You may have seen headlines about the troubles in the retail industry such as bankruptcies, store closures, and once-leading retailers now struggling to survive. So you may be worried about investing in retail real estate investment trusts, or REITs.

While these headwinds are certainly concerning, it's important to realize that not all retail is in the same category. Sure, many malls and shopping centers are in rough shape, but some retail properties are performing quite well as investments. In fact, thanks to the retail industry's weakness, as well as pressures caused by rising interest rates, many retail REITs that are doing extremely well are trading for attractive valuations and paying high dividend yields.

So let's get right to it. Here's a rundown of what you need to know about REITs before you buy your first one, as well as three retail REITs that could make fantastic long-term additions to your stock portfolio.

Family walking through a mall, carrying shopping bags.

Image Source: Getty Images.

What is a REIT?

REIT stands for "real estate investment trust." There are two main types of REITs -- equity REITs and mortgage REITs. Equity REITs invest in commercial real estate, such as apartment buildings, malls, hotels, etc. Mortgage REITs don't own physical real estate. Instead, they invest in mortgage-backed securities, mortgage servicing rights, and other mortgage-related investments.

For the remainder of this discussion, I'll be referring to equity REITs when I use the term "REIT," but it's important to be aware of the two very different types of investments that are considered REITs.

Equity REITs allow everyday investors to put their money to work in commercial real estate, which can be a surprisingly stable and lucrative asset class over the long run. Without equity REITs, commercial real estate simply would be out of the realm of affordability for most investors. While you can buy a residential investment property for $100,000 or less in many cases, malls, hotels, and large apartment buildings often cost many millions of dollars.

The one must-know metric for REIT investors

As with all stocks, it's important for REIT investors to understand the concept of valuation -- that is, how cheap or expensive a stock is trading relative to its profits, sales, or other metrics. Before we proceed, you'll notice when we get into the analysis of three retail REITs that instead of using the traditional price-to-earnings, or P/E ratio, for valuation, I use a different metric known as price-to-FFO (funds from operations). Here's why.

Traditional methods of calculating net income, or "earnings," don't work well with REITs. Specifically, there's a real estate-specific item called depreciation, which allows real estate investors to deduct the purchase price of a property on their tax return over a number of years. This is true if you buy an investment property to rent out; it's also true for large REITs that invest in properties like malls.

The problem is that depreciation isn't an actual expense, so it makes a REIT's earnings look much lower than they are. In fact, REITs sometimes report negative net income, even though they're making lots of money.

Because of this, we use the FFO metric when valuing REITs. This makes adjustments to account for depreciation, as well as some other earnings-distorted items, in order to give REIT investors a better picture of how much money these companies are making and therefore their ability to pay (and hopefully increase) the distributions they make to shareholders.

Many REITs use metrics called "normalized FFO," "core FFO," or "adjusted FFO," as well. These make further adjustments to give the most precise earnings figure possible. For example, a company's normalized FFO may exclude certain one-time expenses, so investors can see how much money the REIT is generating on an ongoing basis. When available, these adjusted FFO metrics can be useful when determining a REIT's valuation.

P/FFO, and most other valuation metrics for that matter, are best used when comparing companies with other companies in the same industry. In other words, it might not be an effective comparison to look at the P/FFO ratios of a retail REIT and an office building REIT.

All things being equal, a lower P/FFO is better than a higher one. However, in the real world, all things are generally not equal. Therefore, P/FFO should be used as just one piece of the puzzle when doing research on stocks. If you find a big discrepancy between two stocks in the same industry, the next question should be why there's such a difference.

REITs' unique tax structure is a big advantage

One of the unique features of REITs has to do with their tax treatment. REITs are required to distribute at least 90% of their taxable income to shareholders every year in order to keep their REIT status. This is the main reason why REIT dividend yields -- that is, the dollar amount of dividends paid as a percentage of share price -- are generally much higher than other dividend stocks. Why would these companies want to do this? Simple -- REITs are not taxed at the corporate level, which is a big benefit.

Unlike with most dividend stock investments, REIT profits are taxed only once, when shareholders receive their dividends. On the other hand, most other types of dividend-paying companies can be taxed twice -- first with the corporate tax and again with dividend taxes after paying dividends to shareholders. It's important to mention that REIT dividends are generally treated as ordinary income and therefore aren't eligible for preferential qualified dividend tax rates.

This means that REITs get to keep (and pay out) more of their profits than they would if they chose a traditional corporate structure. However, it also means that if you hold REITs in a taxable (non-retirement) account, you could end up paying more tax on REIT dividends than you do on your other dividend stocks.

Even so, this still is a huge tax advantage over many other types of businesses. Because of this, REITs can make excellent investments in tax-advantaged retirement accounts like IRAs, which can maximize the long-term compounding power of high dividends.

Wait -- isn't retail in trouble?

Many investors are hesitant to get involved with any retail-oriented investments, and it's not difficult to see why, given the long list of high-profile retail bankruptcies in recent years. Since 2016, retailers that have filed for bankruptcy include Aeropostale, Pacific Sunwear, Sports Authority, The Limited, Wet Seal, Hhgregg, RadioShack, Payless, Gymboree, Vitamin World, and Toys R Us -- and this isn't close to being a complete list. The rise of e-commerce indeed has caused major problems in the retail industry.

