A growing number of yield-hungry investors are finding refuge in one of the last areas of high-yielding and relatively safe investments:real estate investment trusts (REITs). With dividend yields averaging twice that of common stocks, some as high as 10% or more, you might question the safety and reliability of REITs, especially for conservative, income-seeking investors. REITs should play a role in any diversified portfolio focused on growth and income, as they all aim for high dividends and can offer some potential for capital appreciation.

How do REITs work?

A REIT is a security, similar to a mutual fund, that invests directly in real estate and/or mortgages. Equity REITs invest primarily in commercial properties, such as shopping centers, hotels, and office buildings, while mortgage REITs invest in portfolios of mortgages or office buildings. mortgage-backed securities (MBS). A hybrid REIT invests in both. REIT shares trade on the open market, so they are easy to buy and sell.

The common denominator among all REITs is that they pay dividends composed of rental income and capital gains. To qualify as securities, REITs must pay out at least 90% of their net profits to shareholders in the form of dividends. For this, REITs receive special tax treatment; Unlike a typical corporation, they pay no corporate taxes on the profits they pay out. REITs must continue to pay 90% whether the stock price rises or falls.

REIT Dividends and Taxes

The tax treatment of dividends from REITs is what differentiates them from regular corporations, which must pay taxes on corporate profits. For this reason, dividends paid by regular corporations are taxed at the most favorable dividend tax rate, while dividends paid by REITs do not receive favorable tax treatment and are taxed at tax rates on ordinary income up to the maximum rate.

Part of a REIT’s dividend payment may be a capital gains distribution, which is taxed at capital gains tax rate. Investors receive reports that break down income and capital gain shares. Investors should only hold REITs in their qualified retirement accounts to avoid higher taxes.

The Power of Dividend Reinvestment

Typically, when dividends are paid, investors receive them in the form of checks or direct deposits that accumulate in investors’ cash accounts. When this happens, investors must decide what to do with the cash as they receive it.

Many companies and a growing number of REITs now offer dividend reinvestment plans (DRIPs)which, if selected, will automatically reinvest dividends in additional shares of the company. Reinvesting dividends does not relieve investors of tax obligations.

Not all REITs offer DRIPs; Before making an investment, make sure the option is available. Also ask about REIT transaction fees. Typically, DRIPs charge no sales fees because the shares are purchased directly from the REIT.

Most investors are aware of the power of interest or compounding returns and its effects on the growth of money over time. A REIT DRIP offers the same opportunity. Given the higher yield of a REIT, a DRIP REIT can generate a higher growth rate. REIT dividends can increase over time, which, when used to purchase additional shares of the REIT, can accelerate the compounding rate even further.

REIT shares have the potential to increase in value over time, increasing the value of the holding because growing stocks tend to pay even higher dividends. Even if a REIT’s stock price declines, investors still benefit in the long run through the dollar-cost averaging effect.

The recurring purchase bonus in dollars

Dollar cost averaging is an investing technique that takes advantage of falling stock prices.

For example, let’s say an investor buys 100 shares of a REIT at $20 per share and pays a monthly dividend of $200. The stock price drops to $15 when the investor receives their first monthly dividend of $200, and this is reinvested in the REIT.

Paying the $200 dividend would then purchase 13 new dividend-paying shares at $15 per share. The total holding is 113 shares worth $2,195. The new cost basis for the entire stake is now less than $19.50 per share.

When the stock price increases, the dividend payment will purchase fewer shares, but the investor will generate a profit more quickly on their entire holdings due to the lower cost basis.

If the REIT’s stock price continues to rise and fall, the cost basis should always be lower than the current stock price, meaning the investor still makes a profit.

The security and reliability of REITs

Many financial planners recommend holding real estate for diversification purposes. Many REITs have a long history of generating continuous and growing dividends, even during the tumultuous housing crisis of 2008.

A successful REIT typically invests in a large portfolio of geographically dispersed properties with financially strong tenants, which can mitigate any real estate property volatility.

REITs are liquid investmentsbut, to achieve the best possible result, they must be held in a properly diversified portfolio over the long term. By adding a DRIP to a REIT, investors gain significant downside protection.