When most investors think of real estate investment trusts, or REITs, they think of apartments, hotels, malls, and office buildings. However, there are REITs that own property types you may not have considered, and some of these companies are quite large.

In this episode of Industry Focus: Financials, host Michael Douglass and Motley Fool contributor Matthew Frankel discuss REITs that own timberlands, data centers, and telecommunications towers.

A full transcript follows the video.

This video was recorded on June 4, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, June 4th, and we're doing an episode about what we'll call surprising real estate investment trusts, or REITs. Basically, we had a listener question about a timber REIT, and we'll talk about that more in just a few minutes. Matt thought this would be a great chance to talk about businesses people usually don't expect to be REITs, because we tend to expect, frankly, apartment owners, office buildings, shopping malls, we expect REITs for those kinds of properties. But, today, we're going to be talking about, as I noted, a timber REIT, another REIT that owns data centers, and a third that owns cell towers.

But, before we get into that specific discussion, let's talk broadly about REITs just for a couple of minutes. I think most folks who have listened to the show have heard us talk about REITs in the past, so we'll try to keep things short. But, for anyone new or for anyone who just needs a refresher, we'll just spend a couple of minutes real quick talking about how real estate investment trusts work, the benefits and drawbacks to investing in them, and the major sectorwide issues that they usually face. First off, what is a REIT, and how do they function, Matt?

Matt Frankel: First of all, I'm thrilled we're finally doing an episode about REITs. I think this is the first one since I've been on the show, and I've been bugging you about it for a while.

Douglass: [laughs] The first strictly REIT episode, yes.

Frankel: Yeah, we've mentioned them. In the simplest form, a REIT is an investment vehicle that pools investors' money to buy real estate. Think of them in terms of how a mutual fund is a pool of investors' money that buys stocks or bonds. A REIT is a pool of investors' money that buys real estate. It's real estate that investors generally didn't have access to before. That's why they were created. I don't know about most listeners, but I personally could not run out and just buy a shopping mall today if I wanted to. That's why REITs can be such a great investment vehicle. They allow everyday investors access to property types that they normally wouldn't. 

Before we go any further, one distinction to make is, REIT is kind of a broad term. There's two main classifications of REITs. You have equity REITs, which is what we normally are talking about when we say the term "REIT," which means companies that own physical properties; and mortgage REITs, companies that invest in mortgage-backed securities and other assets. Generally, if we're talking about mortgage REITs, we will specify. But if you just hear the term "REIT" come out of our mouth, then we're generally referring to equity REITs.

Douglass: And that's in part because we tend to really prefer equity REITs as businesses, so we tend to not talk about the mortgage REITs as much. As well, they're a much narrower subset. If we're ever talking about them, as Matt noted, we'll really call that out. Today, we're just discussing equity REITs.

Frankel: Right. Just to go through a few of the things of what makes a REIT a REIT, the rule is, they have to have at least three-quarters of their assets invested in real estate, and must also derive at least three-quarters of their income from rents, interest payments, sales of real estate, or other sources derived from the real estate itself. They also have to pay out most of their income as dividends, which is one of the reasons investors tend to love these, especially in retirement accounts where they don't have to pay taxes. REITs tend to pay higher dividends than most other companies. They also have to be owned by at least 100 people, and no one can own a majority of a REIT. The rule is that no more than 50% of a REIT can be owned by five or fewer people. Generally, REITs limit individual ownership to a 10% stake. 

Douglass: Right. There are a couple of issues with REITs that bear noting. As Matt pointed out, REITs are required to pay out a lot in dividends. That's how they get that tax benefit where they aren't otherwise paying income taxes or business taxes. This issue, then, is that, because they're having to pay out so much in dividends, they can really only effectively fund growth one of three ways. One is by selling old properties and buying new ones. That doesn't necessarily translate to growth, but sometimes it can. The second is by taking on debt. You tend to find that REITs tend to be very debt-laden, and they tend to be very interest rate-sensitive. We'll talk about that more in a minute. Thirdly, issuing equity, AKA diluting shareholders, AKA putting more shares out on the market and selling them. So, what you'll tend to find with REITs is that they usually do some sort of combination of all three of those. 

