By Tim Begany
If you're a commercial real estate enthusiast, then you know the real estate investment trust (REIT) sector has been hot. Even with a simple index fund like Vanguard's REIT Index ETF (NYSEARCA:VNQ), you could've made nearly 23% annually on the sector during the past three years, including fund expenses.
Many individual REITS have done even better. General Growth Properties Inc. (NYSE:GGP), a large rental property and shopping center owner, for instance, has delivered an astounding three-year annualized return of 64%. Extra Space Storage Inc. (NYSE:EXR), the nation's second-largest owner and operator of storage facilities, has returned 51% a year for the past three years.
That's wonderful, and it's exactly the sort of performance we all hope for. But it also means you should be extra careful about generally sky-high REIT valuations. The MSCI U.S. REIT Index, a commonly used proxy for the entire U.S. commercial real estate industry and the benchmark for funds like the VNQ, currently has a price-to-earnings (P/E) ratio of about 65. And this is just the sector average -- many individual REITs have even higher P/E multiples.
Such high valuations are truly scary because if you buy REITs now, when prices are so high, then you are more susceptible for major losses if the sector hits a rough patch. Plus, higher stock prices mean lower dividend yields. The VNQ, for example, despite its nice annual return, sports a relatively modest 3.2% yield.
But the good news is, you can still find individual REITs with far more reasonable valuations and significantly less downside risk than the overall sector. Carla Pasternak owns several of the best REITs the market has to offer in her High-Yield Investing newsletter, and I've identified three of my favorite high-yielding REITs for you to consider right now:
1. HCP, Inc. (NYSE:HCP)
Industry: Health care facilities
P/E ratio: 31
HCP is the largest health care REIT in the United States, with holdings in 46 states. The company's 936 properties include senior housing, skilled nursing facilities, acute care hospitals and medical office buildings.
The macro trend behind this REIT that makes it appealing is obvious: Baby Boomers are aging, and many of them will drive business to HCP's properties in one way or another in the coming decades.
Because of its broad diversification and relationships with dominant, cost-efficient service providers, analysts estimate the company can realistically maintain yearly revenue growth rates of 8% (currently $1.8 billion a year) and 6% for earnings per share (now $1.47). A good portion of future growth potential is already priced into the stock, currently about $45 per share, but a 25% gain to around $56 a share is feasible during the next five years. Because of strong cash flows, the company can readily sustain 5% dividend growth. This would raise the payout from a current $2 a share to about $2.50 in the coming five years, and maintain an attractive yield of about 4.4%.
2. Senior Housing Properties Trust (NYSE:SNH)
Industry: Health care facilities
P/E ratio: 26
Senior Housing Properties is a lot like HCP but substantially smaller, with 370 properties in 38 states and annual revenue of $542 million. Like HCP, the company owns senior housing, skilled nursing facilities and other health care properties. The stock also boasts a secure dividend with a current payout of $1.52 a share. It's also a key holding in one of Carla's High-Yield Investing portfolios.
The big difference is that Senior Housing Properties has been expanding noticeably faster, growing revenue by 24% a year since 2009, compared with 18% annual growth for HCP. And the company is likely to keep growing faster than HCP, too. Analysts project Senior Housing to increase earnings per share by 7.5% annually, compared with 6% for HCP. Acquisitions have been the main growth catalyst, with the company adding $3 billion of new assets to its portfolio since 2007. Acquisitions have been mainly of medical office buildings because those are typically higher-revenue assets.
Because growth through acquisitions costs money, the company may only be able to raise dividends at a 3% rate to $1.76 a share by 2017. But the stock has more appreciation potential than HCP, so the projected rate of earnings growth would increase earnings to $1.21 per share in 2017 from the current 84 cents a share. Based on the current earnings multiple of 26, you could be looking at a per-share stock price of $31.46 in five years ($1.21 x 26). This would be good for a 43% gain from the roughly $22 a share the stock sits at now.
3. Hospitality Properties Trust (NYSE:HPT)
Industry: Hotel and motel
P/E ratio: 23
Hospitality Properties Trust is a REIT that owns 288 hotels and 185 travel centers in 44 states, Puerto Rico and Canada. Most of its hotels are operated under the Marriott, InterContinental or Hyatt brands.
Some REIT investors are concerned that a reduction in HPT's attractive $1.80-a-share dividend is imminent because of expensive renovations taking place on 200 of the company's hotels this year and next. I don't think a dividend cut is likely anytime soon, though. During the past 12 months, HPT accumulated $74 million of free cash flow after paying dividends and shelling out $295 million for renovations and other capital expenditures. What's more, in 2013, analysts project revenue will at least equal 2012's estimated $1.3 billion. They also say earnings could climb 8% to $1.35 a share from $1.25 a share in 2012. This should set the company up to comfortably maintain the dividend at current levels until renovations are complete. Once these renovations are concluded, dividend growth should resume at a steady 3-4% annual rate, reaching about $2 a share by 2017.
Risks to Consider: Because the REIT sector as a whole is so richly valued right now, even more reasonably-priced REITs like the ones I've described could be pulled a lot lower if the overall sector fell out of favor.
Consider trimming back REIT holdings with nosebleed P/E ratios and reinvesting the proceeds in much better values like HCP, Senior Housing Properties and Hospitality Properties. In all three REITs, you'll get a higher yield and some downside cushion since they don't have as far to fall.