Unconventional Income From Uncommon Stocks – REITs

This is part III of the series, Unconventional Income From Uncommon Stocks. The series is meant to be an absolute beginner’s introduction to uncommon stocks. The focus of this post is on REITs.

Imagine owning and renting out property without the hassles of maintaining it! You don’t have to worry about finding renters, collecting rent, paying taxes or even maintaining the property. And best of all, you can sell anytime, making such investments even better than owning physical real estate.

To understand REITs, imagine a group of people pooling their money to buy some property and then renting it out. The rent collected is shared among the group proportional to the money they contributed to the pool. Come tax time, each individual in the group pays taxes proportional to his share of the property.

What I just explained is what’s called an Equity REIT. Equity REITs invests in Real Estate properties and generates cash flow from the rents collected. There is one more kind of REIT called a Mortgage REIT. Mortgage REITs lends to borrowers and generates income from the mortgage interest it collects.

To avoid taxation at the trust level, REITs must distribute 90% of their income to its unitholders. Which means, the yields from REITs are usually pretty high and avoids double taxation of dividends. Another advantage of REITs is that not all of the dividend received is taxable. Some of it is considered return of capital due to depreciation and other expenses and are not taxable! Return of capital also reduces your cost basis, which means the longer you hold on to the REIT, the lower your cost basis gets and you pay taxes on the capital only when you sell your share (tax deferred). You will however pay taxes on the portion of dividends that comes from actual earnings.

When it comes to picking a type of REIT, there are lots of choices. There are REITs specializing in Malls, Apartments, Healthcare, Self-Storage, Industrial, Offices, Mortgages etc. Or you can get a bit of everything by choosing a REIT index fund!

Here’s a comparison of a REIT that I like and own, with the S&P 500 for the past 10 years.

Realty Income REIT Vs. S&P500

Realty Income REIT Vs. S&P500

That’s without taking into account the dividends! The current yield on this REIT is over 5%!

Realty Income, the REIT used above is a free standing REIT that leases properties to commercial enterprises. It has properties in over 49 states with over 37.6 million square feet of leasable space! It also pays monthly dividends to boot!

REITs complement a balanced portfolio and its income generating potential makes it ideal for investors seeking regular income.

Sounds too good to be true, what’s the downside of owning a REIT?
First, your dividends are taxed as ordinary income which is normally higher than dividend tax rates. So yes, you’ll pay more for the dividends.

Second, you have to do your bit to calculate depreciation and expenses to reduce cost-basis. All this makes tax time much more involved that owning a dividend paying stock.

What about Mortgage REITs?
Their business model is very simple, but do remember, they are highly sensitive to rate increases. Don’t let their high dividends fog your judgement!

Should REITs be held in a retirement account or a regular account?
Since income from REITs are taxed at individual income tax rates, it makes sense to hold them in a retirement account. This also means no hassles, come tax time!

What are your thoughts on having REITs in a portfolio? Do you own any REIT stocks? Are you planning on increasing your allocation?

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23 thoughts on “Unconventional Income From Uncommon Stocks – REITs

  1. I owned, but no longer own, a REIT. I didn’t mind it but decided to simplify my accounts, so I dumped it. It’s definitely easier than chasing tenants for rent…

  2. I’ve been thinking about investing in a Reit mutual fund and put it in my Roth IRA. I used to own some Reits in my stock portfolio but sold it. Since I am still renting and don’t own any real estate, I wanted to have some exposure to real estate. If I invest in it, it’ll probably be in the Vanguard Reit Index Fund.

  3. My friend has quite a bit of money in REITs and loves the passive income. One thing that scares me about them is that when the real estate market tanked the REIT he has money in literally lost 60-70% of it’s value, and hasn’t recovered to that level. I suppose the possibility of bubbles comes with exposure to real estate, though.

  4. I hold an REIT fund in one of my retirement accounts. I was lucky enough to get into it during the recession so it’s performed amazingly well since. REITs are definitely a great way to diversify your holdings a bit more.

  5. This is my first exposure to REITs but I really like the idea as presented here. I will definitely be doing some further research. Thanks!

  6. I have some REIT funds in my IRA. It didn’t do too well this year and I’m a bit disappointed. I’m thinking about selling about half and put it in international bonds. I don’t have any of that at the moment.

  7. I have one REIT as part of my 401k, but it only accounts for 5% of my total holdings. I wonder what percentage you might recommend having in REIT’s as part of a balanced retirement portfolio? So far it is up about 7% from when I first invested in it. Should I put a little more into it?

    • To answer your question, REITs are volatile investments. The rise can be dramatic, but then so can the fall. Compared to other asset classes, most experts would recommend lower exposure to REITs.

      Should you put more into it? Depends upon your allocation plan. If you want 5% exposure to REITs and have a rebalance threshold of +/- 2%, then rebalance when that threshold is reached.

      Good luck!

  8. I own some AMT shares. Not much but I like to pick up stocks when I have “fun” money. What’s the REIT fund that you own, if you don’t mind me asking. Looks like it performed really well.

  9. I like REITs as well and allocate approximately 5% of client’s total assets to the sector. The point about getting an index REIT participating in various parts of the market is important!

  10. I’ve been interested in REITs for a few years now. Most of my holdings are in low cost index funds, and although I’ve avoided them, I’m thinking about getting into them sooner rather than later (nothing large, though). Thanks for the tip to look at VNQ and VNQI!

  11. I like REITS on principle, but right now, a lot of our net worth is tied up in residential real estate (that is, the house where we live!) They do make for easy diversification, though. This is a great post.

  12. I have a little exposure with Vanguard’s REIT Index Fund which is weighted with commercial property but also has some residential holdings. It has performed close to the MSCI REIT Index but still a disappointing 5.6% over 1 year. I’m looking at liquidating this holding and adding to my growth index position.

  13. Our REI ETFs hav been our est performers over the last 4 years. I would suggest keeping an eye on them as soon as interest rates start to rise. They are typically less profitable in higher interest rate environments.

  14. I like REITs and keep 6% of my investments in US REITs (via Vanguard’s VNQ REIT ETF) and 5% in international reits (WPS or VNQI).

    Fundamentally they are fairly simple investments to understand. They own and develop real estate and make money by renting the real estate. And occasionally make money by selling an appreciated property.

    I used to work for a few large REITs as a consultant, and I was always impressed by how focused they were on making a project succeed and dotting all i’s and crossing all t’s.

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