How to Profit with REITs

 |  Includes: BDN, HPT, SRO
by: Investment U

The current bear market has pounded anything that has to do with real estate. Banks and real estate investment trusts have been hit particularly hard.

One of the main problems with banks is that we have no idea how bad the loans in their portfolios are. Banks have been downright deceitful about the number of under-performing loans they've hidden in their balance sheets. And the residential mortgages they hold are dropping in value as the real estate market loses value.

But unlike the banks, real estate investment trusts or REITs have been able to protect their value… and their income.

The majority of REITs own commercial properties with long-term tenants, stable values and fixed income payments. However, this hasn't had any impact on Wall Street's fears. They've dumped anything and everything with property exposure. And this irrational behavior is giving us opportunities to pick up shares of three underappreciated dividend powerhouses…

Understanding the Property REITs Hold

There is very little we can do to assess the loans given by American Express to its cardholders, or by Citibank to a real estate developer in South America, or even the derivatives contracts held by AIG with investment grade counterparties. But we are very capable of understanding the property REITs hold…

  • These are physical assets we can understand - an office building in Herndon, Virginia, development property in Chattanooga, Tennessee, or a shopping mall in Honolulu.
  • Most real estate is leased to long-term tenants; therefore, the amount of vacant space is measurable.
  • The cash flow of real estate investment trusts is regular and predictable.
  • In addition, the ability of a REIT to afford its dividend is apparent. You can easily tell if they have the funds to keep a steady flow of dividends coming.

When Congress created REITs in 1960, they were attempting to let small investors benefit from a diverse portfolio of large-scale real estate investments. While protecting investors through the diversification of these portfolios, the greatest advantage of REITs is in their dividend power.

REITs Distribute 90% of Their Taxable Income

By law REITs are required to distribute 90% of their taxable income. Because these distributions are passed directly to shareholders, taxes are paid only once. It avoids the double taxation of dividends other investments are subject to. (Reducing investment expenses is one of our "4 Pillars of Investing".)

Today, many REITs are trading at multi-year lows, and would represent an attractive investment even without dividends. But it's through the dividends, and the ability to reinvest them, that can lead to the greatest gains. By reinvesting and compounding the dividend growth, investors can see their money double in a short time. Take a look…

Compound Interest
Interest Rate Time to Double
5% 14.2 years
8% 9 years
11% 6.6 years
14% 5.2 years
17% 4.4 years
Click to enlarge

REITs Hold Value During Periods of Inflation

Because they hold physical assets, REITs hold their value during periods of inflation. But investors aren't purchasing more of these dividend machines with today's inflationary environment. In fact, fearful investors have been unloading REITs at bargain prices.

Two real estate investment trusts trading below Net Asset Value [NAV] are:

  • Hospitality Properties Trust (NYSE: HPT), yielding 14%. Previously, HPT was trading above $50 in December 2006 and now it trades for $21 plus change.
  • Brandywine Realty Trust (NYSE: BDN), yielding 11%. BDN was trading for $35 a share in February 2007, and now it can be bought for $15.

Both of these REITs have issues that have exaggerated share price losses.

Brandywine has made some big development bets that have not been living up to plans, and Hospitality Properties Trust acquired a string of truck stops that is slightly outside of its core hotel business. Both were high flyers less than a year ago, but neither firm's assets are devalued enough to chop share prices by over 50%.

If you do not want to trade in REITs directly, look at DWS RREEF Real Estate Fund II (AMEX: SRO). This is a closed-end fund that, due to its leverage, currently yields 13.19%. It's trading at a discount to NAV.

Add it all up and REITS offer you the prospect for attractive total returns and downside protection. A combination of dividends, and potential share price appreciation makes these attractive investments - especially ones with the potential to double in less than five years.