Beleaguered REITs Hope Tax Reform Could Turn The Tide In Their Favor

Real estate investment trusts have been out of favor for some time. They underperformed significantly compared to the rest of the stock market last year and have continued to slump into 2018. Rising interest rates mean many investors may continue to view them as a poor place to park money.

Some industry experts are pinning their hopes on the changes to the tax code turning things around for the sector, although there is little sign it has had much of an impact just yet.

“It’s now more effective to be earning income through a REIT,” EisnerAmper’s Real Estate Services Group Partner-in-Charge Kenneth Weissenberg said. “REITs are going to be much more useful going forward.”

REITs benefit from the changes because the top tax rate shareholders pay on dividends has been reduced, Weissenberg said. REITs do not pay corporation taxes — which was already their main advantage over privately held firms — but dividends have also not been subject to special rates.

Before:

• REIT investors could pay up to 39.6% tax on dividends.
• REIT investors paid 20% on capital gains.

Now:

• Investors will still pay 20% on capital gains.
• Dividends qualify for a 20% deduction because REITs are considered a flow-through entity.
• The top tax rate has gone down to 29.6%.
• Unlike with other flow-throughs, there are no limitations stopping REITs from getting the 20% deduction.

Some have predicted that REITs would bounce back this year, but that has yet to come to fruition.

“I think REITs were left behind to some degree,” said Edward Jones REIT analyst Matt Kopsky of the tax changes, adding sectors with stronger earning growth were the real winners with the changes. “It wasn't negative … [but] relative to other sectors, they were a loser.”

REITs remain out of favor, Kopsky said. But as the 10-year interest rate ticks up it will bring uncertainty, REITs are a good long-term investment.

“It just seems the real estate sector has been hypersensitive, despite the healthy fundamentals,” he said, adding the S&P 500 real estate sector was down 8% as of close on Monday, the worst-performing sector in the market.

Right now, the industry is happy with the tax changes, but everyone is still "digesting" their complexities and impact, according to Deloitte U.S. Real Estate and Construction leader Jim Berry.

He acknowledged REITs were outperformed by the rest of the stock market in 2017, but said when compared to historical levels, their yields are healthy.

REITs took hits in the market swings this year, but Berry said the volatility could eventually be a gift for REITs overall, because it will increase their appeal.

“It should bode well for the REITs, because once again people will look to REITs for stability,” he said. “REITs are considered a very mature part of the investing philosophy of most institutional investors, and it will continue to play a very important role in their investment structure.”

A dipping market may cause challenges for REITs with legacy portfolios, but some new players see it as a great time to set up shop.

“Tax reform is one of a few things that is pushing the market lower,” said NY Residential REIT CEO Jesse Stein, who has just begun raising capital to begin investing in New York City condominiums.

“For us, we think there’s a lot of opportunity in the next year or two before the inevitable rise back up," he said. "We think it’s a great time to get started.”