I Hear REITs Are One of the Best Ways To Get Income From Investing, Especially in Retirement. Should I Buy Them?

Question: I hear REITs are one of the best ways to get income from investing, especially in retirement. Should I buy them or are they too much of a headache?

Answer: It's a done deal. The Federal Reserve lowered the targeted fed funds rate to 4.00% to 4.25% at its September meeting and indicated that it will likely chop off another half percent before year's end. The days of high interest rates are drawing to a close.

Money market rates are now trending lower, and the dividend yield on the S&P 500 is hovering near all-time lows. If you're an investor looking to generate income, that's not what you want to hear.

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So, what's an income investor to do?

For a dependable income option, consider real estate investment trusts (REITs).

Real estate has been a preferred income vehicle for the wealthy for literally thousands of years. And in modern America, it continues to be a coveted store of value and one that comes with tax breaks and preferred financing that simply don't exist elsewhere.

Of course, investing in real estate comes with some drawbacks. Given the high cost of individual properties, it's not so easy to build a diversified portfolio. Property management can be time-consuming and expensive. And buying or selling a property tends to be a slow and cumbersome process.

That's where REITs become an interesting option. REITs are companies that own, operate or finance income-producing real estate such as apartments, office buildings, warehouses or even mortgages.

They allow you to buy or sell a diversified, dividend-paying real estate portfolio with the click of a mouse, just like any other stock. Think of it as a headache-free way to own real estate in your brokerage account or IRA.

Why real estate … and why REITs?

The benefits of real estate are obvious. Property is a natural inflation hedge, and rents tend to rise in line with inflation over time.

Banks are more than happy to lend for real estate with preferential long-term financing at low rates. The tax code also favors real estate, allowing landlords to write off non-cash "phantom" expenses like depreciation.

This makes real estate one of the most tax-efficient investments you're ever going to find. And every dollar not paid in taxes is a dollar available to distribute to the landlord.

It should come as no surprise that REITs tend to be some of the highest dividend-paying stocks in the market. The FTSE NAREIT All REITs Index boasts a dividend yield of 4.2% as of late September.

And popular REIT exchange-traded funds are high-yielders too. Indeed, the Vanguard Real Estate Index ETF (VNQ) currently yields 3.8%. Compare that to the 1.2% dividend yield currently on offer by the S&P 500.

What's more, REIT dividends are competitive with bond yields. At the time of this writing, the yield on the 10-year Treasury note is just 4.1%.

But this is what really tips the scales in REITs' favor. If you buy a 10-year bond today and hold it to maturity, you cannot earn more than 4.1% per year. It's fixed income, after all, meaning it doesn't move.

REITs, however, tend to raise their dividends over time. As a case in point, blue-chip REIT Reality Income (O) has raised its dividend for 112 consecutive quarters (and counting!) and has boosted its dividend at a 4.2% annual compound rate since going public in 1994.

That consistent dividend growth provides inflation protection you're simply not going to get in the bond market, and it can help you maintain or improve your standard of living in retirement.

Dividends are less secure than bond coupon payments, of course. When times get tough, companies often reduce or eliminate their dividends. That certainly happened during the 2028 real estate bust and, to a lesser extent, during the 2020 pandemic. This is why you should always diversify your risk across multiple payers.

Aren't the taxes a headache?

To start, don't worry about tax complexity. The dividends will show up on the 1099 tax form your broker gives you, and it's all plug and play. TurboTax or whatever tax software you use will do the math for you.

REIT taxation is a little quirky, but that quirkiness actually works to your advantage.

Consider this. Bond interest is taxed as ordinary income. Whatever tax bracket you're in, that's the rate you're going to pay on your bond or money market income. If you're a high earner, that could mean paying 37 cents of every dollar earned in interest.

That's not how REITs are taxed.

To start, unlike regular corporations, REITs pay no income tax at the corporate level so long as they distribute at least 90% of their profits as dividends. That's a major contributing factor to the high yields that REIT investors tend to enjoy. Every dollar not paid to Uncle Sam is a dollar available to pay as a dividend.

Beyond that, the dividends are generally taxed at a better rate. While it varies over time and from REIT to REIT, a portion of the payout is generally a tax-free return of capital or taxed as long-term capital gains (generally 20% or less).

According to NAREIT, 78% of REIT dividends in 2024 were considered ordinary income, with the rest classified as return of capital or long-term capital gains. But it's not uncommon to see that number in the 50s or 60s. Additionally, you can often deduct up to 20% of your REIT dividends as qualified business income.

There are a lot of moving parts here, so we can simplify. The tax rate on REIT dividends will generally be a little higher than the rate on qualified dividends from regular common stocks such as McDonald's (MCD) or Microsoft (MSFT). But they will also typically be significantly lower than the taxes you pay on bonds or other fixed-income products.

Again, if you're not a tax whiz, don't worry about it. Any off-the-shelf tax program will do the math for you.

Like all corners of the stock market, REITs are not without their risks. Real estate is subject to boom and bust cycles just like regular common stocks. But if you're looking for retirement income to keep pace with inflation, they deserve a place in your portfolio.

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