An increasing number of yield-starved investors are finding refuge in one of the last areas of high-yield and relatively safe investments—real estate investment trusts (REITs). With dividend yields averaging twice those found in 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 growth and income-oriented portfolio, as they are all about the high dividends and can offer some capital appreciation potential.
Key Takeaways
- Real estate investment trusts (REITs) are one area of the market still offering high-yield, safe dividends.
- Many companies and an increasing number of REITs now offer dividend reinvestment plans (DRIPs).
- DRIPs automatically reinvest dividends in additional shares of the company, which offer the power of compounding interest.
- Generally, DRIPs don’t charge any sales fees, because the shares are purchased directly from the REIT.
- Considering the higher yield of a REIT, a REIT DRIP can generate a higher rate of growth than other stocks.
How Do REITs Work?
A REIT is a security, similar to a mutual fund, that makes direct investments in real estate and/or mortgages. Equity REITs invest primarily in commercial properties, such as shopping malls, hotel properties, and office buildings, while mortgage REITs invest in portfolios of mortgages or mortgage-backed securities (MBSs). 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 consisting of rental income and capital gains. To qualify as securities, REITs must payout at least 90% of their net earnings to shareholders as dividends. For that, REITs receive special tax treatment; unlike a typical corporation, they pay no corporate taxes on the earnings they payout. REITs must continue the 90% payout regardless of whether the share price goes up or down.
REIT Dividends and Taxes
The tax treatment of REIT dividends is what differentiates them from regular corporations, which must pay corporate income taxes on their earnings. Because of that, dividends paid by regular corporations are taxed at the more favorable dividend tax rate, while dividends paid out by REITs do not qualify for favorable tax treatment and are taxed at ordinary income tax rates up to the maximum rate.
A portion of a REIT dividend payment may be a capital gains distribution, which is taxed at the capital gains tax rate. Investors receive reports that break down the income and capital gain portions. Investors should only hold REITs in their qualified retirement accounts to avoid higher taxation.
The Power of Dividend Reinvestment
Generally, when dividends are paid out, investors receive them as checks or direct deposits that accumulate in investors’ cash accounts. When that occurs, investors must decide what to do with the cash as they receive it.
Many companies and an increasing 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 free investors from tax obligations.
Not all REITs offer DRIPs; before making an investment, ensure the option is available. Also, find out about the REIT’s transaction fees. Generally, DRIPs don’t charge any sales fees, because the shares are purchased directly from the REIT.
Most investors are aware of the power of compounding interest or returns and its effect on the growth of money over time. A REIT DRIP offers the same opportunity. Considering the higher yield of a REIT, a REIT DRIP can generate a higher rate of growth. REIT dividends can increase over time, which, when they are used to purchase additional REIT shares, can accelerate the compounding rate even further.
REIT shares have the potential to increase in value over time, which increases the value of the holding as growing stocks tend to pay out even higher dividends. Even if the share price of a REIT declines, investors still benefit in the long run due to the dollar-cost averaging effect.
As of December 2024, the one-year average dividend yield of publically traded U.S. equity REITs was 3.94%.
The Dollar-Cost Averaging Bonus
Dollar-cost averaging is an investment technique that takes advantage of declining share prices.
For example, say an investor purchased 100 shares of a REIT at $20 a share, and it pays a $200 monthly dividend. The share price declines to $15 when the investor receives her first monthly dividend payment of $200, and it is reinvested in the REIT.
The $200 dividend payment would then purchase 13 new dividend-paying shares at $15 a share. The total holding increases to 113 shares with a value of $2,195. The new cost basis for the total holding is now less than $19.50 a share.
When the share price increases, the dividend payment will purchase fewer shares, but the investor will generate a profit more quickly on her total holdings because of the lower cost basis.
If the REIT’s share price continues to increase and decrease, the cost basis should always be lower than the current share price, which means the investor always has a profit.
