Are Real Estate Investment Trusts Safe Investments?

In a yield-starved investment world, should investors be buying Real Estate Investment Trusts (REIT)? Can they bring solid, safe returns? Many investors love them, while some shy away. How volatile are they? How do you evaluate them?

A subscriber recently asked a good question. He purchased a subscription from one of our trusted affiliates, The Dividend Hunter. He looked at a recent recommendation and was “stunned” to find a price/earnings ratio (P/E) over 25 and a payout ratio well in excess of 100%. What gives?

I asked our expert, friend, and colleague, Tim Plaehn for further clarification. I’m glad I did. It was an excellent learning experience and one our readers should appreciate.

DENNIS: Tim, thanks for taking the time for our education. Let’s get right to it. REITs are different from an investing standpoint. The Dividend Hunter seeks out companies in many different businesses that have good and sustainable dividends.

How can a company pay out dividends in excess of profits and still be highly recommended?

TIM: Dennis, thanks for the opportunity to educate, I appreciate it

The particular investment I recommended is currently paying a 6% dividend. The high P/E ratio is not a useful metric to evaluate the safety of the dividend payments.

To answer your question. Most accounting systems are designed for tax purposes. To truly understand the REITs, you must dig further. Here is the prime reason.

As an example, suppose a business buys a $2,000,000 building and rents it out. While they spent $2,000,000 in cash, the IRS does not allow them to charge their profits for the entire amount in the first year. Each year they are allowed a depreciation expense against profit. If they depreciate the building over 20 years each year they are allowed to depreciate $100,000. Depreciation is called a “non-cash” expense.

Let’s assume the tenant pays all the taxes, maintenance, etc., and their net rental income was $120,000. For tax purposes, they would expense the $100,000 in depreciation, reporting a net profit of $20,000.

Although their reported profit is $20,000, they generated $120,000 in positive cash flow which is available for dividends. They could payout 200% of reported earnings ($40,000) and still have plenty of funds available to pay mortgages and grow.

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