How to Cash In on a Little-Known $938 Billion Real Estate Play Without the Hassle of Becoming a Landlord

If you do it right, owning rental property is like writing your own paycheck, with rent checks streaming in month after month like clockwork. But owning rental properties can be time-consuming, expensive, and risky — especially if you’re just starting out. That’s why Ron and Bro are so excited to tell you how to buy into an already-established real estate empire — and claim many of the income benefits of real estate ownership, with far fewer of the headaches! Today you’re invited to discover three of the best-performing real estate investments we’ve ever seen:

 

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Total Income Special Report: REITs

Who says you have to choose between large dividends and capital appreciation? Investors in REITs certainly haven't had to sacrifice anything to generate exciting returns. REITs — real estate investment trusts — may remain a small part of the overall stock market, but for decades they've been treating savvy investors to the best of both worlds: big dividends AND growth. The conventional wisdom has always been that to get big dividends you have to sacrifice growth, but that certainly hasn't been the case with REITs. Since the year 2000, REITs have generated a 12% annualized return against a less than 2.5% gain for the S&P 500. That's not just a fluke of timing, either. In fact, since 1979, REITs have posted a blistering 12.9% annualized gain, outpacing the Russell 3000's 11.6% gain and beating small caps by even more. Those are the kinds of gains that can help keep your nest egg secure in retirement and grow it, so that you're not sacrificing future gains for income today. That's big dividends AND growth.

So what are REITs, and how might they help you secure your financial future? What's the No. 1 misconception regarding REITs and how they perform? What kind of REITs can you invest in, and what kind should you avoid? Read on to find out more, and I'll give you the names of three REIT stocks that I think are poised for solid, long-term gains.

What are REITs?

REITs (rhymes with beats, as in "beats the market") were created by law to help investors own real estate efficiently and profitably. Way back in 1960, Congress decided that average investors should be able to invest in large-scale real estate in the same way they invested in other businesses: by owning an equity stake. Even better, Congress mandated that these real estate companies pay out dividends. And so REITs were born.

Congress gave REITs a huge advantage. In exchange for paying out 90% of their net income to investors, REITs would not have to pay taxes at the corporate level. To maintain their special status, REITs have to keep at least 75% of their total assets in real estate and derive 75% of their gross income from rents, among a few other stipulations. While the high dividends are great for individual investors, the legislation effectively created a permanent financing advantage for REITs. Because of the tax advantage, REITs can finance property more cheaply than can tax-burdened corporations. That advantage has slowly but surely caused more and more real estate to move onto REITs' balance sheets, and it's created great returns for REIT investors. According to the National Association of Real Estate Investment Trusts (NAREIT), REITs have outperformed the S&P over most periods, and they pay larger dividends.

But REITs' legal structure does create some downsides, too. Because they're required to pay out almost all of their net income and, in practice, pay out a substantial amount of their cash flow, REITs do not have a lot of cash on hand for investment. They fund their investments by issuing debt and new stock, and they're among the most consistently highly leveraged public companies. The debt is usually manageable, and investors have grown comfortable with REITs' leverage because of the stable and long-term nature of their rental cash flows. Yet because REITs have to access the capital markets, anytime the markets seize up — such as in 2008-2009 — REITs may be unable to grow or roll over their debt, a potentially dire situation. And while that's rough in theory, in practice it hasn't been a problem for the top managers, who are able to think ahead and structure their REITs' funding to ensure that no single event hurts.

There are two broad categories of REITs — equity REITs and mortgage REITs. Equity REITs have historically been considered less risky because they own and manage the real estate directly, operating more or less like traditional landlords. On the other hand, mortgage REITs own real estate debt and do not manage the properties directly. They simply purchase — and then earn a spread on — debt that underlies commercial properties. Historically, mortgage REITs have been riskier, making them less suitable for a portfolio in any significant amount. For our purposes, let's stick with equity REITs, since they still offer sizable yields and greater safety over economic cycles. Later on, I'll provide you with a list of the major sectors in equity REITs.

