Desperately Seeking Yield Through Equities Redux: Part 5 - Equity REITs

by: Philip Mause

This is the fifth in a series of articles designed to help investors evaluate various strategies for generating dividend yield in equity portfolios. The first article dealt with BDCs, the second with agency mortgage REITs, the third with non-agency mortgage REITs and the fourth featured telecom stocks.

This article deals with equity real estate investment trusts (REITs), which are real estate investment trusts which own buildings and properties as opposed to mortgages. They are subject to the REIT tax rules under which the corporation is able to avoid paying federal income taxes if it pays out at least 90% if its income as dividends to shareholders who are, in turn, generally taxed at the ordinary income level.

In this sector, income can be a somewhat misleading metric, because there is considerable depreciation of assets which are likely not decreasing in value. For this reason, a substitute metric - Funds From Operations [FFO] - is often used. FFO is income plus depreciation and amortization and minus gains on sales of properties. It is probably a more valuable metric in determining the sustainability of dividends. Just in case things were getting too simple, there is also a calculation called Adjusted Funds From Operations [AFFO] or Funds Available for Distribution [FAD]. This involves the adjustment of FFO to take account of straight line rent accounting and investments in the properties which do not produce additional income. Commerical real estate leases often involve landlord outlays for up front "improvements" to the property and, if amortized over the course of a lease, the result can be cash flow which is quite different from income. In addition, I have also seen "operating funds from operations," "core funds from operations," and "funds from operations before specified items."

As a result of these accounting issues, it can become quite difficult to evaluate companies in the sector. The balance sheet really doesn't tell you what the properties are worth, because it is based on depreciated original cost, and the income statement is only one of several metrics to monitor ongoing operations. To make matters worse, the sector is also notable because most companies in the sector have considerable debt in the form of mortgages and, therefore, there is significant leverage.

Of course, one key advantage of the sector over some other yield oriented sectors is that it provides the investor with an opportunity to reap gains due to the appreciation of the real estate assets owned by the equity REIT. On the other hand, the substantial debt carried by many equity REITs amplifies losses in a downturn and can even create refunding issues.

Equity REITs vary enormously; there are REITs that specialize in apartments, office buildings, storage facilties, shopping malls, health care facilities, and industrial facilities. Some REITs have a regional or even a local focus, while others are geographically diversified. As a general matter, the commercial property industry has and will have a substantial amount of debt coming up for renewal and that is always a risk factor.

The table below provides the price and quarterly dividend on June 24, 2011 when the original article was written and the price and quarterly dividend as of this past Friday for Vornado (NYSE:VNO), Home Proprties (NYSE:HME), LTC Properties (NYSE:LTC), Washington Real Estate (NYSE:WRE), HCP (NYSE:HCP), and MPG Office Trust (NYSE:MPG-OLD). Prices are based on data from Yahoo Financial; dividend information is derived from information on each company's website.

Price 6/24/11 Dividend 6/24/11 Price 3/8/13 Dividend 3/8/13
VNO $90.57 $.69 $84.24 $.73
HME $59.69 $.62 $63.77 $.70
LTC $26.71 $.42 $39.36 $.465
WRE $31.30 $.4375 $28.35 $.30
HCP $36.53 $.48 $48.92 $.525
MPG $2.73 ----- $2.77


LTC pays monthly dividends and I have just multiplied the monthly dividend by 3. MPG did not and does not pay dividends. WRE dropped its dividend for the first time in some 50 years and the market reacted adversely to the news.

Reviewing the group, I am somewhat surprised that in a recovering economy these stocks have not done better. LTC has been a favorite of mine: I bought it shortly after the Crash, largely because at the time, it had little or no debt and I was very, very gun shy about leverage. Since then, it has taken on some debt, but that is always one of the advantages of having no leverage - the capacity to go into the debt market and borrow. LTC's FFO for 2012 was $2.26 and so it looks like the dividend is relatively safe.

VNO is broadly diversified, and it appears that the market is developing a preference for "specialty" REITs; the stock is down even though the dividend is up. VNO's FFO calculation is confusing, and I recommend interested investors review its financial releases before pulling the trigger. HME specializes in apartments, which has been a relatively strong part of the real estate market, and I am frankly surprised to see that it hasn't done better. HME has a healthy FFO of $4.13 for 2012, and so a dividend increase may materialize at some point.

WRE is very focused on the Washington D.C. metropolitan area, which is supposedly "recession resistant" (much like the "unsinkable" ships launched from time to time) but seems to have run into problems. It has owned a diverse group of properties and seems to be moving in the direction of specialization by divesting its industrial properties recently. The dividend reduction blindsided shareholders, but with a 2012 FFO of $1.84, the current dividend should be safe.

HCP and LTC both specialize in health care/nursing home facilities and this seems to have become a strong area of real estate as the aging baby boomers settle into their "golden" years. Both of these have done well with. HCP's FFO was $2.78 for 2012 providing reasonable dividend coverage.

MPG is concentrated in Southern California and has been reducing debt and selling off non-core properties, leaving it with a strong position in the downtown Los Angeles office building market. It is in the process of crawling "out of the woods" and could pop nicely if survival became assured and the downtown LA market began to surge as it has done from time to time in the past. Its financials are a bit challenging; in 2012, it had a big gain from extinguishment of debt, but excluding this item, operations appear to be still producing a loss. For MPG, a great deal depends upon the price action in the downtown LA office market.

The entire group has bounced around quite a bit since June 2011. You could have bought many of these stocks at prices quite a bit lower than the June 2011 levels, when the whole sector got slammed in the summer and fall of 2011. If you are convinced that the recovery is for real, that deflation risk is a thing of the past and that financial markets have returned to normal, then this sector should be attractive, because decent yield could be accompanied by appreciation as the value of the underlying properties continues to increase. My general assessment is that the group has become somewhat more conservative about leverage and payout ratios, and so may be in a position to appreciate nicely if the economy continues to improve.

I would advise investors to study the sector, pick a few REITs that appear to be good long term investments and then watch for a pullback during one of the "risk off" phases of the market. I still like LTC and I think WRE should pick up some steam.

Disclosure: I am long LTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.