Q: There seem to be concerns with investing in REITs, particularly international REITS. Some seem to feel this asset class is too volatile. What are your thoughts?
A: My colleague Kevin Grogan, who co-wrote The Only Guide You'll Ever Need for the Right Financial Plan with me, wrote the following response to the above question.
This is a question we get often, and we do find certain aspects of international REITs attractive. As the saying goes: "All real estate is local," which is why international REITs have had historically low correlations with equities. Thus, they're excellent diversifiers of risk.
There are, however, three tax efficiency issues that should concern investors considering international REITs.
Tax Inefficiency of REITs In general, REITs aren't tax efficient investment vehicles, because most of the income they provide is considered either ordinary income or non-qualified dividends. A non-qualified dividend isn't eligible for the preferential tax treatment that qualified dividends receive. In addition, REITs provide much of their return in the form of current income.
Tax Treatment of International REITs Some international REITs are treated as passive foreign investment companies (PFICs) for US income tax purposes. A problem is created because PFICs must mark-to-market their portfolios on an annual basis. Thus, what would otherwise be unrealized gains is converted into income that must be recognized for US tax purposes. In addition, such income is treated as ordinary income. The tax inefficiency created by this situation means investors who aren't in the lowest tax bracket should only hold international REITs in tax-advantaged accounts.
Withholding Taxes on International REITs Foreign governments withhold taxes on dividends in many cases. For taxable accounts, the investor may be able to claim a foreign tax credit for at least a portion of the taxes withheld. Unfortunately, the tax credit has no value for assets held in a tax-advantaged account.
International REITs are an attractive asset class due to their diversification benefits. However, you must consider the asset location concerns we have discussed. The bottom line is that there's no perfect location to hold international REITs. Taxable accounts would be an inefficient location for all investors except those in the lowest tax bracket. Holding international REITs in a tax-advantaged account also creates a tax inefficiency (though a much smaller one) due to the loss of the foreign tax credit. Although the cost of the inability to get a credit for foreign taxes paid depends on the individual fund's holdings, you can use as a rough estimate that the cost will be about 10 percent of the dividend yield.
When deciding on whether to allocate to international REITs, you must weigh the diversification benefits against the total costs of investing in the asset class. For those who value the significant diversification benefits, the benefits will likely exceed the costs.
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