High yields coupled with price appreciation would be the Holy Grail for most investors. Real estate investment trusts, or REITs, own assets that may appreciate when interest rates rise. These underlying assets often become more valuable when interest rates are declining as well. In a nutshell, that is why so many long-term investors view REITs as an important asset class to include in a well-diversified portfolio.
Companies such as: STAG Industrial (NYSE:STAG), Spirit Realty Capital (NYSE:SRC), American Realty Capital Partners (NYSE:VER), and Realty Income (NYSE:O) have provided shareholders impressive total returns for the quarter ending March 31, 2014.
But wait, there is more good news. Each of these companies pays out dividends to shareholders every month. This increases the compound return for investors who choose to reinvest the dividends, as well as investors -- such as retirees -- who are looking to supplement their monthly income.
The IRS requires REITs to pay out at least 90% of their taxable income as dividends. It is something that investors can count on. So, ideally these companies would have a reliable source of cash flow to pay dividends to investors. Do they?
Single-tenant net-lease business model
What if there was a business where revenues were quite predictable? It would look a lot like owning a huge basket of triple-net leases. That is what all these companies do exclusively. Now from time to time these companies buy large portfolios in order to acquire more of these properties. Sometimes there are other types of assets in the bundle, such as: multi-tenant retail, office, or industrial properties. No problem. Usually, these companies sell off these "non-core assets," or spin them out as a separate publicly traded company.
What do these core assets look like?
This is not very hard to explain. In the town where you live there are likely drugstores, such as: Walgreens, CVS, and Rite-Aid. How about free-standing restaurants? Yes. These REITs own most of the real estate where you and your family go out to eat like -- McDonalds, Taco Bell, KFC, and Starbucks. Convenience stores? Check. Dollar stores? Absolutely. Free-standing retail? Yup. Corporate headquarters and mission critical facilities? Of course. You get the idea. The name on the building is not necessarily the company that owns it. However, they do pay the rent. Sweet!
What about expenses and repairs?
This is where the term "triple-net" comes into the equation. Typically, the corporate tenants are required under the terms of the lease to pay: real estate taxes, insurance, and most maintenance. The landlords are usually responsible for the structure, and sometimes the roof. The big picture is that these REITs don't need a huge staff to help maintain thousands of properties. Most of this is done by the tenant. They call the plumber, fix the HVAC, and repair most of what can be broken.
Why is this important?
This business model is ideally suited for profitable growth. General and administrative expenses are simply spread out over more properties and the savings falls to the bottom line. Clearly there are economies of scale to be had. However, it is important for these landlords to understand the credit risks associated with individual companies and business sectors. Likewise, management must decide between being geographically diversified, or doubling down on successful regions where they are experts and are more likely to uncover undervalued properties.
What about the balance sheet?
This is critical for investors to monitor. Publicly traded REITs have many options when it comes to raising capital for growth. The more conservative management is, the greater likelihood the dividends are safe. On the other hand, well managed REITs will take advantage of opportunities to raise capital to grow profitably. Management has many choices to fund accretive growth, including: debt, preferred stock, lines of credit, cash from operations, the sale of non-core assets, issuing additional common stock, as well as mergers and acquisitions
Triple-net single-tenant equity REITs are an asset class that most investors should consider as part of a well-diversified portfolio. It is crucial for investors to look at the balance sheet, geographical and business sector diversification, past track record, and management's vision for growth. I find researching SEC filings and listening in on quarterly earnings conference calls to be a great way to gain valuable insights.
Bill Stoller has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.