This year, we started a financial education series geared towards educating beginning investors and more specifically, beginning dividend growth investors. Our first two articles explain what a dividend is and the dividend payout ratio (and how to calculate it). In this article, we will take a deeper dive into one specific type of holding that can be found in many dividend investors’ portfolio. This holding typically pays a higher dividend, which is why dividend investors are always on the lookout for a great one. If you’re looking into becoming a dividend growth investor, you better get used to reading these four letters…REIT. Here is a deeper dive into what a REIT is and how dividends received from a REIT is taxed.
What is a REIT?
Let’s start with the basics. REIT it stands for Real Estate Investment Trust. Per Investopedia, a REIT “is a company that owns, operates or finances income-producing real estate.” While a REIT may trade on a major index and pay a dividend like any other corporation, their corporate structures and the rules governing them are much, much different than a corporation.
The IRS has published strict guidelines that a REIT must comply with. I’m not going to list out every single rule or guideline, but here were some of the major guidelines:
- 75% of total assets must be considered real estate (or cash and treasuries)
- 75% of the income must come from real estate.
- Pay at least 90% of their taxable income in the form of dividends each year
- Have a diversified group of shareholders. A REIT must have 100 shareholders and no 5 shareholders can own more than 50% of a entity’s stock.
Types of REITs
Now that we understand what a REIT is and some of the rules and regulations that each REIT must achieve, we wanted to explain the two types of REITS. Equity REITs and Mortgage REITS
An equity REIT owns real estate and can take many shapes. Each Equity REIT may invest in a different type of real estate or industry. Here are some examples of sectors and companies that operate in this sector.
- Commercial Real Estate – Realty Income (O) – One of the largest owners and operators of commercial real estate properties. Some of Realty Income’s tenants include Walgreens, Fedex, Dollar General, AMC, Walmart, and other companies. We both own shares in this company and love the monthly dividend.
- Healthcare – There are different types of Healthcare REITS. So providing one specific example is difficult. Some own skilled nursing facilities (HCR Manorcare), assisted living facilities (Omega Healthcare), senior living facilities (Senior Housing Property Trust), medical offices (Healthcare Trust of America) or a combination of different facilities (Ventas and HCP). Of course, there are other healthcare sectors that are not listed since the industry can be very specialized!
- Public Storage and Self Storage – Public Storage (PSA) – PSA is one of the largest REITs that owns and operates the self-storage facilities found throughout the country.
- Cell Towers – American Tower Corp (AMT) – AMT is a company that owns over 170,000 cell phone tower in North America, Europe, Asia, and the Middle East. The company will lease the space on its towers to wireless companies to earn rental income accordingly.
- Shopping Malls – Simon Properties (SPG) – SPG is one of the country’s largest shopping mall owners and operators. For this sector, think your traditional shopping mall with anchor tenants and other rent-paying shops
- Digital Storage/Data Centers – This is one of the coolest REIT sectors if you ask me. This includes companies like Digital Realty Trust (DLR) and Equinix (EQIX).
Of course this list can go on and on. However, hopefully you can see that REITs operate in a ton of different industries and there are no two REITs that are alike. That’s why it is important to read each REITs investor relations page and understand their holdings prior to investing in the company!
A Mortgage REIT is much different than an Equity REIT. Unlike an Equity REIT, which owns property and leases the property to different tenants, Mortgage REITs originate mortgage loans and mortgage-backed securities. Rather than generating rental income, Mortgage REITs make money by generating interest income. Interestingly, Mortgage REITs are not limited to residential mortgages and residential mortgage-backed securities. There are Mortgage REITs that originate residential mortgages (Such as Annaly Capital Management, NLY) and some that originate commercial properties (Blackstone Mortgage Trust, BXMT, or Apollo Commercial Real Estate Finance, ARI).
Key Terminology – What the F-F-O?
When we screen for undervalued dividend growth stocks, one of the key components of our metrics is Earnings-Per-Share (EPS). EPS is a GAAP metric that represents a company’s net income dividend by shares outstanding. GAAP stands for “Generally Accepted Accounting Principles,” the accounting framework by nearly all publicly traded companies. There is some comfort in a company’s EPS figure, as this is an audited number within a company’s financial statements.
Even though a REIT is required to pay out 90% of its income, EPS is not the top metric used to evaluate a REIT. The industry standard is a non-GAAP metric: Fund From Operations (FFO) or Adjusted Funds From Operations (AFFO).
FFO is a figure that begins with Net Income, and then adds back depreciation, amortization, and gains/losses on the sale of properties. The theory behind using FFO over EPS or other cash flow metrics is that it provides a better picture of a REITs true cash flows. Depreciation, amortization, and gains/losses on sales are all non-cash items on an income statement.
Since FFO is a non-GAAP metric, it can be calculated differently for each company. So please make sure you understand each company’s method for calculating FFO and AFFO to ensure you are making an apples to apples comparison.
How Are the Dividends You Receive from a REIT Taxed?
Last, but definitely not least, the most important question for dividend growth investors. Dividends received from traditional equity securities are subject to capital gains taxes. However, this is not the case for REITs, since REITs do not pay taxes at the corporate level
Dividends and distributions (or dividends received by shareholders) from a REIT are not a straightforward distribution. There are several components to each dividend and distribution. Each REIT must provide investors with the following allocations for each dividend and distribution to ensure property tax treatment:
- Dividends – Taxed as ordinary income, not a capital gain.
- Qualified Dividends – Taxed as a capital gain
- Nontaxable Return on Capital – Taxed as a capital gain
There was one huge change in taxation for REIT investors as well as a part of Tax Reform. As a part of the bill, there is a 20% deduction on pass-through income. Since a REIT passes through its income to shareholders, the individual holder will receive a huge benefit as a part of tax reform!
Prior to tax reform, since the majority of your dividend is taxed as ordinary income at a higher tax rate, I held all REITs in my Roth IRA so any future distributions are not taxed. However, this 20% reduction is huge and would potentially impact future investment decisions (in terms of where I hold the investment.
REITs are great investments that can provide investors with a strong dividend yield. REITs also provide investors a way to invest in the real estate markets without the stress of owning a property. Hopefully you have found this guide to understanding a REIT helpful. Now the fun begins and hopefully you will begin performing research to determine if these companies fit your investment profile! Also, if you think we missed any interesting types of REITs or want to also share some knowledge from your experience investing in these securities, please do so in the comment section!
-The Dividend Diplomats