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5 Great Reasons to Invest in REITs

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If you don't have REITs in your portfolio yet, you need to read this.

Real estate investment trusts, or REITs, can be great investments for a variety of reasons. To name a few, REITs offer high-dividend yields, diverse exposure to real estate assets, and favorable tax treatment. Here are five of the most compelling reasons to invest in REITs, as described by our contributors.

Eric Volkman: The best reason to invest in REITs, hands down, is their rich dividends. They pay out nearly all of their profits in this way, so it's no wonder that their distributions are comparatively higher than those of other asset classes.

Four stacks of coins with blocks on top spelling out REIT

Image source: Getty Images.

At the moment, the current average dividend yield of the stocks that comprise the S&P 500 is slightly more than 2%. The big names in the REIT space easily trump this number. Realty Income stands at 4.8% at the moment, for example, as does Welltower. National Retail Properties is right behind them, at 4.7%.

Those are not unusual yields in the sector, and some are much higher. Investors willing to take on more risk can reap rewards inching into the double digits. That's where mortgage REIT Two Harbors stands with its 11.4% yield -- shoulder-to-shoulder with peers like American Capital Agency and PennyMac Mortgage Investment Trust, both at 12.4%.

Not all REITs are created equal in terms of quality and stability, of course, so potential investors should always look at what's behind those yield numbers. But by and large, REITs are far more generous to their shareholders than stocks in other sectors.

Dan Caplinger: Real-estate investment trusts have been around for a long time, but they got much more popular 15 to 20 years ago for a simple reason: investors saw them as a way to diversify their investing portfolios. Prior to that, most investors split their assets between stocks, bonds, and cash, and that simple asset-allocation strategy provided solid returns that included both an income component and long-term growth.

Yet REITs offered a unique set of attributes that made them behave differently than both stocks and bonds. On one hand, the reliable income that most REITs produce was highly attractive to income investors, and the fact that rising rental income over time generally leads to payout increases was especially attractive.

At the same time, even though dividend stocks offer some of the same income advantages as REITs, the real-estate exposure that REITs offer moves in patterns that don't match up perfectly with the broader economy, and so stocks and REITs don't always move in lockstep despite offering long-term positive returns over time. As a result, investors have found that REITs can boost portfolio income, as well as reducing volatility and increasing total appreciation. That's a powerful combination that just about any investor can appreciate.

Selena Maranjian: One reason why now is a particularly good time to consider REITs is because, after a long period of historic and near-historic lows, interest rates are poised to start inching up -- and rising interest rates can be very good for REITs and those who invest in them. That's because rising interest rates are often tied to a strengthening economy, and booming business tends to lead to rising building occupancies, rising rents, and more prosperity for tenants, which can lead to more rents being collected.

Some have feared that rising rates would be bad news for REITs, as they could depress the present value of future cash flows. But Allen Kenney at REIT.com noted: "History shows that share prices of listed Equity REITs have more often increased than decreased during periods of rising interest rates. In the 16 periods since 1995 when interest rates rose significantly, Equity REITs generated positive returns in 12."

Meanwhile, Brad Case, senior vice president at the National Association of Real Estate Investment Trusts, has likened our current environment to the June 2005-to-June 2006 period, when the U.S. economy was growing, and interest rates were rising. He has pointed out that between June 2, 2005, and June 26, 2006, 10-year Treasury yields rose from 3.89% to 5.25%, while REITs gained 20.7%.

Matt Frankel: One reason to invest in REITs is for their inherent tax advantages. While it's true that most REIT distributions don't meet the definition of "qualified" dividends, which are entitled to a favorable tax rate, REIT dividends are not subject to the double taxation that can take a big bite out of most income investors' profits. As long as a REIT pays out more than 90% of its taxable income to shareholders, its profits are not taxed at the corporate level, which allows REITs to pay out higher dividends.

For example, let's say that a company earns $1.00 per share in pre-tax profit, which is subject to a 35% corporate tax rate -- immediately reducing the profit to $0.65. Most traditional dividend stocks don't pay out more than 60% of income, so we'll say that, at most, $0.40 is distributed to shareholders as a qualified dividend. As a qualified dividend, most taxpayers will pay a 15% tax rate on the payment, which brings the effective dividend down to $0.34 per share.

On the other hand, let's say that a REIT earns $1.00 per share in profit. As long as it pays out $0.90 or more, the company isn't subject to corporate-level taxation, so the entire $0.90 is distributed to shareholders, and is only taxable at the investors' top marginal tax rate (between 10% and 39.6% plus a potential 3.8% surtax on investment income). Even the highest possible tax rate leaves an after-tax distribution of about $0.51.

This is especially advantageous if you hold your REITs in a tax-advantaged account such as an IRA, where you can avoid both the corporate tax and the dividend tax.

Sean Williams: Real estate investment trusts are the darlings of income investors for a variety of reasons, as my Foolish colleagues have shown. However, beyond just a superior dividend yield and tax advantages (especially for the wealthy), REITs offer diversification and liquidity that many smaller investors without a lot of capital would struggle to find.

The diversification aspect of REITs can be particularly helpful considering the wide swaths of outperformance and underperformance we've witnessed in terms of home prices and rents around the country. For instance, in the April 2015 Case-Shiller 20-City Home Price Index report, Denver and San Francisco reported 10.3% and 10% year-over-year price increases, respectively. Comparatively, Cleveland and Washington D.C. came in at the other end, with price growth of 1.3% and 1.1%.

If you were invested in the wrong market, you potentially underperformed an already low inflation rate. However, if you've been diversified, the national average for home-price growth is more than 4% -- well above the inflation rate at the moment.

What's a good example? How about AvalonBay Communities ( AVB 3.62% ), which is a residential apartment-community REIT that focuses on more affluent consumers. Avalon operates in 11 states (plus Washington D.C.), has an exceptionally high occupancy rate largely due to its target audience, which is less affected by swings in the economy, and has benefited from strong rental rates in lieu of the expectation of rising lending rates for mortgages.

REITs also offer incredible liquidity that you just can't get from purchasing property. Sure, there are such things as "house flippers" out there, who manage to turn tidy profits from holding a home for a matter of one to two months. However, for the practical investor who's looking further down the road than two months, but wants to have easy access to the exit door once ready, REITs are a great way to participate in real estate investing without having to hold physical property.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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