Let's Talk REITs

On today's financials edition of Industry Focus we break down the Real Estate Investment Trusts (REITs) and our analysts will offer a couple companies they've found stable enough to consider investing in.

A full transcript follows the video.

Gaby Lapera: Hello, everyone. Welcome to The Motley Fool's Industry Focus financials edition, where we talk about companies with business models that sound made up. It's Gaby Lapera here and we have Michael Douglass filling in for John Maxfield who is on vacation.

Michael Douglass: Yeah. Actually, for those of you who miss my tendency toward vocalized pauses and "ums" and stuttering on podcasts, look forward to...

Lapera: I don't miss it.

Douglass: Yeah. Thanks. I appreciate that. Look forward to me on healthcare. I'll be filling in for Kristine Harjes who will be out on vacation. It will be bringing the dream team of Michael Douglass and Todd Campbell back together for at least one encore.

Lapera: Today we're going to talk about the wonderful world of REITs. REIT stands for Real Estate Investment Trusts. This type of company specializes in owning or financing income producing real estate, or a bunch of mortgages. This normally means buying a property like most REITs, the ones that we're really going to focus on today, means buying a property and then leasing it out to a corporate client.

Douglass: Right, or the government, or even some of your mom and pop shops. Think shopping centers, malls, apartment buildings, office buildings, big warehouses and manufacturing facilities; these are the things that REITs tend to own. Including even hospitals and skilled nursing facilities. We'll be talking about that a little further down the line.

Lapera: Bringing it right back to the healthcare.

Douglass: Yeah, I can't resist.

Lapera: To qualify as a REIT ... REITs are special companies. They have special restrictions put on them by the government. To qualify as a REIT you have to invest at least 75% of your total assets in real estate and you have to get 75% of your gross income from real estate and you have to pay out -- I think the technical term is "A whole bunch" -- of your taxable income in shareholder dividends.

Douglass: 90%. It's a big number.

Lapera: Yeah, I was trying to think of a polite way to say that. I realized halfway through that sentence that sentence doesn't typically end that way.

Douglass: That's OK.

Lapera: REITs are super special. They're one of the companies that you're always going to get a dividend from, and if you're not getting a dividend then get out real quick.

Douglass: Yeah. There's something weird going on because that means that the REIT's not making any money. Which usually, more broadly, we're looking for companies that are bringing in some kind of cash.

Lapera: I just want to take a quick minute to point out that there's a difference between an equity REIT which is the ones that specialize in real estate and mortgage rates. Mortgage rates are generally a pretty bad idea.

Douglass: Yeah. It's a riskier investment. Most of your mortgage REITS are investing in mortgages that are agency backed. We're talking agency backed securities from Fannie Mae, and Freddie Mac. Those mortgages carry a fair bit of risk. There are also mortgage REITS that invest in non-agency backed securities.

Lapera: Which are a terrible idea.

Douglass: Well, they carry a great deal more risk. Certainly more risk than Gaby or I are comfortable with. Generally, not for the introductory investor. I would say not for any investor, but certainly not for...

Lapera: Certainly not for the faint of heart, for sure. Part of the problem with mREITs is that they have super high leverage, which is how they can produce these double digit dividend returns.

Douglass: Say that five times fast.

Lapera: Stop stealing my jokes. Our interest rate environment right now is super low. So they can afford to do that, but as soon as the Fed raises interest rates that's going to cut in significantly to the profits of these type of mREIT companies.

Douglass: It's also a bit of a threat for equity REITs as well. The issue here is, when the Fed raises interest rates, essentially the cost of borrowing increases, which then means for a REIT, for a mortgage or equity REIT to make money, it needs to get a better return on its investment. That can be difficult. That can make REITs become more selective because their cost of borrowing grows so much. For mortgage REITs in particular that's difficult, but it could also be an issue for equity REITs.

Lapera: Especially since they tend to be more highly leveraged than the equity REITs. That being said, we've discussed that REITs are not quite like your average company. That means you can't use all your traditional metrics to asses them because they don't work as well. Particularly, price to earnings is not helpful.

Douglass: The thing is, price earnings is required for generally accepted, accountable practices.

Lapera: They have to report it.