Not all REITs are created the same. Some can be publicly traded — what we'll be discussing here — or publicly non-traded or private. Publicly traded REITs have the best corporate governance, are very liquid, and are highly transparent. In other words, it's easy to determine how the REIT is operating and whether it's in the best long-term interest of its investors. For these reasons and others, publicly traded REITs are what we'll focus on, and they're what I suggest investors buy in their own portfolios.

So how do REITs create value?

REITs create shareholder value in many ways, but the major strategies can be boiled down to a few categories: They need to effectively manage the properties they own, buy new properties at attractive prices, sell properties at attractive prices, and finance their assets effectively.

  • Effectively manage property. Management teams position their properties to succeed by courting the right tenants, making repairs and investments when warranted, keeping their properties consistently occupied, and raising rents as appropriate, often with built-in "rent escalators" that keep rents moving higher on a fixed schedule (e.g., an annual basis and tied to inflation). These are a few of the most important functions, but the day-to-day operations of a REIT require even more, including working with troubled tenants to keep the rent flowing.
  • Buy property at attractive prices. For future growth, this is one of the most important functions, and making a smart acquisition is more than just buying at a high "cap rate," which is the net operating income of a property divided by its purchase price. Management teams need to evaluate a number of factors: the strength of the tenant's business, the supply and demand growth in the area, interest rates, and the strength of the local business climate, among others.
  • Sell property at attractive prices. Selling property is a key strategy to keep a REIT growing. Just like buying assets involves more than just finding a high cap rate, selling well requires more than just a low cap rate. By selling assets where future rent growth will not be high or where substantial reinvestment is needed, management can free up cash for more attractive assets. Execs call this "recycling capital," and it's important to move capital from lower-return assets to higher-return ones.
  • Effectively finance. By their very nature, REITs are buying long-lived assets, but of necessity they fund their purchases with shorter-term debt financing, with maturities often ranging from five to 10 years. This creates a potential problem if large debts come due at a time of market disruption, but in practice this is not often a huge issue, because REITs stagger their maturities and roll over their debt in a timely fashion. When rates fall, REITs refinance in order to lower interest expenses. When rates rise, REITs are forced to pay more in interest, but their "laddered" debt means their interest expenses rise more slowly over time, giving the company time to grow itself out of any increased expenses. REITs try to move toward unsecured debt, rather than secured debt, because it gives them more autonomy and latitude for decision making. They also need to balance using fixed-rate debt vis-a-vis cheaper floating-rate debt.

The value that REITs create is reflected over time in a pair of financial measures, one asset-based and the other income-based. The first is called net asset value, or NAV, and it's the estimated value of what a REIT would be worth if it closed up and sold off its assets today. This estimate is based on what similar assets have been fetching in the market, and so it's subject to substantial changes based on the macroeconomic climate, the local economic climate, and the specifics of the asset. With dozens and sometimes hundreds of assets in a portfolio, a REIT's estimated NAV could vary substantially, either above or below, from analysts' estimates. Still, buying a REIT below NAV is a good rule of thumb for avoiding substantial losses, and over time the stock's price should move toward NAV, especially in a well-managed REIT.

The second measure of value creation is funds from operations, or FFO. FFO is an income- or cash-flow-based measure. FFO is similar to net income but adds back depreciation (and some other things) to arrive at a more robust measure of cash flow for the REIT. However, FFO does not usually take into account reinvestment that might be needed in a property to keep it running optimally. REIT analysts often value a REIT on a multiple of its FFO, with stocks typically trading between eight and 20 times FFO.

