Real estate investment trusts, or REITs, are known for their dividends. The average REIT has a dividend yield of approximately 5% as of May 2020, which is significantly higher than the 2.6% yield of the average S&P 500 stock.
However, some REITs pay significantly higher dividend yields than their peers. In this discussion, we'll look at why REITs pay such high dividends and how you can tell if a REIT's high dividend yield is too good to be true. Then, we'll take a closer look at three high-yield REITs that could be worth a look right now.
Before we dive in, it's important to mention that this discussion is about high-yield equity REITs, meaning companies that invest in properties. Mortgage REITs often pay high dividends but are a completely different type of investment.
Why do REITs pay such high dividends?
In simple terms, REITs tend to pay higher dividend yields than typical S&P 500 dividend stocks because they have to.
One of the requirements for being a REIT is that they pay out a minimum of 90% of their taxable income to shareholders. In exchange for doing so, they don't have to pay corporate tax on their income and can simply pass their profits through to shareholders.
One important concept is that taxable income doesn't typically tell the whole story when it comes to a REIT's income. Without getting too deep into the reasons, a REIT's actual income (and ability to pay dividends) is best represented by its funds from operations, or FFO, which is generally significantly higher than its net income. So, most REITs actually pay out more than 100% of their taxable income, and it's completely sustainable for them to do so.
Is a high-yield REIT's dividend safe?
One of the most important concepts for equity REIT investors to understand -- especially those who want high dividends -- is that of a yield trap. In a nutshell, a yield trap is a stock that has both a high dividend yield and problems with the underlying business, such as declining revenue or excessive leverage. The point is that it's important to make sure a dividend is not only high but also sustainable.
There are a few red flags that can help us detect potential trouble in a REIT's dividend:
- High FFO payout ratio: REITs tend to pay out most of their income to investors, but paying out too much is unsustainable. Most REITs pay out 50% to 90% of their funds from operations, or FFO. An FFO payout ratio that's higher than this range (especially over 100%) could be a red flag.
- Declining revenue or FFO: Even if a REIT has an acceptable FFO payout ratio, it won't for long if its revenue is steadily declining. We're seeing this quite a bit in lower-quality retail REITs in recent years. I typically don't suggest investing in REITs that don't have steady revenue growth for at least the past several years.
- High leverage ratio: It's a smart idea to avoid companies with high debt. And while there's no set level of "too high," one good idea is to compare a REIT's debt-to-EBITDA ratio with a couple of its peers. If it's significantly higher, it could be a sign to stay away.
Now, the presence of any of these red flags doesn't automatically mean that a dividend cut is inevitable or that the business is in trouble. For example, it's entirely possible that a company sold some of its assets at a profit, but since these assets are no longer generating income, revenue has declined. Or, maybe the REIT's payout ratio is high right now because of temporary rent deferrals related to the coronavirus outbreak. However, the presence of these red flags without a good explanation could be a sign of an unsafe dividend.
3 top high-yield REITs to buy in May
With all of that in mind, our objective as high-yield REIT investors should be to find rock-solid companies with above-average payouts while avoiding yield traps. I typically define a high-yield REIT as one that has a higher dividend yield than the Vanguard Real Estate ETF (NYSEMKT: VNQ), which is a good indicator of the overall real estate sector and currently yields about 5.1%.
So, here are three REITs with higher-than-average yields that look like excellent stocks for long-term investors to buy in May 2020, followed by a bit about each one.
|Company (Stock Symbol)||Main Property Type||Dividend Yield|
|STORE Capital (NYSE: STOR)||Single-tenant retail||6.8%|
|Healthpeak Properties (NYSE: PEAK)||Healthcare||6.2%|
|American Campus Communities (NYSE: ACC)||Student housing||6.0%|
A business built for steady growth and income
There's a reason that STORE Capital is the only REIT in the investment portfolio for Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B). This is a business designed to produce predictable income growth, as well as long-term capital appreciation, year after year.
If you aren't familiar with the business, STORE (stands for "single tenant operational real estate") invests in freestanding properties, most of which are occupied by tenants in the retail and service industries. These are businesses that are largely recession-resistant and that aren't very prone to e-commerce disruption.
Plus, STORE Capital's tenants sign long-term net leases, which typically have initial terms of 15 years or more; require the tenants to cover property taxes, maintenance, and insurance; and have annual rent increases built right in. It doesn't get much more predictable than that.
To the downside, while many of STORE Capital's tenants are essential businesses, some have been affected by the pandemic. Restaurants are the most represented industry in STORE's portfolio, and it also has significant exposure to fitness centers, movie theaters, and family entertainment centers. These four categories make up 28% of STORE Capital's rental income, and it's fair to assume many of these tenants aren't paying rent.
Having said that, STORE Capital has more than enough liquidity to make it through the tough times, and I'm confident that the company will work with its tenants to come up with a solution that benefits everyone. STORE's executives have all bought shares since the downturn began, and in full disclosure, so have I.
A diverse assortment of properties with lots of growth potential
Healthpeak Properties (formerly known as HCP, Inc.) is one of the largest REITs focused on the healthcare industry. The company owns a portfolio of 621 properties, with concentrations in medical offices, life sciences, and senior housing -- each of which makes up just about one-third of the overall rental income of the portfolio.
The demographics and industry fundamentals are very favorable for healthcare real estate. The existing U.S. inventory of healthcare properties is estimated to be about $1.1 trillion in size, and the vast majority isn't REIT-owned, giving tremendous opportunities to grow by acquisition.
Medical offices in particular are an interesting opportunity, as much of the existing inventory is owned by the health systems and/or physicians who practice in them. Not only that, but with the older segments of the U.S. population expected to explode in size over the next few decades, there should be more demand for these types of properties, which should allow for many development opportunities as well.
So far in the COVID-19 pandemic, Healthpeak's portfolio has held up quite well. Ninety-seven percent of life science tenants have paid April rent, and more than 95% of medical office tenants have as well. The only weak spot is senior housing, for obvious reasons. Due to shelter-in-place orders and virus concerns, move-ins have virtually stopped and occupancy levels have declined significantly. While long-tailed senior housing demand remains favorable, it could be weak for the next few years, and in the meantime, Healthpeak looks like an excellent high-yield REIT option for long-term investors.
Will colleges open in the fall?
American Campus Communities is the only publicly traded REIT focused exclusively on student housing and is also a pioneer in the space. Founded in the 1990s, American Campus is largely credited with creating purpose-built apartment complexes for college students.
American Campus Communities specifically targets public universities where the on-campus housing inventory is outdated and the student body is large. The idea is that by creating an option that's far superior to the on-campus housing that's available and with more student-focused amenities than traditional apartment communities, this is a product that essentially sells itself.
And the fact that a room in one of American Campus Communities' properties actually costs less (on average) than a private room in on-campus housing makes this business even better. In fact, throughout the company's history, properties have averaged an occupancy rate of nearly 98% as the fall semester gets underway.
Speaking of the fall semester, it’s the biggest question mark surrounding the company right now, and it’s the main reason the stock is still down by about 35% since the COVID-19 pandemic hit the U.S. If (and that's a big if) all of the schools where American Campus Communities' properties are located can get back to in-person classes on time this fall, the company could look like a tremendous value at its current share price. However, while a few colleges have already announced definitive plans to reopen in the fall, most have not.
Invest for the long run
As a final thought, it's important to mention that while all three of these look like excellent investments from a long-term perspective, they are likely to be rather volatile while the COVID-19 pandemic is still going on. Invest with the expectation of a bit of a roller coaster ride in the months ahead.
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