In a yield-hungry world, there’s no denying that the dividends offered by real estate investment trusts can be mouth-watering.
Two of our Best Dividend Stocks — Digital Realty Trust (DLR ) and W.P. Carey (WPC ) — are REITs, yielding 4.7% and 6.1%, respectively, which is above the 4.4% average REIT dividend at the end of September, according to the National Association of Real Estate Investment Trusts. The high return of these investments begs the big question: is this a good time to buy REITs?
No Longer an Alternative
For many years, REITs were considered an “alternative,” in that while investors were purchasing equities, they were actually taking a stake in real property of one kind or another (apartment buildings, offices, shopping centers, storage facilities, etc.), the performance of which typically was not correlated to equity price movements. But the price performance of REITs during recent market downdrafts laid that notion to rest, and now it seems that most asset classes move in tandem.
So if REITs aren’t really alternatives, what are they? Due to their legal status as tax-advantaged pass-through entities, at least 90% of a REIT’s income must be returned to shareholders in the form of dividends. This means that REITs can be a very attractive income vehicle. For investors who want safe, reliable income, the challenge therefore is finding REITs that are on solid financial footing and not likely to cut their dividend — and buying them at a reasonable price.
Since REITs must borrow money to expand (they can’t retain earnings due to their advantaged tax status), fears of rising interest rates have pushed REIT shares lower over the past year. The values are so low, in fact, that they are out of sync with the value of the properties underlying the shares. REITs are currently trading at about a 15% to 20% discount to those values, says Michael Knott at Green Street Advisors in a recent story in the New York Times. That discount is one of the widest in at least two decades.
To boost their share price, many REIT operators are planning to engage in stock buyback programs, which means they’ll be increasing their leverage. For many REITs, this won’t be a problem; for others it could make for too much vulnerability if real estate prices and/or rents should soften.
Janet Morrissey, a long-time REIT expert and author of the Times article, suggests that the best REIT picks are those that trade at discounts of at least 20%, have under 40% leverage, have investment-grade ratings and plan to fund the buybacks through property sales rather than borrowing.
What's Your Rate Outlook?
For investors interested in REITs who have done their homework — including finding those REITs that meet the above criteria — the big uncertainty remains the interest rate picture. If you believe interest rates are headed higher, then maybe it pays to be cautious and stay away. In such an environment, REITs stuck with high debt and properties whose value will decline if rates go up could very well cut their dividend and suffer share-price erosion.
But if you believe interest rates will stay low or maybe go even lower, and that the current pricing of REITs reflects the threat of higher rates, this may be a good time to cautiously add good quality REIT shares to your portfolio.
Find a complete list of REITs here.
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