The Most Dangerous Investment in Today's Market

While stock investors celebrate the latest jumps in the stock market, those seeking current income from their portfolios continue to struggle with a big problem: how to get payouts they can count on. Yet with risk-free alternatives starting to dry up, those taking on more risk to sustain their income may get burned sooner than later.

Income investors have seen attacks from all quarters. Short-term Treasury securities continue to yield less than 1% -- before tax. Bank CDs, which until recently paid a high premium to Treasury rates, have come down sharply in recent months; the average six-month CD pays just 1.76%, having gotten cut in half just since October. While last week's announcement of record profits from Wells Fargo (NYSE: WFC  ) undoubtedly stems from the high interest rate margins produced by low rates, savers are paying the price.

Because of this assault on the interest payments they receive, investors are looking to riskier strategies to sustain their portfolio income. One place you can find sky-high yields right now is in real estate investment trusts. But with everyone concerned about dividend cuts that have hammered shares of companies from Dow Chemical (NYSE: DOW  ) to Citigroup, are REITs better placed to protect investors from falling income?

The scoop on REITs
To answer this question, you first have to understand how REITs work. Typically, companies have complete discretion over how much they choose to pay in dividends. Plenty of companies, such as Google and Apple, have never paid dividends; others, such as ExxonMobil, have paid dividends at a steadily increasing rate for decades. This flexibility gives most companies the ability to decide whether they'd prefer to retain cash to reinvest into their businesses or return capital to shareholders.

REITs, however, don't have that flexibility. REITs get a huge benefit that other corporations don't get: they are allowed to avoid corporate taxation. But to get that tax benefit, REITs must pay out 90% of their income in the form of dividends.

Sustainable dividends?
The 90% requirement has huge implications for dividend stability. Unlike other companies, REITs ordinarily can't build up cash cushions to help them keep paying high dividends when income falls. That has caused a few dividend implosions already in the REIT universe:

  • General Growth Properties (NYSE: GGP  ) suspended its dividend entirely late last year.
  • Other REITs, including Simon Property Group (NYSE: SPG  ) , have started paying dividends in stock in order to conserve cash.

Obviously, when REITs no longer earn enough income to sustain payouts, something has to give. That's why investors who see REITs as an answer to their income problems really need to check their numbers before investing. Depending on which REIT you're looking at, you may get much different answers. Consider:

REIT

1-Year Return

Dividend Yield

Payout Ratio

Omega Health Investors

3%

7.7%

128%

Simon Property Group

(53.3%)

8.4%

193%

Public Storage (NYSE: PSA  )

(24.8%)

3.4%

67%

Duke Realty (NYSE: DRE  )

(59.9%)

12.1%

508%

Kimco Realty (NYSE: KIM  )

(69.7%)

17.1%

210%

Sources: Yahoo! Finance, DividendInvestor.com.

Needless to say, many of these stocks have already taken a big drubbing. But with their payouts so high in relation to income, there's no guarantee that the worst isn't yet to come. And certainly for those who might be thinking about buying REITs primarily for their high dividend yields, you simply can't count on those payouts being sustainable for any length of time.

Be wary
The good news for income investors is that dividend yields on traditional stocks are relatively high. And while you'll find your fair share of dividend landmines there too, those companies at least don't share the pressure REITs have to maintain and pay out dividends consistently in order to retain favorable tax status.

For those seeking an income panacea, REITs aren't perfect. Although they generally make a good contribution to an income-producing portfolio, make sure that you choose REITs that will best weather potential income problems without destroying their dividends in the process.

For more on getting income for your portfolio, read about:

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Fool contributor Dan Caplinger loves the income from dividends, even though he just reinvests it. He doesn't own shares of the companies mentioned. Google is a Motley Fool Rule Breakers selection. Apple is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy keeps you out of harm's way.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 13, 2009, at 4:55 PM, Netteligent09 wrote:

    Our NASDAD based companies are speculative stocks. Somehow gamblers love to pump them up. It is not about investment anymore.

    When the worst comes, we will be in huge troubles because we digging a deep hole that we cannot climb out.

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