The return to form for the housing sector and several favorable economic indicators have helped real estate investment trusts outperform the broader market index so far this year.
But there are also differences between REITs and other companies that explain the latter's outperformance.
One difference is in how REITs are valued.
Far too many investors are unaware of the differences that exist between typical stocks and REITs, but their similarities are only skin deep. Although each will have an investor buy into a respective company in return for sharing in profits or losses, the metrics used to value each are entirely different.
Whereas with typical stocks the key indicators are factors such as earnings per share and net income, determining the value of a REIT is different.
In calculating a company's net income, valuations typically account for the depreciation of assets over a certain time period.
Otherwise known as accumulated depreciation, this metric doesn't necessarily affect the net income of a company but rather "represents the total amount of a company's depreciation expenses charged against its net income over the lifetime of an asset," according to Investopedia.
Depreciation, however, doesn't affect REITs in the same way. The assets or properties held by REITs aren't typically subjected to the same laws of depreciation but are nonetheless depreciated, if for no other reason than real estate tends to appreciate year over year.
Despite the annual gains that typically occur in the housing market, there is usually a massive depreciation expense counted against a REIT's net income, but since depreciation rarely takes place, there normally isn't an expense to account for. Those familiar with this concept may be more comfortable referring to it as a phantom deduction.
A REIT's net income has less to do with depreciation than that of a regular stock. Consequently, investors value REITs through the use of a metric known as fund from operations.
As the name suggests, FFOs identify the volume of cash flow directly resulting from operations. In short, a REIT's FFO paints a much more accurate picture of its profitability than net income.
Meanwhile, dividend yields represent the amount that a company pays out each year relative to its share price. What's more, a company's dividend yield may be the easiest way to measure how much cash flow investors can expect for every dollar they invest in a company.
It isn't uncommon for investors to value stock options based on their particular dividend yield.
Some shareholders have come to rely on dividends, REIT or not. Most notably, Home Depot, the home improvement retailer, officially announced a first-quarter cash dividend of 69 cents a share. Payable on June 16, the dividend represents the 117th consecutive quarter that Home Depot has rewarded its shareholders with a paid cash dividend.
There is, however, a specific reason that REIT yields have been able to outperform the rest of the S&P 500 on a regular basis: preferential tax treatment.
REITs are required by the Securities and Exchange Commission to distribute at least 90% of their taxable income to shareholders, as the law prohibits them from funding future growth with profits that they retained. The disbursement of capital awards REITs the ability to retain more of their profits than other stock options, which translates into larger dividend yields for those that hold an equity position.
Stag Industrial, not unlike a lot of other REITs, was undervalued earlier in the year due to investor sentiment and fears of a possible impending housing bubble. As recently as February, Stag shares dropped to $14.97, a 52-week low.
With real estate stronger than it has been in the past decade, shares are starting to climb again. At just over $20 a share, Stag still looks like a very attractive option for those looking to jump on the REIT bandwagon.
Not only is the dividend yield somewhere in the neighborhood of 6.5%, but FFO is at 39 cents a share, up 11.4% from a year earlier. In all, Stag saw its cash net operating income increase almost 20% in the past year to $49.4 million.
Stag's aggressive strategy to acquire industrial properties at attractive cap rates bodes well for its immediate future and should continue to push dividend yields even higher than they already are.
Outside the preferential tax treatments that REITs receive from the SEC, shareholders are awarded some unique tax advantages for their faith in specific REITs as well. Consequently, not all dividend payments are taxed traditionally.
Although most of the dividend payments that shareholders receive are taxed much in the same way they would be if they originated from a regular business, there are some exceptions.
It is entirely possible for a portion of an REIT's dividend to become nontaxable, which is why a lot of investors look to REITs as a source of retirement income. The cost basis of the shareholder is reduced because the yield is essentially treated as a return of capital.
REITs have proven that they belong in the conversation of viable investment strategies this year, but too few investors understand why.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.