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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 best REITs to buy right now
January is a great time to check back in on your portfolio. Indeed, after a year like 2020, you might find that your stock and sector allocations have gotten out of balance. Having done that, if one of your goals in the new year is to buy some out-of-favor real estate investment trusts (REITs), then you should be looking at Federal Realty (NYSE: FRT), W.P. Carey (NYSE: WPC), and UDR (NYSE: UDR).
1. A great retail landlord
Federal Realty has an over-five-decade-long streak of annual dividend increases under its belt, including a dividend hike in 2020. That's an incredible run that puts this REIT into the vaunted dividend aristocrat sphere. You don't achieve that kind of success by accident. The key here is focus.
Federal Realty owns roughly 100 retail centers and mixed-use developments. That's not a huge portfolio relative to some of its peers. However, it is a highly curated list, focused on wealthy regions with dense populations. Federal Realty's third-quarter 2020 earnings conference call highlights just how desirable its locations happen to be, as management noted that retailers have been looking to switch into its properties from nearby locations owned by other landlords. Essentially, the REIT's customers were looking to upgrade their locations, even if it means paying more in rent.
Federal Realty currently offers a roughly 5% dividend yield, which is toward the high end of its recent yield range. The stock is off by roughly a third over the past year. To be fair, it will take time for the company to work through the retail headwinds brought on by the coronavirus pandemic. But for long-term investors, that should be seen as an opportunity to get into a REIT retailers want to work with.
2. Diversification personified
The next name up is W.P. Carey, which is offering investors a roughly 6% yield backed by over two decades of annual dividend increases. That included a hike in every single year since its 1998 IPO. The key to this long-term success is a differentiated business model.
The core of W.P. Carey's business is the net lease approach, which means it owns single-tenant properties for which its lessees are responsible for most of the asset's operating costs. Moreover, the REIT tends to originate its own leases, which allows it greater insight into the financial health of its tenants and gives it the ability to create favorable lease terms. On top of that, W.P. Carey is opportunistic and highly diversified, often putting money to work at times and in sectors that peers aren't.
Some numbers will help here. W.P. Carey's portfolio is broken down between industrial (24% of rents), warehouse (23%), office (23%), retail (17%), and self-storage (5%), with 8% "other" making up the rest. Foreign properties account for roughly 37% of the rent roll, which largely comes from Europe. That's more diversification than almost any other REIT you'll find and allows W.P. Carey a fair amount of latitude when it comes to putting new money to work. In the midst of the pandemic, for example, it announced that it wanted to add to its industrial and warehouse assets. Essentially it was looking to take advantage of the health crisis to invest in property sectors likely to benefit from the societal shift toward online shopping. This is the kind of high-yield stock that would be a good fit for most investors.
3. Riding the apartment trends
The last name here isn't quite as generous on the dividend front, offering a relatively modest 3.8% yield. However, that's still well above the roughly 1.6% yield you'll get from SPDR S&P 500 ETF (NYSE: SPY). And, notably, apartment landlord UDR provides one of the key necessities of life -- shelter.
The stock is down about 15% or so over the past year thanks to shifting trends in the housing market driven by COVID-19 fears. Indeed, people have been moving out of big cities and to more rural areas. If history is any guide, that trend will be temporary. Even so, it is impacting UDR's business right now. For example, the company's large West Coast and Northeast apartment portfolios (combined about half its portfolio) saw notable revenue declines in the third quarter of 2020.
However, UDR actually has a fairly well diversified business. The other half or so of its property portfolio was closer to break even, including revenue advances in its Southeast and Southwest segments. To be fair, overall revenue growth was down about 6% in the quarter, but diversification is helping this REIT muddle through a rough patch. And that's the type of thing a long-term investor should appreciate when looking at an out-of-favor REIT sector like apartments that provide essential services.
A New Year's resolution
Taking a close look at your portfolio in January is a great yearly endeavor to help you keep on top of your investments. But you shouldn't just look at what you own, you should also consider what you might want to add as each New Year gets underway. And on that score, 2021 could be a wonderful time to include out-of-favor retail landlord Federal Realty, diversified net lease-focused W.P. Carey, and an apartment owner like UDR that has spread its bets around.
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