Protected Principal Retirement Strategy: Retiring Without A Million-Dollar Nest Egg - Part VI

Includes: DS, MTGE, PMCT, TWO, WSR
by: Akaralph

Having covered both MLPs and Royalty Trusts, I wish to turn now to Real Estate Investment Trusts as part of our Protected Principal portfolio.

A real estate investment trust, or REIT, is a type of security that trades on the major exchanges and invests in either mortgages [mREITs], properties [eREITs], or is classified as a hybrid (investing in both mortgages and properties.) REITs, by their nature, receive special tax treatment and generally offer investors a higher yield than most dividend-paying stocks. For those of us who do not have the financial resources to buy individual properties, they can be the perfect alternative.

Types Of REITs

A mortgage REIT provides capital to real estate owners or operators via either a mortgage or a loan, or by acquiring mortgage backed securities. They are generally more leveraged than eREITs, use leverage and actively hedge their investments. They carry the highest level of risk of any type of REITs, and consequently, offer a much higher yield. Anyone who was an active investor in 2008 is well aware of what can happen to the mREITs as an asset class, and therefore, should consider them quite speculative as an investment.

An equity REIT usually owns and operates income producing real estate. These assets generally include residences, offices, free-standing retail establishments, strip malls, enclosed malls, industrial buildings, hotels, self-storage facilities, warehouses and medical/extended care (healthcare) facilities.

A hybrid REIT is generally a company that melds the investment strategies used by both mREITs and eREITs.

REIT Operations

In order for a company to be treated as a REIT, it must have most of its assets and income stream linked to a real estate investment or mortgages, and must distribute at minimum, 90 percent of its taxable income in the form of dividends. In addition, it must be managed by a Board of Directors, have at least 100 shareholders a year after inception, invest a minimum of 75 percent of its total assets in real estate and cash, attain at least 75 percent of gross income from real estate related sources, and have not more than 25 percent of its assets consist of non-qualifying securities. There are other operational criteria, but these are the highlights.

How REITs Are Owned

The most typical methods of REIT ownership are: individual stocks, closed-end funds, ETFs and mutual funds.

Investors may invest in both U.S. and foreign REITs without encountering any significant problems buying or selling shares. Investors choosing to purchase REITs on foreign exchanges might have to pay additional commissions, incur foreign taxes on dividends; however, one advantage is that dividends will be received in foreign currencies prior to being exchanged for U.S. dollars, and this can add to dividend amounts received, depending on exchange rates. It can also detract from them should exchange rates be unfavorable. Personally, I use closed-end funds for foreign REIT exposure in most cases.

Evaluating REITs

Key metrics for the evaluation of REITs include: net asset value [NAV], funds from operations [FFO], adjusted funds from operations [AFFO] and cash available for distribution [CAD].

Of course consistent dividend increases are also a considerable factor in ownership of REITs.

REITs are very sensitive to changing economic conditions, and mREITs are particularly sensitive to interest rates.

Oversimplified, the net asset value is the market value of its properties or mortgages less liabilities expressed on a per share basis. This is probably not the clearest definition, and I tend to look more at the increase/decrease of book value.

Funds from operations is a term used by REITs to define cash flow from operations. It is determined by adding depreciation and amortization expenses to earnings and expressed on a per share basis. Funds from operations per share is a better metric for evaluating REITs than earnings per share. Adjusted funds from operations is the sum of the funds from operations, adjusted for recurring capital expenditures. The [AFFO] is an even more accurate measure of evaluating a REITs performance than [FFO].

Cash available for distribution is the difference between [FFO] and recurring expenses (maintenance etc). All of this information is available in quarterly reports and by listening to conference calls.

Before discussing specific REIT allocations in the Protected Principal portfolio, I would like to recommend a few SA authors that I feel have an excellent handle on REITs as an asset class. I try to follow articles published by Brad Thomas, Tim Plaehn and Zvi Bar - they seem to present REITs in a more understandable manner than most.

Protected Principal Retirement Portfolio Allocation

At this point in time, our allocation to REITs is set at 10 percent for eREITs and 5 percent for mREITs. Again, I consider mREITs to be the most speculative asset class in the entire portfolio.

Within the category of eREITs, our 10 percent allocation is set at four percent U.S. REITs and six percent foreign REITs. The entire mREIT allocation is in U.S. positions.

The REIT mix consists of both individual stocks and closed-end funds. The position in closed-end funds affords the opportunity for diversification, particularly in foreign REITs, along with the ability to purchase positions at a discount to net asset value while receiving a higher yield than presently available from individual stocks.


The eREIT component of the portfolio consists of three closed-end funds: Alpine Global Premier Properties Fund (NYSE:AWP), Cohen & Steers Quality Income Realty Fund (NYSE:RQI) and Cohen & Steers REIT & Preferred Income Fund (NYSE:RNP). In addition, I am following three individual stocks for possible addition to the portfolio: Medical Properties Trust (NYSE:MPW), Whitestone REIT (NYSEMKT:WSR) and PMC Commercial Trust (PCC).

