An increasing number of yield-starved investors are finding refuge in one of the last bastions of high-yield and relatively safe investments: real estate investment trusts (REITs). With dividend yields averaging twice those found in common stocks, some as high as 10% or more, you might question the safety and reliability of REITs, especially for conservative income-seeking investors. REITs should play a role in any diversified growth and income-oriented portfolio. REITs are all about the high dividends, and they can offer some capital appreciation potential.

How Do REITs Work?

A REIT is a security, similar to a mutual fund, that makes direct investments in real estate and/or mortgages. Equity REITs invest primarily in commercial properties, such as shopping malls, hotel properties, and office buildings, while mortgage REITs invest in portfolios of mortgages or mortgage-backed securities (MBSs). A hybrid REIT invests in both. REIT shares trade on the open market, so they are easy to buy and sell.

The common denominator among all REITs is that they pay dividends consisting of rental income and capital gains. To qualify as securities, REITs must pay out at least 90% of their net earnings to shareholders as dividends. For that, REITs receive special tax treatment; unlike a typical corporation, they pay no corporate taxes on the earnings they pay out. REITs must continue the 90% payout regardless of whether the share price goes up or down.

REIT Dividends and Taxes

The tax treatment of REIT dividends is what differentiates them from regular corporations, which must pay corporate income taxes on their earnings. Because of that, dividends paid by regular corporations are taxed at the more favorable dividend tax rate, while dividends paid out by REITs do not qualify for favorable tax treatment and are taxed at ordinary income tax rates up to the maximum rate of 39.6% plus the separate surcharge on investment income of 3.8%.

A portion of a REIT dividend payment may be a capital gains distribution, which is taxed at the capital gains tax rate. Investors receive reports that break down the income and capital gain portions. Investors should only hold REITs in their qualified retirement accounts to avoid higher taxation.

The Power of Dividend Reinvestment

Generally, when dividends are paid out, investors receive them as checks or direct deposits that accumulate in investors' cash accounts. When that occurs, investors must decide what to do with the cash as they receive it. Many companies and an increasing number of REITs now offer dividend reinvestment plans (DRIPs), which, if selected, will automatically reinvest dividends in additional shares of the company. Reinvesting dividends does not free investors from tax obligations.

Not all REITs offer DRIPs; before making an investment, ensure the option is available. Also, find out about the REIT's transaction fees. Generally, DRIPs don’t charge any sales fees, because the shares are purchased directly from the REIT.

Most investors are aware of the power of compounding interest or returns and its effect on the growth of money over time. A REIT DRIP offers the same opportunity. Considering the higher yield of a REIT, a REIT DRIP can generate a higher rate of growth. REIT dividends can increase over time, which, when they are used to purchase additional REIT shares, can accelerate the compounding rate even further. REIT shares have the potential to increase in value over time, which increases the value of the holding as growing stocks tend to pay out even higher dividends. Even if the share price of a REIT declines, investors still benefit in the long run due to the dollar-cost averaging effect.

The Dollar-Cost Averaging Bonus

Dollar-cost averaging is an investment technique that takes advantage of declining share prices. For example, say an investor purchased 100 shares of a REIT at $20 a share, and it pays a $200 monthly dividend. The share price declines to $15 when the investor receives her first monthly dividend payment of $200, and it is reinvested in the REIT. The $200 dividend payment would then purchase 13 new dividend-paying shares at $15 a share. The total holding increases to 113 shares with a value of $2,195. The new cost basis for the total holding is now less than $19.50 a share.

When the share price increases, the dividend payment will purchase fewer shares, but the investor will generate a profit more quickly on her total holdings because of the lower cost basis. If the REIT's share price continues to increase and decrease, the cost basis should always be lower than the current share price, which means the investor always has a profit.

The Safety and Reliability of REITs

Many financial planners recommend holding some real estate for diversification. Many REITs have long track records of generating continuous and increasing dividends, even during the tumultuous real estate crisis of 2008. A solid-performing REIT typically invests in a large, geographically dispersed portfolio of properties with financially sound tenants, which can mitigate any volatility in real estate properties.

REITs are liquid investments, but, for the best possible outcome, they should be held within a properly diversified portfolio for the long term. By adding a DRIP to a REIT, investors build in significant downside protection.