About those large dividends…

So how do REITs pay out such high dividends? In addition to REITs' tax advantage, the very nature of the business contributes to REITs' high dividends. A building is a long-lived asset that is depreciated and expensed on the income statement over time, but its useful life is much longer than its accounting life. In fact, while a depreciation expense suggests the building loses value, buildings often appreciate over time, as they are able to produce more income in a growing economy. Because of these mismatches, the cash flowing through the business is much greater than the company's recorded profit. REITs have a special name for this cash flow: funds from operations, or FFO (explained above). So after subtracting any maintenance on the building, the cash flow remaining is available for distribution to shareholders, and it's usually much greater than what the company officially reports as profit.

Don't make the mistake that many investors make. They assume that REITs have to pay out 90% of their FFO. However, Congress requires that REITs pay out 90% of net income, a figure that is usually much smaller than FFO. In practice, however, REITs usually pay much more than they are legally required to.

And why should you own them?

REITs were designed to offer tremendous benefits to investors. By their very structure, they give individual investors the opportunity to own an interest in a diversified set of real estate, but they also can create powerful benefits for your portfolio as a whole and provide numerous advantages in your quest to secure financial freedom. REITs fix two of the biggest problems with owning real estate yourself — the hassle of doing it and the extreme concentration in just a few properties. Here are just a few of the many advantages of adding REITs to your portfolio.

The 4% retirement rule.

You can comfortably build a basket of REITs that pays more than 4% (and growing!) yield. That's important, because that's also the percentage that you can safely spend down on your retirement savings annually and expect it to last your lifetime. If you get a 4% yield from REITs, you don't have to spend down your principal, so you can allow it to compound over time. Even if you do have to spend down principal, the stable yield helps offset that spending, extending your nest egg.

Real estate ownership without the hassle.

REITs get you in the real estate game quickly and less expensively than does buying property, and you get the benefits of real estate — cash flow and long-term appreciation — with none of the hassles of managing the properties yourself. Mortgage payments? Flaky tenants? Cockroaches? These just aren't the hassles you want as you're investing for retirement. By owning REITs, you're outsourcing all these worries to a management team that usually has decades of experience in dealing with them. And that's before we get to all the issues of financing and having a lot of money tied up in only one or two assets that are very illiquid. REITs won't foreclose on you if you don't make a payment. Plus, you can own attractive property types that you'd never be able to own as an individual landlord. REITs give you the benefits of real estate without any of the problems associated with owning real estate. And there's no more paperwork than you'd already file for your tax returns for selling stocks or receiving dividends!

Diversified portfolio of properties.

Another huge benefit of REITs is that you get immediate diversification. You won't have all your real estate eggs in one or two pieces of directly owned real estate. Instead, in each of your REITs you'll have a stake in dozens of quality assets, giving you immediate diversification within the real estate space. Then by buying more REITs, you can diversify by geographic region and by industry (more on the latter below). REITs give you diversity quickly and simply, and you don't have to run around the country finding attractive assets, because you've got experts doing it for you.

Tenants are often world-class companies.

REITs often own properties that are leased to the best tenants in the world — highly profitable companies, many of them publicly traded. These low-risk tenants aren't skipping a rental payment because they lost their job last month, unlike what you might deal with if you owned property directly. High-quality tenants create stability over time.

Attractive and growing dividend yield.

Of course, the dividend yield is what draws many investors to REITs, and the sector is well-known for its large payouts. But what shouldn't be overlooked is the ability of REITs to grow that yield over time as the business raises its rents. So you get the best of both worlds — yield now and growth later. Equity REITs yield an average of more than 4%, easily trouncing the S&P 500's dividend of 2%. And top REITs will be able to grow that payout faster, too. That dividend growth keeps you ahead of inflation, so the real value of your money keeps growing. Below I'll give you a few names that I like for their ability to grow over the long term and keep their dividends up.

Income stability in retirement.

Buy the right REITs — those with proven management teams and sustainable dividends — and you'll get stable income in retirement. There's no greater time to have it. The security of having a regular payout — most companies pay quarterly, though a handful pay monthly — is hard to beat. When companies raise their payouts, usually annually, it's like getting a raise just for being loyal. Often it's a pretty generous raise, too; 5%-7% is not uncommon for some of the top REITs.