Talking about interest rates for a minute, REITs basically make their money, in a lot of ways, by taking money in from outside lenders and then positioning it in properties, and then making money off those properties, more than they're paying out to the lender. As interest rates increase, even if REITs don't have floating-rate debt, even if their debt is fixed, it becomes more difficult for them to take on more debt because those interest rates have increased, therefore the debt becomes more expensive, therefore they can only profitably invest in fewer properties in the future.

Frankel: It's also worth pointing out, some REITs are much better than others when it comes to selling properties to finance new properties. This you'll see more in, say, apartments, when one real estate market has gone up a whole lot. Let's say a company owns a ton of properties in San Francisco, where we all know that real estate has gone crazy over the past decade or so. They could sell those and reinvest the profits in a lower-cost market, in more properties that could have a better return on their investment. 

Douglass: Yes, exactly. There's a lot to unpack with REITs, and with the three that we've picked out, there's a lot more to unpack, so, let's go ahead and hop right in with our first one. As I noted earlier, this first REIT, which is a timber REIT, comes to us courtesy of a listener question on the Industry Focus Twitter. For those interested, that's @MFIndustryFocus. If you ever have questions, pop over to there, or you can send us an email at industryfocus@fool.com. We love getting listener questions. We will dedicate whole episodes to them. Please, if you ever have a stock or an idea or just something that you've been kicking around, we love talking to folks via email, Twitter, carrier pigeon, whatever else works. Just reach out.

This first timber REIT is called Rayonier (NYSE:RYN), that's ticker RYN.

Frankel: This is a business you generally would not think of as being a REIT, because first of all, you don't rent out the timberlands. You use them to generate a product. But the rules are a little bit broader than rental income. Real estate activities are producing most of their income, so they qualify for REIT status. 

Rayonier is a big, big owner of timberland. They own 2.6 million acres of timberland, primarily in three places. Most of theirs is concentrated in the southeast United States. They actually own a lot of land right near where I am right now. In the Pacific Northwest is the other one, and New Zealand is about a third of their income, as well. They have a pretty big international presence, which I think is actually where this question came from, about their international real estate.

Douglass: Yes. The International Theme Week has been the gift that keeps on giving, in a really good way. We've had a lot of great listener questions and we're trying to address as many of them as we can on the show. And yeah, as you noted, that New Zealand exposure was what put this on this one listener's radar. 

It's interesting to me. Timber REITs are interesting if you want to invest in home construction. Rayonier primarily traffics in pulpwood, which is used for paper, and sawtimber, which is used for home construction. So, as home construction ramps up -- and, as a general rule, that's probably expected to happen, mostly because demand has stayed fairly flat, whereas home starts are still well below what we've seen historically. They've been depressed, basically, since the Great Recession and the financial crisis. So, as those continue to ramp up, what we'd expect to see is better sawtimber prices, which could benefit timberland REITs. 

The other reason you might be interested in timber REITs is that they tend to be relatively lowly correlated with the rest of the market. If you're looking for a hedge, which is basically an asset class that will function very differently from most other stocks, then timberland REITs might be interesting for you.

On the flip side of that, I will add a note of caution, which is that timber is largely a commodity. For me, I'm usually a little bit concerned when you have a company that's pretty much wholly reliant on a commodity. Here's a thought experiment for you, just to explain this a little bit more. All REITs are dependent on something else. That's just part of the deal. But if you're Starbucks, and you're trying to build a Starbucks at a particular street corner, chances are good there are only a few buildings that are going to work for you, that have vacancy and that have the right traffic site and line of sight to the road, and things like that. A handful of building owners, perhaps just one REIT or two, will have some pricing power there, because Starbucks really wants to be on this particular street corner, in this particular area, in this particular zip code. 

