Real Estate Investment Trusts or REITS have been around since 1960 and were created to pool investment for real estate. There are many benefits to investing in real estate but not everyone wants (or needs) to be a hands on land lord. Fortunately, REITS take care of this problem by managing it all for you. This asset class allows just about anyone to become a real estate investor without too much hassle.

In addition, the Trump tax cuts of 2017 created a new tax preference from the income from REITS which is why I think this asset class should get a serious new look from this investors looking for income.

First a Brief History

A REIT is a company that owns and in most cases operates, income producing real estate. There are a wide range of REITS, they can own anything from offices to apartment buildings to hospitals and hotels. So what makes a REIT different from any other investment company? A few distinct features:

• There must be a minimum of 100 investors, this prevents anyone from having their own “private” REIT

• It must have at least 75% of its assets in real estate

• It must pay a minimum of 90% of its income as dividends to shareholders

• It must receive at least 75% of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate

There are some other more technical rules but those are the most important ones. REITS can be privately owned by its investors or publicly traded, in fact there are a large number of publicly traded REITS. There are so many that it is an important stock market asset class.

As I mentioned, there can be different types of REITS that have different focuses, some focus on hospitals while other focus on storage. It’s wide open, however I like the breakdown that Investopedia provides in terms of the three basic types of REITS:

• Equity REITs – Most REITs are equity REITs, which buy, own and manage income-producing real estate. Revenues are generated primarily through rents (not by reselling properties).

• Mortgage REITs – Mortgage REITs lend money to real estate owners and operators either directly through mortgages and loans or indirectly through the acquisition of mortgage backed securities. Their earnings are generated primarily by the net interest margin– the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them potentially sensitive to interest rate increases.

• Hybrid REITs – These REITs use the investment strategies of both equity and mortgage REITs.

What I particularly like about REITS is that they can essentially allow the little guy to buy into big real estate. Even if you only have a few thousand bucks, you can still get in the game of owning a commercial building, apartment complex or a hospital buy buying into a REIT. As a starting point, I would recommend the entire REIT index which can be captured through an ETF like VNQ.

One of the features that has been well known about the REIT index is that it tends to pay more in income (dividends) than the broader market. For example VNQ currently yields 4.24% while the Vanguard S&P 500 ETF (VOO) yields 1.91%.

Additionally, historically the sector has outpaced the total return of the rest of the stock market (before taxes at least), so this isn’t necessarily just an income play, there is also long term growth. Capital appreciation has historically been about 7% on top of that 4.24% yield I mentioned earlier, which makes the long term return around 11%, a full percentage point higher than the long term S&P 500 return of about 10%.

The One Drawback

The one drawback to everything that I just mentioned, besides the exposure to the real estate sector, which we all know got hammered in 2008-2009, was the taxes.

Since REITS pay out most of their income to investors, the income is not taxed at the corporate level but rather at the individual investor level. This was a disadvantage to higher income investors, especially after the Bush tax cuts created the Qualified Dividend.

Qualified dividends are taxed from 0% to 20% with most middle class people paying 15% in taxes on their dividends. This is the same rate as capital gains and one of the reasons the super rich have been able to increase their income dramatically in the past 20 years.

REIT dividends are not qualified dividends, qualified dividends come from income that has already been taxed at the corporate level of big corporations like GE or Bank of America, not for specialized corporations like this that pay out almost all of their income to investors.

All That Changed in 2017

With the Trump tax cuts all that changed. There is now a new a new 199A deduction for “pass through” businesses that allows for a 20% deduction on any qualified REIT dividend income.

What this means is that if you make $1000 in REIT dividends, that $1000 used to be taxed at your regular income rate. However now only $800 of that income would be taxed at your regular income rate. There is also no limit in terms of income for taking this deduction, although there is a 3.8% surtax on both REIT and qualified dividends above a certain high income threshold.

This essentially lowered the tax rate for dividends in this asset class and represents a new opportunity for lower and middle income people to get some of the same tax advantages as the rich. Although qualified dividends still offer the lowest tax rates, plotting incomes versus the tax rates on REIT dividends versus qualified dividends shows you that post tax REIT income is now more competitive.

Source: IRS

Conclusion

In short REIT investing has been given a discount and I am a bit surprised to see that the index has only outperformed the S&P 500 by a few percentage points price wise since the tax cut was enacted. Fears of an overpriced market, a softer housing market and rising rates may be putting a damper on the benefits of the tax cut, which means this may be a great time to rearrange your portfolio more towards REITS.

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