Benefits and Drawbacks of REITs

(2 of 7)

Benefits and Drawbacks of REITs

A real estate investment trust (REIT) is a company that owns and manages income-producing real estate. REITs were created by an act of Congress in 1960 to enable large and small investors alike to enjoy the rental income from commercial property. REITs are governed by many regulations, the most important being that they must distribute at least 90% of their taxable income to shareholders each year as dividends; the REIT is permitted to deduct dividends paid to shareholders from its taxable income. Other important regulations include:

• Asset requirements: at least 75% of assets must be real estate.
• Income requirements: at least 75% of gross income must come from rents, interest from mortgages, or other real estate investments.
• Stock ownership requirements: shares in the REIT must be held by a minimum of 100 shareholders.

REITs specialize by property type. They invest in most major property types with nearly two thirds of investment being in offices, apartments, shopping centers, regional malls, and industrial facilities. The rest is divided among hotels, self-storage facilities, health-care properties, and some specialty REITs that own anything from prisons, theatres, and golf courses to timberlands.

The benefits

Some benefits of REITs include:

• High yields: For many investors, the main attraction of REITs has been their relatively high dividend yield. Also, REIT dividends are secured by stable rents from long-term leases, and many REIT managers employ conservative leverage on the balance sheet.
• Simple tax treatment: Unlike most partnerships, tax issues for REIT investors are fairly straightforward. Each year, REITs send Form 1099-DIV to their shareholders, containing a breakdown of the dividend distributions. For tax purposes, dividends are allocated to ordinary income, capital gains, and return of capital. As REITs do not pay taxes at the corporate level, investors are taxed at their individual tax rate for the ordinary income portion of the dividend. The portion of the dividend taxed as capital gains arises if the REIT sells assets. Return of capital, or net distributions in excess of the REIT’s earnings and profits, are not taxed as ordinary income, but instead applied to reduce the shareholder’s cost basis in the stock. When the shares are eventually sold, the difference between the share price and reduced tax basis is taxed as a capital gain.
• Liquidity of REIT shares: REIT shares are bought and sold on a stock exchange. By contrast, buying and selling property directly involves higher expenses and requires a great deal of effort.
• Diversification. Studies have shown that adding REITs to a diversified investment portfolio increases returns and reduces risk since REITs have little correlation with the S&P 500.

The drawbacks

REITs also have some drawbacks, including:

• Sensitivity to demand for other high-yield assets: Generally, rising interest rates could make Treasury securities more attractive, drawing funds away from REITs and lowering their share prices.
• Property taxes: REITs must pay property taxes, which can make up as much as 25% of total operating expenses. State and municipal authorities could increase property taxes to make up for budget shortfalls, reducing cash flows to shareholders.
• Tax rates: One of the downsides to the high yield of REITs is that taxes are due on dividends, and the tax rates are typically higher than the 15% or 20% most dividends are currently taxed at. This is because a large chunk of a REIT’s dividends (typically about three quarters, though it varies widely by REIT) is considered ordinary income, which is usually taxed at a higher rate.