Increasing Dividend Yield Part II: REITs

This is the second installment in a multi-part series that looks at various options used by income investors to boost their yield while waiting for dividend growth to lift their portfolio's overall yield-on-cost. Last week we looked at Utilities. This week we are looking at Real Estate Investment Trusts (REITs).

Below is some background information on REITs from REIT.com:

Congress created REITs in the U.S. in 1960 as a way to make investment in large-scale, income-producing real estate accessible to all investors in the same way they typically invest otherwise – through the purchase and sale of liquid securities. U.S. REITs have seen their equity market capitalization soar from $90 billion to roughly $200 billion in just the past 10 years.

In order for a company to qualify as a REIT in the U.S., it must comply with certain ground rules specified in the Internal Revenue Code. These include: investing at least 75 percent of total assets in real estate; deriving at least 75 percent of gross income as rents from real property or interest from mortgages on real property; and distributing annually at least 90 percent of taxable income to shareholders in the form of dividends.

The 90% distribution requirement and no corporate taxes are the reasons REITs yields are often above average. However, it is important to note that because REITs pay no income tax, they are not eligible for the special treatment as a "qualified dividends", which are normally taxed at 15%. When comparing REIT yields to investments with qualified dividends, you must always look at them on an after-tax basis.

Consider an example where a taxpayer with a federal marginal tax rate of 30% owns a stock with a yield of 6.6%. On an after-tax basis the stock which qualifies for the 15% tax rate, will yield 5.58%, while one that does not qualify will only yield 4.78%.

Like utilities, most REITs rely on new capital either in the form of debt or equity to fund investments, pay debt and pay dividends, albeit to a lesser extent. 

Most REITs are growing their debt and/or shares outstanding, while not always generating sufficient cash to fund their operating expenses, including normal capital replacements (except for UHT). For a company to consistently raise its dividend, it must generate cash flows sufficient to meet operating obligations and to service outstanding debt. Since a REIT is legally required to pay out 90% of its earnings, it is less likely to eliminate its dividend, but it could drastically cut the dividend in the face of persistent weak earnings (like any company).

Similar to the utilities mentioned last week, I purchased some REITs many years ago, but I won't be rushing to add to increase my positions.

Full Disclosure: No position in the aforementioned securities.

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