Sleep Well at Night With This Balanced REIT Portfolio

 |  Includes: EXR, NNN, O, PSA
by: Brad Thomas

The United States has defaulted on its debt five (5) times in the country’s history (1779, 1782, 1862, 1934, and 1979) and with the anticipated government debt ceiling deadline, many investors are experiencing fear and anxiety of a possible 6th U.S. debt default. The U.S. has maintained its AAA sovereign credit rating since 1941. There are 14 other elite members in the AAA club (most of the other countries are in Europe), and while other analysts offer a variety of credit default outcomes, most agree that debt exposure is immensely important in evaluating risk-adjusted portfolios.

An obvious outcome of a U.S. credit downgrade will be increased bond yields as the U.S. could see an additional $100 billion a year in interest rate payments. Of course interest rate risk is a significant concern as it relates to possible credit downgrades and for long-term investors a well-diversified, balanced portfolio should include non-speculative companies with strong “margin of safety” attributes. Unlike the riskier and higher yielding mREITs, the equity REITs operate more conservative platforms with attributes characteristic of long-term investing objectives.

Within the FTSE NAREIT Index there are 123 Equity REITs and 8 asset sectors and the free-standing sub-sector and the self-storage sector have become more relevant for diversification, conservative capitalization fundamentals, and low-risk operating structures. As long-term investors consider diversification, a well-balanced investment portfolio should include durable equity REITs to make you sleep well at night!

Sleep Well At Night (SWAN) Portfolio Strategy

Clearly there are common “margin of safety” attributes with free-standing retail REITs and self-storage REITs. Both sectors provide investors with diverse income and geographic distribution and both sectors provide sound lease occupancy metrics with high demand for facility rentals. And like many name-brand tenants (i.e. WAG, CVS, and AAPL), rental revenues from the free-standing retail REITs have gained recognition as name-brand operators with strategically positioned facilities along highly trafficked corridors and intersections.

As Chris Macke, Senior Real Estate Strategist at CoStar, explains:

With it looking like Congress is going to cut $2.8 trillion dollars over the next ten years this will certainly put downward pressure on the economy and commercial real estate demand. As a result single tenant assets with strong credits on long term leases will provide insulation from any negative effects on the commercial real estate markets.

In addition, the self-storage sector should see considerable growth as the industry is highly fragmented with the larger REITs controlling a minority of the space. As Chris Macke describes:

With more foreclosures expected self storage should see increased demand as newly displaced homeowners downsize into apartments.

As a method to develop a weighted and balanced portfolio model, I designed the following SWAN grading model. As you see, this scaled model system has 10 “margin of safety” attributes and each REIT is graded (by me) on a 1 (worst) to 10 (best) scale. Note, the last attribute is labeled the “retired school teacher” attribute and I will explain later.

Report Card

As the SWAN model illustrates, Realty Income (NYSE:O) received and A+ and National Retail (NYSE:NNN), Extra Space Storage (NYSE:EXP), and Public Storage (NYSE:PSA) all scored a B+. Of course, operating performance and results are a better “real time” barometer so I will summarize the latest REIT results.

Realty Income (O), the “monthly dividend company” ® recently announced (June 30, 2011) that the 42 year old free-standing REIT increased its dividend to 5.25% as its 55th consecutive quarterly dividend increase (paid monthly). With 2,523 tenants and a portfolio occupancy of 97.3% (compared with 96.8% on March 31, 2011), Realty Income is a prototype “sleep well at night” REIT.

Also announced recently (June 30, 2011), Realty Income invested $213.5 million in ten (10) new properties in the second quarter with an average cap rate of 7.5% (due to higher credit tenants like T-Mobile (OTCQX:DTEGY), Fed Ex (NYSE:FDX), and Coca Cola (NYSE:KO)). With $156 million of cash on hand, and no balance on the company’s $425 million credit line, Realty Income has excellent liquidity and funds to capitalize on future opportunities.

As previously mentioned, Realty Income is an exceptional REIT with a long history of paying increasing dividends. The company’s prototype investor is a retired school teacher who depends on the monthly dividend check and, for that reason, the retired school teacher is used by the company as an example of the reliability of the income distributions. (I wrote a detailed Seeking Alpha article on Realty Income here.