For something that's really more of a commodity, like timber, you can work with a lot of different providers. So, I do worry that their pricing power is really fairly weak, and that means that they're going to be largely dependent on broader market trends. So, things might be good a particular year or a few particular years, but the business is going to really struggle to function well in more difficult years. And that's compounded, of course, by interest rates. At the end of the day, if the economy is doing really well, then you would expect more home construction and things like that, home prices to go up. When the economy is doing poorly, they're going to get hit on the pricing side and on the demand side. So, for me, that's a big concern, when I think about this whole class of companies. 

Frankel: Definitely. In other words, it's really hard to identify their competitive advantage from a product standpoint. Their advantage right now is scale and geographic diversity, things like that. But at the same time, is one company's timber really better than the other's? Not really. So, like Michael said, this is definitely a commodities play. 

But, on the flip side, it is usually a very consistent source of income. It's a commodity that is generally always in demand, to one degree or another. Rayonier produce a pretty big yield. They produce 10 million tons a year of usable timber, that's on a sustainable basis. So, this is a great income play, not great for growth. Not great because you're levered to one commodity. I wouldn't put all my money in oil futures, either.

Douglass: [laughs] Right.

Frankel: It's the same idea. It has its pluses and minuses, just like everything else, but I would definitely call this much more of a pure income play.

Douglass: Yes. The dividend is about a 2.8% yield. It's well-covered. That's looking at an FFO or a dividend-payouts-to-FFO ratio. Things look very good there. And I will say, one thing that I'm really pleased by with Rayonier, and something I think they've done a good job with is looking at what's called higher and better use, HBU. That's this idea that, you might have some timberland that could one day be developed into a residential neighborhood or a shopping mall. So, you sell that property to the developer who's looking to do that so that you can then go buy a lot more timberland somewhere else. Because of course, land that's going to be useful for residential development or a shopping mall is going to transact for more than timberland. 

When I mentioned earlier that first way that REITs can acquire new properties, which is by selling old properties and getting new ones, I said, generally speaking, you can't grow that way, because it's more or less a one-to-one kind of thing. Well, that's not necessarily true with timberland, actually. If you're selling these HBU parcels for a really significant markup, then there's this opportunity to acquire a lot more timberland for less. That's certainly a plus. 

As for me, I'm not really a big commodities guy, so I tend to stay away from investments like this, personally.

Frankel: Yeah, I would agree. The other two we're about to talk about are much more growth plays and much less dependent on any one thing. That's where I lean. Actually, the next one we're about to talk about is one that I own personally.

Douglass: One more time, before we head on to it, the stock we were just talking about: Rayonier, ticker symbol RYN.

Our next company, Digital Realty Trust (NYSE:DLR), ticker symbol DLR. This is really a play on data.

Frankel: In articles, I refer to Digital Realty as the tech stock that no one thinks of as a tech stock. It's a REIT. They own data centers, which, if you're not familiar, these are big buildings that house servers and other networking equipment. The idea is that high-tech companies -- think IBM, Facebook, things like that -- need secure and reliable places to store all the data that's flowing through them. That's where Digital Realty and the whole concept of data centers come in.

Digital Realty is one of the biggest players. They're actually the seventh-largest REIT in the market. They own about 200 data centers all over the world. Most of their revenue still comes from the U.S., but they do have a pretty good presence in Europe and Asia. This is a pretty interesting growth story with what's projected to go on in the tech space over the next couple of decades.

Douglass: Yeah. DLR is really interesting. Frankly, from an income perspective, it still looks pretty good. It's a 3.8% dividend yield. Again, well-covered, no issues there. Now, one thing that I have to note about Digital Realty, and it's something to be aware of with most REITs, is the difference between GAAP and cash basis rent. Here's the background. 

Digital Realty has issued guidance, and they've said that, on a cash basis rent, they're expecting their rent to be down a little bit this year. Then, on a GAAP basis, they're expecting it to be up. The reason for that is that, GAAP, or generally accepted accounting practices, requires that you do essentially what's a straight line on your rent. As an example, if you have a lease that, this year, is $10 per year per square foot, and for the next five years, $10 per square foot, and then for the five years after that, it jumps up, doubles, to $20 per square foot -- think of it as $150 per square foot over ten years -- you have to report, on a cash basis, that this year's rent is $10 per square foot. On a GAAP basis, you're reporting it as $15 per square foot, because they require you to straight-line it across the entire term of the lease. 

