As the stock market seems to resemble a wild roller coaster with dark clouds seen in the horizon, an interesting play can be the relatively cash flow stable equity REIT industry.
A REIT (Real Estate Investment Trust) is a tax designation for a corporate entity that invests in real estate. The advantage of this designation is that if the trust distributes at least 90% of its taxable income to its shareholders it would not be subject to federal income tax. This is the main reason why relatively high dividends can be found within the REIT sector that is so appealing to income investors.
Reasons for investing in REITs:
1. Simple business to understand and analyze - equity REITs buy real estate and lease it to tenants. They can be active in one sub-sector (offices, apartments, hospitals, hotels etc.) or in several sub-sectors simultaneously. Their lease contracts can be long term or short term and may include automatic rent increase clauses. More parameters define the various REIT types but at the bottom line - once you lock in on a certain REIT and study it a little bit, understanding its activity and results should usually be straight forward.
2. Stable cash flow and relatively predictable results - unless the occupancy rate suddenly drops you may expect a steady cash flow from the equity REIT you chose.
3. Be opportunistic (1) - in the current real estate market, buying a real estate asset as an investment for a high yield can be a good idea, but it still requires a substantial amount of cash. Additionally, you get no diversification if you only buy one asset. Buying into an equity REIT provides a chance to buy into the depressed real estate market with diversification of tenants, locations, industries or even all of them with as much cash as you can afford yourself.
4. Be opportunistic (2) - REITs that have the option raise funds (equity or loans) take advantage of this once in a lifetime opportunity to expand their portfolio and strengthen their cash flows at bargain prices. In other words, let them do the work for you.
5. Thanks to all of the above relatively high dividend yields are not rare in the equity REIT industry.
Risks to consider in equity REITs investing:
1. Interest sensitive - since most REITs finance at least a substantial part of their asset purchasing by loans, their results become interest-sensitive. In that sense, the current interest rates are good for them but those that will not lock the interest rate for years to come may face difficulties as the interest rate starts rising.
2. Tenant diversification - the higher tenant diversification your equity REIT has the smaller the risk of dividend cuts or decreasing income due to lower occupancy rate if one of the tenants leave.
3. Tenant strength - obviously the stronger the tenants the safer your dividend. For example, equity REITs investing in hospitals whose tenants may be severely impacted by the health reform may not be such a good idea until the uncertainty goes away.
4. Unless the economy really recovers, the REITs may suffer lower occupancy rates. For example, office REITs may find it hard to find new businesses to lease their buildings, shopping malls may experience more empty shops etc.
Listed below are 3 of my favorite equity REITs:
Senior Housing Properties Trust (SNH) - SNH invests in senior housing properties in the United States, including independent living and assisted living communities, continuing care retirement communities, nursing homes, wellness centers and medical office, clinic and biotech laboratory buildings. That means SNH is active in an industry that is expected to expand as the population in the USA grows old. Most of their 370 assets are triple net leased and 94% of their income is private-pay driven, meaning limited exposure to government reimbursement.
Substantial loan repayments are not expected until 2015, and the company enjoys high occupancy rates in most of its asset classes. SNH currently pays a healthy 7% dividend (constantly rising over the last 8 years) and has a price to FFO ratio just below 12.
Because of the relatively strong balance sheet, access to credit lines, high & rising dividend yield and the prospects of the industry in which it operates, SNH is one of my favorite REITs.
One risk besides the general ones mentioned above is the risk of tenant diversification, as one of its tenants - FiveStar Senior Living is responsible to 44% of SNH's NOI. While I do not expect this to cause a problem thanks to the nature of the industry, it should be taken into account.
Government Properties Income Trust (GOV) - GOV owns commercial office properties most of which are leased to government agencies. GOV owns 71 properties amounting to 9 million square feet, about 92% of their income is paid by the US government. That means that 92% of the income is derived from government agencies (FBI, IRS, FDA etc.) that do not tend to relocate their offices frequently and sign long term lease contracts to begin with and no doubt their check will not bounce. For me that is one of the best tenants in the world.
Substantial loan repayments are not expected until 2017, current occupancy rate for GOV is 92% and the weighted average remaining lease term is 5 years.
GOV's stock has been beaten down recently. Initiating a long position in it will make you a landlord of one of the best tenants out there at a low valuation (7.8% dividend yield and 9.94 price to FFO ratio), as well as an owner of an aggressive asset purchasing REIT.
Realty Income Corp. (O) - O is the owner of mainly commercial retail real estate properties in the United States. It leases its retail properties to regional and national retail chain store operators. The company owns over 2600 assets in 49 states, the assets are under long term leases, usually 15 to 20 years; the weighted average remaining lease term was approximately 11.1 years as of March 31st 2012. The company enjoyed high occupancy rates over the recent years with 96.6% as of March 31st 2012.
O calls itself the monthly dividend company, enter their website and you will see much of their focus is on paying their investors ever increasing dividends on a monthly basis. Over the past 43 years it paid its monthly dividends, and has raised them consistently through the last 18 years. The current dividend yield is 4.4%.
O's dividend model is ideal for retirees or income investors since it is backed by strong cash flow, huge and diversified portfolio and managers who try to seize the opportunity to buy more assets at high cap rates (9% in the last quarter).
1. One has to note that if the economy goes into another recession (aren't we there yet?) - some of its tenants may go out of business, causing the cash flow and dividends to deteriorate.
2. With a price to FFO ratio of almost 20, O's valuation is not low. I like buying stocks when they are priced low (who doesn't?) and this is not the case for O right now.
Below is a table with some basic figures for these 3 REITs:
|Market Cap||Investment Portfolio (historical investment basis)||Dividend Yield||Years of Rising Dividends||Price to FFO ratio||Total Debt / Market Cap||EBITDA / Interest Expense||Total Debt / EBITDA|
|SNH||$3.51 Billion||$5 Billion||7.0%||8||11.98||52.8%||3.5||4.6|
|GOV||$1 Billion||$1.5 Billion||7.8%||3||9.94||44.5%||7.3||3.8|
|O||$5.3 Billion||$5 Billion||4.4%||18||19.83||34.1%||3.6||4.4|
Another way to start equity REIT investing may be through ETFs. These will expose you to various equity REITs in various sub-industries and therefore minimize the risk of a single tenant or sub-industry that may get into difficulties.
On the other hand, and that is the case in any ETF, they will expose you to REITs you would not like to invest in if you were given the choice.
If you decide to go this way instead of searching for the right REIT for you, an interesting play can be Vanguard REIT Index ETF (VNQ) - a highly liquid ETF with an expense rate of just 0.1%. VNQ sports a 3.36% dividend yield and is managing over $24 Billion assets.
If you seek diversification, VNQ invests in 111 different equity REITs.
While these numbers sound nice, a quick inspection reveals that the quarterly dividends from this ETF have decreased after the real estate melt down and are now starting to climb back up.
This is the main reason due to which I do not like ETFs - their huge diversification makes you buy good stocks together with bad ones. I prefer to perform an in-depth study on any single stock and reach a go / no-go decision rather than buy into an entire sector regardless of its valuation. It's a lot more work but for me - it is worth the effort.
Disclosure: I am long SNH.
Additional disclosure: I may initiate a long position in GOV within the next 72 hours.