REITs: Real Estate Investment Trusts
Discover which REIT is right for your investing portfolio.
It’s important that we as investors expand our dividend investing world to include Real Estate Investing Trusts (REITs), which currently average a dividend yield of 3.04%, as represented by the FTSE NAREIT All REITs Index (^FNAR)—considerably higher than the 1.3% average yield of the companies in the S&P 500 Index. After the subprime mortgage crisis decimated the real estate market a few years ago, it seemed like housing prices would never recover. But as you can see in the following chart of real estate prices, the national average has recovered very nicely since then.
S&P Dow Jones Indices LLC, S&P/Case-Shiller U.S. National Home Price Index [CSUSHPINSA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CSUSHPINSA, December 14, 2021. Importantly, with the economy continuing to improve, and interest rates still very low, most economists believe there is still plenty of room for growth. And the growth is not just in residential real estate. Just about any subsector you can think of—apartments, offices, healthcare, and hotels—have all prospered with the recovery. Many investors have reaped those rewards. But, let’s face it, most of us don’t have deep enough pockets to be able to invest heavily in real estate, and we probably couldn’t comfortably weather a major downturn, waiting for the next up-cycle. And both of those reasons—high investment dollars required, as well as the associated risks—have played an important part in the rapid expansion of the REIT industry. REITs were created in 1960 by an act of Congress to allow individual investors to participate in the ownership (and profits) of large-scale, income-producing real estate properties. Like mutual funds, they allow individual investors to “pool” their monies to invest, while sharing the risk of the investments. They are also excellent tools when used to diversify your portfolio as well as to allocate your assets. And, as with mutual funds, they are professionally managed. But REITs have one tremendous selling point not shared by most mutual funds—high dividend yields. By law, REITs must return at least 90% of their taxable income to their shareholders, annually, which generally translates into very nice yields for the REIT investor, making these investment vehicles very attractive. But dividends tell just part of the story. For the 20 years leading up to the pandemic, REITs have more than held their own against the broad market, gaining 13.3% (FTSE NAREIT index, including appreciation and dividends), compared to the S&P 500’s 7.7% return. And during periods of stock market volatility and economic uncertainty, REITs will generally outperform the broader markets. There’s a REIT for Everyone Most real estate investment trusts (REIT) own—and usually operate—income-producing properties. There are three primary types: 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 (FNMA) and Freddie Mac (FMCC), government-sponsored enterprises that buy mortgages on the secondary market. Hybrid REITs own properties and make loans to real estate owners and operators. Today, there are some 185 REITs that trade on the New York Stock Exchange, with a total market capitalization of $1.104 trillion. As you can see from the following table (Figure 9), REITs tend to specialize in a particular type of real estate property.
What about Rising Interest Rates? REITs are often discarded when rates are rising (like they are now), but that strategy is frequently misguided. Many investment pros sound the alarm on REITs in rising interest rate conditions, making investors fear not only the loss of generous dividends, but also potential stock collapses. That misconception is far from the truth. Why? It’s based on the assumption that as rates rise, REIT profits will erode, and stock prices will decline. In theory, that looks right, as generally when rates rise in a fixed-income instrument like a bond, prices generally fall. And with mortgage REITs, that’s sometimes true. Many are leveraged to the hilt, so rising rates will usually negatively impact their prices. But for some mortgage REITs and most equity REITs, that notion doesn’t prove out. The following graph (Figure 10) was published in Forbes and shows a more complex picture. It plots monthly data over the past 10 years between 10-year U.S. Treasury Futures and the MSCI US REIT Index (RMZ) and indicates that while there is some correlation between rate hikes and REIT price declines, the most significant correlation is when rates suffer a sharp hike. In contrast, with gradual rate increases, the correlation declined. That’s because gradually rising rates indicate an improving economy, and for REITs, that can mean rising rents and lower vacancy rates, which leads to more profits, and better stock prices.
For the investor, however, when rates begin to rise, REIT investors tend to panic, and that may cause REIT prices to temporarily slide—a buying opportunity, in my opinion. So, the question is, which REIT categories will likely do just fine in a rising rate environment? The tables below (Figure 11) show REIT beta (a measure of volatility) to the S&P 500, as well as to yields. (A higher beta indicates a higher level of volatility.)
You can see that hotel REITs are the most volatile as compared to the S&P 500, which makes sense, as they are also very economically-dependent, but the least volatile when it comes to yield, and that’s because their cash flow is short-term. As long as the economy continues to improve, hotel REITs should also, as consumer discretionary buying rises. Alternatively, Net Lease REITs show the most volatility to yields, which also seems right, as their long-term contracts—while inflation-adjusted—may not keep up with quick rate rises, but they are the least volatile, compared to the S&P, because they have long-term steady cash flow. But these REITs have been known for dividend safety, good steady income, with decent rates, so gradual rate increases shouldn’t bother them too much. So, it’s obvious your investing decision in REITs is not just a function of beta. It’s more involved than that. While rates and economic factors are important, investors must also pay attention to the fundamentals. That means a bit of research, including:
- Revenues and earnings should be growing at a sustainable level. Debt should be reasonable, and the leverage should be used to grow the REIT’s top and bottom lines.
- Compare four quarters of funds from operations (FFO) to the REIT’s annual dividend payments. That is the dividend coverage ratio, which should be more than 1:1, meaning the REIT is earning more than it pays out in dividends.
- Dividend track record—is it stable? Has the dividend been cut? One important note: If the yield looks outrageously high compared to the industry, it may be an indication of too much risk.
- Review the portfolio, including the vacancy rate history, credit ratings of its holdings, and diversification. Find out the geographic regions in which the REIT invests. Check out housing prices, condo conversion rates and the current apartment rental market.
- Valuation of REITs is every bit as important as with any other stock. It’s best not to overpay; that way, you get the benefit of appreciation plus a handsome and steady cash flow.
If your REIT idea meets most of these criteria, exhibiting fundamental strength and value, then this may be an opportune time to add some steady cash flow to your portfolio. I’ve always loved real estate; in fact, I own a small real estate franchise. I love the idea of a diversified real estate portfolio and REITs fit the bill. They have been excellent investments for my subscribers over the years as they offer the perfect opportunity to buy real estate with very little capital. And I believe the boom cycle in real estate is far from over, and REITs make an ideal investment—without the costs or risks associated with actually owning real estate. This concludes my Dividend Investing focus.