REITs are investment vehicles that invest at least 75% in real estate, providing an avenue for investors to participate in the real estate market without having to own property. They consist of anything from medical centers to shopping malls, apartment buildings to office high-rises, and everything in between. Due to special considerations under the tax code, REITs are not subject to corporate income tax if they pay out more than 95% of their earnings to shareholders in the form of dividends. This makes REITs especially attractive to investors seeking a high-yield investment or Drip.
If you're wondering how a company can pay out more than 95% of its earnings and still thrive, you're wondering the right things. See, your Mom was right -- you are smart. "Depreciation" is the name of the game here. REITs are allowed to write off a percentage of the value of the real estate as depreciation, freeing that portion from the taxman's clutches. This special tax exception allows REITs to pay out dividends from depreciation as well as from earnings. Therefore, when measuring the operating performance of a REIT, you take earnings (excluding gains or losses from sales of property or debt restructuring) and add depreciation of real estate. The number you arrive at is what is called Funds From Operations (FFO), which is the customary measure of a REIT's growth.
It's not difficult to imagine that by combining FFO growth with a high yield, REITs can be very competitive with the S&P 500, providing healthy, stable returns, especially for income-minded investors. So, you ask, what's the hitch?
One possible drawback is that REITs are interest-rate sensitive. Their variable rate loans rise with interest rates, leading to higher mortgage costs. With higher interest rates this year than last, many REITs are underperforming the market in 1999.
Also, REITs are dependent on new capital to buy real estate. In order to consistently grow earnings, they must acquire new properties. Since the majority of earnings are paid out to shareholders, that means revisiting the market time and again. Any significant economy slowdown could decrease the flow of funds into REITs and offset earnings expectations.
If you're interested in learning more about REITs, a nice collection of articles and data is available at the National Association Real Estate Investment Trusts website.
Drip on, Fools!