The best real estate investment trusts (REITs) are those that can produce market-beating total returns for investors, which is a combination of their dividend yield and stock price appreciation as their market capitalization rises. To deliver those gains, a REIT must be able to grow the income generated from its real estate portfolio so that it can increase its dividend. Here's a closer look at three top REITs with outsized upside potential that an income investor can buy this month.
Three characteristics of the best REITs to buy
Before we dive into the top REIT stocks to buy, we need to set some ground rules for what makes a publicly traded REIT a worthwhile investment in the first place. Three characteristics stand out as being important drivers of outperformance in REIT investing:
- A strong, investment-grade balance sheet with conservative leverage metrics. Optimal metrics for a REIT include a debt-to-EBITDA ratio of less than six times and a debt-to-capitalization rate of less than 50%. That gives them the flexibility to fund rental property acquisitions.
- A conservative dividend payout ratio. While REITs typically pay out a large portion of their cash flow, those that distribute a more conservative amount will have some additional financial flexibility to finance growth as well as an extra cushion during the inevitable downturn. A good target for a REIT is a payout ratio of less than 75% of its funds from operations (FFO).
- Visible growth prospects. For a REIT to generate strong total returns, it needs to be able to grow its FFO and dividend, which it can do by raising rents at existing real estate properties as well as developing and acquiring new ones. REITs that produce the highest returns, however, often have a significant pipeline of growth opportunities. That comes from focusing on sectors and geographies where demand for rentable space is on the rise.
The top REITs to buy this May
The top REITs to buy this May
With the real estate investment trust market tumbling this year, lots of REIT shares look attractive. However, three that stand out as excellent buys this month are AvalonBay Communities (NYSE: AVB), Medical Properties Trust (NYSE: MPW), and Prologis (NYSE: PLD). Not only do they trade at lower prices, but they also boast having all the characteristics of the best REITs to buy.
Shares of multifamily REIT AvalonBay have tumbled more than 20% this year. Driving that downdraft in this REIT stock is the market's view that the company will struggle to collect rent and keep its properties occupied because of the impact the COVID-19 outbreak is having on the U.S. economy.
The company, however, has weathered this storm much better than the market feared, as its first-quarter results were a bit higher than expected. Further, April rent payments came in at 96% of what it typically collects in a month. Contrast that with many retail REITS, which had lots of trouble collecting rent. Meanwhile, leasing activity, which slowed in March, rebounded in April, though move-ins did decline.
While AvalonBay withdrew its full-year outlook due to the potential impact the COVID-19 outbreak could have on its results, it initially anticipated it would generate between $9.62 to $10.02 per share of core FFO. If it were to deliver earnings in that range, then the payout ratio for its 3.9%-yielding dividend would be a comfortable 65%.
AvalonBay also has a strong balance sheet, backed by a 4.6 times leverage ratio. That conservative financial profile provides AvalonBay with the flexibility to continue developing new apartment communities. While it had to slow construction activity due to the COVID-19 outbreak, it has several projects underway as part of a $4 billion development rights pipeline.
Medical Properties Trust
Shares of healthcare REIT Medical Properties Trust have declined by about 20% this year. That's because of market worries that the company's hospital tenants might not have the cash to pay rent as they battle the COVID-19 outbreak. Instead, Medical Properties Trust recently reported that it collected 96% of its April rent, which is a much higher percentage than other healthcare REITs like senior housing.
Because of that, the company is increasingly confident that it can deliver on its guidance that it will generate between $1.65 to $1.68 per share of normalized FFO. This forecast implies that it trades for an attractive value of around 10 times FFO. Further, Medical Properties Trust boasts a conservative dividend payout ratio of 65% and a low leverage ratio of 5.5 times net debt-to-EBITDA. Those factors put the dividend stock's 6.5% yielding payout on solid ground. Finally, it has seen its asset acquisition opportunity set rise as a result of the pandemic because more hospitals are looking to sell their real estate property to free up this capital for patient care.
Shares of industrial REIT Prologis have declined by about 3% this year. That's because the economic downturn will have some impact on its customers, which will reduce demand for industrial space.
However, the company remains in excellent financial shape to weather this storm. It has a top-notch balance sheet and a well-covered dividend that will only consume about 65% of its FFO this year. That provides it with the financial flexibility to continue expanding. It expects to invest between $500 million and $800 million to start new developments this year while spending another $450 million on the acquisition of additional industrial properties. Meanwhile, it's well positioned to continue expanding in the future since more businesses will likely need industrial space such as warehouses and distribution centers to support the continued growth of e-commerce.
These top-tier REITs look even more attractive this May
While the COVID-19 outbreak is putting significant pressure on the real estate market, the conservative financial profiles of these REITs will help them navigate through these challenging times. It also provides them with the flexibility to continue expanding their commercial real estate portfolios so that they can keep growing their FFO and dividends. Add that upside potential to their lower prices, and these REITs could produce attractive total returns for an investor who buys shares this month.
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