The Motley Fool Previous Page

The REIT Stuff

Dan Caplinger
February 26, 2007

As you look through the latest news headlines, you may have noticed seeing more about REITs than usual. On one hand, they've been the target of large acquisitions, including the recent takeover of Equity Office Properties by the Blackstone Group, and Simon Property Group's (NYSE: SPG  ) buyout offer for Mills (NYSE: MLS  ) . On the other hand, REITs focusing on lower-end mortgages, such as Novastar (NYSE: NFI  ) , are facing a significant reversal of fortune after several years of outstanding performance.

Until recently, however, extremely few investors knew anything about REITs. Excluded from the traditional asset allocation mix of stocks, bonds, and cash, REITs represented an obscure sector where few investors felt comfortable putting their investment capital. After huge double-digit percentage gains over the past several years, however, understanding what REITs are and what role they might play in your portfolio is essential to making the best returns you can earn.

The nuts and bolts of REITs
REIT is an acronym for real estate investment trust. However, don't let the name fool you. Most REITs are organized not as trusts, but as corporations. As such, they have shares of stock just like any other corporation. These corporations tend to have the bulk of their assets either in rental properties or in mortgages. If they meet certain requirements, these corporations can elect to be treated as REITs.

Corporations often choose to become REITs for tax purposes. In general, corporations are subject to corporate income taxes at the entity level. When they pay dividends to shareholders, those dividends are also treated as income on each shareholder's individual income tax return. As a result, corporate investments tend to be subject to double taxation -- a common criticism of the tax laws, and one reason why some stock dividends are taxed at lower rates than other income.

If a corporation qualifies for REIT treatment, however, it is able to avoid being taxed at the corporate level. Instead, the REIT is treated as a pass-through entity, whereby shareholders pay the entire tax liability on their individual tax returns. With corporate tax rates as high as 38%, this can be a substantial incentive for companies that focus on real estate investments.

In order to qualify as a REIT, a company must have at least 75% of its investments in real estate, with 75% of its income coming from rental income or mortgage interest. Most importantly, REITs must pay out at least 90% of their taxable income each year in the form of dividends. This explains why many REITs have such high dividend yields in comparison to ordinary stocks; most corporations retain a larger fraction of their earnings.

REITs are everywhere
REITs have gained in popularity due to a number of factors. During the early part of the decade, when stocks were falling sharply, investors sought alternatives that offered diversification in order to stabilize their dropping portfolio values. Later, when interest rates fell to their lowest levels in 40 years, investors looking for current income had to look beyond traditional fixed-income securities like bonds and bank CDs to generate enough cash to pay for living expenses. When combined with rising real estate markets, the potential for explosive price growth became a reality. One index of REITs is up nearly 25% per year over the past five years.

As REITs have become a more established investment vehicle, financial institutions have offered investors new ways to invest in REITs. Exchange-traded funds like the Vanguard REIT ETF (AMEX: VNQ  ) and iShares Cohen & Steers (AMEX: ICF  ) track the performance of a basket of REITs. In addition, the scope of real estate holdings among REITs has expanded greatly in response to investor demand. A new exchange-traded fund, StreetTracks Dow Jones Wilshire International Real Estate (AMEX: RWX