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3 Pros, 3 Cons of Investing in the Best REITs for Income

Best REITs for income - 3 Pros, 3 Cons of Investing in the Best REITs for Income

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Since their creation in 1960, real estate investment trusts (REITs) have become an increasingly popular investment, and investors frequently seek the best REITs for income. REITs are companies whose assets consist mainly of real estate holdings. They also receive more favorable tax treatment. In exchange, they must distribute at least 90% of their income to unitholders.

Most REITs classify themselves as mortgage or equity REITs. As the name implies, mortgage REITs issue and hold debt tied to real estate. This debt is bundled into mortgage-backed securities. They earn money on the difference between short-term interest rates and the rates charged through their loans. They do not own physical property.

Equity REITs own the physical property and make up the majority of REITs in existence. In most cases, REITs invest in a single property type such as office, retail, industrial, or even unique property types such as data centers or telecom towers.

Investing in REITs can serve as a source of cash flow for income-oriented investors. However, succeeding with REITs means finding the best REITs for income and understanding the advantages and disadvantages of this investment vehicle.

Pro: REITs are required by law to pay out at least 90% of their net income in the form of dividends

The prospect for cash flow attracts investors to real estate. However, a standard fund that happened to hold real estate would not necessarily pass on cash flows to unitholders. The existence of the real estate investment trust mitigates this issue. If an equity takes advantage of a REIT’s tax benefits, by law, 90% of the fund’s net income must be paid to unitholders to maintain their REIT status.

This 90% rule allows investors to collect a higher amount of income than other stocks that pay dividends. This pays off well for investors, as the average REIT dividend stands at 4.59%. Dividends average 1.85% for the S&P 500. Hence, even if one misses out on the top REITs, they still should earn a decent yield. Consequently, the government allows the REIT to deduct the money paid out in dividends from its corporate taxes.

Still, some will trade payouts for stock growth. Such is the case with the industrial REIT Prologis Inc (NYSE:PLD). PLD will not qualify as one of the best REITs for income with its yield of around 2.75%. However, the stock has quadrupled in value over the last few years. The stock’s value has been buoyed by the rise of e-commerce. Online retailing has greatly increased demand for the type of industrial space Prologis owns.

Con: REITs are required by law to pay out at least 90% of their net income in the form of dividends

The 90% payout often acts as a double-edged sword for REIT investors. For one, the rule limits future growth, particularly with the best REITs for income. Because the government requires the company to distribute 90% of its income for unitholders, little capital is left over for acquiring or renovating new properties.

Fortunately, REITs can mitigate this limitation by issuing debt. Still, increased growth usually requires increased leverage. For example, if a retail REIT took on a high degree of leverage at the time e-commerce was reducing the demand for retail space, this could have spelled trouble for that equity.

One can also protect themselves in a REIT ETF, which invests in multiple REITs. In the case of the VANGUARD Ix FUN/RL EST IX FD ETF (NYSEARCA:VNQ) investors can earn high returns. VNQ’s dividend yield stands at just under 4.8%. The stock’s value also quadrupled between 2009 and 2016 before pulling back.

Interestingly, the 90% rule can also hurt some income-oriented investors. In many cases, net income can experience a great deal of fluctuation. For this reason, maintaining a consistent payout only comes with great difficulty. Accounting tricks can keep a dividend stable for a time. Some also borrow purely to maintain a dividend payment, though this could spell trouble for the REIT in the long run.

Without accounting tricks or leverage, remaining solvent will require the REIT to cut dividends when incomes fall and increase them in times of rising profits. Hence, investors should plan for income fluctuations.

Pro: Ease of purchases and sales

Selling a property means a marketing campaign to find a buyer, negotiating prices and terms, securing the legal paperwork, and funding the deal. This process takes at least a few weeks, and even takes years in extreme cases.

However, a REIT functions and behaves like a stock. As long as one is willing to buy or sell at the prevailing price, the REIT can be acquired or sold in seconds in most cases. If one owns millions of dollar’s worth of shares in a relatively illiquid REIT, it may take a series of transactions over time so as not to cause extreme effects on the price. Even then, a purchase or sale becomes a relatively quick process.

One needs to remain aware of this issue if considering an equity such as healthcare REIT Caretrust REIT Inc (NASDAQ:CTRE). Investors might become drawn to the 5% dividend yield and the demand increases driven by baby boomers needing more care. However, with a trading volume averaging about 734,000 shares, a large purchase could send the stock price spiking higher.

Also, if one invests in the best REITs for income, that in itself will serve as a disincentive to sell. But, if need be, most investors can move in and out of REIT positions instantly.

Con: Dividends taxed as ordinary income

In most cases, the federal government taxes dividends at a lower rate than ordinary income. Unfortunately for REIT unitholders, that dividend tax benefit does not apply to their REIT holdings. Consequently, the government defines these distributions as ordinary income. Hence, investing in the best REITs for income will result in larger tax consequences.

The recent tax cut may mitigate this burden. Still, a low-income individual might get away with as little as a 10% tax. A higher-income family could see taxes rise as high as 37% for this type of income. Single filers with an average income would likely pay a 22% tax rate.

This compares to the current dividend tax, which amounts to 0% in many cases. Most would pay no more than a 15% tax and even the highest-income individuals would pay 20% for non-REIT dividends.

A more tax-sensitive investor may want to consider the data center REIT Digital Realty Tr/SH SH (NYSE:DLR) in this case. The yield of around 3.4% is lower than average. However, with the equity enjoying steady stock price increases since 2009, more income comes from capital gains at the time of sale.

Pro: The best REITs for income offer professional management

Many real estate investors are landlords who handle their own property management. These types of investors often live in fear of the dreaded 2 a.m. phone call over a broken toilet. Even those who manage retail or office properties usually have the supplies, equipment, and HR-related issues for maintenance crews who handle the cleaning and landscaping. In addition to maintenance, issues with renovations and construction also become the responsibility of property owners or the managers they hire.

However, with a real estate investment trust, managing these issues becomes the responsibility of the REIT itself. The responsibility of the unitholder consists of monitoring the equity and its distributions. Investors can also unload that obligation by conducting a quick sale in their brokerage account.

Con: REITs still have to pay taxes

Income distributed to unitholders remains free of taxation. However, if the REIT distributes income to non-unitholders, that income is subject to standard dividend taxes. Also, income from the sale of properties subjects a REIT to capital gains tax. The best REITs for income will mitigate this, of course. Still, REIT investors need to consider the tax consequences when buying this type of equity.

Property taxes usually become a REIT’s most significant tax concern. Owners must pay all of the required taxes on properties. Further, in an environment of rising real estate prices, this will likely mean greater tax expenses and, possibly, less income to distribute to unitholders. Investors might also want to lessen their exposure in high-property-tax states. Hence, REITs that invest heavily in states such as Illinois, New Jersey and Texas would likely feel the most effect.

That bodes poorly for equities such as Whitestone REIT (NYSE:WSR). The 9.6% dividend yield might attract interested parties. However, with a heavy presence in both Illinois and its base of operations in Texas, property taxes will hit this stock especially hard.

As of this writing, Will Healy did not hold a position in any of the aforementioned stocks.

 


Article printed from InvestorPlace Media, https://investorplace.com/2018/05/3-pros-3-cons-investing-best-reits/.

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