Our Thoughts

Income Producing Real Estate

There was a time when the three legs of the retirement stool were Social Security, pensions and personal savings. But those days are gone for good and the stool needs new legs. Today, building a more stable three-legged stool requires three key components: (1) paper assets (stocks, bonds, ETFs, etc.), (2) ownership in an operating business, and (3) income producing real estate.

The third leg, income producing real estate, is an excellent way to generate income for retirement, but for many people, purchasing real estate—especially commercial property—is out of the question. An alternative for establishing the third leg (really, the first leg too) can be Real Estate Investment Trusts, or REITs, an investment vehicle created by Congress in 1960 to give the average investor the opportunity to invest in large-scale, income producing real estate.

The typical REIT is engaged in the ownership and operation of income-producing properties such as office buildings, apartments, shopping centers, hotels, etc. Most REITs specialize in only one of these categories, but many are beginning to engage in other real estate-related activities such as leasing, maintenance and tenant services.

As with other large public companies, the day-to-day operations of a REIT are managed by a team of professionals. These professionals are in turn overseen by a board of directors elected by shareholders. Because they are publically traded, REITs are subject to the same corporate governance and disclosure rules as other public companies.

The number and variety of publically-traded REITs make them an excellent vehicle for diversifying an investment portfolio. Our research shows that as of January 1, 2011, there were 153 REITs registered with the SEC, representing $389 billion in market capitalization. And, because the majority of these trade on the major exchanges (NYSE, AMEX and NASDAQ) they provide the same level of liquidity as a stock.

REITs are required to annually distribute at least 90 percent (some distribute 100 percent) of their taxable income to shareholders. If this income is derived from a comparatively predictable and reliable stream of rental fees, the REITs will likely return higher than average dividend income.

One thing to be aware of with REITs is how the income they generate is taxed. REIT dividends are paid out of the company’s taxable income which means that in most cases, shareholder dividends are taxed as ordinary income. Like other dividend paying companies, REITs distribute shareholder tax information on IRS Form 1099-DIV.

REITs offer the potential for moderate, long-term share price appreciation, but it’s their dividend yield that makes them an attractive addition to a properly allocated portfolio. To identify which REITs are best positioned to offer such a steady income stream, you should look for companies that demonstrate the following characteristics:

1. The company should have a history of consistently paying dividends (suddenly spiking yields could indicate a one-time event that the company may not be able to repeat on a regular basis).
2. Low relative rental rates. Companies whose rents are at or below current market levels have more flexibility to raise rents, giving them more upside potential and protection against economic downturns.
3. The company should have strong strategic vision with a proven track record of bringing new properties online quickly and cost-effectively using only moderate leverage. They should also have strong tenant relationships.
4. Location, location, location. Be cautious of REITs that conduct their business primarily in markets that are currently depressed. After all, not all types of properties recover at the same time, so it can take years for certain segments of an overall real estate market to regain momentum after a severe downturn.

While the U.S. is still the largest market for publically traded REITs, the market for like or similar securities is becoming increasingly global. More than 30 countries now offer REIT-like investment vehicles including developed nations like Australia, Canada, Italy and the U.K., as well as emerging market countries such as Bulgaria, Dubai, Malaysia and Pakistan.

REITs may not be for everyone, but for those investors who need or want to add real estate to their portfolios; REITs can provide a transparent, cost-effective way to gain such exposure. In addition to dividend income and potential share price appreciation, REITs provide the benefit of diversification to a properly allocated investment portfolio.