REITs Living on Borrowed Time

Those of a certain age can recall an ad that presented a debate over a certain mint: candy mint or breath mint? It was revealed to be two mints in one.

Real estate investment trusts present similar taxonomic hurdles. Like common stocks, they are listed on equity exchanges and are part of benchmark indices such as the S&P 500. Like open-end mutual funds, they have to distribute 90% of their net income in the form of dividends, but nearly all of these dividends are unqualified for the 15% rate applicable to dividends paid from operations. One exception to this rule is that a REIT dividend attributable to qualified dividends received by the REIT and passed on to shareholders qualifies for the 15% rate.

REIT valuation has its own metric: funds from operations, or FFO. Generally accepted accounting principles, or GAAP, call for real estate assets to be depreciated; this would understate REITs' operating performance. FFO adds this depreciation and gains and losses from nonrecurring items such as property sales back to GAAP net income.

REITs' high dividend yields -- the 12-month yield on the streetTRACKS Wilshire REIT Index fund is 5.46% -- and the ordinary income treatment of these dividends place them economically into a fixed-income sphere. Much like a convertible preferred stock, their current value is their dividend stream plus a call option on the price appreciation of assets in their portfolio.