Most stock market portfolios contain a mix of stocks, bonds, and mutual funds. A commonly overlooked security that I’m a big fan of are REITs. REIT stands for real estate investment trust. They can be a great way for income investors to add diversification and boost income. A REIT is typically a corporation that owns, finances or operates real estate properties within a given market segment. There are also REIT index funds such as Vanguard’s VNQ which tracks real estate investment trust companies within the United States.
For a company to qualify as a REIT, it must have at least 75% of its holdings in real estate properties, treasuries, or cash. They must also receive 75% of their income from real estate. The qualification we really care about is that they must return at least 90% of their taxable income to shareholders in the form of dividends.
In simple terms this means that owning a REIT is a simple and less cash intensive way to gain exposure to real estate markets. An investor is able to buy shares in the underlying company which entitles them to a percentage of regular income distributions. As an income investor, here are some of the reasons I’m a big fan of REITs.
Higher Dividend Yield
REITs typically pay higher dividend rates in comparison to more traditional companies. This is largely due to the requirement that they return 90% of their taxable income to shareholders. Dividend rates of 4.5 – 9% are fairly common in the REIT space. The primary disadvantage to this income is that it is usually non-qualified.
Qualified dividend income is taxed at the much more favorable capital gains rates of 0%, 15% or 20%. Which one of the three rates an investor pays is based on their income level. The higher the investor’s income, the higher the capital gains tax rate for dividend income.
Because the dividend income from most REITs is non-qualified, the investor will pay taxes on this income at their ordinary income tax rate. This can mean a tax rate of 0% to as high as 39.6%. Not great, but the additional yield can offset this disadvantage to a degree. A great way to defer this tax for as long as possible is to own REITs in a tax-deferred account like an IRA. This is exactly where I keep the bulk of my REIT holdings.
Real Estate Segment Options
REITs provide the investor with flexibility in which real estate segments they own. Imagine an investor that wants exposure to healthcare real estate. They could save a few million dollars to purchase actual properties or they can simply purchase shares in a healthcare focused REIT like Omega Healthcare Investors (ticker OHI).
Other common segments for REITs include, apartment housing, shopping malls, warehouses, office buildings, and commercial retail properties. This range of options provides the investor with exposure to real estate markets that would otherwise have a very high barrier to entry.
Lower Hassle Factor
Anyone that’s owned actual rental property can relate to the issues around dealing with tenants. Water heaters break, air conditioning goes out, and then there’s the ever-represent risk of lawsuits due to someone being injured while on your property.
All of those issues are no longer your problem when you invest in real estate using REITs. The investment trust handles all the aforementioned issues. Your only job is to annually evaluate the financial strength of the REIT organization and to collect your dividend income. Time is by far our most valuable resource. REITs allow the investor to control more of their time by acting as a barrier between owners and tenants.
Regular Income
Most REITs pay distributions on a quarterly basis. Therefore, every 3 months the investor has the option of receiving a check or re-investing their earnings for greater ownership in the REIT. Dividend reinvestment can be a great way to grow your ownership position over time.
There are also a few REITs that pay distributions every month. A great one that I personally own is Realty Income Corporation (ticker symbol O). This REIT pays monthly and has a great track record of regularly raising the dividend. Realty Income primarily invests in commercial real estate. I suggest you do your own research to determine which REIT(s), meet your sector and income goals.
While this post is fairly dry reading, I hope it’s provided some food for thought. If your desire is to invest in real estate with little income and without the hassle of owning individual properties, then REITs might be a fit for you. In my short guide on getting started with investing, I list two great REIT index funds along with the percentages that I personally use in my portfolio. If I can answer any questions let me know in the comment box below!
Extras:
A great FREE tool I personally use for tracking my portfolio is Personal Capital. When you click this link to sign up for your free account, both you and I will receive $20. Every little bit helps right?
Full Disclosure: The links on both the Essential Reading and my Books Reviews pages contain my Amazon affiliate code. If you purchase a book using that link I get a few pennies. Doing so does not change the price of the book for you. In addition, at the time of writing this post, I own a position in Realty Income Corporation (O).
Legal Disclaimer: The information provided and accompanying material is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney, CPA or other professional to determine what may be best for your individual needs.
