Real Estate Investment Trusts (REITs) are powerful vehicles for earning some hands-off income. These companies provide investors with a unique way to tap into the world of real estate without needing to take on massive amounts of personal debt. And for mega projects like hospitals, shopping malls, or even energy infrastructure, REITs present the only viable method for everyday investors to gain exposure and earn from these projects.
Why REITs are so good at generating income
Unlike a normal business, REITs don’t pay corporation tax. But there are a few key requirements to maintain this special status. One is that the firm has to operate with the core intention of generating regular recurring cash flows such as rental income. Another is that 90% of the net proceeds must be paid out as dividends.
There are, of course, other requirements. But corporations that don’t tick all the boxes get classified as Real Estate Operating Companies (REOCs) which means taxes re-enter the picture.
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With 90% of rental earnings paid out as dividends, these stocks typically offer far more generous dividend yields. And providing the underlying cash flow doesn’t get disrupted, it means investors can earn impressive volumes of income.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice.
The best REIT on the London Stock Exchange?
The British stock market is home to a lot of these businesses, each specialising in different asset types. For example, Greencoat UK Wind targets wind energy infrastructure, and Londonmetric Property has a vast portfolio of logistics warehouses. However, over the last decade, the best-performing REIT in the UK has been Safestore Holdings (LSE:SAFE).
The self-storage operator has proven there’s tremendous value to be unlocked in its underserved target market. And in the process of becoming an industry leader, the firm’s delivered more than 350% in capital gains over the last decade. That’s even after the shares slid on the back of interest rate hikes. But dividends are where this business truly shines.
Back in 2014, the stock paid a dividend of 7.45p per share. This has been raised every year since. And today, the shareholder payout stands at 30.1p – 300% higher! As a result, those who bought and held this REIT since then are now earning a dividend yield of 15%. That’s a 15% return a year from dividends alone – double what the FTSE 100 typically delivers in total. And as management continues to raise shareholder payouts, this gain may continue to get even bigger.
Risk and reward
Safestore is a perfect example of what happens when a REIT exceeds expectations. But not all of these enterprises have been so fortunate. And in the last few years, many of these enterprises have struggled for a reason we’ve already highlighted – interest rates.
With nearly all net earnings paid out as dividends, these companies are highly dependent on debt financing to expand their real estate empire. When interest rates were near zero, this wasn’t a major problem. But today, the situation’s vastly different. And while rates are expected to be cut in the near future, achieving growth moving forward is likely to be more challenging.
Fortunately, investors can mitigate this risk with a bit of research and diversification. By hunting down the REITs whose cash flow comfortably covers both interest and dividend payments, the probability of a dividend cut can be minimised.
