REITs May Offer an Advantage for Investors

We came across an interesting chart on the overall returns of REITs vs. the S&P 500 and other indexes that we’d like to share.

As you can see below, the historical track record of REITs is pretty impressive. However the conclusions we take from this chart might be a bit different than you might guess at first glance.  In comparing the historical returns of REITs vs. the S&P 500 returns for example, you might conclude that commercial real estate is a superior asset class to stocks; after all, the REIT returns were higher in every time frame over the past 40 years.

Historical Compounded Annual % Total Returns of

REITs and Leading US Benchmarks:

FTSE, NAREIT

S&P 500

 

Barclays Aggregate

US Equity REITs:

Total Return:

Russell 2000:

Bond Index:

1 Year

19.19

13.46

14.02

3.12

3 Year

20.36

13.5

14.71

5.45

5 Year

7.76

4.94

7.38

5.52

10 Year

12.47

8.24

11.16

5.01

15 Year

9.39

4.36

6.01

5.87

20 Year

10.79

8.45

8.76

6.14

25 Year

10.78

9.61

9.49

7.03

30 Year

11.96

10.83

9.33

7.99

35 Year

13.09

11.72

N/A

8.13

40 Year

12.46

10.08

N/A

N/A

* Data as of February 28, 2013
*  Source:  NAREIT

But when you break down the returns and consider how they are taxed, you will see that the gross returns for each of those asset classes were closer to equal.  If we look at the 40-year average returns for example, the S&P 500 averaged 10.08%.  During that timeframe, about 3% of that 10.08% on average came from dividends and the remaining 7% came from price appreciation or growth.  For the REITs, the 40-year average return was about 12.46%, of which about 5 to 5.5% was from dividends and the remaining 7% or so was from growth.  So if the growth was fairly equal, why were the RIETs able to pay out so much more in dividends?

The answer is in how the two assets are taxed at the corporate level.  REITs do not have to pay any tax at the corporate level as long as they distribute at least 90% of their earnings as a dividend to their shareholders.  Other corporations currently pay around 35% to 38% and over the past 40 years have paid as high as 48% on all income, whether it is paid out as a dividend or not.  Obviously, this is a major advantage for the RIETs.

When looking at our 40-year example and factoring in the tax rates, let’s assume an average tax rate of 40% for corporations.  That would mean that in order to pay out their 3% average dividend, corporations would have to earn closer to 5%.

  • For example, let’s say we have a Corporation and a REIT that both earn $1,000,000 ($1m) in profits.  They both want to pay out that $1m as a dividend and both are valued at $20m based on their current stock prices.
    • The Corporation would first have to pay their tax bill, which at 40% would be $400,000, leaving them with $600,000 to pay to shareholders as a dividend.  $600k divided by their $20m value would mean they paid out a 3% dividend.
    • The RIET would not owe any tax (as long as they pay out more than 90% of their income), meaning the entire $1m could be paid out to shareholders as a dividend.  $1m divided by their $20m value would mean that they paid out a 5% dividend.

Historically, this tax advantage for REITs has resulted in approximately a 2% per year higher dividend payout vs. the S&P 500.  This essentially accounts for the difference in the long-term returns between the two asset classes.  Going forward, we are certain that there will be time periods when the S&P 500 performs better than the average REIT.  But given the dividend advantage of the REITs, they are likely to continue to outperform over the long term…and who doesn’t like the potential for higher dividends?