REITs (Real Estate Investment Trust) provide yield hungry investors with an opportunity to earn aggressive distributions in a market that has already placed a premium on securities with a payout. Differentiating themselves through monthly payments, income-based payments, and the fundamental income diversification associated with their sheer scale, they function in a way that is surprisingly distinct from a regular dividend paying corporation. The end result is that investors need to understand how it is that these differences manifest, so that they aren’t mislead into simply purchasing an investment for the sake of chasing a high yield.
The first major distinguishing factor of a REIT that investors should keep in mind when they purchase is that these companies are required to pay out around 90% of their incomes to the shareholders. While this explains how the company can afford to distribute such a high payout ratio, it is also important to recognize how it is that this high payout ratio imposes capital restrictions on the management of that REIT.
With the majority of their incomes being paid out to investors, they must be able to operate their properties (and keep them filled with tenants) on a shoestring budget. From there, the companies are less able to develop their property base because they lack the capital required to pursue these new opportunities. The end result is that REITs will often use a great deal of mortgage debt to financing their expansion, as well as occasionally reissue securities onto the public markets so as to maintain the scale of the operations, but to them simply expand them.
The second major difference between the way in which a REIT and a dividend paying company operate is through their company structuring. Specifically, because of the way in which a REIT operates as a Trust, rather than a Corporation, the distributions made out to the shareholders are not actually dividends, but are income distributions (similar to those made by a bond). This means that investors can be taxed at a higher rate on the distribution (depending on their tax jurisdiction). For example, if an investor were to invest in a corporation paying a 10% dividend, the investor would likely receive a tax credit that makes up for the fact that the corporation already paid tax on the distribution.
The end result is that an investor might pay 30-50% less tax on a dividend, whereas they will pay tax on the full amount of the distribution earned from a REIT. Compared to a REIT paying 10% distributions as well, an investor in a 30% tax bracket would only really be earning 7% on the REIT distribution, while they would earn 8.5% on the corporation, making the corporation a more favorable investment opportunity.
As with any investment opportunity, the trick to determining whether a REIT is a suitable security to place money into depends almost entirely upon the contexts surrounding a given investors portfolio. In this particular situation, the aspects that matter most are then the investor’s yield requirements, and their tax situation going forward.