This Secret Loophole Could Pay Off Huge For REIT Investors

posted on 06-07-2019

There was a time when real estate was out of reach for the small investor.

Back in President Dwight D. Eisenhower's era, policymakers in Washington noted a clear conundrum. A real estate boom was under way, but most small investors were missing out. It would cost a lot of money to build a shopping mall or an office tower, and the lucrative business of being a professional landlord was reserved to those who had lots of funds.

But no more. Since the 1950s, and thanks to Eisenhower, we've had investment instruments that the little guy can participate in -- Real Estate Investment Trusts, better known as REITs. And now, it's not just real estate firms cashing in on the tax advantages of REITs.

I'll tell you more about those big tax advantages in a minute.

REITs are like regular stocks, trading on the major exchanges such as the New York Stock Exchange. They are a class of real estate investment firms that can draw in the funds of smaller investors: You can buy even a single share.

These firms, run by real estate professionals, adhere to one simple rule: More than 90% of profits every year have to be returned to investors in the form of dividends. Yet by doing so, all of those profits made by REITs can bypass federal taxes. Profits are only taxed at the level of individual shareholders.

But there's an interesting movement afoot. It's a loophole non-real estate companies have taken advantage of, one that investors can now cash in on. For tax reasons, the REIT corporate structure has begun to appeal to many firms outside the traditional realm of office buildings, shopping malls and apartment complexes. Take Internet data traffic management firm Equinix (Nasdaq: EQIX).

In early 2012, media reports circulated that the company's stock would zoom higher if Equinix decided to re-classify itself as a REIT. The company's public comments seemed to suggest that the idea had merit. After all, Equinix owned many large and valuable buildings (where its Internet traffic equipment resides) and the company was financially strong enough to pass on most of its profits to investors.

The company successfully petitioned the Internal Revenue Service to let it become a REIT in September 2012, and investors who had spotted this move coming profited handsomely.

Since then, a number of firms have followed Equinix's lead, hoping for similar gains.

Why would these stocks move up in value? Because lower taxes means more money left over for shareholders.

Look for this trend to continue throughout this year.

[InvestingAnswers Feature: REITs: The Easiest Way to Invest in Real Estate]

Today, there are now more than 400 REITs across a few dozen countries, collectively managing roughly $1 trillion worth of real estate. Popular publicly traded REITs in the United States include:

  • Simon Property Group (NYSE: SPG), which focuses on shopping malls
  • Public Storage (NYSE: PSA), self-storage facilities
  • HCP (NYSE: HCP), hospitals and other health care facilities
  • Ventas (NYSE: VTR), hospitals/health care
  •  Equity Residential (NYSE: EQR), apartment complexes
  • Boston Properties (NYSE: BXP), office complexes

But for all of their appeal, because REITs must pass on almost all of their profits, they have little funds left over to pursue growth. If they do choose to expand, they often sell newly issued stock, which means earnings per share won't grow very much (as profits from growth initiatives and the share count grow at a similar pace). So investors really look at these firms as income producers and don't expect to see robust share price appreciation.

Of course, the dividend yield that these firms offer is continually weighed against the payouts that other income-producing investments offer. In recent years, REITs have held a great deal of appeal relative to government bonds and CDs because those financial instruments often offer yields below 2%. In contrast, the yield for a REIT can approach 4% or even 6%.

But what will happen when traditional fixed-income investments like government bonds and bank CDs start to offer more attractive yields when the Federal Reserve starts raising interest rates? Well, the yield on REITs will also have to rise, staying above the rates offered by bonds and CDs because REITs are more risky than bonds and CDs.

Because these REITs can't magically produce higher income streams to boost dividend payments, the only way for these yields to rise is for their share price to fall. (Remember that a dividend yield moves in the opposite direction of a stock price.) That's why REITs may not be a great investment once we enter a period of rising interest rates. But we're not there yet, and right now REITs continue to hold relatively strong appeal in this low-yield, low-inflation environment.

The Investing Answer: With any income-producing investment, higher dividend yields reflect greater possible risk. So a REIT with a relatively high yield may be seen as having a weaker set of real estate assets. The right REIT for you depends on your risk appetite.

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