For context, consider that the average dividend yield paid by stocks in the S&P 500 is 1.9%. In contrast, the average equity REIT (which owns properties) pays about 5%. The average mortgage REIT (which owns mortgage-backed securities and related assets) pays around 10.6%.
Why are REIT dividends so high?
You can read our thorough discussion of what makes a REIT a REIT in this article. But for this discussion, it’s important to know two basic principles:
First, to be a REIT, a real estate company needs to pay out a minimum of 90% of its taxable income.
Second, if a company meets the definition of a REIT, it doesn't pay corporate taxes.
Here’s why these two principles are so important. Not only are REITs required to pay out almost all of their taxable income, but if they do, this income isn’t taxed on the corporate level.
To illustrate why this is such a big benefit, let’s say a REIT earns a taxable profit of $10 million. By definition, it has to distribute at least $9 million to shareholders.
Meanwhile, a standard (non-REIT) corporation also earns a profit of $10 million in 2019. Based on the 21% corporate tax rate, there will be $7.9 million left after taxes. Even if this company wanted to distribute 90% of its profits to shareholders, this would translate to about $7.1 million. Nearly $2 million less than the REIT.
Finally, it’s worth mentioning the differences between equity REITs and mortgage REITs when it comes to dividends. You’ll notice from the chart earlier that Annaly Capital Management pays more than double the next-highest payer on the list. Annaly is a mortgage REIT.
Here’s why mortgage REITs tend to pay huge dividends:
Equity REITs produce a combination of stock price appreciation and income. Commercial properties generate rental income -- but they also tend to increase in value over time. On the other hand, mortgage-backed securities are purchased only for income. Mortgage REITs deliver the maximum amount of income within certain risk parameters. They have little or no regard for the appreciation potential of their assets.
Don’t read too much into taxable income
While REITs need to pay at least 90% of taxable income, most equity REITs pay 100% or more. This may sound like an unsustainable practice, but it’s actually quite the opposite.
Without getting too deep into a discussion of REIT earnings, let’s just say that taxable income isn’t the best representation of how much money a REIT makes. Companies can write off real estate investments for tax purposes over a number of years. This results in an annual deduction called depreciation. While depreciation lowers a REIT’s taxable income, it doesn’t actually cost anything.
Funds from operations, or FFO, is a better metric to look at. It adds depreciation back in and makes a few other adjustments to give a clearer picture of a REIT’s profitability.
If a REIT earns taxable income of $1.00 per share and has FFO of $2.50, it wouldn’t be unusual to pay out $2.00 per share in dividends. In fact, a payout of 70–80% of FFO is the industry average, regardless of taxable income.
REIT dividends have unique tax implications
The downside to REITs avoiding tax on the corporate level is that their dividends have a complicated and disadvantageous tax structure on the individual level.