A real estate investment trust (REIT) is a beautiful thing for substantially minimizing taxes for investors. Regular corporations pay corporate taxes first, and then they pay dividends out of after-tax income, which are taxed again at the investor level. REITs eliminate corporate income taxes if they distribute 90% of their income, which in turn is taxable only once in the hands of the investors. And to have a REIT status, you don't have to invest in real estate, so the name is a little confusing.
There are many different kinds of REITs, but here are several categories that have been making news lately.
The mortgage mess has been making headlines for some time. There are REITs that borrowed money in the short-term capital markets, invested in mortgage-backed securities and other mortgage loans, collected the difference in yield, and lived happily ever after. That is, until the mortgage market did the unthinkable: declined faster and farther than at any other point in history, literally wiping out some mortgage REITs. Two good examples are Thornburg Mortgage and Friedman Billings Ramsey
Thornburg was delisted and now trades on the Pink Sheets. (Do yourself a favor: Don't even bother looking up the symbol.) The equity is virtually worthless, as management gave it away to convertible debt holders with new debt and warrant issuance. The other such disaster, Friedman Billings Ramsey, is an investment banking REIT that had the misfortune to buy its mortgage REIT sibling FBR Asset several years ago … and then when it realized that the losses would be huge, it spun off the investment bank as FBR Capital Markets
Even though FBR still owns a majority stake in the investment bank, those who want to speculate should focus their efforts on researching FBR Capital Markets, not the penny stock parent.
Suffice it to say that what Annaly is doing is much less risky than what our penny stock mortgage REITs were doing -- it uses less leverage. I've followed the stock for a while, and I've noticed that management is more conservative, which depressed the REIT's profitability in the heydays of mortgage REITs, but at least the company is still around. The stock currently yields 13% and trades at 1.2 times book value, which, in my experience, has been a good entry point for the stock, especially given that the yield curve is likely to remain steep for a very long time.
The yield curve is the difference between short-term interest rates (Fed funds now at 0%-25%) and longer-dated bonds (10-year Treasuries yield 2.9%, while 30-years yield 3.6%). This huge difference between short-term and long-term interest rates is very profitable for mortgage REITs and banks that can borrow short and lend long, but they have to have survived the current mortgage mess to be able to do it!
Real estate REITs
Real estate REITs are not created equal. REITs that have strong exposure to shopping malls will see serious problems, in my opinion, as retail bankruptcies tend to spike in a recession. Those situated in strong regional economies, like Washington REIT
To understand how recession-proof the D.C. area is, consider this: Washington REIT just announced its 188th consecutive quarterly dividend at equal or rising rates. Moreover, the company has increased its dividend every year for 38 years. Impressive. The REIT yields 6.7% and is one of the most defensive around.
You would think that with housing what it is, timber-producing REITs will not be doing well. After all, with fewer houses being built, there is less lumber being used. But nothing could be further from the truth. Profitability is down for Plum Creek Timber
Plum Creek is holding off on harvesting timber while the market is weak. Management is also holding off on land sales in weak markets such as Florida, while selling more land for development from its timber portfolio in attractive markets in other regions such as Mississippi.
Plum Creek is the largest and most geographically diverse private landowner in the country. And they don't make any more of it, so this is a great income-producing play on scarcity of land and development of more real estate in coming years. Yes, this bear market in housing will some day be over, trust me.
Even in these extreme conditions in housing, net earnings in its last quarter were $95 million, compared to $118 million in the same quarter of 2007. Revenue did fall to $461 million from $504 million a year earlier, but the government just reported the weakest new home sales on record. I would say that this makes it a great entry point for Plum Creek, which yields 5%.
When it comes to REITs, the highest yields are not necessarily the best choices. Stick with those that are the most sustainable, such as Washington REIT, Annaly, and Plum Creek. They are more conservative in nature, but this is why they are likely to do well, even in this recession.
More on REITs:
Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Annaly Capital Management is a Motley Fool Income Investor recommendation. The Fool owns shares of and covered calls on Plum Creek Timber. The Fool has a disclosure policy.