Dividends are nice, but dividends that grow over time are even better. And, dividend stocks that combine a growing income stream with the potential for lots of share price growth are the best kind of all. One excellent place to find this powerful combination is with real estate investment trusts, or REITs. Here are three reasons why you should consider REITs for your portfolio.
Favorable tax structure
The reason REIT dividends tend to be some of the highest in the market is because of their tax structure. Specifically, if a REIT pays out at least 90% of its net income to investors, its profits aren't taxed on the corporate level.
This is in contrast to most companies, which have to pay corporate income taxes of up to 39% on their profits before distributing dividends to shareholders, and then another set of taxes are footed by shareholders when they receive dividends. Sure, "qualified" dividends are taxed at a more favorable rate of 15% for most investors, but the combination of dividend taxes and corporate taxes consumes a large percentage of corporate profits. And, it's impossible to avoid corporate taxation on profits, even by holding shares in a tax-advantaged account like an IRA.
On the other hand, REIT investors who hold their shares in a tax-advantaged account don't pay any annual dividend taxes at all. If the shares are held in a taxable brokerage account, it's important to point out that most dividends distributed by REITs are not "qualified," and are therefore taxed at investors' marginal tax rate, but it's still a favorable tax structure over most corporations.
A naturally growing income stream
Historically, rent has risen at an annual rate of between 0.9% and 3.2%, depending on the type of property. Therefore, equity REITs, which derive their income primarily from renting out properties, have a naturally increasing income stream.
This is especially true for REITs specializing in commercial properties, whose tenants generally sign long-term leases with initial lease terms of 10 years or more, typically with annual rent increases built right in. In general, these leases are triple net, which means that tenants are responsible for paying the property taxes, building insurance, and maintenance expenses.
This leads to predictable, rising income that often grows even faster than inflation, making these stocks great choices for retirees and other income-seekers who are concerned about losing purchasing power over time. In fact, three out of the five largest components of the S&P High Yield Dividend Aristocrats index are REITs that own commercial properties.
Income and growth
It's common knowledge that the value of real estate tends to increase over time. And, unlike the value of your home, the value of rental properties is primarily dependent on its ability to generate income. In other words, if a particular property's rental income increases by 5%, its resale value can be expected to increase by a similar amount.
Because of property appreciation, as well as the fact that most REITs use some degree of leverage when acquiring properties, REITs have the potential for lots of share price growth on top of the dividends they pay out. Here are a couple of examples:
Realty Income Corporation (NYSE:O) is a leader in freestanding retail real estate, and because of its solid credit rating, it has the lowest cost of capital among its peer group. The company acquires retail properties in highly desirable locations, and its long-term triple-net lease strategy has kept occupancy above 96% no matter what the economy has been doing. The company recently announced its 76th consecutive quarterly dividend increase, and thanks to property appreciation and a smart acquisition and disposal strategy, Realty Income has produced an average total return of 18.2% per year since its 1994 IPO. To put this kind of growth in perspective, consider that $10,000 invested in Realty Income's IPO 22 years ago would be worth nearly $400,000 today.
Welltower Inc. (NYSE:HCN) has been around for 45 years and invests in healthcare properties, with a particular focus on senior housing. The company's strategy is simple: Acquire healthcare facilities that are newer than peers' and are located in desirable areas, and then partner with some of the best operators in the business to run them. And, it works. Over its 45-year history, Welltower has produced annualized total returns averaging 15.6%.
Risks of REIT investing
So far we've mainly discussed the upside potential of REITs, but our discussion wouldn't be complete without acknowledging the risks involved.
For starters, interest rate risk is significant, and for a few reasons. Most obviously, higher interest rates mean higher borrowing costs, which usually leads to smaller profit margins. In addition, investors buy REITs for their high dividends, which are much more appealing when interest rates are low and bond yields are relatively small. Once low-risk bond investments start paying more favorable interest rates, it can create selling pressure on REIT stocks. The current and persistent low-interest environment is the main reason REITs as a group have performed so well lately.
In addition to interest rate risk, there is some degree of economic risk, as a recession could lead to increased vacancies and lower market rent. This risk varies significantly between different property types -- for example, apartment vacancies tend to climb quickly in bad economies, while as we've discussed, many types of commercial properties can be less affected.
No stocks with the potential to produce double-digit total returns year after year are without risk, and there are certainly some risks to be aware of before buying REITs for your portfolio. However, when weighing the pros and cons of REIT investing, I think it's pretty clear that the reward potential greatly outweighs the risks.
Matthew Frankel owns shares of Realty Income and Welltower. The Motley Fool recommends Welltower. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.