Real estate investment trusts, or REITs, did not have a great year in 2016. While there may be some company-specific reasons for individual REITs' performance, for the most part, the decline had nothing to do with the businesses themselves. Instead, the decline was due to the forecast for higher interest rates, which has created some nice opportunities to scoop up high-dividend REITs at a discount. Here are two of my personal favorites that are on my watchlist as we head into 2017.
Information storage with an A-list clientele
Iron Mountain (NYSE:IRM), with a 6.6% dividend yield, is in the business of information storage and management. This includes storage of records and data in its facilities, as well as a document-shredding service that makes up about one-tenth of the company's revenue.
One of my favorite things about Iron Mountain is its incredibly diverse and stable tenant base. The company has more than 220,000 customers, including 94% of the Fortune 1000. The company's operations are in 45 countries on six continents around the world.
Furthermore, Iron Mountain's storage facilities (which account for the bulk of its revenue) are an extremely low-maintenance type of property. Not only does the space generate more revenue per square foot than self-storage and industrial real estate, but its ongoing expenses are much less. To put it in perspective, I've written about how low-cost the self-storage business is. The average self-storage operator pays 5% of its net operating income in maintenance expenditures. Iron Mountain pays just 2%. In fact, Iron Mountain's storage facility net operating margin of 81% beats the self-storage average of 68% handily.
In addition, while most self-storage tenants are on month-to-month leases, Iron Mountain's leases are in terms of years -- three, on average, for its large tenants, and the average item in storage has been there for 15 years.
As far as risk factors go, the company derives nearly 40% of its revenue from services, not storage, and this revenue stream could be vulnerable in tough economic times. And, the company has a slightly higher leverage ratio (debt) than I'd like to see, however Iron Mountain seems to agree, having set in motion plans to decrease its leverage significantly by 2020.
A defensive investment that just got even better
I've written many times about healthcare REITs as excellent long-term investments, and there are several that are, but Welltower (NYSE:HCN),with its 5% yield, is still my hands-down favorite of the group. Not only is it the largest player in the space with more geographical diversification than most, but there are a few other reasons to love the company.
First, here's why I love healthcare real estate in general. For starters, it's a defensive asset class that should do just fine during recessions. After all, healthcare is one thing people need no matter how the economy is performing. Furthermore, the U.S. population is aging rapidly, with the 65+ age group expected to roughly double by 2050 and older age groups growing even faster. Older people use healthcare more, and spend more (either out of pocket or through insurance) than the rest of the population. The average person in the 65-84 group spends more than double the national average, while those in the 85-and-up group spend nearly five times the average American.
Additionally, the healthcare real estate market is highly fragmented and in the early stages of REIT consolidation. No REIT has a higher market share than Welltower does at 3% of the industry, and less than 15% of all healthcare properties are owned by REITs. For other property types, such as malls and hotels, the figure is closer to 50%. In a nutshell, not only is there a growing market, but there's lots of existing opportunity as well.
I like Welltower in particular for its focus on stable, private-pay (as opposed to government reimbursement) assets. In fact, the company recently announced a significant portfolio repositioning that will increase the concentration of private-pay assets to 92% and set up the portfolio to take advantage of the higher-spending aging population with a greater concentration of senior housing.
Like Iron Mountain, Welltower isn't without risk, and I recently wrote an article on Welltower's risk factors which you can read here.
What about interest rates?
To be perfectly clear, I'm saying that I would buy these stocks right now as long-term investments only. If you don't have a minimum of five years to hold these stocks, you're probably better off looking elsewhere.
As I alluded to in the introduction, REITs can be vulnerable to forces beyond their control, specifically interest rates. Just the thought that interest rates were about to start rising was a big reason for the sector's decline in the second half of 2016, and for these two stocks' poor performance. In fact, both stocks underperformed the S&P 500 significantly over the past six months -- Welltower by about 16% and Iron Mountain by 23%.
Interest rates are bad for REIT prices, as when rates rise, investors expect higher yields from "riskier" investments (as compared to things like Treasury bonds) such as REITs, which creates selling pressure on share prices. It's entirely possible that these two could go down further in the next few years, and if President-elect Trump is successful in creating the type of economic growth he claims he will and rates spike faster than the market anticipates, that's exactly what I expect.
In a nutshell, these two stocks could go up and down significantly over shorter periods of time, but over the long run, these businesses are rock-solid winners. Invest with the long term in mind, and you should be just fine with these high-dividend REITs.