FOOL'S DEN
Considered REITs? Buffett Has

Looking for tamer investments? Need something to round out that tech-laden portfolio? Try real estate investment trusts (REITs). They offer a dividend yield, tax benefits, predictability, and a hedge to inflation and technology investments. Take another look at this misunderstood market -- Warren Buffett has.

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By Todd N. Lebor (TMF TeeTime)
January 9, 2001

Pull up the Barcalounger, take a seat, and get comfortable. The preacher is in the house. With the Nasdaq moving from irrational exuberance to irrational pessimism, many investors are sniffing around for "safer" investments. Real estate investment trusts (REITs) popped up on Buffett's radar screen a couple of years ago, and there are several reasons why I think he opened up his wallet for them. Perhaps it's time you familiarize yourself with the benefits of REITs. 

Do not mistake this article for an invitation to run out and buy REITs or even a REIT index fund. As I stated in a recent Rule Maker article, extrapolating current trends should not be mistaken for due diligence. That said, my intention is to capitalize on the downtrodden Nasdaq and strong REIT performance to draw your attention to REITs.

REITs had a phenomenal year in 2000 (up 26%) relative to the Nasdaq (down 39%). But, even more promising is the 12.4% (equity REITs only) return over the last 20 years compared to the S&P 500's 15.4%. Unfortunately, I could not begin to cover REITs in a 1,000-word article, so I suggest reading the introductory PDF file on the National Association of Real Estate Investment Trusts' (NAREIT) website entitled Investing in REITs. That report contains some graphs that I reference in this article. I will concentrate on four aspects -- cash dividend, tax benefits, predictability, and hedge -- that distinguish REITs from most other equity investments.

Cash dividend
Simply put, REITs have to pay out a high percentage of their earnings. It's the law. The tax code provides REITs with favorable tax status (no corporate income tax), but in return the IRS applies tedious rules to REITs (they must pay dividends and they have to invest in real estate).

Yet, contrary to popular belief, REIT investors are not burdened with reading and understanding reams of bean-counter lingo. The laws are aimed at ensuring that REITs follow the guidelines, not at confusing individual investors. One obvious benefit to the dividend requirement law is that investors do not have to worry about a REIT discontinuing or drastically reducing its dividend as AT&T (NYSE: T) recently did. The average equity REIT dividend yield is around 7.5%, and not all of that is taxable. Which leads to the second feature of REITs -- tax benefits.

Tax benefits
REITs are creatures of the tax code, which might explain why many individual investors have shied away from them. Yet, buying shares in a REIT is no different than buying shares of Intel (Nasdaq: INTC).

REITs benefit from not paying corporate tax (most of the time) and pass this benefit on to their shareholders with healthy dividends. The dividend requirement has two major impacts: It limits the growth pace of REITs by reducing their re-investable capital, and it exposes individual investors to the unfamiliar practice of adjusting the cost basis of stock. "Ugh," I can hear you saying. "I don't want to have to keep records on the basis of my stock!" Don't worry, it's easy and definitely worth it.

It is not uncommon for REITs to pay out a dividend that exceeds their "taxable income." This results in a portion of the dividend being classified as a "return of capital" under the tax code. Last year, the return of capital portion was 18.5% on average. Rather than pay income tax on the entire cash dividend, you only pay tax on the ordinary income portion of the dividend and reduce the basis of your holdings by the return of capital amount. Sounds confusing, but it is simple to track and it usually results in paying a lower tax on dividends.

Here is an example: Johnny Investor owns 100 shares of Skyscraper, Inc. (Ticker: TALL) with a $25 per share basis for total holdings of $2,500. Skyscraper pays a $2.50 dividend per share annually, netting Johnny $250 in dividends by the end of the year. Johnny is in the 28% income tax bracket. Normally, Johnny would pay tax of $70 ($250 x 0.28) on his dividend income. But, before filing his taxes in April, Johnny checks the NAREIT website for 1099 information on Skyscraper's dividends. He notices that $0.50 of the $2.50 per share dividend is classified as a return of capital, therefore he only reports $200 of dividend income and subsequently reduces the basis of his Skyscraper shares to $2,450 ($2,500 less $50).

The immediate result is a lower tax. Johnny pays $56 ($200 x 0.28) in taxes rather than $70. But, the real tax savings are realized at the time of sale. When Johnny sells his shares, assuming he has held them for more than 12 months, the cost basis of his stock is lower, resulting in a higher capital gain and a higher capital gain tax. Why is a higher capital gain tax better, you ask? It has a maximum tax rate of 20%, much lower than the 28%, 31%, and 39.6% ordinary income tax rates that dividends are subject to. Effectively, Johnny has deferred taxes on cash received and lowered his tax rate.

Predictability
The primary revenue source for REITs is rent. Rent is determined by contractual leases that often span multi-year periods. Therefore, near-term cash flows are very predictable, adding to the stability of REITs. These periods vary by property type. For example, hospitality (hotel) REITs have the least-predictable rent income because such income is day-to-day. Apartments rely on one-year terms, but office, industrial, and retail rents range from a year to 20 years, sometimes longer.

Hedge
REITs offer a natural hedge against inflation because rents generally rise with rising prices. But, REITs also offer a hedge against volatile tech companies. The graph on page one of Investing in REITs visually emphasizes this statistically significant point. When the tech-heavy Nasdaq was up, REITs were down. When the Nasdaq plummeted last year, REITs posted solid returns. But, as the chart on page nine shows, with a correlation of 0.01 between the Nasdaq 100 and REITs, there is no correlation. REITs move independently of tech stocks, not necessarily in the opposite direction. Therefore a REIT investment is not anti-tech.

I believe there are several other reasons for the independence of REITs from the overall equities market, including, but not limited to, low volume, small market caps, and lack of understanding by the average investor. Bear in mind, General Electric (NYSE: GE) has a market cap three times greater than all the publicly traded REITs combined.

REITs offer a smorgasbord of unique features not seen by other equity investments. High dividend yields, tax benefits, predictability, and a technology hedge are just a few. If I have failed to convince you, perhaps Warren Buffett can. Buffett has been dabbling in several REIT stocks for years, including First Industrial Realty Trust (NYSE: FR), JDN Realty (NYSE: JDN), Tanger Factory Outlet Centers (NYSE: SKT), and Town & Country Trust (NYSE: TCT). For disclosure purposes, I own First Industrial. For bragging rights, I owned it before Buffett!