Real Estate Investment Trusts
High Yields, Diversification and a Liquid Way to Own Real Estate
By Nancy Zambell,
Editor of Investment Digest and Dividend Digest
During bull markets, there’s a category of equities that’s often ignored by mainstream investors. But during periods of market uncertainty, it’s a category that they run to for security—and some very high dividends.
Yet what most retail investors don’t realize is that this particular sector often generates outstanding returns in many market scenarios, as you can see in the table below. That’s because the big money—the institutional investors—often park their money in these equities to diversify their portfolios and to help them mitigate any losses among the rest of their holdings.
The sector I’m talking about is Real Estate Investment Trusts (REITs). Like mutual funds, REITs allow investors to pool their money to purchase shares in a larger group of investments—in this case, real estate or real estate-related investments. The underlying properties can be office buildings, land, apartment complexes, hotels, shopping centers, warehouses, single family homes and even real estate mortgages.
By pooling their money, investors can easily participate in the ownership (and profits) of large-scale, income-producing real estate properties and mortgages—for a lot less money, risk and headaches than if they owned each of those properties outright.
I’ve always retained a few Real Estate Investment Trusts (REITs) in my investment portfolio—through bull and bear markets, good and bad economic cycles and periods of rising and falling interest rates.
There are a lot of good reasons for this strategy. REITs offer:
- Portfolio protection. Most of the time, the prices of real estate do not correlate exactly with REITs, so the REITs in your portfolio can help protect your returns if the stock market corrects.
- Diversification of assets. Pooling your funds with thousands of other investors allows you to participate in a selection of real estate properties that you probably wouldn’t be able to purchase—or afford to maintain—on your own. Also, diversification among many properties and/or mortgages and often, geographic regions, provides some safety if one property or region doesn’t perform as expected.
- They’re professionally managed by folks who know the real estate market in and out.
- They’re secured by the tangible value of the physical real estate properties or mortgages that make up the REIT
- Liquidity. About 166 REITs are currently registered with the Securities and Exchange Commission (SEC) and most are traded on national stock exchanges. Unlike real investment property that can take months, or even years to sell, you can easily buy and sell shares of REITs all day long—just like any other stock.
But there’s one even more important reason why REITs have often flourished … they tend to offer outsized dividend yields.
You see, by law, REITs have to pay out at least 90% of their taxable income to their shareholders every year in order to avoid paying corporate taxes. That translates into nice yields for REIT investors, and makes them very attractive for income investment.
According to the National Association of Real Estate Investment Trusts (NAREIT), the average dividend paid by REITs in 2006 was 3.69%. Just seven years later, in 2013, they paid out $29 billion in dividends, with an average yield of 5.45%. That kind of income is nothing to sneeze at—or ignore.
In fact—in certain periods of economic cycles—it’s not uncommon to see yields as high as 21% in this sector.
Usually a high yield like that could be a sign of trouble, as it’s very difficult to sustain that payout level for a long period of time. But during opportunistic cycles, it’s smart to take advantage of these high payouts, as long as the fundamentals are there. Generous dividends can significantly add to your overall portfolio returns.
REITs are Highly Diversified
Savvy investors realize that portfolio diversification is very important, to help you protect your holdings in case one particular stock, sector, or industry should be impacted by adverse events. Owning REITs is a great way to add a different kind of asset to your portfolio.
REITs are divided into three categories: equity REITs (91%), mortgage REITs (7%), and hybrid REITs (2%).
Equity REITs primarily own and operate income-producing real estate, but have become diversified into additional real estate activities, including leasing, maintenance and development of real property and tenant services.
Mortgage REITs lend money directly to owners and operators of real estate or acquire loans or mortgage-backed securities. Many of them also manage their interest rate and credit risks using derivative strategies such as securitized mortgage investments and dynamic hedging techniques. Their best-known investments are Fannie Mae and Freddie Mac, government-sponsored enterprises that buy mortgages on the secondary market.
Hybrid REITs own properties and make loans to real estate owners and operators.
And categories of REITs are further diversified by the types of properties or investments they own:
You can see how easy it is to participate in a diverse number of real estate properties by owning REITs, and you’ll never get that midnight call to fix a leaky roof!
Rating the REITs
But … before you invest, I want to give you some tips on selecting the right REIT. Just as with any stock, while the sector can look very promising, not every stock in the sector will prove a winner. So to help you weed out the losers, here are some of the criteria that I rate REITs by:
- Is it currently trading at an undervalued level? Look at the REIT’s P/E ratio, compared to its own historical trading level, as well as that of its peers.
- Debt should be reasonable, and the leverage should be used to grow the REIT’s top and bottom lines.
- Cash is king! It helps stave off the hungry wolves in bad times and gives a company significant flexibility in expansionary cycles.
- If the yield looks outrageously high compared to the industry, it may be an indication of too much risk.
- Revenues and earnings should be growing at a sustainable level.
- Is management active or have they passed their duties onto some operating entity?
- Find out the geographic regions in which the REIT invests. Check out housing prices, condo conversion rates and the current apartment rental market.
- Are the company’s tenants strong and credit-worthy (can they pay their rent?)
- Evaluate the FFO. Depreciation tends to overstate the property value decline of an investment. So instead of using the payout ratio that most dividend investors are interested in to evaluate your REIT, look at its funds from operations (FFO) instead. FFO is equal to net income minus the sale of any property in a given year and depreciation. So to get the yield, divide the dividend per share by the FFO per share.
- Consider your tax situation. Because the dividends are usually hefty, REITs are sometimes best-suited for your retirement funds, but please consult your tax advisor.
Alternatively, you might consider a REIT index fund, mutual fund or exchange-traded fund. Many financial websites offer screens to determine the best funds and ETFs; two of my favorites are:
And http://www.reit.com/nareit provides a wealth of industry information as well as total industry and sector indexes.