Is Now A Good Time To Have More Tactical REIT Exposure To Increase Dividend Income?

Includes: DLR, O, VER
by: Brad Thomas

Earlier this week I wrote an article, Is It Time to Double Down in REIT Town?, in which I examined the "buying opportunity emerging in REITs" and I warned that "before jumping back in" investors should "make sure they read the fine print". More specifically, I explained that "REITs are becoming an attractive buying opportunity for income-seeking investors willing to risk more price declines in the near term".

My argument for buying into a REIT selloff is simple: If you think the economy is going to improve, you should own REITs. I believe now is a good time to have more tactical REIT exposure today simply based upon the premise that REIT prices are down but the economy is not. I'm not advocating that investors should take the "labor day plunge" and begin loading up REIT shares. In fact, I warn the "market timers" to "be prepared for increasing volatility, and don't expect REITs to go straight up to new highs like we saw prior to May. Those days are over, at least for a while."

So how can I can I wave the yellow flag of caution and the green flag of buying at the same time? Especially since no one knows the extent of the REIT sell-off and whether or not REITs will trade lower in the near term.

Here's why. An income investor should take advantage of the market opportunity to increase their dividend income - that's the green flag. That intelligent dividend investor should recognize that now is a terrific time to put their money to work and although REIT prices are down, fundamentals are strong and the economy is improving. Simply said, there is a window of opportunity to build a solid portfolio of income stocks that will pay off over time.

Remember that it's much better to be in an environment with increasing fundamentals and rising rates, versus decreasing fundamentals and lowering rates. Over the long term, REITs have proven to be a good hedge against inflation because of an ability to raise rents in an inflationary environment. Real estate has low correlation with the broader market, which increases return and reduces risk, and really completes an asset allocation model.

Now, Let's Go Shopping For Some Dividends

Recently I ran across an article on the website, Buy Like Buffett. I thought the article, 10 D's of Dividend Investing, was loaded with good tips so I decided to use it to demonstrate some very sound REIT securities (Note: I used 8 out of 10 tips in this article).

Tip #1: Dividend Growth Over Dividend Yield - One of the most tempting things to new dividend investors are high yielding stocks. Many of the highest yielding stocks are made up of income trusts or companies ready to make a dividend cut, similar to what the banks experienced a few years ago. Instead of focusing only on dividend yield, investors should be looking at dividend growth. A company that continues to increase its dividend by 10% every year with a low yield is much better than investing in an unstable company with a current 10% yield.

Utilizing an SNL Financial filtering tool, I prepared the chart below that illustrates REITs that increased annual dividends by at 10% or greater from 2011-2012. Note, American Realty Capital Properties (ARCP) went public in 2011 so the dividend increase of 204% was not a year-over-year calculation.

The chart below illustrated these 15 REITs that increased dividends from Q1-13 through Q2-13.

Tip#2 Dividend History - Most of the time, the past is no prediction of the future. However, when it comes to the top dividend paying stocks, a company's dividend history can give investors some hints about the future. The dividend aristocrats index, published by Standard and Poor's each year is a good place to start. The index only includes companies that have consistently raised their dividends for at least the past 20 year's annually.

Most Seeking Alpha readers know that David Fish produces a monthly DRiP Investing report that lists US companies that have paid and increased dividends repeatedly. By filtering the stocks, Fish categorizes them into three buckets: (1) the champions (25 or more straight years of higher dividends), (2) contenders (10-24 straight years of higher dividends), and (3) challengers (5-9 years of higher dividends). There are 16 US Equity REITs that are included in the combined champion, contender, and challenger categories.

Tip #3 Don't Overpay for Dividend Stocks - There are growth stocks and then there are blue chip dividend stocks. Investors should never overpay for a dividend stock. Even the best investments go on clearance every once in a while. Dividend stocks are no different and investors should never overpay to own them.

One of the best ways to determine the value of a REIT is by utilizing the price-to funds-from operations ratio. In a previous article I explained that price-to-earnings had no meaning in REIT-dom since P/FFO is a more standardized metric that analysts use to compare earnings. As I wrote:

By utilizing price to FFO valuation, analysts and investors can determine the trading history of each REIT by itself and relative to the entire REIT sector. Accordingly, payout ratios are based on AFFO (adjusted funds from operations) because it more accurately measures cash flow when compared to net income (due to depreciation), and given the contractual nature of lease payments today, earnings growth rates are higher than the S&P.

