Another Hit to High-Yielding REITs?

Income-hungry investors have turned to real estate investment trusts for some of the highest yields in the market. But while many shareholders still have an appetite for investment income, several REITs could get news in the coming months that could cause an exodus from their shares.

Later in this article, I'll reveal what one analyst sees in the future for several real estate investment trusts, along with the impact it could have on their shares. First, though, let's review why REITs have become so popular in the past several years and the trends that have been affecting them more recently.

The REIT place for income
Real estate investment trusts are a special type of business entity. As their name suggests, REITs make investments that are related to real estate, whether in raw land, developed property, or in securities tied to real estate. The quirk in the tax code that makes REITs attractive to investors right now is that in order to get their beneficial tax treatment, REITs have to pay out the bulk of their income to shareholders in the form of dividends.

Because of that requirement, REITs have been a popular income-producing investment for years. During the real estate boom, investors could benefit not only from income but also from potential capital gains as REITs' underlying assets appreciated in value. Yet even after the real estate market tanked, the low interest rate environment that followed gave rise to highly profitable conditions for mortgage REITs. Annaly Capital (NYS: NLY) and Chimera Investment (NYS: CIM) were among the many mortgage REITs that capitalized on the profit opportunity, and investors jumped in for their double-digit dividend yields.

Saying goodbye to REITs?
But according to analyst Charles Behette of Investment Technology Group, some REITs could face a hurdle in the coming months. As quoted in Barron's, Behette expects that at the next rebalancing for the Russell 2000 index, several REITs, including Invesco Mortgage Capital (NYS: IVR) , RAIT Financial (NYS: RAS) , and Dynex Capital, will be taken out of the small-cap index.

That may not sound like a huge deal. But with trillions of dollars around the world tracking various Russell indexes, including the Russell 2000, the impact of additions or deletions from the index can be enormous. Especially for smaller, less popular REITs, the loss of index-related volume can also make their shares far less liquid, leaving investors with much more perilous conditions in which to buy and sell shares.

The deletions result from a change in the methodology that Russell uses to figure out which companies go into the index. For the first time this year, Russell plans to add a screen to exclude REITs and publicly traded partnerships that generate unrelated business taxable income. The move will make things a lot less complicated for investors who hold index-linked investments in retirement accounts, where UBTI can cause big problems including the potential loss of tax-exempt status. That's the reason Behette also expects Compass Diversified (NYS: CODI) to exit the Russell 2000 as well, despite its being organized as a partnership rather than a REIT.

Be on the lookout
In many years, stocks that are set to enter or exit the Russell 2000 end up trading with increased volatility in and around the month of June, when Russell figures out which companies are likely to be affected by its rebalancing. Therefore, if such volatility would be problematic for your investing strategy, then now's the time to start thinking about how to deal with it. If enough people get out of these REITs anticipating the Russell move, then share prices could drop from lack of demand.

As long as investors need income, REITs will stay popular. But in choosing the best investment, you shouldn't ignore what index-related maneuvers could do to certain REITs.

If you need income, there are other ways than REITs to get it from your investments. Get help from The Motley Fool's special report on retirement investing, where you'll learn three stock names that could help you reach your financial goals. It's free, so get your free report today and start preparing for a richer retirement.

At the time thisarticle was published Fool contributor Dan Caplinger knows you can have too much of a good thing. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy helps you keep your guard up.

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