Earlier this year, the Fed spooked the market by suggesting that it would reduce "quantitative easing."
This resulted in a sell-off of interest rate-sensitive stocks such as real estate investment trusts. As we now know, the recent shenanigans in Washington have led to tapering being taken off the table, at least for the foreseeable future. As a result, interest rates may remain stable or even move lower. This has resulted in a buying opportunity for REITs.
What is a REIT?
REITs were created by Congress in 1960 to provide a way for small individual investors to participate in the income stream from large-scale real estate projects. A REIT is a company that owns and operates properties. A unique feature is that they must distribute 90% of their taxable income each year. This makes REITs a first-class choice for income investors.
How to evaluate REITs
REITs are not evaluated in the same manner as other companies. Rather than using typical financial measures like the price-to-earnings ratio, it is more appropriate to use a metric called funds from operations. FFO is a measure of net income that excludes depreciation.
For most companies, depreciation of equipment is a legitimate expense since equipment wears out and must be replaced. Real estate does not wear out, though, and may even appreciate over time. FFO is thus a measure of the cash flow and the dividend-to-FFO ratio is a good indication of a company's ability to maintain dividends.
1. Profiting from the aging population
Health Care REIT (NYSE: HCN) has 1,025 properties in 46 states. It has a wide assortment of senior housing units, skill nursing facilities, medical centers, and life science buildings. In 2011, 13.3% of the population was above 65 years old. By 2030, however, this percentage is expected to increase to a whopping 18.3%.
Since people over 65 visit medical offices 6.9 times a year (compared to only 2.3 times for people under 45), this aging of the population should bode well for Health Care REIT.
To prepare for this eventual increase in business, the company has been on an acquisition romp and has done a good job of integrating the new properties into its portfolio. It has a superior stable of properties, with 82% private pay and 80% in affluent markets.
FFO is expected to increase by about 8% this year. The company has paid dividends without interruption for 170 quarters. The dividend rate is 5% with a dividend-to-FFO ratio of about 80%. Even with these excellent fundamentals, however, the stock has dropped almost 20% since May. This dip makes it worth a look.
2. Steady dividend payer
Realty Income (NYSE: O) is a favorite with income investors since it has paid 511 monthly dividends since 1970 and has had 70 dividend increases since it was listed on the NYSE in 1994. Realty Income owns 3,681 commercial properties in 49 states. This represents a total of more than 53 million square feet of leased space, with a 92% occupancy rate. The retail segment represents the majority (79%) of Reality Income's portfolio.
In late January, Realty Income made a large acquisition of American Realty Capital Trust, which substantially increased its FFO and allowed the company to raise dividends. The dividend yield is a hefty 5.5% and the dividend-to-FFO ratio is a relatively high 90%, but is expected to drop to about 83% next year.
The company's stock price has dropped more than 25% since May, creating a good opportunity to acquire a top-notch company at a bargain price.
3. Largest owner of shopping malls
Simon Properties Group (NYSE: SPG) is the largest owner of shopping malls and outlet centers in the United States. It owns 326 properties in North America, Europe, and Asia.
Simon Properties will spend about $1 billion per year through 2016 for redevelopment and expansion. This should result in increased FFO and potentially an increase in dividends.
Over the last year, all of the company's financial trends such as occupancy rates and rents have all been favorable. The dividend yield is 3.3% and the dividend-to-FFO ratio is a solid 55%. Mall owners had been the best-performing REITs over the previous four years but have fallen on hard times as the lackluster economy has taken its toll.
Simon Properties' stock price has shed about 12% since last May. However, as the economy improves, people will return to shopping malls. This means that, at the current price, Simon Properties potentially represents a good buy for patient investors.
4. Big apartment operator
Apartment Investment and Management (NYSE: AIV) owns and operates apartment buildings. It owns more than 265 properties containing 67,977 apartments in 42 states. Its occupancy rate is a high 95.2%, reflecting effective management. The leasing environment is improving, and Apartment Investment is reducing its affordable housing segment to concentrate more on higher-income properties.
The company has a strong balance sheet. Its FFO increased 12% in 2012 and continues to climb. Its dividend yield is at 3.4% and the dividend-to-FFO ratio is only 48%, which could result in higher payouts in the future.
Even with these excellent prospects, however, Apartment Management is still selling at a discount of about 12% from its May high. As the economy improves, renters will migrate to more expensive housing, creating more profits for this undervalued stock.
Foolish bottom line
The decision by the Fed to continue asset purchases, combined with the improving economy, is a large plus for REITs. Interest rates are also expected to remain low. The environment is favorable for REITs, and the current downturn represents an excellent entry point. REITs are not for the faint of heart, but if you can tolerate the ups and downs, then these four companies will almost surely reward the long-term investor.
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