More diversified investment portfolio.

Adding REITs to your portfolio can create greater diversification, greater returns, and more stability, because REIT performance is largely uncorrelated with the rest of the market. Because of their contractually guaranteed cash flows, REITs are among the most stable of companies, and that doesn't change too much even when recessions hit. Sure, REIT stocks might go down like the rest of the market, but they are more resilient and operate on a longer horizon.

What kinds of REITs can you buy?

Basically, almost any kind. While REITs pay dividends by law and are tax-advantaged, there's a lot more to a REIT than that. The term REIT can be monolithic, encompassing sectors that have vastly different characteristics. REITs "slice and dice" their business in a variety of ways beyond this large level, and they can focus on geography (regional, national, international), tenant (large corporations, government, individuals), location (urban, suburban, rural), and even subsector (skilled nursing versus senior living, malls versus shopping centers). In short, there are an unlimited number of ways for a REIT to cut its niche.

NAREIT recognizes 11 major types of equity REIT, and the cyclicality of each depends a lot on the underlying dynamics of each industry, including the macroeconomy, local economy, and supply-demand balance in each market, among other factors.

  • Residential — Owner of apartments, manufactured housing, and now single-family housing.
  • Retail — Assets include all kinds of retail properties: shopping centers, malls, and big-box stores, among others. Some REITs focus on specific property types — for example, grocery-anchored shopping centers — to help reduce cyclicality.
  • Office — Assets include office properties, and the REIT may be focused on a specific tenant or geographic area.
  • Health care — This is among the most stable REIT sectors, since demand is constant, and government funding and private funding remain stable and are even growing, though at a relatively low level. Assets include skilled nursing facilities, senior living communities, and hospitals.
  • Industrial — Assets include a range of industrial properties, including warehouses, storage facilities, and other types of distribution centers.
  • Self-storage — This has been a fast-growing subsector in the past few decades, as houses overflowing with stuff move to self-storage facilities.
  • Lodging — Lodging REITs own hotels and then frequently contract out management. Results fluctuate highly across the economic cycle, and this is probably the most cyclical of all the REIT subsectors.
  • Infrastructure — Assets include infrastructure such as data centers and telecommunications towers and properties. These have been high-growth sectors of late.
  • Timberland — There are just a handful of these REITs, which own land that grows timber. And timber grows even when the economy is down, though overall economic conditions affect end-market prices for timber and other products.
  • Diversified — Like the name implies, these REITs own a mix of assets that cross the standard lines, such as office properties mixed with industrial properties.
  • Specialty — This is a bit of an omnibus category and includes whatever doesn't fit in the other subsectors, including outdoor advertising, movie theaters, and fitness centers.

Is it time to buy REITs now?

This is a great question, especially given the stunning performance of REITs since the 2008-2009 financial crisis. According to a June 2016 report by JP Morgan, REITs led the major asset classes in five of six years (2010-2012, 2014-2015) after the crisis and ran strong in 2016. So is it time for underperformance, reverting to the mean?

If so, it's not obvious. REIT valuations today appear to be in line with historical levels despite their strong run, and 2016's solid performance was set up by the previous year's completely moribund 2.8% gain — a gain made thanks only to the power of dividends. So REITs won the race in 2015 mostly by default, as other asset classes took a step back rather than any definitive step forward.

But plenty of REITs did get whacked in 2015, as investors began expecting the Fed to raise short-term rates. It was a fantastic buying opportunity, as traders sold based on the No. 1 fiction about REITs — that they do poorly when interest rates rise. You'll often see this bandied about in the financial media as if it's received wisdom, when it's merely conventional falsehood, something "everyone knows."