National Retail Properties Inc. (NNN) announced recently (July 15, 2011) a dividend increase of $1.54 per share and its 22nd consecutive year that the free-standing retail REIT has paid increased annual dividends per share. National Retail is one of only four publicly traded REITs and 105 publicly traded companies in America to have increased annual dividends for 22 or more consecutive years.

As of July 15, 2011, National Retail owned 1,223 Investment Properties in 46 states with a gross leasable area of approximately 13.3 million square feet. Investment portfolio occupancy was 96.9% as of March 31, 2011 (compared with 96.4% a year earlier). New investments during the quarter ended March 31, 2011 included 29 properties of around $55.1 million.

Also recently announced (on May 26, 2011), National Retail closed on a new $450 million unsecured credit facility with an option to increase its size to $650 million. This new credit line matures on May 2015 and is priced at LIBOR plus 150 basis points. The current dividend yield is 6.1%. (I wrote a detailed Seeking Alpha article on National Retail here.

Extra Space Storage Inc. (NYSE:EXR) recently (July 28, 2011) announced its second quarter 2011 results and included in the highlights is 22% quarterly year-over-year FFO growth and increased same-store occupancy (currently 89.0% as of June 30, 2011). Also, the REIT announced increased same-store revenue and net operating income of 4.7% and 7.8% respectively, as compared to the same period in 2010.

Thanks in part to the company’s improved occupancy rate, Extra Space has raised its dividend by around 40% in 2011 and the current dividend is 2.7%. During the latest quarter, Extra Space acquired 24 properties (in 11 states) and added 26 properties to its third party management platform. With a market capitalization of around $1.9 billion and 853 facilities (owned or managed) in 34 states, Extra Space continues to deliver a diverse and well-capitalized REIT model. I wrote a detailed Seeking Alpha article on Extra Space Storage here.

Public Storage (PSA), the largest of the self-storage REITs, boasts a market cap of around $20.37 billion. With around 2,052 facilities in 38 states and 189 facilities in Western Europe, Public Storage controls in excess of 130 million square feet in U.S. self-storage facilities. In addition, its strong occupancy rate of 90.6% is among the highest in the industry. Public Storage has a current dividend yield of 3.18% and the company has returned 19.56% since the beginning of the year. Due to rising occupancy rates and average rates on the rise, the dividend payment recently increased around one-fifth and there is plenty of room to grow.

Building a Sound REIT Portfolio

As referenced above, all of these four equity REITs have announced impressive results with strong occupancy rates and diversely safe tenant portfolios. In addition, these focused operating platforms represent some of the safest investment alternatives within the equity REIT index. Furthermore, by combining these four high quality REITs in a strategic portfolio, an investor achieves further diversification (within the portfolio) and reduces exposure with one REIT sponsor or REIT sector. And with a balanced risk-adjusted REIT portfolio, capital preservation and sustainable dividends are a must!

Here is a snapshot of the FTSE NAREIT Index detailing the free-standing retail sub-sector and the self-storage sector:

And, here is a snapshot of the four above-mentioned equity REITs with an equal percentage invested and combined annualized stock price growth and dividends. As you can see, these four REITs combined averaged 25.5 % year-over-year.

click on images to enlarge

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And since Realty Income was graded an A+ in the SWAN model (“margin of safety” test), I included a 40% allocation in the weighted model (below) with 20% allocated to the remaining REITs. With an objective of minimizing downside risk and increasing long-term value and dividend growth, the strategic SWAN model aims to provide investors with unparalleled capital preservation and durably dependable income. As you see below, the projected annualized returns are less glamorous as the previous illustration (last 12 months) since Realty Income and Public Storage are moderately priced. As noted, the SWAN investor is more concerned with long-term value making the primary goals to be:

  1. Principal preservation.
  2. Sustainable income.

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Building a well-balanced investment portfolio should include some high quality REITs. By developing a strategic risk-adjusted REIT portfolio, an investor can maximize his or her investment objectives. A long-term investment strategy should include funds with disciplined capitalization, fundamentally diverse revenue drivers, and sustainable and growing dividends.

Realty Income, National Retail, Public Storage, and Extra Space are all top-tier equity REITs with proven operating metrics and conservatively accepted safety attributes. By combining these four REITs that occupy an average of 94.45 % of store fronts and over 6,651 facilities, an investor benefits from a blended dividend yield of around 4.25% and attractively balanced stock appreciation.

So as other speculative investment alternatives keep you up at night, remember how the retired school teacher slept like a SWAN!

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