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Recommendation: Think about upcoming mortgage REIT earnings (Part 2)

Mortgage ETFEnlarge GraphContinued from Part 1

What exactly is a REIT?

A real estate investment trust (REIT for short) is a tax-advantaged vehicle for investors. Unlike typical publicly traded companies, they don’t pay corporate tax. Think about a dividend from a garden-variety company. The company pays corporate tax and then distributes some percentage of its after-tax income (called a “payout ratio”) to the investor as a dividend. The investor then pays personal income taxes on that dividend income. So for most companies, investment income is double-taxed—first at the corporate level and then at the personal level. Even if the company does not pay a dividend, if the price of the stock increases by the amount of the earnings and the investor sells the stock, he or she will incur a capital gains tax liability.

For REITs, as long as they’re invested in real estate assets and pay out 90% of their earnings as dividends, they’re not taxed at the corporate level. The investor pays all the taxes. So what type of investor will find REITs attractive? Income investors. REITs pay much higher dividends as a rule than the Standard & Poor’s 500 index as a whole.

How to choose a REIT

Given that REITs must pay out 90% of their earnings as dividends, their dividend streams can be lumpy. If they have a great quarter, they pay a big dividend. If they have a lousy quarter, they pay a lousy dividend. So, when analyzing a REIT, you have to pay attention to a few things.

First, based on what you think interest rates are going to do, choose a REIT that has the asset base that will perform best. Think we’re headed into a recession? Think we’re going to experience inflation? Think the yield curve is widening? Think the economy is about to take off? You’ll want to position differently for each scenario.

This analysis continues in Recommendation: Think about upcoming mortgage REIT earnings (Part 3).