Do REITs deliver better long-term return than C-corps due to tax savings?

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EpsilonDelta
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Do REITs deliver better long-term return than C-corps due to tax savings?

Post by EpsilonDelta »

"In this world nothing can be said to be certain, except death and taxes." - Ben Franklin.
It is also certain that, other things being equal, lower tax bills must mean higher return on your investment.

Since REITs do not pay corporate tax, can we say that they have higher expected return insofar as their tax savings with respect to C-corps? A simplistic example: since US corporate income tax rate is 21%, a C-corp with P/E = 10 would pay 2.1% of its market cap as income tax per annum; a REIT with P/FFO = 10 would not pay tax; therefore, the REIT would have 2.1% higher expected return than the C-corp ceteris paribus.

(1) Is my understanding correct? or am I missing something about corporate taxation in C-corps vs REITs?
(2) If so, what would be its implication in one's portfolio construction and optimization?

Of course, I recognize that (i) REIT distributions are not tax-efficient in taxable accounts, and (ii) taking greater sector-specific risk may not suite everyone, particularly those with limited investment horizon. Still, could we recommend a significantly larger-than-market allocation in REITs for young investors who can (i) tolerate potentially greater volatility, (ii) accommodate REIT allocation in Roth IRA, and (ii) have long investment horizon?

David Swensen recommended 15% allocation in REITs in Unconventional Success (source: https://www.bogleheads.org/wiki/Lazy_po ... _portfolio). Could his experience of managing Yale endowment, a tax-sheltered long-term investment, have played a role in his recommendation to overweight REITs?
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squirrel1963
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Re: Do REITs deliver better long-term return than C-corps due to tax savings?

Post by squirrel1963 »

I keep about 10% of the equity portion in Vanguard US REIT fund in tax deferred.
LMP | Liability Matching Portfolio | safe portfolio: TIPS ladder + I-bonds + Treasuries | risky portfolio: US stocks / US REIT / International stocks
gougou
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Re: Do REITs deliver better long-term return than C-corps due to tax savings?

Post by gougou »

What about MLPs? They also pay no tax at the entity level, and their effective dividend tax rate is even smaller than REITs and C-corps.
The sillier the market’s behavior, the greater the opportunity for the business like investor.
petulant
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Re: Do REITs deliver better long-term return than C-corps due to tax savings?

Post by petulant »

One theoretical point you are missing is that the real estate assets eligible for REITs may involve lower pretax expected returns than business activities included in a typical C corp. For example, if the typical C corp has an expected pretax ROE of 13.5% and aftertax ROE of 10%, while the REIT has a pretax ROE of 10% all of which is distributed, then there is no difference. Further, the widespread availability of an advantageous structure like the REIT would be expected to cause this outcome--that is, once Congress creates the tax preference, all assets eligible for the tax preference should quickly increase in value until aftertax returns are equivalent.

In reality, the effect mentioned above would be complex to measure since business activities typical of C corporations involve greater tax advantages than real estate, such as even more aggressive depreciation schedules.

Given the factors above, there might be a tax arbitrage opportunity if the capital market reaches an equilibrium only for some taxpayers, leaving some to reap greater benefits. For example, there is some reason to think that municipal bond interest, generally not taxed to individual taxpayers, creates a windfall to the wealthiest taxpayers in the 37% bracket because the municipal bond market reaches equilibrium with taxable bonds at modest marginal tax rates like 24%. (IOW TEYs might be the same around 24%, so that TEYs for municipal bonds would be much higher for 37% taxpayers.) In this case, taxpayers with no or very low tax brackets such as families unable to fill the standard deduction or charitable endowments would reap a windfall by shielding any of the real estate income from tax. This would only be relevant, though, if such investors otherwise had strong views on the expected returns of REITs vs. stocks, rejected or discounted diversification benefits, etc.

Generally, I wouldn't get worked up about the REIT tax preference as an individual investor.
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EpsilonDelta
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Re: Do REITs deliver better long-term return than C-corps due to tax savings?

Post by EpsilonDelta »

petulant wrote: Wed Aug 17, 2022 5:04 pm One theoretical point you are missing is that the real estate assets eligible for REITs may involve lower pretax expected returns than business activities included in a typical C corp. For example, if the typical C corp has an expected pretax ROE of 13.5% and aftertax ROE of 10%, while the REIT has a pretax ROE of 10% all of which is distributed, then there is no difference. Further, the widespread availability of an advantageous structure like the REIT would be expected to cause this outcome--that is, once Congress creates the tax preference, all assets eligible for the tax preference should quickly increase in value until aftertax returns are equivalent.

In reality, the effect mentioned above would be complex to measure since business activities typical of C corporations involve greater tax advantages than real estate, such as even more aggressive depreciation schedules.

