The power of dividend reinvestment in REITs
Once upon a time in the United States, ordinary savings accounts paid over 5% interest. The May 31, 1979, issue of The New York Times reported that federal regulators were allowing commercial banks to pay 5.25% interest on their savings accounts, while savings and credit unions and credit unions mutual savings could pay up to 5.5%.
The reason for such a “high” rate of return was the inflation rate in 1979 – 11.35%. Inflation was a problem throughout the 1970s – anyone remember President Gerald Ford’s 1974 program called “Whip Inflation Now” or “WIN”? The program had little effect. Inflation fell in the late 1970s, but exploded by the end of the decade. It peaked in April 1980 at 14.76%. By comparison, the current US inflation rate in April 2022 is 8.3%.
To secure more deposits when they were able to pay higher interest on their accounts, banking and savings and loan marketing programs in the late 1970s and early 1980s touted the importance compound interest. Compound interest earns interest on the interest you’ve already earned. Some famous quotes about compound interest have been attributed to Benjamin Franklin and Albert Einstein. Whether or not they actually said these things is up for debate, but the statements are still quite informative:
Benjamin Franklin: “Money makes money. And the money that money makes, makes money.
Albert Einstein: “Compound interest is the eighth wonder of the world. He who understands it, wins it; whoever does not, pays for it. (Albert Einstein died in 1955. The earliest reference to this quote is in a 1983 New York Times blurb).
Investor.gov, of the United States Securities and Exchange Commission (SEC), describes compound interest as follows:
Compound interest is the interest you earn on interest. This can be illustrated using basic math: if you have $100 and it earns 5% interest each year, you will have $105 at the end of the first year. At the end of the second year, you will have $110.25. Not only did you earn $5 on the initial deposit of $100, but you also earned $0.25 on the $5 interest. While 25 cents may not seem like much at first, it adds up over time. Even if you never add another penny to that account, in 10 years you’ll have over $162 thanks to the power of compound interest, and in 25 years you’ll have almost $340.
Dividend reinvestment is the ninth wonder of the world
If compound interest is the eighth wonder of the world, compound dividends – especially dividends from real estate investment trusts (REITs) when reinvested in more stocks – are the ninth wonder of the world.
Banks no longer offer regular 5.5% savings accounts like they did in 1979. It is extremely difficult today to earn substantial interest on fixed income accounts. The highest paying savings account as of June 9, 2022 earns only 1.25% interest.
Such a low interest rate, even when compounded, offers little to those dependent on fixed income assets, such as retirees. On top of that, when there is an annual inflation rate like today of 8.3%, people living on fixed income instruments fall behind daily. In a very real and personal way, they realize their continuing decline in purchasing power every time they put gas in their vehicle or shop at the grocery store.
REITs offer the potential to increase principal. REITs often increase stock prices, even more than the general stock market. The National Association of Real Estate Investment Trusts (Nareit) measures the performance of equity REITs daily. For the 20-year period ending December 2019, the FTSE Nareit All Equity REITs Index measured that REITs outperformed the Russell 1000 11.6% versus 6.29%.
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Comparison of Compound Interest and Compound Dividends
Let’s compare the interest from fixed rate savings accounts with the potential returns from REITs. An important difference between these savings accounts and REITs is their level of risk. Although REITs are generally considered less risky than stocks, they still carry risk. For example, when you deposit $10,000 into a savings account—called “capital”—you know you’ll get your capital back. With a REIT, return of capital is not guaranteed. When you buy into a REIT, you are investing; When you deposit money in a bank account, it is considered savings.
In this example, the first investor puts money into a savings account that pays 4% interest – this rate is only used as an example because you might not find a savings account today paying that interest rate. Due to compound interest, the amount of the savings account increases each year, although the interest rate remains the same at 4%.
After a period of 30 years, this savings account increases by more than three times its value. If the investor is able to maintain the savings account for 50 years, its value will increase by more than seven times more than what was originally deposited.
The second investor uses the money to buy several shares of a REIT, using an online brokerage account. Dividends are reinvested in more shares of the REIT. Suppose this REIT pays a dividend of 4% (which is the same as the interest rate the first investor earned in a savings account). The major difference comes from the potential for the REIT’s share price to increase by 3% each year, which is not unreasonable for a REIT, even if this growth is not guaranteed.
After 30 years, the REIT shares of the second investor in this example would have risen more than 7.5 times more than the initial deposit. If the investor can hold the REIT shares in the brokerage account for 50 years, the value has the potential to grow more than 30 times the initial deposit.
If your personal risk tolerance and financial situation allow it, what choice would you make, especially in an inflationary environment?
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