REIT-holders ride real estate, reap dividends
When Congress passed the $350 billion tax-cut bill last month, it purposely left Real Estate Investment Trusts largely out of the package.
But the REIT industry isn't quaking in its boots.
"It's not a big blow to REITs or to REIT investors," says Daniel McNeela, an analyst at Morningstar Inc., a Chicago firm that ranks mutual funds. "[REITs] have valuable qualities that people should appreciate."
One is big fat dividends - on average about 7 percent. For retirees or other investors seeking a high, steady return on their money, that's hard to beat.
"They don't face that much dividend competition from the rest of the corporate world," says Keith Pomroy, an analyst at SNL Financial, an information and research firm in Charlottesville, Va.
The new bill reduces the maximum individual tax rate for dividend income generally from 38.6 percent to 15 percent (from 2003 through 2008) and for capital gains generally from 20 percent to 15 percent (from May 6, 2003 through 2008).
But dividends from REITs, which invest in residential and commercial real estate of all sorts, don't qualify for that break. That's because REITs already don't pay corporate income tax on most of their earnings. By law, they must pass on 90 percent of their otherwise taxable income to their shareholders.
On a pretax basis, REITs pay four times the average dividend of the stocks in the Standard & Poor's 500 index, and even on an after-tax basis, three times as good, notes Steven Wechsler, president of the National Association of Real Estate Investment Trusts in Washington.
But some companies - some utilities, tobacco, and a few banks - do pay good dividends, and their stock prices rose sharply after President Bush signed the new tax bill.
For investors in the 73 mutual funds that invest in the nation's 180 REITs, the dividends help bolster share prices - though not always. REIT-fund share prices are subject to the stock-market price variations of the REITs in their portfolio.
Over the past few years, however, REIT funds have outperformed most other funds. Through June 6, the average REIT fund had a three-year annualized return of 14.7 percent, according to Morningstar. In the same time frame, the typical fund investing in a blend of corporate stocks lost 10.9 percent a year.
"This kind of performance doesn't go away because of this tax law," says Mr. Wechsler.
REITs didn't go entirely without benefit from the tax bill. The 15 percent tax rate will apply to capital gains on the sale of REIT stock by an investor and to some REIT capital-gains distributions. It will also apply to REIT dividends attributable to dividends received from non-REIT corporations, and to REIT dividends attributable to income subject to tax at the REIT corporate level.
Wechsler figures about one- quarter of dividends will benefit from the 15 percent rate. Of course, about half of dividend income - including that of REITs - goes into tax-sheltered investments, such as 401(k)s.
The other related advantage of REITs to investors is that they don't move in lock step with other corporate stocks.
A study by Sanford C. Bernstein & Co., a research and money-management firm, found that only 30 percent of the price movement of REITs from 1991 to 2002 can be explained by the movement of the stock market as a whole. In the past three years, the correlation was only 19 percent.
So, like bonds and to a lesser extent international stock investments, REITs dampen the impact of the overall market's losses and volatility on an investment portfolio.
Mr. McNeela suggests that an investment in REITs directly or indirectly in REIT mutual funds of up to 10 percent of a portfolio is reasonable. He cautions that the handsome return of REITs in the past three years may not be repeated in the next three years.
"REITs aren't always going to outperform the rest of the stock market," McNeela says.
One key factor will be what happens to REIT dividends. Some REITs, especially those investing in apartments or hotels, have cut dividends. Apartment rentals have been hit by low mortgage rates, making it easier for families to buy a house rather than rent an apartment. Hotels have suffered along with the travel industry as a whole after the the terrorist attacks of Sept. 11, 2001.
But Wechsler maintains that more REITs are increasing their dividends rather than decreasing them - despite the slow economy.
By some measures, most REITs have more than adequate cash flow from rents or other returns to pay their dividends. "Their safety, in general, is pretty good," says Mr. Pomroy.
According to NAREIT, all of the nation's REITs own about $300 billion of real estate.
In total, the nation has about $5 trillion in "investment grade" real estate. REITs compete with business or other investors for those properties when they are sold.
On average, the value of the properties held by REITs probably just about matches the value of all their shares - their capitalization, the experts reckon.
Shares of REITs invested in shopping centers are said to be overvalued, relative to the underlying value of their properties; office REITs undervalued. The calculations are difficult to make, hanging on prices of comparable properties that are sold.