What that basically means is, they're getting people in on some relatively cheap rent today, but they're planning to raise the rent pretty significantly on them over a longer time period, and that's a good sign for the business' growth.

Frankel: Yeah, definitely. Speaking of growth, there's a bunch of reasons to believe in the data center story. Digital Realty, first of all, has been very aggressive in acquiring competing data center REITs over the past couple of years. They've grown by leaps and bounds, and I actually think they'll continue to do so. That's why I own the stock. They're basically a play on the fact that the need for data storage and data transmission will continue to increase over time. A lot of people think that the data market's getting kind of saturated, devices are streaming as much data as they're going to, but that's really not the case. 

The big catalyst I like for this is the whole Internet of Things market. The number of connected devices is soaring. When you think of just how many of your devices are internet-connected compared to a few years ago -- my doorbell is internet-connected right now. That would have seemed crazy five years ago. My vacuum cleaner has an internet connection. [laughs] Things like that. That's growing at a 34% annualized rate right now. And that's going to fuel the need for, like I said, secure and reliable transmission and storage of data.

So, although this market's big, Digital Realty is a very, very big player in the space, we could just be scratching the surface of the need for data centers in the world.

Douglass: Yeah. And at the end of the day, tech companies tend to -- now, this isn't true for all tech companies, necessarily -- want to operate on a pretty asset-light model. They don't want to necessarily be controlling a bunch of data centers and paying for all that real estate upkeep. It's much easier to just pay somebody else to do it, so you don't have that stuff on your balance sheet, so you can focus on reinvesting your cash in anything else, in development, in research, in new ideas, in innovations, in new apps. It's a really attractive business for a lot of reasons.

And frankly, it's growing pretty quickly. Rental revenues were up 31% year over year. Of course, funds from operations were only up a few percentage points, about 7%, because of both operating expenses and share issuance, which, again, is one of the ways that these companies grow. There are a lot of puts and takes there. But, it's an attractive company that really functions a little bit like one of those growth-plus-dividend stocks. And for my money, that can be pretty darn attractive.

Frankel: 7% is actually a pretty high rate for real estate. Most REITs aim for 2-3% for share rental growth. This seems to be more of the norm. One other thing I'd like to point out about Digital Realty is that they have a very diverse tenant base, and they have a ton of great companies that rent from them. Their top ten include Facebook, I mentioned, IBM, Verizon, AT&T, JPMorgan Chase is a big tenant of theirs. And they have 2,300 customers, so they're not very dependent on any single one. Getting back to what we were talking about Rayonier, where they're dependent on just one thing -- not that it's going to happen, but Facebook could go bankrupt tomorrow, and Digital Realty would be just fine. That's great diversity to have.

Douglass: So, that's our two cents on Digital Realty Trust, ticker symbol DLR.

Let's turn to our third one. It's interesting that you talked about a tenant going bankrupt, because this third one actually is facing some of that issue right now. We'll talk about that and unpack that a bit more. That's American Tower REIT (NYSE:AMT), ticker AMT, which is really a play on cell towers.

Frankel: Yeah. American Tower owns two things, essentially. They own the land that the cell towers are built on. Most people who are listening can probably see a cell tower from their daily commute to work. They own the land that they're built on and the tower itself. They do not own the antennas, the cables, the other equipment that you see on there. That's where the tenants come in. They buy this land, construct a tower, and a company like, say, Verizon would install their transmitters on the top so customers can have better access to data. 

They have 160,000 cell tower sites. This is a big, big, big REIT. It's actually the largest REIT on the market. And it's very international. The name American Tower might throw you, but their biggest market is actually India. About 40,000 of the 160,000 are in the U.S. Almost 60,000 of them are in India. They also have a lot of towers in Brazil, Mexico, Nigeria is a big market. They're pretty much all over the globe. 