AWP (Alpine Premier Global Property Fund) is, in my opinion, the best that Alpine has to offer, and I have owned it for over a year. It presently is selling at a seven percent discount to net asset value, pays a monthly dividend of $.05 (8.9 percent yield) and offers a 70 percent exposure to foreign REITs. RQI is a Cohen & Steers fund, presently 81 percent invested in U.S. REITs. This fund presently is priced at a three percent discount to its net asset value and pays a quarterly dividend of $.18 (6.7 percent yield). This has been in the portfolio for well over a year, and was purchased at a much lower price. RNP is also a Cohen & Steers fund that holds common stocks, preferred stocks and debt instruments. It sells at a 4.5 percent discount to net asset value, pays a $.30 quarterly dividend (7 percent yield) and offers a 62 percent exposure to U.S. stocks. I do not presently own RNP in the Protected Principal portfolio.

Attaining a yield in the range of eight to nine percent by owning individual eREIT U.S. stocks is difficult at this time. However, MPW, WSR and PCC remain attractive as portfolio candidates.

MPW (Medical Properties Trust) is a hybrid eREIT that develops, operates and leases healthcare properties to operating companies and healthcare providers. It also provides mortgage loans. The stock is currently priced under $10 a share and has been paying a quarterly dividend of $.20 (8.2 percent yield) since December 2008. Funds from future operations have exhibited a recent increase and the stock is worth further consideration.

WSR (Whitestone) is a unique eREIT, in that it owns office, warehouse and retail properties in redevelopment areas in the Southwest U.S. Occupancy rates are increasing and funds from operations are trending upward. The monthly dividend has remained consistent at $095 since the company's inception in 2010, and the stock certainly warrants further consideration.

PCC (PMC Commercial Trust) provides loans to businesses, but is treated as a real estate investment trust. It presently pays $.16 quarterly, and although I follow it, I would rank it third behind both MPW and WSR.

To determine the level of yield that can be expected from the eREITs, I provide the example of owning each of the three closed-end funds discussed previously. The example is based upon a hypothetical 100 share purchase of each.

AWP - 100 shares @ $6.70 = $670 (less commissions)

RQI - 100 shares @ $10.72 = $1072 (less commissions)

RNP - 100 shares @ $17.23 = $1723 (less commissions)

The total cost would be $3465, and total annual dividends received would be $252, for an average yield of 7.3 percent. Note: The portfolio is presently over weighted in AWP so the yield is actually above eight percent.


Anyone who owned mREITs (and held) through the debacle of 2008 - 2009 knows that extreme caution must be exercised in owning this asset class. Aside from NLY, many of the mREITs that operated (and paid extremely high yields) in the 2006 - 2008 time frame are no longer with us. There is a new breed of mREIT that has emerged of late, and is typified by stocks like American Capital Agency (NASDAQ:AGNC), Two Harbors Investment (NYSE:TWO), American Capital Mortgage (NASDAQ:MTGE) and several others. These have certainly performed well, rewarding investors with high yield; however, all are subject to interest rates and how the economy performs. For those of you who own them, I suggest careful diligence, as there could easily be a repeat performance of 2008.

The Protected Principal Retirement portfolio presently contains only one mREIT - Newcastle Investment (NCT). My watch list includes MFA. Both NCT and MFA survived the mREIT disaster and seemingly management has learned from the experience.

NCT has almost doubled off its lows of last October, and earnings last quarter were up significantly. Quarterly dividends have increased from $.10 in June 2011 to a current level of $.20 for a present yield of just under 11 percent. This is not nearly in the range of that offered by AGNC, TWO, MTGE or the other mREITs, but I believe it might be more sustainable, plus there is a good opportunity for price appreciation and total return.

I would place MFA just below NCT on the food chain, and although I do not own it in the Protected Principal Retirement portfolio, it is certainly a candidate below $8 a share. MFA, like NCT, presently offers an 11 percent yield, and its quarterly dividend has fluctuated between $.225 and $.27 over the past two years.

An additional way to spread the risk in the mREIT asset class is through ETF ownership. REM (iShares Mortgage REIT ETF) has increased payouts since December of 2010 and offers diversification among the largest of the high yield mREITs. It has returned over 19 percent year-to-date, and has an average three year return of just over 14 percent. I do not own this in the Protected Principal Retirement portfolio, but it is also on the watchlist.

From the above, us mid-rangers have the ability to achieve a better than average yield without sticking our necks out too far chasing higher yielding REITs. The closed-end funds give us diversification at prices below net asset values, and the individual stocks noted seem to currently reflect stable management and an upward bias.

In the next article, we will turn our attention to closed-end funds.

Disclaimer: The stocks mentioned are not recommendations but serve as "food for thought" for those of us at, or nearing retirement age. I am not a registered investment advisor. According to SA, neither RQI, nor NCT are valid symbols - but they are.

Disclosure: I am long (AWP).