The Safety and Reliability of REITs
Many financial planners recommend holding some real estate for diversification. Many REITs have long track records of generating continuous and increasing dividends, even during the tumultuous real estate crisis of 2008. Note that even though some REITs might have experienced increased net operating income in 2008, many factors contributed to their need to cut dividends (including high payout ratios and leverage).
A solid-performing REIT typically invests in a large, geographically dispersed portfolio of properties with financially sound tenants, which can mitigate any volatility in real estate properties.
REITs are liquid investments, but they should be held within a properly diversified portfolio for the long term for the best possible outcome. Investors build significant downside protection by adding a DRIP to a REIT.
Advantages of REIT Dividends
Let’s chat through some of the benefits of reinvesting REIT dividends. As we’ve discussed, reinvesting REIT dividends allows investors to harness the power of compounding. Each dividend payment is used to purchase additional shares or fractions of shares, which in turn generate their own dividends. Over time, this cycle creates exponential growth in the investment’s value.
When dividends are reinvested within tax-advantaged accounts like an IRA or 401(k), the growth is tax-deferred, meaning investors won’t pay taxes on the reinvested dividends or their earnings until withdrawals are made. This means the entire dividend can be reinvested with accelerating growth and tax benefits. Over decades, this can make a significant difference compared to taxable accounts.
Also, there may be some fee benefits to doing this. Like we talked about earlier, many REITs or brokerage platforms offer DRIPS at no extra cost. This means instead of having to buy and sell securities at random times, investors can eliminate transaction or commission fees.
Challenges of Reivesting REIT Dividends
One of the primary challenges of reinvesting REIT dividends is dealing with market volatility. We talked about how REITS can be reliable and provide a certain level of security. However, this largely depends on broader market conditions. REITs are tied closely to the performance of the real estate market and things like interest rates, which means their values can fluctuate significantly.
When dividends are automatically reinvested, investors may unknowingly purchase additional shares at a high price during market peaks. This makes it difficult to capitalize on market dips, where buying more shares at a lower cost would provide better long-term growth opportunities. Note that it is difficult to time the market consistently.
There’s also some tax implications to think about. Unlike dividends from some other investment vehicles, REIT dividends are generally taxed as ordinary income. This means that even if the dividends are reinvested, investors are still liable for taxes on the full amount received. This could mean you have to come up with an alternative cash flow from a different source to cover the expense of this investment.
Another challenge is the potential for over-concentration in REITs. When dividends are continually reinvested in the same REIT, the investor’s exposure to that specific asset class or market segment increases. We talked earlier in the article about how REITs could act as a diversifying asset. After a while, especially if dividends are reinvested, you may need to consider diversifying away from REITs.
What Is a REIT Dividend?
A REIT dividend is a payment distributed to shareholders from the income generated by a real estate investment trust. REITs own, operate, or finance income-producing properties such as apartments, office buildings, malls, warehouses, and healthcare facilities.
How Do You Reinvest REIT Dividends?
To reinvest REIT dividends, investors typically enroll in a Dividend Reinvestment Plan (DRIP). Many REITs and brokerage platforms offer DRIPs, which automatically use dividends to purchase additional shares or fractional shares of the REIT.
What Are the Benefits of Reinvesting REIT Dividends?
Reinvesting REIT dividends provides multiple advantages. First, it leverages the power of compounding, where reinvested dividends generate additional returns over time, accelerating portfolio growth. Second, for investors using tax-advantaged accounts like IRAs, reinvesting dividends allows the full amount to grow tax-deferred, avoiding the annual tax burden typically associated with dividends in taxable accounts. Lastly, DRIPs often come with cost savings,
Are REIT Dividends Taxed Even If Reinvested?
Yes, REIT dividends are subject to taxation even if they are reinvested in a taxable account. Most REIT dividends are considered ordinary income, meaning they are usually taxed at the investor’s regular income tax rate.
The Bottom Line
Reinvesting REIT dividends allows investors to compound their returns by using dividend payouts to purchase additional shares, often through cost-efficient DRIPs. While this strategy offers long-term growth potential, it also comes with challenges such as market volatility, tax implications, and risks of over-concentration.