Real estate investment trusts – or REITs, for short – give investors the opportunity to experience the economic benefits of owning real estate without any of the day-to-day hassles associated with being a traditional landlord.
For these reasons, REITs can make appealing investments for long-term investors looking to benefit from the income and appreciation of real assets.
The sheer number of REITs means that investors can also benefit from the implementation of a fundamental, bottom-up security analysis process.
There are currently about 171 REITS; you can see the full list here.
Because there are so many REITs that currently trade on the public markets, investors have the opportunity to scan the industry and invest in only the best-of-the-best.
To do this, an investor must understand how to analyze REITs. This is not as easy as it sounds; REITs have some different accounting nuances that make them distinctly different from common stocks when it comes to assessing their investment prospects (particularly with regards to valuation).
With that in mind, this article will discuss how to assess the valuation of real estate investment trusts, including two step-by-step examples using a real, publicly-traded REIT.
What is a REIT?
Before explaining how to analyze a real estate investment trust, it is useful to understand what these investment vehicles truly are.
A REIT is not a corporation that is focused on the ownership of real estate. While real estate corporations certainly exist (the Howard Hughes Corporation (HHC) comes to mind), they are not the same as a real estate investment trust.
The difference lies in the way that these legal entities are created. REITs are trusts, not corporations. Accordingly, they are taxed differently – in a way that is more tax efficient for the REIT’s investors.
How is this so?
In exchange for meeting certain requirements that are necessary to continue doing business as a ‘REIT’, real estate investment trusts pay no tax at the organizational level. One of the most important requirements to maintain REIT status is the payment of 90%+ of its net income as distributions to its owners.
There are also other significant differences between common stocks and REITs. REITs are organized as trusts.As a result, the fractional ownership of REITs that trade on the stock exchange are not ‘stocks’ – they are ‘units’ instead. Accordingly, ‘shareholders’ are actually unit holders.
Unit holders receive distributions, not dividends. The reason why REIT distributions are not called dividends is that their tax treatments are different. REIT distributions fall into 3 categories:
The ‘ordinary income’ portion of a REIT distribution is the most straightforward when it comes to taxation. Ordinary income is taxed at your ordinary income tax rate; up to 39.6%.
The ‘return of capital’ portion of a REIT distribution can be thought of as a ‘deferred tax’. This is because a return of capital reduces your cost basis. This means that you only pay tax on the ‘return of capital’ portion of a REIT distribution when you sell the security.
The last component – capital gains – is just as it sounds. Capital gains are taxed at either short-term or long-term capital gains rate.
The percentage of distributions from these 3 sources varies by REIT.In general, ordinary income tends to be the majority of the distribution.Expect around 70% of distributions as ordinary income, 15% as a return of capital, and 15% as capital gains (although, again, this will vary depending on the REIT).
REITs are best suited for retirement accounts because the majority of their payments are taxed as ordinary income.Retirement accounts remove this negative and make REITs very tax advantageous.
This doesn’t mean you should never own a REIT in a taxable account.A good investment is a good investment, regardless of tax issues.If you have the choice, REITs should definitely be placed in a retirement account.
