent portfolio diversifiers. This asset class has relatively low correlation with other financial assets, which is unique. This means that REITs generally don’t move in the same direction or to the same extent as the rest of the market, and it makes the sector almost irreplaceable in its role as a portfolio diversifier.
In fact, if REITs weren’t paying much in terms of income, this feature alone would still make them attractive for individual and institutional investors alike. Why? Because adding something that does not move in unison with the rest of your holdings reduces your overall risk.
But REITs do pay. The iShares U.S. Real Estate ETF (IYR), an ETF with broad exposure to REITs, currently yields 3.8%. That’s a lot higher than the average yield of stocks in the S&P 500 (which is about 2%).
And they do have the potential to move higher. Even though the markets have been strong this year, REITs have been stronger yet.
As the chart illustrates, the total return for IYR (which includes dividends) is 11.5% for the year, compared to the 8.4% total return for the S&P 500.
Overall, REITs have benefited from the Fed’s policies of near-zero interest rates, and also received a shot in the arm after Brexit, when it became clear that central banks will continue their easy monetary policies.
The sector can be tricky, however.
First, because REITs distribute untaxed income, the dividend can be classified as ordinary income, capital gains or return of capital. Of course, these generally are taxed at a different rate, and investors should pay special attention to their annual tax forms, which REITs are required to provide. As far as I’m concerned, a little more work at tax time and a higher potential tax rate are a small price to pay for the stronger dividends and their potential for growth.
Second, there are two types of REITs that differ vastly: mortgage REITs and equity REITs. Their businesses are different enough that the S&P 500 on August 31 will separate equity REITs into a new sector but will keep mortgage REITs within the financial sector, where they belong.
That’s because mortgage REITs are in the finance business. Mortgage REITs provide financing for real estate by purchasing or originating mortgages and mortgage-backed securities, and earn income from the interest on these investments.
Mortgage REITs invest in residential and commercial mortgages, as well as residential mortgage-backed securities and commercial mortgage-backed securities.
Mortgage REITs are more vulnerable to changes and dynamics in interest rates than almost any other stock group. That’s because their mortgage investments are funded by debt and equity. The wider the spread between the interest income their mortgage assets generate and what they cost, the better — and the opposite: as the spread narrows, their income shrinks.
And while I do own one of the best mortgage REITs in the business in the portfolio of my premium newsletter, The Daily Paycheck, it should be understood that these stocks are not for everyone.
Equity REITs: A New S&P 500 Sector
Generally, when you say REITs, you think equity REITs. And you are right in most cases, as those REITs constitute the majority.
These companies acquire commercial properties (shopping centers, apartment buildings, self-storage facilities) and lease the space to tenants, who pay rent. A typical equity REIT, therefore, benefits from low interest rates because while it needs to borrow big, it can borrow cheap. At the same time, its tenants also benefit from the low-interest rate environment.
Take for example two REITs I own in The Daily Paycheck. One specializes in real estate for shopping centers, while another provides locations for data centers for large tech and telecom companies. Both have fared well in this low interest rate environment. In fact, they are up 34.7% and 37.2%, respectively, so far this year. Despite these healthy bullish run-ups, they both still yield a solid 3.5%.
Those aren’t typos. These numbers show the tremendous demand and potential for REITs. It just goes to show that when it comes to searching for income, you don’t have to settle. There are a slew of options out there — you just have to know where to look.
If you’re looking for bigger yields and higher gains in this challenging environment, I invite you to learn more about The Daily Paycheck. We own some of the most promising income investments the market has to offer, and my subscribers are using them to earn thousands of dollars in extra income each and every month. To learn more about The Daily Paycheck and how you can join us, simply visit this link.
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