What are the biggest differences between dividend stocks and real estate investment trusts?
It’s an important question, especially for income investors, who seek a reliable, safe, and meaningful flow of cash from their investments and are less concerned about hunting the next 10-bagger stock (a stock whose price appreciates 10 times the initial purchase price).
Not only is it important, but it’s increasingly relevant, since REITs have experienced a massive spike in popularity in recent years; in 2016, REITs and other real estate-focused stocks were officially given their own sector, expanding the count from 10 to 11 sectors.
[See: 7 Ways to Tell if a Stock Is a Good Price.]
The biggest surface difference between REITs and dividend stocks is that REITs typically pay much higher yields than dividend stocks. Yields of 4 to 5 percent on REITs are fairly common — and can even be much, much higher — while only 11 of the non-REIT names in the Standard & Poor’s 500 index yield more than 5 percent.
But things aren’t that simple, and investors need to know the ins and outs, pros and cons of each instrument.
Tax differences. It makes sense REITs yield so darn much: They’re legally required to pay out 90 percent of their taxable income to unitholders, which allows them not to be taxed at the trust level. With rare exceptions those high-yield distributions, however, are then taxed at your income tax rate — which regardless of your tax bracket is much higher than the long-term capital gains rate.
Dividend stocks, on the other hand, are double-taxed. The company itself gets taxed on its profits, with dividends being paid from retained earnings, and then investors get taxed on that dividend income. Qualified dividend income is taxed at the long-term capital gains rate, ranging from just 0 to 20 percent, depending on your tax bracket.
Dividend stocks: payments make statements. “Dividends themselves are representative of a company that is mature and strong enough to pay them,” says Jack Leslie, chartered financial analyst and portfolio manager of the Miller/Howard Income-Equity Fund (ticker: MHIEX).
“The company has to pay them in cash; dividend increases can be viewed as a message from management that the future will be something like the past, but better,” Leslie says. Companies that pay dividends assume they’ll have to pay that dividend forever, which speaks volumes.
REITs are different. Their real estate portfolios are bringing in cash every month, and they’re simply distributing a huge chunk of that back to unitholders. Payments can fluctuate from one period to the next; distributions themselves simply don’t tell you much about the health of the trust.
Sensitivity to interest rates. One of the most important things to know about REITs is how they react to the ebb and flow of interest rates.
“REITs have quite high sensitivity to interest rates,” says Jay Hatfield, president of InfraCap and portfolio manager of InfraCap’s REIT preferred ETF. “It’s because investors use them as an alternative to investing in fixed income.”
The more rates rise, the more investors will sell REITs and put that money into bonds. “If you believe interest rates are a little low right now then REITs are likely to underperform in that market,” Hatfield says.
Dividend stocks can also be a bit sensitive to interest rates — utilities stocks especially — but as a class, REITs have far more interest rate risk.
Frequency of payout. Dividend stocks traditionally issue quarterly payouts, and REITs often do as well, but it’s somewhat common to come across a REIT that actually pays its dividend monthly. This is advantageous for anyone who needs to supplement their monthly income.
A guard against inflation. “REITs generally provide protection against inflation, since real estate prices have historically been sensitive to inflation rates,” says Lowell Miller, founder and chief investment officer of Miller/Howard Investments.
[Read: Are REITs Right for Your Retirement Portfolio?]
When the consumer price index is on the rise, you can generally expect commercial and residential real estate to be on the rise, and rents to be increasing as well.
Dividend stocks are not so monolithic as to be universally a good inflation hedge — it depends on the business!
Valuation metrics. The price-earnings ratio is typically the first place investors go when they’re trying to figure out how to value a stock. Based on a company’s growth prospects, investors determine a certain multiple of earnings that would be a fair price for that stock.
But the P/E ratio doesn’t translate to REITs. Instead of earnings, there are different numbers and ratios investors need to know.
“FFO, or funds from operations, is basically an estimate of cash flow, and is a reasonable estimate of what an investor would expect to pay a multiple of,” Hatfield says.
Various sites will display FFO per share for you, but to calculate it yourself, just add depreciation and amortization to earnings, then subtract gains on sales. From there, you can assign it a multiple to determine what a fair price should be.
“Usually the FFO multiples are not very different from stock market multiples,” Hatfield says, so you can think of them the same way.
Influence of tax cuts. REITs have a notable disadvantage in one area: “They will not benefit from tax reform,” Hatfield says.
That’s because they already pay no trust-wide taxes, so there won’t be any extra money to distribute to unitholders.
But dividend stocks would all benefit, since as normal corporations they are subject to corporate taxes; if those go down, earnings go up, which is good for the share price and dividend sustainability.
The Bottom Line
Rarely in the stock market are comparisons truly apples-to-apples. It’s not as simple as just looking at the yield of a REIT, looking at the yield of a dividend stock, and buying the REIT because its yield is higher. There are quite a few subtleties to mind.
Where are we in the interest rate cycle? Are tax cuts ahead? What’s inflation doing? Is this REIT trading at a fair FFO multiple? Have I considered what taxes I’ll pay on that hefty yield?
[Read: 7 Best Dividend Stocks to Buy for the Rest of 2017.]
These are some of the questions to ask yourself when comparing dividend stocks and REITs.
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Dividend Stocks vs. REITs: The 7 Biggest Differences originally appeared on usnews.com
