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"Appearances are often deceiving." - Aesop

When investors look into income investments, such as bonds, MLPs, closed-ended funds and real estate investment trusts, one of the first considerations is yield. Like a hungry wolf, the appearance of a higher relative yield looks very appealing to the income investor.

The main goal of an income portfolio is to mitigate risk while maximizing income. While capital must be preserved, each additional percentage point of yield makes a huge difference to the bottom line. For example, the difference between one percentage point of annual yield on a $600,000 portfolio is $6,000 per year, or $500 per month.

For example, if an investor is taking 4% annual distributions on a monthly basis with a $600,000 portfolio, then the cash payments would be $2,000 per month. Up that distribution level to 5% and the payment is increased to $2,500, while 6% leads to $3,000 and so on. The additional yield can add up very quickly.

Building A Balanced Income Portfolio

When investing in stocks, bonds, commodities and cash-equivalents, the equity portion of an income portfolio often consists of an allocation to real estate investment trusts (REITs). U.S. REITs must pass on at least 90% of taxable income to their shareholders by law and as such, the REIT market yields higher than the general market.

A great starting point for an income portfolio is to attain an aggregate yield over 4%, such that 4% of the annual portfolio value can be distributed on a monthly basis. By yielding over 4%, the portfolio generates additional cash for the year and cushions the investor against any unforeseen dividend decreases.

Defining The Yields On Equity REITs

In today's interest rate environment, U.S. REITs currently have a trailing twelve month [TTM] yield of 4%, as measured by the iShares U.S. Real Estate Index ETF (IYR). In relation to the S&P 500, as measured by the SPDR S&P 500 ETF (SPY) TTM yield of 1.9%, the higher yield appeal of REITs gives the income investor incentive to participate in the sector.

The IYR fund holds both equity REITs (those that own and lease buildings) and mortgage REITs (mREITs). The mREIT class generally holds a higher risk versus equity REITs and they do not specialize in owning and leasing real property, so by the real estate definition of this article they are excluded from the conversation.

Regarding the equity REITs, yields generally have in inverse relationship to market size and also range according to specialized sectors such as storage, office, residential, industrial and health care.

For example, the $15.56 billion residential landlord Avalonbay Communities (AVB) currently yields 3.56% while a smaller competitor, $5.1 billion Camden Properties Trust (CPT), yields 4.21%. When comparing residential REITs to health care REITs, HCP, Inc. (HCP) is actually larger than AVB with a market cap worth over $18 billion yet it holds a much higher yield of 5.28%.

In this comparison, which can be backed up with further research, the investor can note that health care REIT yields are currently higher versus residential REITs and that smaller REITs, on average, yield more than larger REITs.

Beware Of High Yield Equity REITs

In building a portfolio that yields over 4%, equities must average at least 4% as commodities and cash will lower the aggregate portfolio yield. By targeting higher-yield REITs, the equity portion of the portfolio will be enhanced.

With many income investors holding large dividend growers such as Wal-Mart Stores Inc. (WMT), 2.78% yield, and The Coca-Cola Company (KO), 2.37% yield, REITs can offer 5%+ yields to help maintain the over 4% equity yield target.

One mistake investors often make however is buying REITs based on their yield alone. To purchase a diversified, small-cap REIT with a higher yield than a comparable larger peer may be acceptable, however one must consider larger risks at play as even the most stable dividend player can be at risk of capital loss and dividend reductions.

Three U.S. REITs With High Yields To Avoid Now

While investors enjoy finding great companies to buy and hold, it is also important to note popular REITs that have inherent threats to both capital growth and dividend stability. In this regard, the following three equity REITs may appear interesting on the outside due to an above-market yield, however due to fundamental problems, each could be viewed as a poor investment for the time being.

1. Digital Realty Trust (DLR), 6.5% yield

Digital Realty Trust is an office REIT that specializes in data storage buildings around the world. Prior to May 2013, DLR had been seen as an investment darling due to a long history of stable and growing dividends and sector leadership in the data storage market.

At the peak price this year of $74 in late April, DLR was yielding 4.2%. In early May however, the market started to dump DLR shares after the hedge fund Highfields Capital announced their large short position.

Today Digital Realty Trust has accumulated a negative 29.3% YTD return and is down over 35% from its peak. The lesson here? Beware of stocks with a huge short interest, even if they are recommended by analysts or authors and appear to be fundamentally sound.

In addition to losing major shareholder value, the stock offers several additional real reasons that should warn the "margin of safety" investor to "avoid this stock at all costs."

