ETF: REIT ETFs and income

Last week we discussed some of the challenges of investing in dividend-centric ETFs. To recap, it’s incredibly difficult to predict when companies will pay dividends. Since index-tracking products are entirely rules-based, filtering for an unpredictable factor like whether the board is in the mood is tricksy.

The CoreShares Divtrax ETF tries to eliminate this uncertainty by only including companies that have consistently paid a dividend for at least seven years. If a company in the index fails to pay a dividend for only one year, it is excluded from the ETF.* This ETF leads the pack, but the pack also includes a couple of creatures that don’t even belong in the same species, like the Preftrax and Shari’a ETFs.

Real estate investment trust (REIT) ETFs are also participating in the dividends race, but we’re entering Hunger Games territory. First of all, these ETFs are all about property, so they influence the asset allocation in your portfolio. Property investments are considered less risky, and by extension less rewarding, than their equity brethren. The lower risk has to do with the physical nature of the asset. Since there’s a building and a stand that can be sold, the argument goes, you won’t be left clutching only a bouquet of sadness if a company goes belly-up.

The second argument in favour of these investments is the fact that they pay you. They’re not tight-fisted about it either. Companies that invest in property collect rent – like a buy-to-let flat, but on a huge scale. REITs are required to pay at least 75% of its taxable earnings to investors each year (kind of weird how these companies don’t have the option of “growing the business” with investor income, isn’t it?). Lastly, since REITs are listed companies that grow over time, investors can benefit from income as well as capital appreciation. It’s like bonds and shares had a money baby.

While many investors are excited by the potential tax benefits of REIT ETFs, it’s important to note that the REIT gets the tax benefit. You benefit only indirectly. For example, if a REIT sells an asset, it is not liable for capital gains tax (CGT) in the way that an ordinary company would be. That’s great for investors, because a company that pays less tax has more money to send your way.

The REIT vehicle itself is not taxed, but as an investor you are still liable for income tax** and capital gain on REIT shares. The high income payments and associated tax liability is why many One Lappers prefer holding their REIT ETFs in a tax-free investment environment. Remember, dividends are taxed at 20%, but income from property ETFs will be added to your annual income and charged at your marginal rate. Even in the highest income bracket, you’ll only ever be liable for 18% capital gains tax. It’s important to be aware of this pay-off.

Another downside of all that income distribution is that the capital appreciation side can be anaemic. If 75% of your income gets paid to shareholders, you don’t have many reserves for your world domination strategy. Rental income is great, but it is also dependent on having tenants. If you have an office park in an area where nobody needs an office, you’re stuck with shell nobody wants to buy.

Have a look at the performance of some REIT ETFs below (the Sygnia and Stanlib offerings are too new to be included). The income distribution is juicy, but even the Satrix 40, which has been a pit of despair for the past five years, has outperformed. A 41.2% growth rate over five years isn’t changing lives, but compared to the REIT ETFs it seems positively giddy with growth. That said, it paid only 2.4% in dividends.

ETF	Performance	Dividend Yield
CoreShares PropTrax TEN	1 year -13.8% 5 year +24.6%	6.3%
CoreShares PropTrax SAPY	1 year -12.3% 5 year +16.3%	6.9%
Stanlib SA Property ETF	1 year -13.7% 5 year +10.4	8.2%
CoreShares S&P Global Property ETF	1 year -2.8% 5 year N/A	1.6%
Satrix Property ETF	1 year -12.3% 5 year N/A	6.5%

*If, over a period of seven years every company in the index fails to pay a dividend at least once and no other companies qualify, we might enjoy a good display of footwork at the S&P office. Whether a company’s dividend strategy is influenced by its inclusion in the ETF is difficult to say, since dividend payments seem to depend solely on the whims of a group of highly-paid bros. Whether a sub-par company with low liquidity can exploit this strategy to be included in the ETF is also something worth thinking about.

**While the SENS announcements on REIT ETFs refer to a dividend tax, income from REITs are taxed at your marginal rate, not the 20% dividend withholding tax rate. You could be paying more tax on income from these ETFs than any other investment return, including capital gains. Thanks to our friend Stealthy Wealth for pointing this out.