These Dividend Rock Stars Will Deliver Returns Even With Rising Interest Rates

With the fear of higher interests rates in the future, triple-net lease REITs are still a good choice for stable returns.

Jan 27, 2014 at 12:07PM

There's been a lot of turmoil and uncertainty as the Federal Reserve begins to slowly pull back its bond-buying program. But income-oriented investors looking for solid dividends should still have confidence in the returns potential of triple-net lease REITs.

There are three triple-net lease REITs I believe we need to address in particular. They are Realty Income (NYSE:O), National Retail Properties (NYSE:NNN), and WP Carey (NYSE:WPC). All three have a long track record of strong dividend performance and give different exposure to the sector.

Ben Bernanke's big announcement
The world of income-minded investors was thrown for a loop on May 22, 2013. Fed Chairman Ben Bernanke suggested that he might begin tapering the central bank's monthly bond buying program. Almost immediately, investors started jumping out of bonds. But it wasn't just the bond market that took a hit -- real estate investment trusts (REITs) got hammered as well.

The REIT market is very sensitive to interest rate movements because everyone from developers to builders depend on borrowing. As evidence, the FTSE NAREIT index hit its peak the day before Bernanke's announcement. Fast-forward to November, and REIT shares had collectively lost about 11%. 

Yet all income vehicles are not created equal, and the REIT sell-off was probably premature. I believe Fed tapering should be looked at as a warning for bonds, but an opportunity in the REIT market.

Why REITs will be better than bonds going forward
Income may be the name of the game, but REITs and bonds are two totally different instruments. If you own a bond, you become a company's creditor. Bondholders receive interest payments and get their principle back. REITs deal in tangible assets, real estate, which can gain value. In order to pay no corporate taxes, REITs must pay out at the very minimal 90% of their taxable income as dividends.

Many experts in the REIT industry believe the hit took after the tapering announcement was unfounded because rising interest rates are a catch-22 for REIT investors.

In a recent interview with CoStar News, Brad Case, VP of Research with the National Association of Real Estate Investment Trusts (NAREIT) stated, "Because the truth is, when interest rates go up, it usually means the economy is strengthening. That's good news for REITs and means that returns will be strong." 

During the last REITWorld conference in San Francisco, one of the industry's biggest professional conferences, NAREIT backed up its vice president's claim with analysis that shows REITs have performed well in 12 out of 16 periods of interest rate increases since 1995. 

What complicates the market is that REITS are not a one-size-fits-all industry. There are so many sub-sectors with their own little nuances that generalizations can't be made across the board. And that's a good thing for income investors. One of these sub-categories is gaining steam on the investment front because of its stable stream of income that doesn't seem to be affected by rate movements or economic changes.

Triple-net lease REITs: Solid enough to withstand rising rates or tough economy
A triple-net lease is a lease agreement where the tenant of a commercial building is required to pay for net real estate taxes, net building insurance and net common area maintenance on the property. Paying those three costs is how the contract got its name.

Since the tenant is paying for the costs usually taken care of by the owner, the tenant is charged a lower rent than that of a standard agreement. In REIT terminology, this translates into a stable income stream with minimal operation costs. That gives the investor higher and more predictable dividends.

Another plus for this sector of REIT is the strength of its tenants. Triple-net leases deal with the Walgreens, Wal-Marts, and Dollar Generals of the world. They own and invest in these types of retail giants over long contractual periods -- and these companies are well-equipped to weather most economic storms. 

NAREIT has put out data that triple-net REITs distribute some of the largest dividends -- around 4.66% -- in the equity REIT sector. 

Three different ways to play this REIT sector
Realty Income, commonly referred to as the "Monthly Dividend Company," is on a roll -- it's increased its dividend 19 years in a row and is now yielding 5.7%. It is arguably the major player in this sector. The company has a real estate portfolio of over 3,800 commercial properties in 49 U.S. states and Puerto Rico. The majority of its tenants have high credit ratings like FedEx, Walgreens, and Family Dollar.

National Retail Properties has paid and increased its dividend for the last 24 years. It owns 1,850 properties in 47 states and differentiates itself by concentrating exclusively on "small-box retail" and owning smaller transactions -- and it dominates that market. 

For 15 straight years, WP Carey has paid and increased its dividend. W.P. Carey owns and manages an investment portfolio worth more than $15 billion. It concentrates on long-term sale-leaseback and build-to-suit financing for companies and has a strong international presence. 

These are three different plays in the same sector of REITs, and these companies were sound enough to distribute and increase their dividends during the last recession. I believe they should have no problem doing the same thing in an improving economy.

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