As someone with a background in real estate investment, an interesting software career, and a busy family life, I have turned my attention towards dividend paying stocks, and in particular REITs as a way to build passive income. There are several reasons for this and you can find some of them in more eloquent articles from nareit or Motley Fool, so I’ll refer you to them for more academic reasons.
It is (Mostly) Passive Income
One of the most important criteria at my current point in life as a 38 year old, father of 4, and manic startup software engineering VP, is that I need the investment to be as passive as possible. Public equities provide this for me since companies must disclose financial statements and publish reports giving me at least some insight into company performance at a glance. I’ve developed a good eye over the years of finding squirrelly financial statements through doing years of credit analysis. I’m willing to skip the tax benefits of direct or LP private real estate because they would be more intensive commitments both in terms of time and minimum dollar investment.
With REITs you get fractional ownership and diversification over multiple properties that could be spread across different cities, states, or countries. Building a diversified portfolio of rental properties takes a significant time and financial contribution. I’m willing to earn less return to get diversification at the moment.
Preservation of Value
Real estate is a stable asset class so preservation of value is usually quite good when investing in REITs as long as you know how to value an income stream. Doing a Discounted Cash Flow or using the Dividend Growth Model will reduce your risk when making an investment in a REIT. Of course, it is always a good idea to understand the underlying business strategy and economics while analyzing a REIT for potential investment.
Finally for the most important reason: Utility
I’ve been fortunate to do ok in my career. I’d like to turn any wealth that I create into something useful. Eventually, I’d like to earn enough dividend income to cover much of my living expenses and be financially free. In the short term I want to fund vacations and smaller discretionary items with dividend payments. But, in the long-term, I have a strategy in my mind to build a larger income stream based on what I think my earnings will look like over the next few years. Effectively, I will be periodically converting restricted stock that don’t pay out dividends into primarily REITs.
Why not Dividend Stocks?
There are legal implications to REITs that make their tax treatment different to standard equities. Currently, most dividend paying equities that are not REITs or Master Limited Partnerships can become Qualified Dividends and are taxed at capital gains rates. The current tax law allows for REITs to not pay income tax if they distribute 90% of their net income. On the other hand, receivers of dividends are taxed at their marginal tax rate instead of the qualified rate (15-20% at the time of writing).
In addition to the higher yield and return of capital, current US tax law allows REIT investors to deduct 20% of distributions as a passthrough deduction. So the overall benefit is to significantly incentivize you to invest in REITs.
Let’s compare absolute outcomes based on a overly simple model with the S&P 500 ETF (SPY) to a REIT (VNQ). If you have a sufficiently low income you could have almost zero tax liability if you only owned SPY since most of the equities are normal corporations. If this is the case then a model $1,000,000 investment in SPY & VNQ what is the better performer in absolute income?
|Ticker||Yield||$ Dividend||20% Deduction||Tax Rate||$ Tax||Net $ After Tax|
The clear winner is VNQ. Even though the tax benefit of qualified dividends is greater, the significantly higher yield more than pays for the tax benefit. This doesn’t tell the whole story since it excludes things like dividend growth and diversification benefits, but I think it makes it fairly clear that it is acceptable to pay higher taxes for more absolute income if that is your investment goal.
Hopefully, this clarifies some reasons that I like REITs as an asset class and why I’ve been spending time doing more research and building tools to make investing in them a bit easier. I’d love to hear about your thoughts in the comments!
If you’d like to get started investing in REITs, I’d recommend reading two great books by James Lomax. First is a brief introduction to REITs and why they’re such great vehicles for wealth creation. The links below are affiliate links. I’ve bounced ideas off of James for investment purposes and love the value that he provides. Click on the images to view them.
The second is a deep-dive into the metrics for successfully analyzing REITs for safety and profitability.