Tax Cut Could Make
REITs Less Attractive

The real-estate industry is viewing the 2003 tax package as a mixed blessing.

While the dividend-tax cut may have a bit of downside for real-estate investment trusts, the capital-gains tax cut could be good for commercial real-estate owners.

Investors who own REIT stocks won't be getting the tax break on dividends that investors in other stocks will: REITs were excluded under the reasoning that they already don't pay corporate income taxes. (REITs -- mostly publicly traded real-estate companies that own commercial properties such as office buildings, apartment complexes and malls -- must pay out at least 90% of their taxable income in the form of dividends to shareholders, which exempts them from taxes.)

Investors in REITs still will have to pay a 38.6% tax on the dividends they receive, as opposed to the lower rate of 15% that will apply to non-REIT dividends, except in cases where REIT dividends are considered capital gains or result from taxed activity.

Dividends have been one of REITs' most-heavily touted attributes, leading them to stand out with investors seeking income-producing stocks. As of May 23, REITs' average yield was about 7%, compared with about 2% for the Standard & Poor's 500-stock index, according to Morgan Stanley. If other sectors begin increasing -- or start paying -- dividends, investors may look elsewhere for yields that are taxed at a lower rate.

Lee Schalop, analyst at Banc of America Securities in New York, said recently that the change could make REITs "relatively less attractive," at least in the short term. David Shulman, of Lehman Brothers, said the firm expects a "marginal shift in preferences" by investors who are dividend-income oriented away from REITs and toward standard dividend-paying corporations.

Falling stock prices of REITs would hurt their access to capital, meaning they couldn't issue equity and raise proceeds to expand their business either by purchasing more property assets or buying other real-estate companies. One alternative available to REITs would be to borrow, but if they borrow too much, they could jeopardize their credit ratings.

Meanwhile, there was broad agreement throughout the real-estate industry that the reduction of the tax on capital gains from assets sold to 15% from 20% would be good for commercial-property owners. "This will free up the equity in real estate to go out and invest in other projects, other real estate, or other spending," says Larry F. Soehren, president of Building Owners and Managers Association International, a Washington trade group representing 19,000 members, owners and managers across North America. "It's definitely a stimulus."

Industry leaders remain optimistic the popularity of REITs, which have outperformed companies in the S&P 500 index for the past three years, won't suffer as a result of the dividend exclusion. "We don't see this as a negative," said Steven A. Wechsler, president of the National Association of Real Estate Investment Trusts, a Washington trade group for REITs. "The fact is the average dividend provided by REITs on a pretax basis is about four times that of [companies in] the S&P 500 and about three times that of the S&P 500 after tax at the new rate. That's still a very significant difference."

Mr. Wechsler also said REITs remain attractive because their stocks tend to move in the opposite direction of the broader market and swing less wildly than stocks and bonds. As of late May, REITs posted a total return (stock price plus dividend) year to date of 12.6% compared with 6.7% for companies in the S&P 500 index, according to Morgan Stanley. In 2002, REITs posted an average return of 3.6% compared with negative 22.1% for the S&P 500.

Some financial planners who have a portion of their clients' portfolios invested in REITs or REIT mutual funds, said they weren't going to change their recommended allocations right now. But they left open the possibility they would if other kinds of companies start paying attractive dividends. Robert Tull Jr., a certified financial planner and owner of Tull Financial Group Inc., Chesapeake, Va., said he would consider altering the amount his clients hold in REITs if dividends offered by non-REITs became "compelling enough."

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