It's easy to say "I like REITs (Real Estate investment Trusts)" or "I don't like REITs," but ultimately, neither statement is sensible because there are vast differences within the group. We tend to think of these as income vehicles and that, at least, is accurate since they do tend to pay yields well above those of the average stock. But variations in risk and yield can be considerable.
Among the 168 REITs in StockScreen123.com with market capitalizations of at least $100 million, the average yield is 5.3%, ranging from a low of zero to a high of 16.4%. Income investors typically recognize a direct relationship between yield and risk, and can comfortably assume that Mr. Market is very worried about the prospect of dividend cut or elimination at the REIT yielding 16.4%. Those with no yields aren't necessarily low risk - they may be troubled REITs that already had to eliminate payouts. But there are 35 dividend-paying REITs yielding less than 3%; we can assume the market regards these as carrying relatively low risk.
We can also subdivide the group by area of focus. The Standard & Poor's GICS database offers seven sub-groupings: Diversified, Industrial, Mortgage, Office, Residential, Retail, and Specialized. The Mortgage REITs (those that invest in mortgage debt, not in properties) are the highest-yielding area, averaging 11.1%. That's no surprise considering the market's fear of continuing defaults. The lowest-yielding group is the one I'm most interested in right now: the Residential REITs, where the average yield is 3.5%, ranging from a low of 2.1% to a high of 6.4%.
Normally, income investors hesitate to chase the top yields, but when the group as a whole bears relatively low risk, as I believe the case to be here, I'm OK with favoring the highest yields. I back-tested this strategy on StockScreen123 (the three highest yielding residential REITs, with the list rebalanced every four weeks) and saw that the hypothetical portfolio appreciated 20.0%, versus an 18.2% gain for the S&P 500 and a 7.4% gain for a portfolio comprising the three lowest-yielding selections. Over the past five years, the overall returns (price appreciation plus income) were 61.0% for the high-yielders and 38.7% for the low-yielders, versus minus 4.2% for the S&P 500.
I'm aware that in the latest year, the high-yield strategy was only marginally better than the S&P 500, but I believe the future will differ. Given the still-precarious state of the economy, and hence corporate earnings prospects, I'm not ready to bet the farm on the S&P 500 being able to sustain its recent pace. Meanwhile, I really like the prospects for residential REITs. Traditional homebuilding, or at least housing as we've come to know and love it during the past three decades, may not regain its flair for a long time. Inventory remains high. Lending standards, although not as neurotic as during the worst of the recent crisis, still remain tighter than they've been in a long time. And disposable incomes continue to remain iffy. But demand is still there. The solution is to trade down in purchase price and/or to rent.
Two of the three REITs suggested by my screening strategy should benefit from this.
UMH Properties (UMH)
This company operates manufactured home communities in the Northeast and upper Midwest. Typically, it owns the land on which manufactured homes are placed and gets a rental fee. Manufactured housing refers to homes that look generally like regular houses, but instead of being built on-site from scratch, large sections (wall panels, roof sections, etc.) are built in factories and assembled quickly at the site. Many can look almost indistinguishable from conventional homes and be placed in regular residential neighborhoods. UMH, however, focuses on smaller, lower-cost (less fancy) models that can actually be assembled in the factories and trucked to the sites - communities that specialize in these structures. In theory, the owner could lift the home off the site and ship it elsewhere, but as a practical matter, it's assumed that the homes will stay permanently where it's initially placed. The communities are like many other residential developments: private roads, landscaped grounds, recreational amenities, etc.
The virtue of all this - at least nowadays - is cost, which can range from 10% to 45% cheaper than traditional housing. UMH prefers to deal with residents who own their homes and just lease the land, although in this economy, renting is significant. UMH holds out hope that some of these renters will eventually become buyers, but renting is an important way for people to get into homes and for developers to get cash flow while waiting, for who knows how long, until the overall housing market improves.
UMH is the highest yielding residential REIT, at 6.4%. In other words, it's the riskiest selection in the context of a generally lower-risk group. It owes its position to the way it lives dangerously in terms of how much of its FFO (funds from operations, which is net income plus depreciation excluding unusual items) it pays out as common dividends. In the first six months of 2011, it paid out 92%, and when you add in preferred dividends, it seems UMH needs to depend on the continuing willingness of many common shareholders to use the DRIP (Dividend Reinvestment Program) which, along with the recent issuance of the preferred, is tantamount to using externally-raised capital to contribute to a common dividend. This sort of thing can't persist long. My willingness to consider UMH assumes that improved business fundamentals (improved rental demand, improved demand for low-cost housing) will soon allow UMH to stop doing this sort of thing.
Sun Communities (SUI)
This outfit offers a much less dicey relationship between distributions and FFO (about 70% in the 2012 first half) and a lesser but still very nice yield: 5.5%. It, too, operates manufactured home developments and sells pre-owned homes, but over a much broader part of the U.S. and covering a very wide range of price and quality even by manufactured home standards (some looking like nice selections but others looking quite, let's be polite and just say "downscale"). It also operates sites for RVs (recreational vehicles), which contributes about 5% of annual revenue.
Fundamentally, SUI is doing well. Home sales, same-site occupancy and same-site revenues were all up in the first half of 2012, and the company is adding to its portfolio of properties. Many of the homes (shown on the web site under its for-sale or for-rent listings) are not exactly pretty. But this is a tough economy, so the ability to serve financially-strapped customers may pay off more than an ability to impress with glitz.
Most important, comparing SUI to UMH, I'd be fine with owning both (with the yield averaging to 5.95%), but if you want just one, I'd sacrifice the yield and go for SUI which, it seems, offers a disproportionately large drop in risk.
Campus Crest Communities (CCG)
This REIT, the intermediate-yielding selection (6.0%) provides an interesting change of pace: student housing. It's an interesting business. CCG properties are preferable to traditional dormitories because they are newer (many dorms were built to accommodate the post-World War II baby boom and are now showing their age) and offer private rooms (a bigger deal to a modern generation that includes many who never had to share a room while growing up), private bathrooms, study lounges and kitchens. And unlike traditional off-campus housing, students who rent from CCG rent by the bedroom, not by the apartment unit, which spares considerable collegiate anguish in finding reliable roommates lest someone (or his or her parents) get stuck for a disproportionate share of the rent.
The wholly-owned property portfolio was 84.8% pre-leased for the 2012-13 academic year (versus 82.9% a year earlier). Six new developments are coming on stream and three projects for 2013-14 have commenced. The dividend has been running near 80% of FFO, which increased 9% in the latest quarter.
Relative to SUI and UMH, CCG is in the middle in terms of yield. But the level of risk strikes me as being closer to that of SUI at the lower end of the range.