If you joined me for last week's article, you know that I promised to return this week with some opportunities for you to further diversify the REIT portion of your investment mix. However, I really didn't feel like it, so I decided to write about carnies instead.
Only kidding. To be honest, I just look for any opportunity to use the word "carnies." There's just something fun about saying it. I really can't explain why. Anyhow, let's get back to reality land, and down to business.
As a reminder, these articles initially developed out of some great questions from the participants of our Asset Allocation seminar. So, let's give them a big Foolish round of applause to show our appreciation. (Oh for Pete's sake, stop clapping. No one can hear you, after all. It was just a figure of speech.)
One of the main concerns our readers have expressed about jumping into REITs is that real estate has had such a successful run over the past few years. Let's face it, even a tin shack in the middle of a landfill is probably going for twice what it was a few years ago. (If you'd like to hear me vent on real estate prices, check out The Housing Frenzy.)
Sky high
This has, as you might suspect, contributed to some pretty spectacular gains in REITs as well. That means there are good reasons to have valuation concerns. So, where does that leave someone who's nervous about the overall REIT sector, but would still like to take advantage of the income-generating, volatility reducing benefits of REITs?
As we discussed last week, diversification is key, but whereas last week we were focused on diversifying your portfolio with REITs, today we're focused on diversifying your REIT allocation with some different REIT categories.
Certainly, the investments that we discussed last week are diversified. However, because most REITs tend to be of the varieties that generate rental income, the indexes are skewed a bit towards this group. And this is one of the categories that can be most affected by cyclical factors.
Fortunately, some REITs are less correlated with the overall real estate sector than others, and as such, a combination of these various REIT classes can leave you with a portfolio of REITs that move fairly independently of each other. That's our goal here: Building a portfolio with all the benefits of REITs, while protecting ourselves from a downturn in any particular sector of the real estate market.
OK, with all that said, let's talk about the REIT sectors that provide us with the spice of life: variety.
Mortgage
The mortgage REIT sector is fairly large in its own right, and as such, many basically classify REITs into two categories: mortgage REITs and property REITs. Just as property REITs generate income from a portfolio of real estate, mortgage REITs generate income from buying bundles of pooled mortgages. The similarities pretty much end there, however.
Typically these REITs raise or borrow funds to invest in collateralized mortgage obligations (CMOs) that are packaged by the likes of Fannie Mae (NYSE:FNM), Ginni Mae, and Freddie Mac (NYSE:FRE), and carry an actual or implied AAA rating.
Mortgage REITs are effectively using leverage to exploit the spread between long-term interest rates and short-term rates. With that in mind, these things can be very sensitive to interest rate speculation, making them volatile investments at times. These securities are not for the feint of heart.
That said, with added risk comes added reward, and these REITs have proven an ability to maintain double digit yields over time. The best managed mortgage REIT in the business is Annaly Mortgage (NYSE:NLY), managed by Michael Farrell.
Mr. Farrell has shown remarkable skill in conservatively navigating murky interest rate waters. I classify the shares as being fully valued at this level, but for income-seekers, the yield is still a hearty 11.5%.
Timberrrrrr!
One of my favorite financial authors is Paul Sturm, who has a regular column in SmartMoney Magazine. A couple of years ago, Mr. Sturm wrote an article detailing the benefits of adding timber to one's portfolio, and he made compelling arguments around why this asset class deserved attention.
For starters, a diversified timber portfolio would have returned 13.3% annually over the past 40 years -- not bad. And timberland is a remarkably low-risk asset, with levels of volatility resembling bonds more than stocks. Even better for our purposes, timber tends to perform best when stocks and bonds suffer, and it moves fairly independently of other REITs.
In this category, Plum Creek Timber (NYSE:PCL), the second-largest private owner of timber in the country, is one of the best managed in the business.
Plum Creek shares struggled last November when a prolonged downturn in the timber market, caused by a flood of cheap Canadian lumber, forced it to slash its dividend. This was the first ever such cut after fourteen years of steady increases.
Management could certainly have maintained the dividend, which was over 9% at the time, by harvesting more trees or taking on debt. However, it chose to make the tough decisions that were required to ensure the best long-term creation of shareholder value.
The company insists the current dividend of $1.40 per share, giving it a current yield of 5.3%, is sustainable and will be increased as pricing power returns. The shares aren't likely to set the world on fire anytime soon, but it should be a stable income producer going forward.
Health care
Health care offers some of the more interesting REIT opportunities available. Overall, these securities are set to benefit a great deal from the aging of the baby boomers. These guys basically own and/or operate income-generating health-care facilities.
One of the most appealing companies in this sector is Health Care REIT (NYSE:HCN). Don't let the lack of creativity with the name fool you, as this company has been quite adept at managing its business. The firm invests primarily in skilled nursing and assisted living facilities, but also maintains some specialty care facilities. It has good geographic distribution with 244 facilities across 33 states, and is yielding a saucy 7.72%.
The bottom line
These are just three interesting sectors of opportunity, and I wish I had the space to detail more, but these should provide a good starting point for diversifying your REIT allocation.
If you have the interest, a little digging will turn up a great many other appealing subcategories, such as storage REITs like Public Storage (NYSE:PSA) and Shurgard (NYSE:SHU), or some interesting new REITs in the banking sector like American Financial Realty Trust (NYSE:AFR) -- though the latter is fresh from an IPO and I would recommend a lot of due diligence before considering it as an investment.
Overall, I hope this gives you a good launching pad for intelligently adding a diverse mix of REITs to your portfolio. To discuss REITs, come join us on our Real Estate and REITs discussion board.
Fool On!
Mathew Emmert owns a tin shack in the middle of a landfill, but it has risen 200% in value over the past year. He also owns shares in Annaly Mortgage and Plum Creek Timber, and if you'd like to see the rest of his portfolio, check out his profile. The Motley Fool has a disclosure policy.