The trending selloff in REIT-dom has provided investors with better entry points - some fairly valued and some bargains. Here is a snapshot of several REITs with attractive valuations (as seen in my recent article):

Tip #4 Dollar Cost Averaging - Dollar cost averaging is a good technique to use for any long term portfolio. The idea is to make equal purchases of a stock that are spread out over a couple months (or years). This prevents an investor from overpaying for a stock and helps bring an investment to actual market levels. Anyone in a company sponsored retirement plan is probably already dollar cost averaging their investment. Every time you contribute money from your check to your 401k, you are using this technique.

The latest REIT selloff has provided investors with a good opportunity to take advantage of dollar cost averaging.

Tip #5 Diversify - Every investor has probably heard analysts talk about diversification. It is important to own stocks from different sectors in order to limit exposure to one particular industry. Diversification is probably even more important to a dividend investor.

In a previous article I wrote:

Your broad exposure to real estate should include minimizing tenant, property type, and geographic risk. To be properly diversified across geographic and property types, an intelligent investor should gain diversified exposure to commercial real estate mandated by the full spectrum of structured options. These options - customized, mutual funds, or ETFs - are becoming increasingly easy and that is also why it is essential that one should include diversification as part of your DNA.

Tip #6 Dividend Payout Ratio - We already know that dividend history and yield are important measures of income stocks. Dividend investors must also pay attention to the dividend payout ratio of a company as well. A company who continually increases their dividend each year could be a great investment opportunity. However, if the dividend increases are coming at the expense of earnings, then there could be a problem. The payout ratio will tell investors how much of a company's earnings are being used to pay the dividend to common shareholders.

Tip #7 Dividend Reinvestment Plans - A dividend reinvestment plan (NYSEARCA:DRIP) can provide a great opportunity to start dollar cost averaging in your portfolio. Either through your broker or directly through the company you are investing in, you can setup a DRIP which automatically reinvests dividends into more shares of stock. These plans are automated, don't charge commissions, and can help investors build wealth.

Earlier this year I wrote an article on REITs that offer direct investment plans. Here is the link.

Tip #8 Tip Discipline - Having discipline is important for all investors no matter what type of investment strategy they use. Dividend investors are no different to this stock tip. If you believed every rumor or the hype you hear on the news or internet, you would probably be tempted to buy stocks that are overpriced and sell ones in your portfolio that you shouldn't. Educate yourself, develop a trading strategy, and stick to it.

Why Should I Buy These Rate Sensitive Stocks?

The mistake in labeling commercial properties--and therefore equity REITs--as "interest rate sensitive investments" is wrong. They (REITs) just aren't very sensitive to interest rates, mainly because interest rates tend to move up with a strengthening economy (and down with a weakening economy). However, mortgage REITs are much more sensitive to rates since they are essentially "a spread business".

In my previous article I stated that:

Dividend investors should seize the day and take advantage of what I consider to be an attractive time for acquiring high quality REITs. Mr. Market has baked in the fear of rising rates when in fact; REITs have defensive mechanisms in place to deal with the gradual movements (in rates): long term debt (relatively little current or interim need to refinance) and durable current income (not subject to short term economic swings).

Here are 11 REITs that pay a dividend yield of at least 5%:

I thought this snapshot would provide you with an interesting comparison of Realty Income's (NYSE:O) dividend history with Digital Realty's (NYSE:DLR) history:

Also, the chart below provides some interesting comparisons with Realty Income's dividend yield and the 10-Treasury Note:

To boil it all down, what are your options for income today? Are you sitting on the sidelines waiting on rates to rise? So what happens when they do? The economy improves? So what happens then? That means the economy is better right? Then rents rise, right? So, what are we worried about? Maybe, we're worried about the loss of doing nothing at all?

So what's wrong with this picture?

The author is also the Editor of a monthly REIT newsletter called The Intelligent REIT Investor.


Source: SNL Financial

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.

Disclosure: I am long O, CSG, DLR, VTR, HCP, HTA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.