Given the factors above, there might be a tax arbitrage opportunity if the capital market reaches an equilibrium only for some taxpayers, leaving some to reap greater benefits. For example, there is some reason to think that municipal bond interest, generally not taxed to individual taxpayers, creates a windfall to the wealthiest taxpayers in the 37% bracket because the municipal bond market reaches equilibrium with taxable bonds at modest marginal tax rates like 24%. (IOW TEYs might be the same around 24%, so that TEYs for municipal bonds would be much higher for 37% taxpayers.) In this case, taxpayers with no or very low tax brackets such as families unable to fill the standard deduction or charitable endowments would reap a windfall by shielding any of the real estate income from tax. This would only be relevant, though, if such investors otherwise had strong views on the expected returns of REITs vs. stocks, rejected or discounted diversification benefits, etc.

Generally, I wouldn't get worked up about the REIT tax preference as an individual investor.
Thank you for the feedback! It looks like the case for classical aphorism, "don't let your tax tail wag your portfolio."
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EpsilonDelta
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Re: Do REITs deliver better long-term return than C-corps due to tax savings?

Post by EpsilonDelta »

gougou wrote: Wed Aug 17, 2022 4:46 pm What about MLPs? They also pay no tax at the entity level, and their effective dividend tax rate is even smaller than REITs and C-corps.
MLPs are intriguing, but I believe they are impractical for most investors.
Holding individual MLPs create massive K-1 hassles; I'm certainly not gonna do that in this lifetime.
MLP funds are organized in three ways: (i) C-corp, (ii) ETNs, (iii) RIC-compliant funds. I believe that none of them are appropriate for the majority of investors (Disclaimer: I could be wrong in below points)
(i) C-corp MLP funds must pay tax on distribution they receive. You thus put the corporate tax you wanted to avoid right back there!
(ii) ETNs are bonds, so their distributions are taxed bond-like, so they are not tax efficient if held in taxable account. Plus, you are now exposed to single-company counterparty risk.
(iii) RIC-compliant funds must have <25% limited partnerships, meaning that, to have relevant MLP exposure (say 5%), you need to allocate 20% of your portfolio to these funds. Since most of their holdings are also in energy and utilities, you are allocating 20% of your portfolio in energy and utilities: a massive sector-specific risk.
gougou
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Re: Do REITs deliver better long-term return than C-corps due to tax savings?

Post by gougou »

EpsilonDelta wrote: Wed Aug 17, 2022 5:46 pm
gougou wrote: Wed Aug 17, 2022 4:46 pm What about MLPs? They also pay no tax at the entity level, and their effective dividend tax rate is even smaller than REITs and C-corps.
MLPs are intriguing, but I believe they are impractical for most investors.
Holding individual MLPs create massive K-1 hassles; I'm certainly not gonna do that in this lifetime.
MLP funds are organized in three ways: (i) C-corp, (ii) ETNs, (iii) RIC-compliant funds. I believe that none of them are appropriate for the majority of investors (Disclaimer: I could be wrong in below points)
(i) C-corp MLP funds must pay tax on distribution they receive. You thus put the corporate tax you wanted to avoid right back there!
(ii) ETNs are bonds, so their distributions are taxed bond-like, so they are not tax efficient if held in taxable account. Plus, you are now exposed to single-company counterparty risk.
(iii) RIC-compliant funds must have <25% limited partnerships, meaning that, to have relevant MLP exposure (say 5%), you need to allocate 20% of your portfolio to these funds. Since most of their holdings are also in energy and utilities, you are allocating 20% of your portfolio in energy and utilities: a massive sector-specific risk.
OK, but REITs are 100% real estate, so I guess there's also a massive sector-specific risk as well. Even if REITs deliver a better tax-adjusted long-term return, that may not compensate for this sector risk.

I personally don't find K1s complicated. And you can hire a CPA to do it for $50 or less.
The sillier the market’s behavior, the greater the opportunity for the business like investor.
loukycpa
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Re: Do REITs deliver better long-term return than C-corps due to tax savings?

Post by loukycpa »

Assuming tax policy and rates stay constant, I don't think REITS will have a higher risk adjusted return versus other corporations that are subject to corporate income tax because of their tax status. If you believe the market is efficient and investors are rational (especially over the long term), corporate tax burden is already reflected in share prices set by the market. Investors are looking and comparing after tax earnings and cash flows when they evaluate one company versus another.
"The safe assumption for an investor is that over the next hundred years, the currency is going to zero." - Charlie Munger
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JoMoney
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Re: Do REITs deliver better long-term return than C-corps due to tax savings?

Post by JoMoney »

You could probably find individual examples where that's the case, but broadly speaking, no.
Keep in mind that publicly traded securities are priced by the market, and if there is some segment that expects higher return the market price can and would (eventually) adjust to some equilibrium price.
Real estate investments have limited growth potential outside of buying new properties, yet they can frequently have influxes of new investment capital that needs to be deployed. If some particular REIT is doing well, new investors will come in, and it's a rare situation that whatever new property it buys is as good/profitable as the portfolio it already owned, and similar to how an active mutual fund manager that performs well when small but can't scale up with new cash inflows something similar can happen to a REIT - even worse with a REIT the return on their existing equity can become diluted as the REIT acquires more and more properties, and unfortunately there is a principal agent problem with the REITs management generally more than happy to expand their domain by accepting new money inflows.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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