However, notice that there are a few general themes in this list. First, most of these aren't discount-oriented retailers (with the exception of Payless). While they may have good sales from time to time, they aren't the focus of the business. On the other hand, retailers with a discount-oriented business model are doing quite well, for the most part. Warehouse clubs, dollar stores, and outlets are a few examples of retail businesses in this category. Discount-oriented retailers tend to offer bargains either comparable or better than those available online, making them rather e-commerce resistant. They also are recession resistant, as when people need to cut back during tough times, they tend to actively seek out bargains.

Another thing to notice is that none of the retailers on the list run experiential or service-oriented businesses -- that is, businesses that need to be experienced in person. Fitness centers, theaters, and gas stations are examples of service-oriented businesses, as are restaurants. For the most part, these businesses are immune to e-commerce headwinds because they're businesses people need to physically go to and aren't in the same boat as the "troubled retailers."

Finally, the bankruptcy filers on the list are companies that generally sell things people want as opposed to selling things people need. Another name for retail businesses that sell things people need is non-discretionary retail, and this is another area that's doing quite well. Drug stores are a great example. Sure, most of what you find in a drug store also can be purchased online and usually for less money. However, these are items people need, and often in a limited amount of time -- such as medication -- so they tend to do just fine against e-commerce, while also having some intrinsic recession resistance.

The bottom line is that the term "retail" is extremely broad, and not all retail businesses are in the same boat when it comes to e-commerce headwinds.

Three top retail REITs to consider

With all of that in mind, here are three REITs that can allow you to invest in the right kinds of retail. Thanks to retail-sector headwinds, as well as pressure from rising interest rates, these REITs are trading at rather low valuations and pay relatively high dividend yields, as you can see in the chart below.

Here's a brief description of each company, and why each could be a great long-term investment to make right now.

Company (Symbol)

Recent Share Price

Dividend Yield

Price-to-FFO 

Realty Income (NYSE:O)

$52.77

5%

16.6

National Retail Properties (NYSE:NNN)

$39.83

4.8%

15.2

Simon Property Group (NYSE:SPG)

$159.62

4.9%

13.3

Data Source: TD Ameritrade. Prices and yields current as of May 8, 2018. Outlooks for 2018 FFO are from company first-quarter 2018 earnings reports and are based on the midpoint of each company's 2018 FFO.

A massive net-lease retail REIT with added diversification

Realty Income is a net-lease REIT, specializing in freestanding, single-tenant retail properties. Think drug stores, dollar stores, and warehouse clubs that are in their own buildings. As of March 31, 2018, Realty Income had a total of 5,326 properties in its portfolio. While the majority (81%) of the portfolio is made of retail properties, there also are significant holdings in office and industrial properties as well, adding an element of diversification.

If you're not familiar with net-lease real estate, here's a brief explanation. A net lease -- also commonly referred to as a triple-net lease -- is a long-term lease agreement that requires the tenant to pay for certain property expenses. Specifically, triple-net leases require the tenants to pay for property taxes, insurance, and most maintenance expenses.

These lease agreements are favorable for REITs like Realty Income for two main reasons. First, the shift of these expenses to the tenant eliminates most of the variable expenses of owning property. For example, if a REIT owns a hotel, there's no way to accurately predict the property taxes and insurance expenses of owning the property over time, which creates uncertainty. With a net lease, this isn't an issue.

Second, net lease agreements tend to have long initial terms -- generally 15 years or more -- and also have "escalators" -- or rent increases over time -- built right into the lease. The combination of these two advantages creates a predictable, growing stream of income and minimizes vacancy and turnover.

Not only is Realty Income's lease structure favorable, but nearly all of its retail tenants fit into the three categories I mentioned earlier. In fact, just 6% of Realty Income's rental income comes from "vulnerable" types of retail. Just to name some of Realty Income's top tenants:

Company

Percentage of Portfolio
(by Rental Revenue)

Category

Walgreens (NASDAQ: WBA)

6.7%

Non-discretionary

FedEx (NYSE: FDX)

5%

Service-based

Dollar General (NYSE: DG)

3.8%

Discount-oriented

LA Fitness

3.8%

Service-based

7-Eleven

3.6%

Non-discretionary

Dollar Tree (NASDAQ: DLTR)

3.5%

Discount-oriented

AMC Theatres (NYSE: AMC)

3.5%

Service-based

Data Source: Realty Income.

To further illustrate how strong Realty Income is, consider that, despite the retail headwinds in recent years, the company finished 2017 with 98.6% occupancy -- the highest year-end occupancy since 2006.

Furthermore, Realty Income has a rock-solid balance sheet, with just 31% of its capitalization coming from debt. In fact, Realty Income is one of a select few REITs with an "A" (A3) credit rating from Moody's. "A" credit is well into the range of "investment grade," which applies a very low risk of default. 

