So a few people that read my blog and follow the IG page have been asking for my latest investment advice. I thought I had been hammering home the point on multiple posts about the themes I feel I discuss the most: indexing through ETF’s, minding your post tax income and finding new and innovative ways to increase your overall income outside of investing.
Putting Some Fire in Your Tank
However indexing is boring. The results are spectacular over time but I get that you don’t want to just keep throwing money at the same thing. Despite the fact that this actually works, I also understand that psychologically, people also need some stimulus to keep them engaged and interested in investing which helps to motivate them to save and invest more.
If I had to give it a name, I would call this your “fun” investing money. Money that you throw at something that’s maybe not typical in your portfolio, that engages you in a new market and helps you learn something. I wouldn’t recommend putting more than say 5% of your portfolio in this “fun” money but if the psychological factor of something new helps motivate you to save and invest more, then even if it’s not a great investment, it can still be an overall net positive for you.
Back to REITs
One area I explored a few months ago which I had mentioned to someone recently was Real Estate Investment Trusts or REITs. These are pass through entities that own and manage real estate. I won’t go into the full details because I already have a broad overview of REITs which you can read here but basically they pay out 90% or more of their income, can be geared towards a number of different strategies (from owning hospitals to mortgage bonds) and depending on the period and the index you choose, have outperformed the broader market in the past.
To give some context to the outperformance mentioned above, as you can read here, the FTSE NAREIT All Equity REITS Index returned 12.87% annually from 1978 to 2016 while the broader market Russell 3000 Index returned 11.64% annually. Over that 38 year period, that little 1.23% outperformance means you would have almost 60% more money at the end of that period. So you see the power of outperformance, even by a seemingly small amount, over a long period of time.
The reason I was recommending REITs is that first I think the recklessness of the housing market prior to the crisis is still too fresh for it to fall into such imbalance so as to produce a crisis again. The other reason was that the Trump tax cuts which were enacted at the end of 2017, gave REIT owners a significant tax cut. Although the rates paid on REITs would still be higher than the rates paid on qualified dividends, I really thought I hammered the point home when I shared the chart below:
Source: IRS
In retrospect though, this really didn’t hammer home the point I was trying to make in terms of the REIT tax cut. What may hammer home the point a little better may be to look at a table of the REIT tax rates paid before the 2017 tax cuts against what owners paid after.
Source: IRS and authors calculations
If you take a look at the above you will see that the the three tax brackets from $19,050 to $315,000 in income all received a REIT tax cut of above 30% from the previous rate. What this means is that if you are middle or upper middle income, you received a serious tax cut to your REIT income which gives you a big new tax incentive to invest in this sector. For many people that will mean paying only a few percentage points over what they are currently paying for qualified dividends.
The Tax Cut on Steroids
This is important because the REIT index has normally provided a higher dividend yield compared to the broader market. Even after the tax cut the Vanguard REIT Index ETF (VNQ) as of today is yielding 4.05% while the S&P 500 Index ETF is yielding 1.57%.
If you were to look at the new post tax yields for VNQ based on today’s yield versus what they would have been under the old tax rates, you would get the table below.
Source: IRS and author’s calculations
You can see that the cut bumped up the post tax yields in the best case scenarios by 20 to 30 basis points.
That amount may not sound like a lot but that’s because the yields are lower. One of the wild things about the REIT sector is the mortgage REIT niche of this sector. Basically what a mortgage REIT does is buy mortgage bonds which pay out rates similar to your typical mortgage but then use leverage to borrow and juice their returns. With the use of leverage they can produce eye popping dividend yields and payouts to investors. This is one reason mortgage REITs have become closely followed by those retirees who have not saved enough for retirement and require huge payouts of their portfolios to maintain their lifestyle.
One mortgage REIT I have been following for many years is Annaly Capital Management (NLY). This is a mortgage REIT that buys mostly government agency securities which align with the origination standards of Fannie Mae and Freddie Mac. It essentially means that they hold quasi government guaranteed securities and use leverage to increase their payout.
Annaly hedges their high payout through interest rate swaps which need to be consistently rolled over. In rising interest rate environments like the one we currently have, this means that their interest rate hedges will increase in cost and the payout may need to be lowered in these scenarios. This is exactly what has been happening to NLY lately as it just cut its dividend again recently pushing the stock to drop to $9.05 a share from $10 before the announcement.
Even so, the stock currently yields 13.26%. If you look at this yield after taxes like in our table before, you start to see the difference in yields from the tax cut.
Source: IRS and author’s calculations
In this example, some tax brackets are getting a full percentage point more in yield, which is significant in a market that is yielding only 1.5% overall.
Conclusion
My recommendation is not to go out and buy NLY for the yield. I do think that the REIT sector continues to look attractive compared to the overall market and the tax benefits are an added plus that can boost your returns.
It is worth noting however that a good part of the yield of the REIT index is made up of mortgage REITs. Including one or two in your portfolio for entertainment or for those that really enjoy the risk and like current income isn’t that bad as long as it is only a small portion of your overall holdings.
Do any of my readers here hold REIT stocks or mortgage REITs? Feel free to leave a comment below with your experience and thoughts.
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