Douglass: Right. There's a compelling argument that one of the uses with gap earnings per share is that it essentially takes in depreciation of buildings, automobiles, and real estate as well. For these REITs, real estate actually grows in value over time instead of going down in value, or at least it doesn't depreciate on the schedule that you're used to from the IRS.

Something they argue is a little more helpful is funds from operations, which kind of adds that back in, or zeroes that out.

Lapera: Right. When you look at the funds from operation, what you want to see is a value around something similar to a price to earnings ratio. The other thing to think about with REITs is when you look at other companies and you see a ton of debt that's something to worry about, but with REITs it might not be as worrisome as it would be with someone like a toy retailer.

Douglass: Right. That's because they make their money, a lot of times, on their spread between their cost of their borrowing and what they're able to purchase with that. You would expect them to be more leveraged than the average company. Maybe not as leveraged as some of the mortgage rates are. Again, we're talking equity REITs here as the better investment, particularly for someone who is new in the space.

You will tend to see more leverage than you would see in an average company. A debt ratio that is a red flag for another company might not be that way for a REIT.

Lapera: That's one of the reasons it's really important to check a REIT's credit rating before investing because the credit rating dictates how cheaply they're going to be able to take on debt in order to fund their operations.

Douglass: Of course, that sometimes depends on the debt you already have. It's a bit of a cycle, but that's definitely a very important thing. If you can keep that low cost to capital even in a rising interest rate environment -- theoretically when at some the Fed actually increases rates -- that's going to be a big benefit to whomever has that good credit rating.

Lapera: The other thing to look at is the dividend yield rate. A healthy dividend yield rate for most REITs is around 4%-6%. Again, if you see them going super high like you do with MREITs, typically there's something hinkey going on, or they've just taken on a ton of risk in order to fund that.

ON the other hand, if they're too low it could be that there's something wrong with the company, or that they are in the process of expanding. I think you had an example.

Douglass: Yeah. There's a company whose ticker is AMT. They're American Tower Corporation. They pay out a 2% dividend, but they are growing very quickly. I think one of the things with the dividend is, like every number, it's just a number until you know the story behind it. You need to understand why a company is paying out a high dividend, or a low dividend.

Let's say it's really high. Maybe that's because the stock has been unnecessarily beaten down by the market and the market is missing an opportunity that you can then take and get this great dividend yield and potentially some growth once it returns to a more traditional valuation.

It could be that there's very good reason for that valuation to be so depressed. Maybe it's because they're really exposed to interest rate risk. Maybe it's because the folks that they're taking on, one of them might be going out of business, or being merged into another. This happens in retail all the time.

One company buys another. Think about it this way. If Walgreen bought Rite Aid, for example -- and I don't think this is going to happen, but let's pretend -- they're across the street from each other. It wouldn't make sense to continue operating both. That might be a risk for a REIT that happened to own a bunch of buildings that Rite Aid was leasing.

That's the sort of thing you have to understand. You really have to look deep into that story and go a step beyond the numbers and the headlines to really understand what's going on.

Lapera: Basically, kids, you need to do your homework. Talking about that, both of us have looked into some REITs and we've both come up with one REIT each that we'd like to talk a little about.

Douglass: Good for a starter investor; someone who's interested in the sector, but might not be that knowledgeable about it. At least not yet.

Lapera: Right. These people have fairly good business practices, they're pretty transparent on their 10Ks, so they'll be a bit easier to wrap your mind around. Do you want to start, or should I?

Douglass: Why don't you start?

Lapera: All right. I'm going to be talking about Realty Income (O 0.11%). Realty Income is one of the largest retail REITs out there. It has one of the best track records. I know what you're thinking. You're like "Oh, man. Brick and mortar retail is going the way of the dodo. The Internet is cool and that's what I use to order all my groceries."

Most people don't do that. Reality Income is super smart about the type of tenants that it takes on. It focuses on tenants that absolutely need to have a physical foot print. Those like fast food restaurants, gyms, convenience stores, pharmacies, movie theaters, grocery stores; these are all places that people typically need to physically go to in order to get stuff.

They also have these massively long 20 year, triple net leases. A triple net lease is cool for a REIT because it means the tenant, not the REIT, is responsible for insuring the building, taking care of all the maintenance, and paying all the taxes for the property.

Douglass: Yeah. Don't forget utilities as well.

Lapera: Oh, yeah.