The proof is in the performance. Even after the recent poor performance, Realty Income has delivered 15.7% annualized total returns since its 1994 NYSE listing. In other words, a $10,000 investment in Realty Income in 1994 would be worth more than $330,000 today, assuming reinvestment of all dividends. And speaking of dividends, not only does Realty Income yield 5% right now, but the dividend has been increased 96 times since its NYSE listing 24 years ago.

A pure-play net lease REIT

In many ways, National Retail Properties is quite similar to Realty Income, but there are three key differences you should know about.

First, National Retail is significantly smaller (although it's still a big REIT), with 2,764 properties. Second, it's a pure play on net-lease retail real estate -- meaning that its portfolio is 100% retail. And third, Realty Income focuses on investment-grade tenants (those with high credit ratings/low risk of default), while National Retail is more comfortable with properties occupied by non-investment-grade tenants.

As a result, National Retail Properties' risk of tenant default is slightly higher, but properties occupied by non-investment-grade tenants tend to generate better returns and faster rent growth. In exchange for taking on the slightly higher level of risk, landlords can generally demand more favorable lease terms from lower-credit tenants. And don't be too worried about the risk -- National Retail's impressive 99.2% occupancy rate is even better than Realty Income's. Plus, National Retail's credit rating (BBB+/Baa1) is just slightly lower.

Furthermore, the companies have lots of common tenants, such as LA Fitness, AMC Theaters, and 7-Eleven, all of which are among both companies' 10 largest tenants.

National Retail has a pretty impressive performance history of its own. The company has a 28-year streak of consecutive dividend increases (that's longer than 99% of all publicly traded companies), as well as 12.9% annualized total returns over the past 25 years, easily outperforming the S&P 500, as well as the NAREIT Equity REIT Index, which tracks the equity REIT market (REITs that own properties, like National Retail does).

A-list malls and a dominant outlet portfolio

It may seem odd that I've included a mall REIT on this list. After all, most of the retailers on my "bankrupt list" are (or were) mall retailers.

However, just like all retail isn't the same, mall retail can be divided into several different categories, as well. Lower-quality malls and shopping centers (known as Class B, C, or lower) are struggling. Meanwhile, Class A malls are thriving.

Malls are categorized in "classes" based on factors such as their age, location, amenities, and more. While many malls in the lower classes are experiencing dramatically reduced foot traffic and widespread vacancies, Class A malls still are attracting shoppers in droves thanks to modern amenities, wider variety dining options, and more experiential destinations.

This is especially true in the case of Simon Property Group, which is the largest REIT of any kind. Simon operates a massive portfolio of top-notch malls and also has a dominant market share in outlet centers, which it operates under the Premium Outlets brand name.

In a nutshell, Simon has done a fantastic job of adapting its properties to changing consumer preferences and recovering from the troubles of certain retailers. In fact, half of the 10 most valuable U.S. malls are owned by Simon. Top Simon malls include Sawgrass Mills in Sunrise, Florida, Forum Shops at Caesars in Las Vegas, and King of Prussia Mall in Pennsylvania.

Simon has had to deal with bankrupt and struggling retailers, just like many of its peers. However, Simon's management sees the many department store closures in its malls, such as Sears and J.C. Penney stores, as some of its largest opportunities. Simon has been redeveloping these closed department stores into hotels (in its malls), fitness centers, entertainment destinations, and modern dining options.

On a similar note, Simon has emphasized "mixed-use" mall properties. For example, in 2017 Simon opened a 120,000-square-foot Class A office space, three hotels, and a 300-unit residential development in its malls. The logic here is that if people are working, staying, and living at Simon's malls, they'll become a built-in source of steady shopping and dining traffic.

The strategy seems to be working. Despite the retail industry's struggles, Simon's retailer sales per square foot are up 4.2% year over year and its properties are generating 3.2% higher base minimum rent. At just over 13 times this year's FFO projection, Simon looks like a steal in 2018.

Long-term investments

To be clear, I'm suggesting these three retail REITs as long-term investments. There's no way to know when the wave of struggling retailers and bankruptcies will start to taper off, and until it does, I completely expect retail REIT valuations to remain depressed.

Additionally, it's important to be aware that REITs -- as well as most other dividend investments -- are sensitive to rising interest rates. As rates rise, investors expect higher returns from their income investments, and since dividend yield is a function of price, rising rates tend to put pressure on REIT prices.

It's widely expected that the Federal Reserve will continue to gradually raise interest rates for the next few years. And while this expectation largely is priced into REIT stocks at this point, if rates end up rising faster or higher than expected, it could certainly create more downward pressure on these stocks.

Having said that, these stocks have performed well through a variety of economic climates in the past, including rising-rate environments, and there's no reason to believe that their records of outstanding long-term returns will end anytime soon.

The bottom line is that in one year, two years, or even in five years, there's a strong possibility that you won't be thrilled with the returns of these three REITs. However, over the long run -- which I define as a decade or more -- I'm confident that you'll be glad you added these stocks to your portfolio while the retail industry was down in the dumps.

Matthew Frankel owns shares of FedEx and Realty Income. The Motley Fool recommends FedEx. The Motley Fool has a disclosure policy.