REITs offer income, but come with high tax burdens

By Dian Vujovich
Special to the Daily News

Investing in real estate investment trusts (REITs) when income is the primary goal comes with consequences. Namely, taxes.

REITs, created in 1960 by Congress to allow everyone a chance to invest in income-producing properties, have turned out to be an investment product that's popular and rewarding.

Over the last 50-plus years, REITs have broadened their investment appeal and now provide a way to invest in everything from energy, shopping malls, apartments, office buildings, high-end hotels, cell towers, timber, health care, mortgages and the list goes on.

Additionally, the investment choices aren't limited only to those in the United States. Today, there are global REIT offerings in more than 30 countries.

As for performance, the FTSE NAREIT All REIT Index has enjoyed a total return gain of 19.6 percent year-to-date through Oct. 22. That's more than 12 percent higher than the year-to-date return of the S&P 500.

While certainly something to crow about, not all types of REITs are rewarding. The reason? Ninety percent of them in the marketplace are equity REITs and, as such, are subject to the same trends, fluctuations and volatilities of that marketplace.

A short one-month look back at the overall performance for all types of equity REITs provides a snapshot of the volatility of this investment: At the end of September, equity REITs closed that month down nearly 6 percent. Last month, through Oct. 22, that group was up almost 6.5 percent.

"REITs, like stocks, can be volatile," said Jack Ablin, chief investment officer at BMO Private Bank. "Because they are traded in the market, they trade more like stocks do than they do physical real estate property."

Buying and selling REITs is usually easier than finding a buyer for your $3 million condo on the beach and doesn't require paying hefty real estate commissions. Brokerage fees will do.

REITs, the rich and taxes

For those in the highest tax brackets, thinking twice before investing in a REIT could be more beneficial than focusing only on the income the investments may provide.

"The good news is they can offer investors high yields," said Louis Navellier, a part-time Manalapan resident and chairman and founder of Navellier & Associates. "The only problem is that income is going to be taxed."

Because a REIT must pay out 90 percent of its taxable income each year to shareholders in the form of dividends and because REITs are taxed as ordinary income, that tax consequence can be a big concern for investors with adjusted gross incomes of over $200,000 for individuals and $250,000 for couples.

That means top wage-earners would find the income from their REIT investments taxed at the highest federal level of 43.4 percent. Plus, the tax rate could be higher if the state they call home has an income tax. (The 43.4 percent tax rate reflects the highest federal rate of 39.6 percent plus the 3.8 percent surtax added for the Affordable Care Act).

But not all REIT distributions are so richly taxed. Capital gains distributions, for instance, are taxed at a maximum rate of 15 percent.

Also, investors in lower income-tax brackets would only be subject to the tax appropriate in their tax brackets.

"While normal dividends are taxed at 23.8 percent (20 percent maximum plus the 3.8 percent surtax), we would not normally recommend REITs for wealthy investors who are in the max tax bracket," said Navellier, who has been managing private accounts for high-net-worth individuals since 1987. He thinks many would be better off investing in high-quality dividend paying stocks.

Interest rates and REITs

No doubt about it, the falling interest rate environment coupled with the Quantitative Easing policy initiated in 2008, have resulted in a boon for equity REIT returns. Low interest rate environments typically do.

Yields on 30-year Treasury Bonds have fallen from roughly 7.5 percent in 2007 to around 3 percent today, according to TreasuryDirect.gov. During that same time period, equity REIT returns have soared: The average total return for all equity REITs at year-end 2007 was down over 19 percent, but today the average total return is up as much.

"REITs are very sensitive to interest rate movements in two ways," Ablin said. "First, as an income alternative, REITs suffer as yields rise and their dividend offering becomes less competitive to other income instruments."

His second point: "REITs employ debt financing and would suffer higher funding costs as rates rise."

If not REITs for income, then what?

Master limited partnerships, preferred stocks, high yielding bonds and quality stocks with a history of doubling their dividends are other ways top-tier taxpayers may increase their income. All, like equity REITs, carry risks and aren't a fit for everyone.

As for interest rates, upticks are certain to be a future event. Precisely when, or what triggers the upward move, are two of the biggest questions facing Wall Street, advisors and investors.

Neither Ablin nor Navellier expect to see interest rates rising anytime soon. Nonetheless, they caution investors to make sure their portfolios are diversified.

"People need to have certain financial goals. And REITs may be a part of the solution in meeting their goals, but may not be the whole solution," Navellier said.