In the current macroeconomic environment characterized by a high degree of uncertainty, modest growth, and low interest rates, investors are finding Real Estate Investment Trusts (REITs) attractive because of the trusts' relatively high dividend yields, relatively stable and predictable lease-based cash flows, and access to capital at favorable terms. As the global economies, especially those in Europe, are severely distressed, investors are seeking investment instruments with relatively low exposures to slowing growth and sovereign debt issues internationally. Thus, given the mostly-domestic profile of their income sources, U.S. REITs are gaining support among investors looking for havens from the international volatility.
In principle, REITs are attractive as they offer consistent current income, paying at least 90% of their taxable income as dividends. Therefore, they usually carry higher dividend yields than many dividend-paying stocks and U.S. government bonds (graph 1 below). As investments, REITs bring diversification to investment portfolios, given the REITs' low correlation with the broad equity and bond markets. At the same time, they provide investors with a targeted exposure to residential and commercial property markets. Overall, REITs have proven to be successful investment vehicles for patient investors, yielding higher total returns than the broad equity and bond markets (graph 2 below).
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Most REITs have had a spectacular year so far. Measured by the FTSE/NAREIT indices, equity REITs produced a total annualized return of 17.2% in the first seven months of this year. Mortgage REITs, which invest in mortgages on real estate properties, had a total return of 23.2%. On average, equity REITs are currently yielding 3.4% annually, while mortgage REITs are yielding 12.5% per year. There are many individual REITs that are boasting higher yields than the averages. Among specific property types, the retail REIT sector, investing in shopping centers and regional malls, had the highest total returns in the first seven months of this year, averaging 23.6%. One infrastructure REIT had the second-highest return so far this year, averaging 20.8%. Healthcare, timber, and self-storage REITs followed them with total returns of 19.8%, 18.3%, and 16.7%, respectively.
Investors seeking a broad exposure to REITs can invest in REIT exchange-traded funds or low-cost mutual funds. For example, iShares FTSE EPRA/NAREIT North America (IFNA) is an exchange-traded fund with 90% of its assets in U.S. real estate holdings. It invests in 131 different REITs, including the likes of Simon Property Group (SPG), HCP (HCP), Ventas (VTR), Public Storage (PSA) and Equity Residential (EQR). These individual REITs yield more than the S&P 500 index on average and the 10-Year Treasury bond. The iShares FTSE EPRA/NAREIT North America has returned 32% over the past three years and pays an annual dividend yield of 2.84%. It assesses a management fee of 0.48%.
Another investment instrument providing a broad exposure to the U.S. REIT market is Vanguard REIT Index Fund (VGSIX). This mutual fund tracks the MSCI U.S. REIT Index, consisting of some 111 securities across the shopping mall, office, healthcare, apartment, and storage sectors. The fund has returned 29.3% annually over the past three years and currently yields 3.1%. The fund assesses a low 0.24% management fee.
There are a number of options for investing in the sector-specific REITs. They range from the sector-specific REIT ETFs, such as iShares FTSE/NAREIT Residential Index Fund (REZ), offering an exposure to the residential real estate markets. This ETF yields 2.82% annually. An exposure to retail malls and shopping centers can be attained by investing in iShares FTSE/NAREIT Retail Index Fund (RTL). It also yields 2.82% per year. Similarly, investors can gain exposure to the office/industrial properties by investing in iShares FTSE/NAREIT Industrial & Office Index Fund (FNIO), which yields 3.04%.
High-yield chasers have plenty of opportunities to invest in mortgage REITs. Some of the notable names include American Capital Agency (AGNC), yielding 14.9%, Annaly Capital Management (NLY), yielding 13.1%, and Anworth Mortgage Asset Corporation (ANH), yielding 11.0%. All these are agency mortgage REITs, with limited credit risk, due to the absence of exposure to the creditworthiness of the underlying borrower and mortgages being guaranteed by government-sponsored entities. The currently stagnant housing market is a boon for mortgage REITs. It is a reason for interest rates to remain low and the yield curve to remain steep for an extended period of time. That environment bodes well for mortgage REITs.
Going forward, REITs are likely to perform well. The Fed's policy of keeping interest rates low for at least another two years guarantees access to capital at low interest rates. The improving labor market suggests that the demand for housing rentals will remain robust, boosting performance and investments in multifamily residential REITs, such as AvalonBay Communities (AVB), the second largest publically-traded U.S. apartment owner, San Francisco-based BRE Properties (BRE), Washington, DC-focused Equity Residential and UDR, with a good exposure to the New York City market. These REITs have yields of 2.8%, 3.2%, 2.2%, and 3.5%, respectively.
A rebound in the economy, and especially the recovery in the labor market, could also boost performance of the mall and office REITs. Good office space-focused REITs are Boston Properties (BXP), SL Green Realty (SLG), with a Manhattan exposure, and Mack-Cali Realty (CLI). These three REITs currently yield 2.0%, 1.2%, and 6.8%, respectively. A good example of a retail-focused REIT is Simon Property Group, the shopping mall owner and the largest U.S.-based REIT. It is currently somewhat pricey, as it trades at 8 times its book value, compared with the industry's ratio of 3.1. The company pays a dividend yield of 2.7%.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.