3 High Yield REITs: High Return or High Risk?

Includes: HPT, NLY, WRE
by: Chuck Carnevale
Investors seeking income are often attracted to Real Estate Investment Trusts (REITs) because they normally have higher than average dividend yields. With interest rates on fixed income vehicles near record lows, it's only logical that these same investors seeking income would be even more motivated to look to Real Estate Investment Trusts (REITs). Although Real Estate Investment Trusts do not possess the same characteristics as operating companies that are found on the various stock exchanges, most REITs can be thought of as equity investments in contrast to debt instruments. In essence, REITs are to real estate what common stocks are to operating companies.
Even though the first two letters of REIT stand for real estate, not all REITs invest in real estate. In addition to real estate REITs, there also are mortgage REITs and hybrids. Therefore, it's important to keep in mind that not all REITs are the same. There are many important considerations that prudent investors need to consider when evaluating a specific REIT prior to investing. Furthermore, although a higher than average dividend yield is a characteristic that most REITs have in common, the source and the future predictability of the dividend income available can be vastly different.
In this article, we are going to look at the three highest yielding REITs of the 25 covered in the Value Line Investment Survey. We chose this universe on the basis that the Value Line Investment Survey, in theory at least, only covered reputable and substantial REITs listed on the New York Stock Exchange. The summary and review F.A.S.T. Graphs™ below provides essential “fundamentals at a glance” on Annaly Capital Management (NYSE:NLY), Hospitality Properties Trust (NYSE:HPT) and Washington REIT (NYSE:WRE).
These selections will provide a cross-section of the various types of REITs. The first is a mortgage REIT, the second is a specialty REIT and the third is a diversified REIT. An important objective of this analysis is to point out how each REIT should be analyzed on its own merits and risk profiles. Even though many REITs offer above-average yields, there are many differences that the investors need be aware of when evaluating the future. For a more comprehensive explanation of the many variations of REITs, follow this link to our previous article 10 High Yield REITs: Do the Yields Justify the Risk? Published on November 16, 2010.
F.A.S.T. Graphs™ Summary and Review
Annaly Capital Management, Inc. (NLY)
Corporate Overview
“Annaly Capital Management, Inc, commenced operations on February 18, 1997 as a self-managed self-advised company. We have elected to be treated as a real estate investment trust (or REIT) under the Internal Revenue Code. We own and manage a portfolio of mortgage-backed securities. Our principal business objective is to generate income for distributions to our stockholders from the spread between the interest income on our mortgage-backed securities and costs of borrowing to finance our acquisition of mortgage-backed securities and from dividends we receive from our taxable REIT subsidiaries.”
Earnings and price correlated F.A.S.T. Graphs™
Annaly Capital Management (NLY) functions as a mortgage REIT, and as such, their earnings-per-share can be greatly influenced by interest rates and the overall health of the mortgage market. According to their press release on January 7, 2011 the company presented their monthly commentary for January; providing comments on housing finance. In this release they discussed how America's housing finance system was one of the most efficient in the world until underwriting standards started to slip around 2004. From the F.A.S.T. Graphs™ below we can see the significant impact that this had on earnings and dividends.
F.A.S.T. Graphs™ Price and Dividends Only
Below we see Annaly Capital Management's dividend record and price performance since 1997. Although price was reasonably stable over this period of time, there are wide variations in their dividends paid. Investors, who are seeking a stable and reliable stream of future income, need to give this record careful consideration. Even though current yield is extremely high at over 14% per annum, prospective investors need to understand that future dividend yields could vary widely.
The calculated performance results associated with the above F.A.S.T. Graphs™ provides a more comprehensive perspective of this company's historical performance and dividend record. There are approximately 13 years of historical data reported below (the graphs start in October 1997 and includes one year of forecast). Annaly Capital Management (NLY) found the need to cut their dividend on five occasions since 1997, and some of the cuts were dramatic.
However, the total dividends paid over this time were substantially more than investors could have found with most any other reputable investment choice. Although, capital appreciation was about average, it was lower than total cash dividends paid. This is prima facie evidence which illustrates that the primary attribute of this mortgage REIT is their dividend paying potential. Before investing in this high yield mortgage REIT, investors need to carefully consider the current and future state of government intervention in the mortgage market and the potential of an improving economy and higher interest rates. The most important concern would be the impact this had on spreads, which is the primary source of distributable cash flows for Annaly Capital Management.
Hospitality Properties Trust (HPT)
Company Profile
“Hospitality Properties Trust is a real estate investment trust, or REIT, which owns 289 hotels and 185 travel centers located throughout the United States, Ontario, Canada and Puerto Rico. We do not operate hotels or travel centers. Instead, all of our properties are operated by unaffiliated hospitality management companies as part of 13 combination management or lease agreements. As of September 30, 2010, the largest combination agreement based upon investment includes 145 travel centers located in 40 states and the smallest combination includes 11 hotels with 2,096 rooms located in eight states. Our hotels are operated by some of the largest and most experienced hotel management companies in the world, including Marriott International, InterContinental Hotels, Hyatt Corporation and Carlson Hotels Worldwide. Our travel centers are operated by TravelCenters of America LLC (NYSE Amex: TA).”
Earnings and price correlated F.A.S.T. Graphs™
From the graph below we find that Hospital Properties Trust (HPT) produced a reasonably steady record of earnings and dividends until they hit a wall during the great recession of 2008. As a REIT that owns properties dependent upon the hospitality industry, their prospects for growth are heavily reliant on the general state and health of the economy.

