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Real Estate Investing with REITs

As the memory of the financial crisis recedes, the real estate market shows signs of recovery. You may believe excellent investment opportunities exist now—and that might be the case. Nevertheless, you may be reluctant to buy investment property. Inexperienced investors can make costly mistakes, property management will be either expensive or time consuming, major commitments of capital might be required, and investment real estate is illiquid. For any or all of those reasons, you may consider investing in real estate investment trusts (REITs) as an alternative. You can buy and sell many different REITs, just as you’d trade shares of common stocks. A given REIT can be diversified, and REIT funds provide even more diversification. What’s more, you can invest in REITs with only a few thousand dollars.

 Real differences

Broadly speaking, REITs fall into two categories.

Equity REITs own one or more properties. Often, they specialize in various types of real estate. One REIT might own only office buildings, for example, while another REIT might own shopping centers.

 Mortgage REITs own debt instruments. They buy existing mortgages, collect payments from borrowers, and pass the money through to investors.

 Some REITs are hybrids, owning both properties and mortgages.

 Investment implications

In a way, all REITs are hybrids. Equity REITs, for instance, reflect the performance of both the real estate market and the stock market. In a strong real estate market, property values rise. Higher property values, in turn, tend to boost the prices of REIT shares. On the other hand, a stock market crash can sink equity REITs. From May 2008 to February 2009, for example, the Financial Times Stock Exchange National Association of Real Estate Investment Trusts (FTSE NAREIT) U.S. Equity REIT Index fell by 62%, as the stock market collapsed. The values of the office buildings, shopping centers, and other properties held by REITs may not have dropped to the same degree. (Since that bottom, more than four years ago, this equity REIT index has more than tripled. As of this writing, it is 28% higher than in May 2008.) While equity REITs are a mix of stocks and real estate, mortgage REITs combine the features of real estate and bonds. The yields paid to investors reflect interest rates on real estate mortgages. These REIT shares, however, tend to trade with the bond market: if interest rates rise in the future, mortgage REIT shares probably will fall along with bond values.

 Tax treatment

Under the U.S. tax code, REITs are required to pay investors at least 90% of their taxable income each year. This payout reduces or eliminates a REIT’s obligation to pay corporate income tax. By comparison, dividends paid to investors by regular corporations may be taxed twice: both the company and the investor can owe tax on those dollars. As a result of this tax treatment, REITs generally have relatively high yields. In 2013, equity REITs generally pay around 4% to investors. By comparison, the yield on the

Standard & Poor’s 500 Index of large company stocks is around 2%. Mortgage REITs currently yield about 7%, versus 3% for U.S. corporate bond indexes. Besides the high yields, REIT investors may benefit from favorable tax treatment. Example: Jill Young invests $10,000 to buy 200 shares of ABC Office Building REIT at $50 a share. In 2013, Jill receives a $400 (4%) dividend. On the IRS Form 1099- DIV that ABC sends to Jill, she sees that $100 is a long-term capital gain, $100 is ordinary income, and $200 is a return of capital. Therefore, Jill will owe tax on $100 at favorable capital gain tax rates and $100 at ordinary income rates. She’ll owe no tax on her $200 return of capital. (Generally, REIT dividends do not get the special low tax rates on “qualified” dividends.) Although Jill avoids tax on her $200 return of capital in this example, she must lower her basis by $200—$1 per share—to reflect her $200 return of capital. This reduction drops her basis from $50 to $49 and will increase the tax she will owe in the future on a profitable sale. Nevertheless, the REIT tax treatment works in Jill’s favor, because she avoids paying ordinary income tax now and may owe tax on a future sale at lower capital gains rates.

 Building out

The REIT universe is broad, covering many varieties of investments. Some REITs do not trade publicly; they might offer higher yields but also restrict your ability to sell for many years. Other REITs have been created outside the U.S. These global REITs may offer profit potential, in fast growing regions, but they also might have specific risks found in local markets. Altogether, carefully selected REITs may deliver substantial cash flow, portfolio diversification, and participation in real estate growth. Be sure to look closely at any REIT before investing, so you’re confident you understand the risks involved.