They're a really nice growth play on emerging markets because of this, because a lot of emerging markets don't have the mobile device penetration that you see in America. This is still a young market in a lot of areas of the world, and there's a lot of growth catalysts domestically, with 5G data transmission expected to be rolled out over the next few years. It's a really big, geographically diverse and very in-demand type of real estate.

Douglass: Yes. A quick note, though, of caution on American Tower. Their organic tenant billings growth is falling off because of Indian carrier consolidation, which I teased a little bit earlier. That's heavily impacting, as you can imagine, their Asia segment. What's interesting, though, about this piece of things, though, is that one of the big concerns with American Tower is that if consolidation happens in, say, for example, the United States -- Sprint and T-Mobile are talking about merging, and that's not the first conversation like this that has occurred. There's a concern that, as these companies work to wring out synergies, that they might end up reducing their AMT footprint. And that's a concern that investors should be aware of.

Now, I think, because of the things you talked about, Matt, particularly 5G, and the fact that the rest of the world is very much going to want to catch up to that, there's still a lot of growth opportunity here. But, we should be aware that they tend to be relatively levered to the market leaders in whatever their country is. Kind of makes sense. And, if that number of market leaders decreases over time as people get bought out, that could be an issue down the line.

Frankel: Yeah, definitely. One of their big drivers of profit is having more than one tenant on a single tower. To Michael's point, I would actually be really curious to see how many, say, Sprint and T-Mobile shared towers there are that won't be necessary if that merger goes through. That's definitely one thing to think about. They could have two, three, even four tenants on the same tower without much of a cost increase to them. This is a great way that they've been driving their profit. And as consolidation happens, if that's where the trend ends up going, you could definitely see that eat into profits.

Douglass: Right. Definitely an issue there. That said, the underlying business metrics look pretty good. The dividend is a 2.2% yield. That's relatively low. But, again, that's in large part because the company has been growing quickly and the dividend hasn't been able to quite keep up. Revenue is up 8% year over year last quarter. Adjusted funds from operations, or AFFO, per diluted share, up 9.5%. This is a company that's growing pretty rapidly, and it looks pretty darn attractive -- particularly, again, for a company of its size, as you mentioned, Matt.

Frankel: Yeah. American Tower is actually 6% of the entire REIT market. That's how big they are. Like you said, they're growing very rapidly. And in a lot of their markets around the world, this technology is still where we were ten, 15 years ago, if that. So, there's still a lot of room to grow. 

Definitely watch the consolidation. Like I said, I will be really curious to know how many shared towers there are in their portfolio, especially between the companies that are thinking about merging. But, that's just, like you said, something to keep in mind. This is a very well-covered dividend, very diverse, great revenue stream, and great business model, how they can just add new tenants to towers as they come up.

It's also important to point out that this isn't just cell towers. American Towers' towers also do radio transmission, things like television. They're multi-purpose. It's not just cell technology we're talking about.

Douglass: Right. So, that's American Tower, ticker symbol AMT. Matt, 30 seconds, which one's your favorite of the three?

Frankel: Digital Realty, hands down, just because, like I said, I love the data center growth story over the next few years. The stock trades at an excellent valuation. Check out some of my articles if you want to read more about that. I've actually added to my position several times over the past few years, and it's one of my largest holdings.

Douglass: I've thought really hard about Digital Realty over the last few years, and I keep not pulling the trigger, but maybe this episode will finally be the catalyst that I need.

Folks, that's it for this week's Financials show. Questions or comments, you can always reach us at industryfocus@fool.com. As always, 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. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!

Matthew Frankel owns shares of T and Digital Realty Trust. Michael Douglass owns shares of FB and SBUX. The Motley Fool owns shares of and recommends American Tower, FB, SBUX, and TWTR. The Motley Fool owns shares of VZ and has the following options: short October 2018 $135 calls on American Tower and long January 2019 $80 calls on American Tower. The Motley Fool recommends TMUS. The Motley Fool has a disclosure policy.