Real estate investment trusts (REITs) have grown in popularity since the financial crisis, so much so that real estate is now the eleventh major component on the S&P 500 Index. As entities that own or finance income-generating properties, REITs offer investors diversification benefits and the opportunity to earn regular income.
Despite their promise of strong returns in a growing industry, REITs have underperformed the market in recent years. REITs produced compound annual growth of 10% between 1971 and 2015, but changing market dynamics have since put pressure on funds exposed to retail property. But aside from these challenges, investing in REITs contains certain subtleties that every yield-seeking investor needs to consider.
The 90% Rule
Even with a challenging market, REITs are considered a staple for many investment portfolios thanks to the 90% rule. As the name implies, this rule stipulates that real estate trusts must distribute 90% of their taxable earnings to existing shareholders. To the inexperienced, this sounds like guaranteed dividends. There’s only one catch: the payouts are not generated from the company’s earnings.
This largely explains why so many REITs have low payout ratios. In equity research, the payout ratio is the percentage of net income that a company pays out as dividends. A payout ratio 20% means for every dollar of net income, 20% is being paid to shareholders in the form of dividends.
The Securities and Exchange Commission (SEC) has set out the guidelines for the 90% rule for REITs:
“To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90% of its taxable income to shareholders annually in the form of dividends.”
It’s Not About Earnings
In the above context, the word “taxable income” has a very specific meaning. To determine an asset’s cash flow and earnings, investors generally refer to financial results as explained through generally accepted accounting principles (GAAP). At first glance, a REIT’s GAAP earnings might reveal that it hasn’t made any money at all and, therefore, does not need to issue a dividend payment. However, some REITs with negative GAAP earnings still pay dividends.
That’s because a REIT’s dividend distribution is not based on earnings, but is part of the company’s cash flow statement. A cash flow statement essentially outlines what a company does with the money it earns. For REITs, dividends show up on the cash flow statement. In this context, earnings include peculiar accounting rules that sometimes produce low payout ratios for these types of companies.
One of the most important rules within the context of REITs is depreciation, which is included in the income statement as a cost of doing business even though it doesn’t affect a company’s cash. If you remove depreciation, many businesses that don’t have any earnings are technically making money.
These provisions make the 90% rule less relevant for many REITs. It, therefore, comes as no surprise that companies like PS Business Parks (PSB ) and Digital Realty Trust (DLR ) do not follow the rule. The rule is even less relevant to companies with exposure to real estate, but do not generate the bulk of their business from property-related ventures. In this vein, diversification is key to overcoming the 90% rule.
Yet, some REITs like Realty Income Corp (O ) do, in fact, follow the 90% rule because it provides other benefits. In general, REITs do not pay taxes at the trust level insofar as they distribute 90% of their income to shareholders. Of course, REITs that follow this rule still pay corporate taxes on any retained income.
In general, there are other accounting techniques that companies can employ to reduce their payout ratio, such as retaining more of their earnings to reinvest in the business.
Want to know about exchange-traded funds (ETFs) that can provide you a convenient way to have a well-diversified exposure to the real estate sector? Click here.
Utilize our Dividend Screener to find high-quality dividend stocks by sector, including real estate. You can use this screener to compare different dividend-paying REITs. For instance, consider selecting the REIT stock category under the Company Basics filter to view these REITs.
The Bottom Line
Although the 90% rule looks great on the surface, dividend payments are far from guaranteed. The rule highlights once again how accounting standards can impact our investment decisions, and why they must be carefully evaluated before selecting stocks. After reading the above, a REIT with a low payout ratio shouldn’t be nearly as confusing.
Check out what investors are currently interested in by visiting our Most Watched Stocks Page.