The ink has yet to dry on President Trump’s new signature tax law and one thing is already clear: real estate investors are by far the bill’s biggest winners. Among other things, the bill effectively limits the taxation of income paid by REITs to 29.6%.1 The bill accomplishes this by allowing pass-through entities to deduct 20% of income from taxation with the remaining 80% taxed at the investor’s marginal rate. While this deduction is generally phased out for most other businesses, REITs are exempt from the bill’s phase out requirements.
Given the new preferential tax treatment of REIT dividends, should investors now overweight REITs in their portfolio? We argue against doing so. While REITs should be part of a diversified investment portfolio, there is no evidence to suggest investors should overweight REITs in response to the new tax law.
First, based on after-tax yield alone there remain superior alternatives to REITs. At the reduced rate of 29.6%, the after-tax yield on the MSCI US REIT Index will be 2.83%. However, despite REITs’ preferential tax treatment there will continue to be several other asset classes with higher after-tax yields; MLPs (4.86%), Preferred Stocks (4.62%), High Yield Bonds (3.58%), and Telecom stocks (4.32%) all offer investors after-tax yields greater than those offered by REITs.2
However, this focus on dividends undersells common stocks since REITs pay out 90% or more of their total income. In contrast, most companies pay out about 30% of their earnings to common stock investors in the form of a dividend. The remaining 70% or so is kept as retained earnings. Management uses retained earnings to grow the company or pay down debt. Retained earnings benefit investors through higher share prices. Mathematically, investors should be indifferent between retained earnings or dividends since they benefit equally from both.
Second, any analysis of after-tax yields focused on investors in the highest marginal bracket misses an important point: most investors aren’t in the highest marginal bracket, which under the new law applies only to investors with taxable income over $600,000. Subsequently, the marginal tax advantage enjoyed by REITs over lower yielding asset classes erodes for investors in lower tax brackets. This is because investors in lower brackets with income below $479,000 pay a lower capital gains tax on qualified dividends. For example, investors in the 32% and 35% brackets (with taxable income between $315,000 and $479,000) pay only a 15% capital gains tax on qualified dividends. In contrast, investors in these same brackets will continue to pay a 29.60% tax on REIT dividends. In addition to those asset classes previously mentioned, Investors in the new 35% bracket will also find higher after-tax yields on utilities (2.89%) and telecom stocks (3.51%) than on REITs.3
Third, based on risk, REITs come up short relative to other high yield asset classes. With a beta of 1.3, REITs are second only to financials among all sectors in the S&P 500 and have the third lowest correlation to treasury yields at -0.28.4 Compare this to a beta of virtually zero for 10-year municipal bonds, which sport an after-tax yield of 2.41% with no market risk.5 In a rising rate environment, REITs will likely face significant headwinds.
Further, with a correlation of 0.79 to the S&P 500 Index, REITs have little to offer in terms of diversification that investors couldn’t achieve with other asset classes sporting higher after-tax yields.6 For example, with a correlation of 0.75, high yield bonds offer investors similar diversification benefits but with a higher after-tax yield. While it is true that most high yield asset classes have negative correlations to Treasury yields, this observation only proves the point that yield-focused investors should remain globally diversified across multiple sources of yield and resist overweighting any specific asset class based on tax treatment alone.
Finally, with the MSCI US REIT Index trading at 38.2x forward earnings7, REITs appear to be priced for perfection. Indeed, without preferential treatment showered upon REITs by the new tax bill, one wonders what the downside might’ve looked like for the asset class had the new tax law panned out differently. There also appears to be little prospect that the asset class will grow its way out of these high valuations. The Fed predicts three rate hikes in 20188 and analysts forecast below market earnings growth for the Real Estate sector in 2018 (6.3% for real estate versus 11.8% for the S&P 500).9 This comes on the heels of below average earnings growth of 6% in 2017.10
In closing, investors should resist overweighting REITs based on tax treatment alone. Not all investors will capture the same after-tax yield from each asset class. This is because US tax law treats investors differently based on income. Careful consideration should be given to each investor’s unique income tax situation in determining which asset classes offer the best after-tax yields. However, unlike taxes, all investors will capture the same exact diversification benefits and risks offered by each asset class. Subsequently, rather than simply overweighting specific asset classes based on after-tax yield, investors should also carefully consider the unique risks and diversification benefits each asset class offers as part of a diversified portfolio.
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1 “REIT Investors to Gain from Tax Legislation”, The Wall Street Journal. December 19, 2017. Note that this calculation does not include the ACA’s 3.8% Net Investment Income Tax (NIIT). The effective tax on REIT dividends for investors in the highest marginal bracket will be 33.4%. The Tax Cuts and Jobs Act provides for 20% deduction of income for pass-through entities.
2 Data from FactSet, JP Morgan Guide to Markets (November 30, 2017), and Morningstar. All data as of November 30, 2017.
7 MSCI. https://www.msci.com/documents/10199/08f87379-0d69-442a-b26d-46f749bb459b
8 Bloomberg. https://www.bloomberg.com/news/articles/2017-12-13/fed-raises-rates-while-sticking-to-three-hike-outlook-for-2018
9 FactSet Earnings Insight, December 22, 2017