Owningshares in a
real estate investment trust (REIT)
is one of the simplest ways to purchasereal estate .
Real estate
has "real" value that investors can touch, feel and understand.
This tangible value, combined with the limited supply of
high-quality real estate, makes REITs one of the most stable
investment alternatives around.
Without REITs, an investor would have to invest large sums of money
(often borrowed) to be able to buy properties. The investor would
have to personallyguarantee the loans and would be liable for
whatever happened to the property.
With a REIT, the only risk is the amount invested.
REITs: the basics
Most REITs own land or buildings and make money by renting these
spaces to individuals or businesses. Some REITs also earn interest
on real estate securities, such as
mortgage
bonds
. Other REITs simply fund various real estate ventures.
Most investors buy REITs for their rich dividends. The average
diversified property REIT offers an annual
dividend yield
of 7.5% -- more than triple the average 2.0%
yield
paid out by members of the S&P 500
Index
. That's money in your pocket.
Even better, the cash usually keeps coming in regardless of whether
a particular REITs' share price goes up or down. That's because to
preserve their unique tax advantage, REITs are required by law to
pay out 90% of their income as dividends to shareholders. In
return, REITs are not subject to corporate
income tax
.
On the downside, since REITs don't pay income taxes, their
dividends are usually fully taxable, which means the dividends you
receive will be taxed as ordinary income, up to 35%. Most REIT
dividends don't qualify for the reduced 15%
dividend
tax rate.
But even after the extra taxes, the yields most REITs pay are far
higher than the
taxable equivalent yield
you'll get from most other common stocks. Savvy investors can avoid
these extra taxes entirely by holding REITs in a tax-advantaged
account like a
Roth IRA
.
Buy the stock, not the yield
While most people buy REITs for their rich dividend yields,
investors who choose their stock based exclusively on its yield
could be making a huge mistake. That's because corporate dividend
payments are by no means guaranteed.
Even though a company might be paying a healthy 10% dividend yield
now, it may not be able to sustain such a rich payout if its
business model
isn't solid. Since companies usually extract dividend cash from
earnings
, payouts could be slashed if profits are pinched.
For example, U.S. automakers were traditionally known for their
handsome yields. But once the industry stopped turning a
profit
, dividends began to evaporate. Investors that bought
Ford (NYSE:
F
)
lost their dividend in 2006. After one dividend cut,
General Motors (NYSE:
GM
)
finally suspended its dividend in the summer of 2008.
The most profitable stocks are those that generate the greatest
total return through dividends and share price
appreciation
. REITs with long track records of a steady dividend and share
price growth are your best bet.
Investors should also look for companies that offer a
dividend reinvestment plan (DRIP)
, which allows investors to reinvest dividend payments to buy more
shares
without incurring transaction fees.
But even if you can find a REIT that meets these criteria, one
additional factor is paramount: It's important to know exactly what
the REIT owns.
Property type is key
Many REITs specialize in a property type, such as offices,
apartments, warehouses, regional malls, shopping centers, hotels or
healthcare centers. Others, like
Duke Realty (NYSE:
DRE
)
, own a mix of retail, industrial and office property. A few others
invest in specialty properties, such as
Entertainment Properties (NYSE:
EPR
)
, which owns movie theatres.
To get a feel for how a REIT makes money, you should always pay
close attention to the type of property each REIT owns.
Each real estate sector is affected by different economic factors.
If the
job market
is booming, for instance, then office REITs could be attractive
because more people are working and more space is needed to
accommodate them.
If consumer spending is on the decline, then a shopping
center REIT like
Regency Centers (NYSE:
REG
)
might be headed for challenging times as retailers feel the pinch.
Property type can also tell you how predictable a stock's income
stream might be. Mall REITs, which typically require tenants to
sign 10-year leases, usually generate more predictable income than
apartment REITs, which tend to lease for shorter periods of time.
Knowing the quality and diversity of the REIT's tenants will also
give you a sense of the reliability of its income.
Larger, diversified or geographically dispersed REITs are less
exposed to regional weakness and major economic cycles. These REITs
tend to be more stable over the long haul. A company such as
Equity Residential (NYSE:
EQR
)
owns apartments in various markets across the United States and is
less sensitive to local economic conditions.
On the other hand, smaller, more specialized REITs often provide
the greatest growth potential. A niche-player such as
SL Green Realty (NYSE:
SLG
)
, which owns offices solely in and around New York City, is
positioned for success if that particular market does well.
Action to Take -->
Even after you know what to look for, finding the best REIT for
your money and with the greatest potential for long-term returns
can be tricky. Pay close attention not just to each firm's dividend
yield, but also to its property portfolio, its growth prospects and
its valuation level relative to that of its peers for those with
the best profit potential.
-- Carla Pasternak
Disclosure: Neither Carla Pasternak nor StreetAuthority, LLC
hold positions in any securities mentioned in this article.