Real estate has been a preferred asset class of wealthy investors for literally thousands of years — since mankind gave up a nomadic lifestyle and settled into civilization. But real estate plays a critical role in today’s financial world.
Most of us will never own investment real estate. It’s a hassle to manage. No one wants to get a call about a broken toilet at 3:00 a.m. Most millionaires would even struggle to build a diversified portfolio of properties, given the expense.
In my opinion, that’s why REITs are so valuable. They are diversified baskets of investment properties that trade publicly, just like shares of Apple or Microsoft. You can even hold them in an IRA or 401(k) without issue.
REITs come in all shapes, sizes and subsectors. You can invest in REITs that specialize in apartments, warehouses or strip malls. You can even find more exotic ones that own data centers and cell towers. Think of any property imaginable, and there is a subsector of REITs likely specializing in it.
Inflation Hedge
Given a long enough time horizon, the value of all currencies goes to zero … or at least close to it.
I hope that day is decades or centuries in the future for the dollar. But it will get there, even at the Federal Reserve’s targeted inflation rate of 2%.
Inflation of 2% compounded over 20 years means that it would take $1.49 in 2041 to buy a dollar’s worth of goods or services today. In 50 years, it will take $2.69 to buy something that would cost a dollar today.
Finite Asset
Unlike financial assets, which can be replicated infinitely at will, there is a finite amount of real estate. That doesn’t mean real estate is always the best investment. It goes through cycles just like everything else.
But as a long-term asset class, it’s as good of an inflation hedge as anything, in my opinion.
Not only should the value of the real estate keep pace with inflation, but the income thrown off the properties should also grow, as leases rise with inflation in most cases.
Taxes
We already established that real estate rises in value over time. Yet, according to tax rules, it falls in value due to depreciation.
Depreciation is a phantom expense in that no money ever leaves your pocket. But it has a real impact on your tax bill. Oftentimes, depreciation expenses are high enough to offset a good chunk of your income.
REITs benefit from this, as a portion of their dividends is often classified as non-taxable “return of capital” rather than taxable dividends.
And it gets better. REITs also benefit from a special tax status above and beyond that given to ordinary real estate investors. So long as a REIT pays out at least 90% of its net income as dividends, it owes no federal income tax whatsoever. And every dollar saved in taxes is a dollar available to investors.
Income Play
In my view, REITs are among the highest-yielding stocks you’re ever going to find. The tax break is part of that. Avoiding corporate income taxes eliminates one of the single biggest expenses for most companies.
But leverage also plays a role here. I’m not a fan of companies taking on debt to juice their returns. Sure, it boosts earnings per share in the short term but only at the expense of creating more risk.
Who can forget Bank of America and General Electric having to go hat-in-hand to Warren Buffett for a loan following the 2008 meltdown? That’s what happens when management gets cavalier with debt.
Takeaway
But real estate is a different animal. Debt is often assigned to a specific piece of property that has the cash flows to support it. And when done prudently, it can juice the income available to distribute as dividends without adding a significant amount of risk.
Bottom line: REITs are high-income, low-tax inflation hedges with the liquidity of stocks. If you don’t invest in at least a few REITs in your income portfolio, you’re doing it wrong in my opinion.
This post first appeared on August 17 on the Money & Markets blog.
Photo Credit: soomness via Flickr Creative Commons
DISCLOSURE
This piece is provided as educational information only and is not intended to provide investment or other advice. This material is not to be construed as a recommendation or solicitation to buy or sell any security, financial product, instrument, or to participate in any particular trading strategy.
This article is not intended as tax advice and is provided for educational and information purposes. Interactive Advisors does not provide tax advice. All references to tax matters or information provided here are for illustrative purposes only and should not be considered tax advice and cannot be used for the purpose of avoiding tax penalties. Investors seeking tax advice should consult an independent tax advisor.