Why does this belief persist? It's based on the faulty assumption that REITs are like bonds, but they most certainly are not bonds. A bond offers a clearly defined set of cash flows over a given period. Whatever you pay for the bond, you're getting only those cash flows in the form of interest payments and no more. If interest rates go up, those cash flows are worth less in terms of real goods and services because of the time value of money, and so the bond's price goes down. The situation is much different for REITs.

Healthy REITs are able to grow their cash flows over time — yes, even when rates rise. So they're adding cash-flowing properties and are able to increase their payouts. And because they stagger their debt financing across many years, their cost of funding does not spike higher at the exact moment that interest rates go up. And rising rates generally coincide with rising prosperity and a strong economy, meaning that REITs are raising rents while times are good. That's nothing like a bond. Moreover, as financing costs increase, cap rates adjust higher so that REIT buyers can earn an adequate rate spread on their investment. Well-managed REITs increase their dividends over time, even through rising rates.

This intuitive conclusion is born out in empirical research as well. Asset manager Gerstein Fisher investigated how REITs fared in both rising- and falling-rate environments dating back to 1978. Their conclusion: "In sharp contrast to bonds, REITs have performed better in rising-rate than in falling-rate periods." Here's how the figures shook out:

Asset Class Average Monthly Return
(Rising Rates)
Average Monthly Return
(Falling Rates)
U.S. REITs 1.28% 1.06%
U.S. equities 1.21% 0.85%
U.S. bonds 0.47% 0.63%

Gerstein Fisher's research suggests that REITs did just fine amid rising rates and, in fact, better than U.S. equities generally. Plus, REITs outperformed by an even greater margin when rates were falling. Bonds? Not even a contest.

This work is corroborated by research from NAREIT suggesting that REITs generated absolute positive returns in 12 of 16 rising-rate environments since 1995, and very positive returns in nine of those periods. There's just not evidence to support the claim that REITs fare poorly when rates go up, though it's something that "everyone knows." That belief has cost investors a lot of money since mid-2015, as they have scrambled to avoid declining REIT prices, only to have REITs rally hard off of depressed prices.

So how should you buy REITs?

When adding REITs to your portfolio, you can do just as you would with any other stock:

  • Above all, diversify. Don't buy just the highest-yielding REITs, tempting though it is.
  • Forget trying to time the market.
  • Add money to positions over time and regularly.
  • Look for well-managed companies with sustainable dividends.
  • Be willing to pay up — a little bit — for top companies.
  • Think longer term, especially when buying real estate.
  • Reinvest the dividends if you don't need the cash now.

If you're looking to build a portfolio of dividend dynamos, focus on the sustainability of the dividends and the long-term track record of management. Even if you overpay somewhat for a good or great company with sustainable dividends, it’ll grow its way out of any small amount that you've overpaid, and you'll be collecting the growing dividend all along the way.

Three for the money

So with that as a preamble, let me introduce you to three REITs that I think are great long-term buys: Gramercy Property Trust (NYSE: GPT), Ryman Hospitality Properties (NYSE: RHP), and Care Capital Properties (NYSE: CCP). Here's why you should consider them as potential investments.

Gramercy Property Trust (NYSE: GPT)

This diversified REIT invests in office and industrial properties, though CEO Gordon DuGan will pick up a bargain in specialty real estate when he can. Gramercy operates as a net-lease REIT, meaning that its tenants — usually investment-grade — are on the hook for not only rent, but also virtually all operating expenses for the property, including taxes and maintenance. What makes Gramercy special is that DuGan thinks like an investor, and he's always on the hunt for a good deal. Here's a great example: In 2015, DuGan picked up Chambers Street Properties at a greater than 20% discount to net asset value. From the beginning, DuGan's plan was to keep the best properties, liquidate the less-attractive ones at somewhere near fair value, and roll the proceeds into better real estate — all in a two-year period. DuGan has hit his goal of liquidating assets in less than a year and is well on the way to reinvesting the proceeds at better cap rates. In effect, DuGan took advantage of Mr. Market's oversight and created value for shareholders in a way that few CEOs care to do, doing the dirty work of closing on a transaction and then pursuing a lengthy marketing process for more than $1 billion in property. The move should help the stock's valuation over time as the company rapidly gains scale.

