“Don’t tax you, don’t tax me…tax that fellow behind the tree…” -- Louisiana Senator Russell B. Long
We’re apolitical here at Millionacres, but we’d be foolish to not acknowledge that our government’s regulatory and fiscal policies have an impact on the broader investment landscape.
However, we know any conversation about politics can become acrimonious and emotional, which is antithetical to prudent investing. It’s important investors interpret governmental actions rationally and without bias. Here's some guidance in this area.
The tax situation
Here’s what we know so far: The Biden administration aims to raise taxes. And that makes sense, considering the national debt now exceeds $28 trillion, the government plans to spend at least $2 trillion more in infrastructure and other social initiatives, and we have the lowest tax rates in decades.
Broadly, there have been two areas of focus for the Biden administration:
- Corporate taxes: As a part of the first part of the infrastructure tax bill, the Biden administration has proposed raising the corporate tax rate to 28%, an increase from the current rate of 21% but still below the 35% statutory rate before the Tax Cut and Jobs Act went into effect in 2018. While many companies pay far less than the statutory rate, it will affect corporate earnings to some degree.
- Capital gains: Recent reports are the president aims to raise the long-term capital gains tax for Americans earning more than $1 million per year to as high as 43.4%, inclusive of the ACA surtax, a steep increase from the current top marginal rate of 23.8%.
Understandably, investors sold off stocks on the day the capital gains news was reported. Investors looking for an asset class less affected by these taxes should check out high-quality real estate investment trusts (REITs).
On the corporate tax side, REITs will mostly be unaffected. Since the structure was established by Congress in 1960, REITs are considered a pass-through entity for tax purposes, provided they follow guidelines like ensuring 75% of income is from real estate and distributing at least 90% of its taxable income to shareholders.
This designation means federal corporate taxes are not levied on most REIT profits. When corporate tax rates increase, REITs become relatively more attractive than other stocks that are subject to higher rates and will see their after-tax profits decrease.
On the dividend side, things are admittedly more complicated. There are three distinct ways REITs distribute cash to shareholders: ordinary dividends, treated as ordinary income for tax purposes; return of capital, nontaxable at time of distribution but lowers cost basis; and long-term capital gains, subject to the changes listed above.
REIT investors are looking for returns from distributions, the bulk of which are considered ordinary dividends for tax purposes. Ordinary income is currently subject to a smaller 2.6-percentage point increase at the top rate, according to Biden’s proposed plans.
Because of this, REITs look comparably more favorable than in recent years when compared to growth stocks that provide the bulk of returns from capital gains while avoiding the double taxation of companies that pay qualified dividends. If Biden’s capital gains tax is enacted, it’s probable wealthy investors would sell off growth names, and income-producing assets like REITs will see increased capital flows.
It’s important to reiterate these changes on the personal side are only for investors that make over $1 million, according to reports, and most investors will not be affected, but it appears REITs have been spared from most of the current proposals and could be the perfect investment for a higher corporate and capital gains environment.
3 REITs all investors should know
Realty Income (NYSE: O) is the leader in the single-tenant net lease space, which allows the company to work with stable Fortune 500 tenants like Walgreens (NASDAQ: WBA), Dollar General (NYSE: DG), FedEx (NYSE: FDX), and Dollar Tree (NASDAQ: DLTR). The company puts a premium on risk management by seeking investment-grade clients (12 out of its top 20) and even maintaining an investment-grade credit rating itself.
Because of these choices, Realty Income is considered a lower-risk REIT. For example, despite the pandemic, the portfolio occupancy rate for Realty Income barely budged, ending 2020 with 97.9% occupancy across its nearly 6,600 properties.
However, most investors know more about Realty Income’s distribution policy. Trademarking the term “The Monthly Dividend Company,” Realty Income has lived up to the promise, recently declaring its 610th consecutive monthly dividend in April.
Unfortunately, shares are not as cheap as they once were due to the fact the company has advanced 40% in the last one-year period. Currently, the company yields 4% and trades at 20.4 times 2020’s AFFO. However, if you’re looking for a lower-risk REIT with a monthly payout, Realty Income should be on your list.
Biden’s tax plan will not impact REITs to a large degree, but the infrastructure bill could boost American Tower (NYSE: AMT). Increasingly, the U.S. government is starting to understand that internet and broadband access are critical infrastructure due to the increased digitization of our economy. Former President Trump briefly considered nationalizing the 5G grid to better compete with China for next-gen technologies.
However, American Tower has a compelling story even without Washington’s help, as wireless companies like AT&T (NYSE: T) and Verizon (NYSE: VZ) are planning to spend $35 billion in capital expenditures in 2021 to build out their 5G networks.
American Tower benefits from wireless expansion, as its business is to buy and build base towers these telecommunications companies place their communications equipment on while charging them rent. Essentially, American Tower is a landlord to these companies.
And American Tower is a dividend growth story. The stock currently yields about 2%, but when you take into consideration that the company has increased its dividend every quarter since 2012, the investment looks more appealing. Last year, the company increased its collective dividend payout by 20% during a pandemic that slowed planned telco capital expenditures.
Shares of American Tower have been stuck in neutral during the last year, although the company grew adjusted funds from operations per share by 7.5% during the year to $8.49, which provides excellent coverage for the annualized dividend of $4.84 per share.
Perhaps the REIT with the longest tailwind for growth is CareTrust REIT (NASDAQ: CTRE). The REIT is a relative newcomer, the product of a spinoff from senior living and skilled nursing operator The Ensign Group (NASDAQ: ENSG) in 2014.
Even now, the Ensign Group is its largest tenant, representing 33% of CareTrust’s annual rental income. The opportunity is the proverbial “Silver Tsunami,” where elderly Americans will need housing and assistance at senior living and assisted living facilities on a massive scale in future years.
The company has continued to grow its dividend, with the payout now 66% higher than in 2015. The last raise of 6% was due to the company’s strong management during the pandemic, where it was able to buy quality assets for cheap while competitors like Welltower (NYSE: WELL) and Diversified Healthcare Trust (NASDAQ: DHC) had to cut payouts.
The company has performed well during the pandemic, up 61% over the last one-year period, and currently yields 4.3%, with a per-share payout of $1.06. Management issued annual guidance for 2021, with normalized funds from operations of approximately $1.41 at the midpoint, which is more than enough to service the dividend.
The Millionacres bottom line
You’re likely about to be deluged with opinion pieces about Biden’s plan in the weeks ahead, and much of it will be partisan politics masquerading as financial advice. It’s important to keep in mind a few points.
Remember that politics is the art of the possible. Due to a nearly split legislative branch, these figures are a starting point for discussion and negotiation. A lower top marginal rate on long-term capital gains for high earners than currently proposed appears more likely. Additionally, the timing of tax increases will determine the market’s reaction.
Finally, while these changes appear to spare REITs, it’s important to not let tax implications fully dictate your investment thesis. For most Americans, these proposals will have low to no direct impact. However, this is a good opportunity for investors to further look into REITs as an income investment.