Yield-seeking investors are familiar with real estate investment trusts (REITs) and master limited partnerships (MLPs) for the simple fact that very few investment vehicles offer the same dividend-earning potential. While they share many similarities, REITs and MLPs differ in terms of income distribution and fund criteria.
From a tax perspective, REITs and MLPs are both considered pass-through entities, which means they distribute income to their investors. Funds that meet this key criterion are not required to pay income tax at the business level.
REITs and MLPs: Knowing the Difference
Despite sharing a similar tax code, REITs and MLPs differ along several important strata. For starters, REITs are corporations with regular management structures and shareholders, whereas MLPs are partnerships with so-called unitholders (i.e., limited partners). Investing in a REIT gives you an ownership share in a corporation, whereas MLP investors possess units in a partnership.
REITs and MLPs also differ in terms of fund structure. A REIT can be one of two kinds: equity REIT or mortgage REIT. The former owns physical property that is actively managed and the latter are financial investments (i.e., investing proceeds in mortgage-backed securities). For MLPs, most investment opportunities are found in the energy sector. This has to do with the pass-through criteria established by the U.S. tax code. To qualify for this income tax benefit, 90% of an MLP’s income must come from real estate, natural resources or commodities. As such, most MLPs focus on oil and natural gas.
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In terms of tax reporting, REITs can be held in a tax-deferred retirement account. While this is also the case for MLPs, partnership income may be classified as unrelated business income (UBIT). If UBIT exceeds $1,000 each year, it could face tax penalties.
In terms of dividend income, REITs can pay out everything from earned income, capital gains and return of capital. The vast majority of the distribution paid by MLPs are defined as a return of capital. REITs are required to pay out 90% of their income in the form of dividends but there is no such requirement for MLPs.
Consistency of Income
One of the most important differences between REITs and MLPs is how consistently they distribute payments to investors. REITs are widely considered to be more reliable income vehicles, especially those involved in real estate. As such, they exhibit very little payment volatility and REIT prices tend to be stable over the long term.
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MLP distributions, on the other hand, can be highly volatile because they are backed by commodity-focused industries that are vulnerable to large price fluctuations. As such, an MLP’s unit price is heavily impacted by its distribution, making this asset class more volatile.
Risk-averse investors in need of long-term income stability generally opt for equity REITs. However, investors who have some wiggle room can play MLPs for a potentially high-yielding distribution – but with added volatility.
That said, MLPs typically exhibit stronger balance sheets than their counterparts in the REIT sector. As of Dec. 31, 2017, REITs exhibited higher average leverage when compared with MLPs. For example, the Vanguard Real Estate ETF (VNQ) had a leverage (net debt-to-earnings before interest, taxes, depreciation and amortization) of 5.9 compared with 5.5 for the Alerian MLP ETF (AMLP). As of Oct. 22, 2018, AMLP had a higher yield at 7.89% compared with 4.99% for VNQ.
REITs tend to utilize higher leverage than MLPs due to the high financing costs of accumulating real estate inventory while at the same time meeting the 90% distribution criteria. At the same time, MLPs exhibit a relatively stable long-term fee-based income structure that leads to lower borrowing requirements. For these reasons, MLPs tend to perform better in higher interest-rate environments; higher rates make servicing debt more expensive, thereby placing downward pressure on high-leverage funds.
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The Bottom Line
REITs and MLPs offer yield-seeking investors plenty of opportunity to earn above-average results. However, each carries its own set of advantages and disadvantages, depending on one’s underlying goals.
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