The tax structure of real estate investment trusts allows them to pass cash flows, and therefore tax obligations, through to shareholders, but only if the REITs meet certain conditions, including paying out at least 90 percent of annual income as dividends. A REIT’s distribution yield is its most recent distribution, annualized and divided by the REIT share price at the time of the yield measurement. For example, suppose a REIT that pays dividends monthly just declared a distribution of $0.08, all stemming from rental income. Multiplying by 12 gives you an annualized distribution of $0.96. If the shares are selling for $20, the distribution yield is 0.96/20, or 4.8 percent.
The true yield measurement is the total 12-month distribution divided by NAV, since it’s composed of a larger set of data. If our example REIT had actual one-year dividends of $1, the true yield would be 5.0 percent. True yield also smooths out the effect of any special one-time dividends paid by the REIT.
While this seems simple enough, a few wrinkles must be considered:
- Snapshot: The yield is a snapshot in time. Publicly traded REITs have constantly fluctuating share prices, which means the yield also is ever-changing. Typically, the yield is quoted as the annual dividends divided by the most recent trading day’s closing price. For private or non-traded REITs, the price given is the most recent net asset value (NAV), which the issuer declares every day, month or quarter. Public non-traded REITs actually do trade on secondary marketplaces, so you can calculate their yields by looking at the last price.
- Distribution: The dividend should really be called the distribution because it is made up of three components:
- Income from rents and interest: At least 75 percent of a REIT’s assets must be in the form of real estate. These properties throw off rent income and mortgage interest. No more than 5 percent of income can be derived from non-qualifying sources, such as non-real-estate business or service fees. Additional income might include interest from Treasury debt and other sources. Most REITs reserve a share of their assets as cash so that they can opportunistically purchase properties on short notice.
- Capital gains from the sale of properties: Income generated by the sale of real estate is distributed as a “qualified” dividend, meaning it qualifies for capital-gains treatment. Properties sold after one year are subject to lower, long-term capital-gains tax rates, which increases the after-tax value of this distribution component. A REIT might sell properties it helped to develop or improve. Also, it might decide to sell some of its rent-producing properties, perhaps to reinvest the proceeds in a higher-returning property.
- Return of capital: REITs pass through cash flows, which include depreciation and other expenses and are considered non-taxable returns of capital. Some REITs promise a minimum fixed distribution amount. If income and capital gains fall short of this minimum amount, the REIT might return some of the capital contributed by shareholders. Return of capital is not part of the yield and is not taxable. To calculate yield, you must back out any returns of capital from the REIT’s dividends. In addition, a return of capital reduces the cost basis of the REIT-holders’ shares. The reduction of basis is taxed as either a short-term or long-term capital gain/loss when the shares are sold.
When considering the yields of competing REITs, a prospective shareholder will want to look at both its cash flow from operations and cash available for distribution. Higher numbers reduce the risk that a dividend will be missed. These cash numbers are independent of depreciation, which is a non-cash expense. Profits derived mainly from depreciation might not be sustainable and thus introduce risk into dividend payments. In other words, distributions that include a relatively large return of capital should be viewed with caution.
Risk is a very important factor when comparing REITs. All things being equal, a riskier REIT should offer a higher yield. A high-risk REIT is one that invests in speculative properties where the chances of defaults or capital losses are significant. A properly diversified REIT helps to mitigate risk by limiting the damage that can be caused by any one property deal going sour. On the other hand, a systemic downturn in the real-estate sector can defeat the diversification effects of owning multiple properties. Diversification in a larger context, in terms of owning many different asset types, can reduce the risk of owning a REIT even in a weak real-estate market, because other asset types (such as bonds) might do well in the same economic environment.
Risk is often measured as the standard deviation of return on an investment. The Sharpe ratio can be used to compare the risk-adjusted returns of different REITs (or any other investments). It is calculated as the average return (or yield) minus the risk-free return, all divided by the standard deviation. The risk-free rate is usually considered to be the return on three-month Treasury bills. By comparing the Sharpe ratios of competing REITs, you have a better idea of the share of yield due to risky investments, which might mask a lack of astuteness on the part of a REIT’s investment manager.
In general, yields on REITs are relatively high, due to the inherent risks associated with real-estate investments. In the 12 months ending on June 30, 2016, Australian REITs delivered a return exceeding 22 percent. They provided an annual compounded return of 17 percent over a five-year period.
In summary, the yields on REITs are directly tied to their riskiness. The logic of diversification suggests that REITs and other real estate investments can increase portfolio returns and/or cut risk when added to a mix of conventional assets such as stocks and bonds. The share of portfolio assets allocated to real estate holdings depends on an investor’s interests, knowledge, required return and risk tolerance.
