Yield refers to the amount of money an investment pays to shareholders on a regular basis, expressed as an annualized percentage of the investment's price. When it comes to real estate investment trusts, or REITs, the yield refers to the dividends paid to investors, typically either monthly or quarterly, as a percentage of the current stock price.
To be clear, yield can be calculated in several different ways, especially when it comes to fixed income (bond) investing or other types of real estate investments such as rental properties. For example, you might hear terms such as "yield to worst call." And when it comes to tangible investments like rental properties, you might hear things like "yield on cost." However, for the purposes of our discussion of REITs yield, the calculation is usually a rather simple one based on the REIT's current share price.
What is a REIT's yield?
As mentioned, a REIT's yield is expressed as its annual income distributions as a percentage of its current share price. REITs tend to be relatively high yielding dividend stocks, so it's crucial that REIT investors understand how yields work.
The calculation to find a REIT's yield is actually quite simple:
- Add up the REIT's expected distributions over a 12-month period: If it pays quarterly dividends, multiply its most recently declared dividend payment by four. If it pays monthly, multiply by 12.
- Then, divide this annual dividend rate by the current share price of the REIT.
- Multiply by 100 to convert this to a percentage.
Let's look at a real-world example. As I write this, one of my favorite REITs, Realty Income (NYSE: O), pays a monthly dividend of $0.2275 per share and trades for $73.04, so:
- Multiplying the monthly dividend by 12 shows an annual dividend rate of $2.73 per share.
- Dividing this by the share price of $73.04 gives us .037.
- Multiplying .037 by 100 results in a yield of about 3.7%.
Before we go on, there are a few things to keep in mind:
- There's no set-in-stone rule when it comes to rounding yields, but one decimal place is the most common way to express these figures.
- Some companies pay special dividends, which are one-time payments to shareholders. (For example, if a REIT sells a bunch of properties, it might decide to distribute some of the proceeds to shareholders as a lump sum. These are not predictable or repetitive, so while they represent income to shareholders, it's generally misleading to consider these payments when expressing the REIT's yield.)
- One important principle is that because a REIT's yield depends on its share price, the calculated yield can change constantly. Rising share prices result in lower yields, and falling share prices result in higher yields.
- Similarly, REIT share prices often fluctuate with yield. For example, falling interest rates generally push all investment yields lower, so it's not uncommon to see REIT yields fall when interest rates move downward.
- REITs often raise their dividends regularly, so the calculated yield may turn out to be based on less than shareholders will actually receive over the next 12 months. Even so, yield is calculated based on the current periodic dividend rate, not the projected distributions over the next 12 months.
Is a REIT's yield safe?
REITs tend to pay above-average dividend yields, especially when it comes to mortgage REITs, but how can you tell if a REIT's dividend is too good to be true?
One important yield concept all REIT investors should learn is payout ratio. This is the ratio of a REIT's distributions to its profits, or funds from operations (FFO). In other words, this tells you if a REIT is earning more money than it's paying out. Remember, REITs are required to pay out at least 90% of their taxable income, but because of the tax-advantaged nature of real estate investing, taxable income isn't usually a great indicator of how much money a REIT is actually making.
Let's say that a particular REIT paid out $2.00 over the past 12 months and generated FFO of $3.20. Dividing these two numbers shows an FFO payout ratio of about 63%.
There's no set-in-stone rule for how much of FFO a REIT should be paying out. That said, I generally consider payout ratios in the 60% to 85% range healthy for REITs. Anything higher could be cause for concern. Anything over 100% should definitely set off red flags unless there's a very good explanation for it.
In short, just looking for the highest yields isn't necessarily a good investment strategy.
What about after-tax REIT yield?
Another important concept to understand is after-tax yield, especially if you invest in REITs in a standard (taxable) brokerage account.
As a simplified example, if an investment yields 5% and you pay an effective 20% tax rate, this means you get to keep 80% of the income. 80% of a 5% yield translates to an effective yield of 4%.
Of course, it's not always quite that simple, especially when it comes to REITs. Here's why:
- REITs generally don't qualify for the favorable "qualified dividend" tax rates most stocks do, but that isn't always true. In fact, the income you receive from one REIT can actually represent several types of taxable income. However, for the purposes of calculating effective yield, it's a good rule of thumb to assume that REIT dividends are ordinary income, taxable as ordinary income at your marginal tax rate (tax bracket).
- REIT distributions are eligible for the 20% pass-through tax deduction, provided that your other income allows you to use it. This effectively reduces a 35% tax bracket to 28%, for example.
- Don't forget about state taxes when doing the calculation. Since REIT distributions are generally considered ordinary income, you'll probably have to pay tax on distributions at your applicable marginal state income tax rate as well.
For a less-simple example, let's say that you own a REIT in a taxable brokerage account, and it pays a 5% dividend yield. You are in the 32% marginal tax bracket, and you qualify for the pass-through tax deduction. We'll say your marginal state tax rate is 6%.
In this case, the pass-through deduction reduces your marginal tax rate on REIT dividends to 25.6%. Adding in your 6% state tax rate brings your total REIT dividend tax rate to 31.6%. Subtracting this from 100% shows that you get to keep 68.4% of your REIT dividends. Multiplying this figure by your 5% yield shows an after-tax yield of about 3.4%.
To be clear, if you invest in REITs through an IRA or other tax-advantaged account, you don't have to worry about this. However, if you own some of your REITs in a taxable brokerage account, knowing how to calculate after-tax yield can help you compare your REIT yields with other types of dividend yields as well as tax-free yields from municipal bonds.
REIT yield versus total return
As a final thought, it's important to point out that REITs are total return investments. In other words, REITs are generally designed to produce a nice combination of income and long-term equity appreciation. The point is that a REIT's yield should only be one piece of the puzzle. Don't invest in a REIT just because you like its dividend yield. Instead, look for REITs that have strong and sustainable dividend yields and lots of long-term growth potential.
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