A Few Things to Know About These High Yielders

With low yields everywhere around us, real estate investment trusts are hot. Normally viewed as a boring subsection of the market, REITs now have all the buzz and chatter usually associated with biotechs or microcaps.

According to data from Capital IQ, there are 177 REITs trading on major U.S. exchanges. The average trailing-12-month dividend yield among those REITs is 5.3%. Compare that with the 1.7% or so the S&P 500 is paying out right now, and it's easy to see why investor interest has spiked.

Now, the absolute highest-yielders in this bunch are mortgage REITs such as Annaly Capital. Mortgage REITs, or mREITs, offer tantalizingly high yields, but also come with a great deal of risk. Bill Mann has called mREITs "teeny slices of equity strapped to an atom bomb of debt." That's not to say they're bad -- just that they come with more inherent peril.

Today, though, I'm going to focus on the more common equity REIT. The highest-yielding equity REITs include Hospitality Properties Trust (NYSE: HPT  ) and Medical Properties Trust (NYSE: MPW  ) , paying 7.2% and 7.3%, respectively. Hospitality owns and leases hotels in North America, while Medical Properties leases health-care facilities nationwide.

For prospective investors in Hospitality Properties, Medical Properties, and other equity REITs, I asked REIT expert Ralph Block how to invest in REITs, and how to spot the biggest misconceptions circling these stocks.

A former lawyer, Ralph is a leading expert on REITs, having literally written the book on investing in them: The fourth edition of his Investing in REITs is in the works right now. He is a former co-manager of the Undiscovered Managers REIT fund, and he's been personally investing in REITs for more than 40 years.

Our interview covered a variety of REIT-related topics; what follows is an edited portion of our conversation. (Note: My discussion with Ralph was mostly focused on equity REITs.)

Brian Richards: When evaluating a REIT, how important is management? Does it make or break your thesis, or can a good REIT survive with bad management?

Ralph Block: It really depends on where we are in the real estate cycles. If the cycle is favorable and we're seeing increasing occupancy rates, increasing rental growth, and properties that aren't terribly expensive, most any REIT can do reasonably well, even with a mediocre or less-than-mediocre management team.

But when things get tough you really want an outstanding management team, not only because they're able to protect cash flows on the downside because of tenant relationships or what they've done with their properties. AMB Property (NYSE: AMB  ) is probably a good example. The industrial sector has been hit pretty hard in the Great Recession, but if you look at AMB's vacancy rates, you know, they're significantly below what they are nationally, and that's because they manage them well, they've chosen properties in really good locations.

So overall, speaking generally, management is very important to me. And one of the problems, of course, for newer investors in the REIT space is that sometimes it's just really hard to tell who the really good REIT management teams are unless you've followed them for a long time. So what I see with a lot of people new to REITs is that they invest on the basis of statistics without really going beyond those because they don't have the ability to do that.

Richards: If I'm a retail investor and I want to buy specific REIT stocks, what's your advice to me for what should I look for in a REIT? What should I keep tabs on if I own a REIT? What are some of the key things that people should be looking for?

Block: I think one of the key things is the balance sheet. The REIT industry had the scare of its life just a couple of years ago, and it was because a lot of REIT management teams were not keeping a close enough eye on the balance sheet, and they were measuring leverage by the amount of debt they had relative either to the stock prices or to the value of their properties -- they weren't looking at debt versus EBITDA, which is a more conservative way of looking at things.

Going forward, while the credit squeeze is pretty much over at least for the medium and larger REITs, we don't know when it's going to come back. And so what I'm thinking now is that while the balance sheet has always been important, it's even more important going forward because it's defensive in the event credit all of a sudden dries up again. (Who knows if it's going to happen? It might.) And also, it gives a REIT a lot more flexibility to pursue opportunities because they can easily borrow money at a much lower cost to make acquisitions, do developments, or whatever.

So the balance sheet is very important. Management is, in my opinion, equally as important. That's a harder call because if you haven't lived with a REIT for a number of years it's really hard to gauge management. But one way you can do that is to compare a REIT stock's performance record against its peers, and if you see some that seem to have outperformed over a five- or 10-year period and management hasn't changed, then you know these guys are probably doing something right.

Particularly for newer REIT investors, I think it's important to focus on the larger names simply because they have been successful, they've been able to grow, they've been able to get capital. And so I think until you get more experience I would stay away from the smaller names. And I think it's also really important to invest in enough different REITs so that you get exposure to different kinds of geographical locations as well as sectors.

Richards: What do you think are the biggest misconceptions of investing in REITs?

Block: This is not a misconception, but I think it's kind of a bias, and I spent a lot of time in all the editions of my book on this point: REITs have a disadvantage in that equity investors don't really understand commercial real estate. REITs don't make a product, and they don't really provide a service. They own things, they charge rents for them. And they have their own lingo -- NOI and depreciation and all this kind of stuff.

So the typical equity investor hasn't really spent the time to understand the dynamics of commercial real estate so they tend to be reluctant to go where they don't really understand too well. And commercial real estate folks look at REITs and say, "Oh, well they're stocks. We don't understand the stock market and it's a floating craps game. We don't want to be involved in stocks."

So you know, REITs had been pretty much orphans. But that has changed over the years, and with the addition of REITs into the S&P 500 index more people are having to look at them. So I think that is changing but it's changing slowly, but then I think there are a couple of misconceptions, too.

One is, if I've read this once I've read it 100 times: When an article will have a caption saying, "Is now the time to get in to REITs?" or "Is now the time to get out of REITs?" And so the misconception there is that REITs are trading vehicles because they tend to be cyclical, but you know, everything's cyclical. Even technology's cyclical.

And I found that if you tried to, if you were sort of interested in REITs and you started reading all these stories about commercial real estate declining in value and whatnot, when were you going to have sold? You were going to sell in early 2009 -- and in hindsight, that was the time to back up the truck.

So when it comes to REITs, for retail investors the best thing to do is buy some good quality companies. If they don't want to watch them real closely, buy either a mutual fund or an ETF or good quality companies like Simon Properties (NYSE: SPG  ) or AvalonBay (NYSE: AVB  ) , or you know, Boston Properties (NYSE: BXP  ) , and just hold them for the long term. They're really not trading vehicles; they're just too hard to trade. And over time people will do well with them as indicated by those long-term performance numbers.

And I guess the last misconception -- and probably one of the most important -- is that people think of REITs as risky because they think of commercial real estate as risky. And they think commercial real estate is risky because it's usually financed with debt, and it's the debt rather than the asset class that creates the risk.

If you buy anything on margin, it's going to be risky no matter what it is, even T-bills. So I think there's a misconception that owning good quality commercial real estate is riskier than it is.

For more on REITs, read Ralph's thoughts on Weyerhaeuser and the target REIT allocation a diversified portfolio should have.

Fool.com managing editor Brian Richards does not own shares of any stocks mentioned. The Motley Fool owns shares of Annaly Capital and has a disclosure policy.


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