These problems include:

  • A weak 2013 performance leads to negative momentum.
  • Pricing just above YTD low.
  • Poor performance relative to peers.
  • Tax-loss selling risk due to weak performance and time of year.
  • Risk of higher yield spread due to 10-year Treasury yield advances.
  • Improper accounting of office space (yes, an office REIT did not account for their own office space properly which inflated past FFO and lowered Q3 2013 FFO).
  • Fund manager sales likely by year end due to momentum chasing. Nobody wants to be holding onto a losing bag year-end with a fund that is not beating the market.
  • Huge short interest.
  • Lower barriers to entry in digital office space.
  • New public market participants that offer digital office space, thus leading to a substitute good effect.
  • Negative REIT market sentiment leading momentum to the downside.
  • Development projects put on hold.
  • Poor corporate communications.
  • Poor leadership.

To expand on the poor corporate communications and poor leadership record, as this can be viewed as biased statements, the CEO of DLR recently showcased indifference to the company stock performance and investor confidence. At a recent investor conference in San Francisco, an analyst asked the CEO of DLR a question regarding DLR development projects being placed on hold. According to Brad Thomas, a U.S. REIT investor and author who was at the event, the CEO of DLR stated

That falls under (the category) of stuff happens.

This answer is very weak and in my opinion, should be a wake-up call for investors. When investors have lost major capital, the last thing they want to hear from the CEO is "stuff happens." It is a reckless communications error in judgment that borders on indifference to both company performance and investor confidence. When the leader showcases such indifference to company performance or investor concerns, it could be taken as a clear sign to shop elsewhere.

DLR is a falling knife that has caused nothing but pain to long investors. At $56 per share in mid-October 2013, a 6% yield may have looked tasty. At the current price of $47.97 however, DLR showcases how chasing yield can be detrimental to your investment health.

2. Whitestone REIT (WSR), 8.4% yield

Whitestone REIT is a high-yielding shopping center landlord based in Texas. By first glance, the yield looks quite appealing however it comes with some heavy baggage.

  • The company does not cover their dividend with FFO. Q3 2013 FFO was $0.23, while the quarterly dividend (distributed monthly) remained at $0.285.
  • Short history as public company.
  • No historical raise in the dividend.
  • Dividend financed through loans.
  • Interest-only loans on the books.
  • Small market capitalization.
  • Limited geographic diversification.
  • Low property count relative to peers.
  • Dangerously high level of debt.
  • CEO relocation expenses that negatively affect 2013 FFO.
  • Incorrect supplemental financial statement in the WSR 2013 Q2 (June 30, 2013) Supplemental Operating and Financial Data report regarding the debt level.
  • Negative momentum, down 23.9% from 2013 peak.
  • Sits near 52-week low.

For further reading, an in-depth analysis on the strengths and weaknesses at WSR has been added to the end of this article.

3. Physicians Realty Trust (DOC), 7.3% yield

Physicians Realty Trust is a new public REIT based in Milwaukee, WI. Launched into the market this July and capitalized at under $150 million, DOC has a very limited history and a very small relative market capitalization.

While DOC many be a good long-term play, the high yield does not justify the risk. Currently DOC has a history of only one dividend, which is not covered by FFO. The lack of FFO coverage can be associated with growth as the company has used funds from the IPO to buy properties.

The property count at Physicians Realty Trust is very small and the geographic diversification does not hold economies of scale. The property count is only one to five properties per state, which is more expensive to manage on a per-property versus larger peers.

Unlike DLR and WSR, Physicians Realty Trust has earned a positive YTD return and is just 5.2% off its 52-week high. With such a small market size, the above 7% yield could lend appeal to a larger health care REIT that would be able to easily finance a buyout.

A larger suitor could offer synergies that would reduce the cost of doing business at DOC. As such interest has yet to be publicly explored, due to the small size, lack of history and lack of dividend coverage, it appears that DOC may need some time before the individual investor can declare a clean bill of health.

Conclusion

When searching for income in the REIT world, some companies may look appealing by offering above average yields. The three REITs selected here offer what may be considered a "yield-trap," which is a threat to capital stability, capital growth and long-term dividend appreciation.

Just because a person you want to date is gorgeous and well-dressed, it does not mean that they have a career, a complimentary personality or a value system that makes for a good partner. Keep that in mind when looking for long-term investments, as a healthy stock with lift will outperform a pretty one that drags you down.

An investment that yields 4% above market yield that proceeds to drops 5% in six months destroys a year's worth of above-market dividends in half the time. Don't fall prey to the yield trap and always remember that a falling knife is very difficult to catch.

To view The 4% Plan, an income portfolio guide to achieving a 4% diversified yield, please read The 4% Plan - A Permanent Income Stream Solution.

To learn more about the heavy baggage associated with WSR, please read Whitestone REIT: An Unusual 8.2% U.S. Real Estate Play.

Source: Chasing Yield: Don't Buy These 3 REITs