Dividends can be an incredible way to create passive income by investing in the stock market. While many investors focus on traditional dividend stocks, real estate investment trusts, commonly referred to as REITs, can be an excellent source for reliable dividends because of their unique structure. If you're looking for ways to diversify your portfolio into real estate or possibly grow your dividend income, here's why REIT dividends are a game-changer for investors.
What makes REIT dividends so special
REITs have strict requirements to follow to benefit from some of the tax advantages of this classification, such as paying zero corporate tax. Specifically, REITs avoid double taxation on earnings, unlike standard non-REIT corporations, by not requiring to pay income taxes at the corporate level. Instead, taxes are only paid at the shareholder level on dividends received.
Some of the requirements for REITs include having at minimum 75% of its assets in real estate or real estate-related securities, such as mortgages or real property. REITs also must earn at least three-fourths of their income from real estate through things like rental income or mortgage income. But most importantly, REITs are required to pay at least 90% of their taxable income to shareholders in the form of a dividend.
Because of this requirement, investors often benefit from higher-than-average dividend returns by investing in a REIT.
Big savings allows for game-changing dividends
To show you why this is game-changing, here's a hypothetical example. If a REIT earns a taxable profit of $20 million, it must distribute at least $18 million to shareholders. If a standard non-REIT corporation made a profit of $20 million, based on the average 21% corporate tax rate, there would be $15.8 million left after taxes. Let's say the same standard non-REIT company wanted to graciously distribute 90% of its profits to shareholders -- this would translate to about $14.2 million, nearly $4 million less than the REIT.
Historical dividend returns for REITs, as tracked by the National Association of Real Estate Investment Trusts (NAREIT), is 2.8% on average, which is over double the average dividend payout from the S&P 500, which is currently 1.32%.
While 2.8% may not seem like much, it's important to remember this is the historical average. Dividend payouts from REITs are often closer to the 3% for Equity REITs and the 9% for Mortgage REITs, much higher than the historical average for all REITs. In 2020, publicly listed REITs paid out approximately $51.7 billion in dividends, and the private sector paid over $2.2 billion in dividends, which translates into a lot of money paid to investors.
Types of REITs to invest in
There are both private and publicly-traded REITs to invest in. Private REITs are allowed to set their requirements for who can invest, including having a minimum investment requirement or limiting investment options to accredited investors only. Publicly traded REITs are usually more popular among investors because of the ease and access of investing through a brokerage account.
However, private REITs shouldn't be discounted. For example, BREIT, the largest private REIT, is owned and managed by Blackstone Group, the largest investment fund in the world, has done exceptionally well since it was first available to invest in back in 2017. The company has yielded anywhere between a 4.4% to 5.2% dividend return, depending on what share class you invested in.
At the start of 2022, there were over 225 publicly-traded REITs, including equity and mortgage REITs. Equity REITs are companies that invest, own, manage, and lease physical real estate, earning revenues from rental income from any of the following real estate industries:
- Residential, which includes apartments, mobile homes, and single-family rental homes
- Health care
- Data centers
- Specialty properties like casinos, amusement parks, movie theaters, or farmland
- Or a mixture of these sectors
On the other hand, mortgage REITs originate or invest in real estate debt, such as commercial or residential mortgages or mortgage-backed securities (MBS). Such REITs earn revenues from the interest paid on the debt or from the spread between the purchase and sale of the mortgage-backed securities.
Mortgage REITs use a much higher amount of debt in order to leverage their portfolio for growth, which means they are a riskier investment class when compared to equity REITs. However, their dividend payouts are often much higher. For example, Annaly Capital, one of the largest mortgage REITs by market cap, is paying an 11.4% dividend return to investors right now. While Simon Property Group, one of the largest equity REITs by market cap that specializes in the ownership and operation of malls and retail centers, pays a 4.5% dividend return right now.
Are REIT dividends sustainable?
It's not uncommon to see a REIT pay 100% or more of its taxable income to its shareholders through dividends, which may seem unsustainable over the long term, but there's more to than what meets the eye.
Most REITs earn much more than their taxable income because they benefit from several tax deductions, including the deprecation of real estate, which is writing off a portion of the real estate's value over time to adjust for wear and tear.
REIT investors should instead look at a company's payout ratio as it relates to its funds from operations (FFO) because its FFO adds back in depreciation among other adjustments to give a more accurate idea of the REITs profitability. A 70%-80% payout of FFO is the norm in the industry, although some REITs fall outside this range at both the high and low ends of the spectrum.
The challenge with dividend REITs
Although investors certainly can benefit from higher-than-average dividend returns from REITs, it does come at a cost. According to the IRS definition of "qualified dividends," most dividend stocks qualify as a dividend income, meaning they get charged at a lower long-term capital gains tax rate. But REIT dividends don't meet that qualification, meaning most REIT distributions will be taxed as ordinary income, which is taxable at your marginal tax rate.
In 2020, by market-cap-weighted average, 58% of the annual REIT distributions qualified as ordinary taxable income, 14% percent as a return of capital, and 28% qualified as long-term capital gains.
Should you invest in REITs?
REITs can be an incredible way to diversify your portfolio and gain exposure to the growing real estate market while earning consistent dividends. But like all investments, REITs do come with risk. Right now, the market is experiencing a lot of volatility, and with the rise in interest rates, demand for real estate in each prospective sector could change for better or worse. Therefore, it's essential to understand the unique risks, opportunities, and factors that impact the sector's performance, including management strategies, supply and demand, and long-term demand drivers.