F.A.S.T. Graphs™ Price and Dividends Only
When looking at Hospital Properties Trust (HPT) from the perspective of dividends and stock price we find that price is very sensitive to dividends. This quality REIT paid a steady stream of dividends until they were forced to cut them, thanks to the recession of 2008. As you can see from the F.A.S.T. Graphs™ below, the market didn't take kindly to the large reduction in dividends. On the other hand, an improving economy could send Funds From Operations (FFO) and dividends headed back up. Therefore, today's historically low price could indicate an excellent time for investors, willing to take some risk, to build a position.
F.A.S.T. Graphs™ Price, Dividends and Funds From Operations [FFO]
Traditional operating companies report net income, in contrast REITs report cash flow differently under an accounting convention referred to as Funds From Operations [FFO]. The following quote from REIT.com under their section “All about REITs” summarizes what it takes to classified as a REIT.
“In order for a company to qualify as a REIT in the U.S., it must comply with certain ground rules specified in the Internal Revenue Code. These include: investing at least 75 percent of total assets in real estate; deriving at least 75 percent of gross income as rents from real property or interest from mortgages on real property; and distributing annually at least 90 percent of taxable income to shareholders in the form of dividends.”
The following F.A.S.T. Graphs™ looks at Hospitality Properties Trust from the perspective of price correlated with dividends and Funds From Operations (FFO), the green shaded area marked with an “O”, on this F.A.S.T. Graphs™. The dividends are represented by the purple looking line (the line is actually the same blue as dividends above, but shaded over with light green giving it a purple hue). This illustrates the 90% payout ratio required of Funds From Operations referenced above.
The following performance chart associated with the graphs above show that Hospital Properties Trust (HPT) generated strong dividend cash distributions for shareholders until 2009. As the recession took its toll, this REIT was forced to cut their dividend by 75% and their stock price followed the dividend down. This is a risk that investors in REITs need to be aware of. The recession also created a capital loss since 1997. However, this REITs’ normally high dividend yield, even when considering the drastic cut in 2009, still produced above-average total shareholder returns.
Washington Real Estate Investment Trust (WRE)
“Washington Real Estate Investment Trust is celebrating its 50th year as a self-administered, self-managed, equity real estate investment trust. WRIT owns and operates income-producing real estate properties in the greater Washington, D.C. region. We invest in a diversified portfolio that includes office, industrial/flex, medical office, retail and multifamily properties and land for development. This strategy has proven successful through nearly five decades of established performance in the nation's capital.”
Earnings and price correlated F.A.S.T. Graphs™
The price and earnings correlated F.A.S.T. Graphs™ on Washington REIT illustrates the importance of dividends over reported earnings regarding Real Estate Investment Trusts (REITs). Even though reported earnings steadily fell from 2001 all the way into the great recession of 2008, stock prices continued rising. However, they did finally give way to recessionary pressures towards the end of 2008 through and into the first quarter of 2009.

F.A.S.T. Graphs™ Price, Dividends and Funds From Operations [FFO]
From the F.A.S.T. Graphs™ below we clearly see that stock price correlates more to Funds From Operations [FFO] than reported earnings. Since the dividend component is so important to investors in REITs, this should not be a surprise.
The performance results associated with the above F.A.S.T. Graphs™ show that Washington REITs’ steady operating results produced the strongest capital appreciation of the three REITs covered in this article. Furthermore, the same steady operating performance enabled them to modestly grow their dividend. Consequently, their shareholders were able to enjoy a good balance between growth and income.
Summary and Conclusions
We hope that this analysis provided some deeper insights into the world of investing in Real Estate Investment Trusts [REITs]. There are many benefits to investing in this asset class in addition to the obvious high dividend yield that most REITs offer. One of the most important is diversification into attractive real estate opportunities that are often beyond the wherewithal of most individual investors. Simply stated, REITs are stocks that typically invest in real estate. Therefore, you could look at REITs as liquid real estate.
Liquidity, however, could also be looked at as a two-edge sword. Because real estate is typically associated with the lack of liquidity, it often gives the illusion of being less volatile than other equities. But since legislation by Congress created REITs in 1960, that all changed. As you can see by the price action on the F.A.S.T. Graphs™ above, the stock prices of REITs can be quite volatile at times. And, like stocks that represent operating businesses, the fortunes of REITs are directly tied to the cash flows they are capable of generating for their shareholders (typically depicted as Funds From Operations, FFO).
Most importantly, we hope that this report encourages investors to look beyond the glitter of a high dividend yield alone. What appears extremely attractive at first glance may not stand up to closer scrutiny. On the other hand, the high yield offered by some REITs, may represent an incredible opportunity for both growth and high income. These decisions need to be made on a case-by-case basis, because not all dividend yields are the same, nor are all Real Estate Investment Trusts [REITs]. But given today's low interest rate market, Real Estate Investment Trusts [REITs] appeared to be an asset class worth evaluating more fully.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.