At a price around $27, Gramercy pays an attractive yield in the neighborhood of 5%, but its low payout ratio means that the company should be able to grow its dividend in the double digits for years. DuGan plans to grow Gramercy into "the blue-chip REIT" in the net-lease space, and I believe he's well on his way.

Ryman Hospitality Properties (NYSE: RHP)

Ryman is a lodging REIT with a twist: It owns only convention hotels — just four of them at the moment, though another is on the way. And nobody does conventions like Ryman, which owns more top-10 convention hotels than anyone, providing substantially more meeting space per room than do large rivals, plus an all-inclusive experience, which is valued by meeting planners. You may know some of its properties, all under the Gaylord brand — Opryland (Nashville), National (Washington, DC), Texan (Dallas), Palms (Orlando), and the soon-to-be Rockies (Denver). These properties are built specifically to cater to conventions, and that allows Ryman to book business years in advance — nearly three years on current bookings. The REIT held up much better than peers did in the 2008-2009 recession, with declines in profitability of 9%, less than one-quarter of what peers registered.

Supply growth looks modest, and meeting attendance is growing, playing to the REIT's strength and translating into strong earnings growth over the next few years, at least. Already Ryman puts up the strongest revenue per available room of comparable hotel REITs, and EBITDA sits atop peers' as well. Ryman drives further marginal revenue by attracting "transient" customers to fill up rooms during slower convention times. Management has smartly designed its properties to be expanded and developed as demand increases.

At a price near $62, Ryman pays an attractive 4.8% yield, with a payout ratio that's in line with industry averages. Management under CEO Colin Reed is very returns-focused, and it should be, with insiders owning roughly $78 million in stock, and Reed owning more than half that amount. I also like that management — in a very atypical move for a REIT — issued a $100 million stock-repurchase authorization, and was buying shares at around $46 in early 2016, so that's a benchmark for a very attractive price.

Care Capital Properties (NYSE: CCP)

This health-care REIT was spun off in 2015 from one of the most successful REITs in the market, Ventas. Now the executives who helped generate double-digit annual returns at Ventas for over a decade are in charge of Care Capital, which owns skilled nursing facilities. Care Capital leases its 340 properties under long-term net-lease contracts to nearly 40 health-care providers, making it the second-largest pure owner of skilled nursing facilities. The remaining average lease term is nearly nine years. The REIT has locked in rent escalators of 2.3%, while rent coverage is in line with industry averages. Skilled nursing facilities are some of the most cost-effective health-care operators, making them a preferred solution for insurers and government payers.

For the moment, however, investors are concerned that recent changes to government payment schemes known as bundled payments will hurt profitability. But on the second-quarter 2016 conference call, management stated that these programs will have minimal impact on the company and its operators. Overall, the landscape looks favorable. Baby boomers are graying quickly, funding is stable, and the supply of skilled nursing facilities has been stable to slightly falling over the past decade. With just 16% of skilled nursing facilities owned by public REITs, management thinks it's a great moment for the well-financed Care Capital to roll up smaller local and regional players. Given the high level of fragmentation, the REIT has a long runway to acquire rivals and gain further scale. CEO Ray Lewis helped assemble the current portfolio during his 13-year tenure at Ventas as either president or chief investment officer, so he's intimately familiar with the assets.

At a price around $25.50, Care Capital trades at less than 18 times estimated 2016 earnings — that's cheap. The REIT targets a 76% payout ratio, and the dividend today comes to 8.9%. With an experienced management team running the show and a game plan of rolling up the industry, Care Capital looks like a great long-term investment at today's prices.

Motley Fool data as of February 8, 2017