Douglass: It's a beautiful thing.

Lapera: The REITs are basically saying if they give you the building, it's all their responsibility, but they're still going to charge them for having it. That's great for them. That's how they can make so much money. It just cuts down on cost and ensures a super steady revenue stream because they are so long term; those 20 years long leases.

The other things that's cool about Realty Income is that they have a lot of really long term tenants, which means they are probably a well-run company because they've been able to foster and maintain these relationships over such a long time. It's really hard to buy that kind of loyalty.

Beyond all that, Realty Income has some healthy numbers. Their FFO is around 16, they have really responsible debt and stock to capitalization ratio that's around 30, which is lower than a lot of its peers, and their dividend is very sustainable around 5%.

Douglass: Yeah. It's a beautiful company and it's the goliath in its space of retail. That's a company that's done well for a long time and certainly looks poised to do very well, especially leveraging that size and that scale that they have longer term, and those triple net leases.

In a lot of ways I can't help that my roots are in healthcare. I always think a little bit from a healthcare perspective because I think there are so many massive demographic shifts that are pushing in the direction of healthcare. These include the greying of America, the growth in script drug use. Also things in the United States like the Affordable Care Act and Medicaid expansion; these should be beneficial to the healthcare space on the whole, for the medium to long term. That's our investing time horizon.

One of the big dogs in the space is called HCP, Inc (DOC 1.21%). Really complicated there. They pay about 6% dividend and they are very broadly exposed across healthcare. Going from an investor presentation at the end of their first quarter, they were about 38% senior housing, about 24% post-acute and skilled hospitals and nursing facilities, 14% life science, 14% medical office buildings, 5% international, 5% hospital; really across the board in clinical healthcare.

Leaving aside your pharmacies, the clinical side of healthcare; they're really broadly exposed across that entire portfolio. Keep in mind, that was Q1. Q2 numbers are a bit different, but still similar. You get a sense of the size and scale and dispersion that they have. If any single part of the portfolio had a lot of trouble, they have a lot of the rest of the portfolio to fall back on.

It's a healthy company. One of the interesting things about it and about FFO is, FFO is still subject to the same problems of gap earnings per share. One is: in earnings per share you tend to not zero out acquisition related costs. That's why some REITs also report an FFO, which is adjust Funds From Operations, and FAD, which is Funds Available for Distribution.

Lapera: It's important to note: for both of those, there's no standardized way to do them. Everyone is doing them differently. Don't take it as an 'apples to apples comparison across all REITs.

Douglass: Right. If one REIT is trading at a 16 price to AFFO ration and another one is at 22, that doesn't necessarily mean anything until you understand what exactly is going into the AFFO calculation.

Lapera: They put it in their 10Ks, or 10Qs.

Douglass: Right. They have to explain it. For HCP, once you zero out some of those acquisition related costs and some other, one time numbers there; AFFO has very steadily increased last quarter and their Funds Available for Distribution -- which is what they think of in terms of being able to pay out dividends -- is healthily above the amount they're paying out in dividends.

That indicates dividends are stable, sustainable, and has a good opportunity for further expansion. A 6% yield is pretty good. Neither Realty Income Group, nor HCP is going to necessarily be one of those rocket ship like return companies.

Lapera: It's great to own and hold for a really long time. 

Douglass: Yeah. I think particularly for folks who are focused on income. Folks who aren't necessarily looking for huge, broad, immediate growth, but are looking for steady, sustainable, still growing income...

Lapera: Thank you. Michael is saying this much better than I did. This is a great way for you to continue investing in the stock market, even if you're in retirement without having to worry about the risks and volatility of your more traditional stocks.

Douglass: Yeah. Not to say they aren't still volatile because all stocks carry risks. These REITs are big, they've been around for a long time and they've had this proven record of success through multiple financial downturns. They're really powerful companies. It's a complicated space. It's not easy to invest. It's complicated anywhere, but I'd say REITs aren't the easiest of the stock market.

Lapera: They're not an intuitive thing to think about.

Douglass: Yeah. It is a space where, if you're smart about the long term trends and also thinking about being smart about where you're deploying your capital it can still be a very good place for people to invest.

Lapera: Absolutely. That wraps up our show. I just want to remind our listeners that people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against. So, don't buy or sell stocks based solely on what you hear. See you all next week!