4 REITs Recommended by Morningstar

Includes: ARE, FRT, O, OFC, VTR, WELL
by: Brad Case

An article published yesterday by Philip J. Martin in the Toronto Star has a good discussion of the strategic role of publicly traded REITs, and makes four specific recommendations. Martin is a Morningstar equity strategist with 20 years of experience in real estate investment. His recommended REITs are:

Those recommendations are based on a detailed set of investment criteria:

  • A history of incremental increases in both portfolio Net Asset Value and business model fair value (Morningstar's net asset value added and fair value analysis).
  • A full-service real estate skill set (acquisition, development, property management), which we feel more appropriately positions the equity REIT to exploit growth opportunities and manage risk, and cash flows throughout the real estate cycle.
  • Lower FFO dividend payout ratios (top 20% of industry, which we currently estimate to be 35%-40%).
  • Debt/EBITDA less than 6.0 times.
  • Fixed charge coverage ratios more than 2.5 times.
  • Niche, competitively advantaged operating strategies.
  • Operating strategies and portfolios focused on need-driven, less cyclical consumer services, such as health care or necessity/value retail.
  • Operating strategies not overly dependent on strong economic and employment growth or consumer discretionary spending.

Beyond the specifics of making current "buy" calls, Martin's piece has a good analysis of both the long-term strategic benefits of a REIT allocation and the current market opportunity for REITs:

We believe equity REITs should be part of a long-term investment strategy based on a number of benefits, including diversification, their ownership of high-quality commercial real estate portfolios, sustainable yield and income growth potential, flexible capital structures, and relative risk, reward, and volatility. We also feel equity REITs are well-positioned to manage through potentially challenging economic circumstances, including slower than expected economic growth and/or rising inflation or interest rate environments.

Finally, Martin's piece summarizes the results of Morningstar research showing that a REIT allocation of 20% of the total investment portfolio has historically boosted portfolio returns while also reducing portfolio risk:

According to a Morningstar study, since 1972, a diversified portfolio (stocks, bonds, treasury bills) with 20% allocated to equity REITs experienced an average annualized total return and Sharpe ratio of 10.5% and 0.45, respectively. For comparison purposes, the diversified portfolio with no allocation to equity REITs delivered an average annualized total return and Sharpe ratio of 10% and 0.39, respectively. The Sharpe ratio helps determine how well an investor is compensated for the risk taken in a specific investment. The higher the Sharpe ratio, the better. In short, the diversified portfolio, including a 20% REIT allocation, generated higher returns with lower risk.

I should point out that last week I posted a different article with four REIT recommendations by Martin, including ARE and O (which also appear in the Toronto Star article) along with Federal Realty Investment Trust (NYSE:FRT) and Health Care REIT (HCN). I've seen recent Seeking Alpha articles by other authors that included discussion of several of these companies, including O, ARE, VTR, OFC, and FRT.

Disclosure: I am long Vanguard REIT Index Fund and ING Global Real Estate Fund.

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts (NAREIT). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.