The Right REITs, Right Now

Now’s the time to consider investing in Real Estate Investment Trusts (REITs). With Barack Obama safely re-elected as president, the country’s easy-money policy is likely to continue under Federal Reserve Chairman Ben Bernake.

The result: very low interest rates (with the potential threat of inflation down the road), and continued recovery in the real estate market.  

In such a scenario, entities that can borrow at low rates and invest for dependable higher returns are sitting pretty. In particular, REITs that are borrowing to invest in new properties can offer both growth (through rising share prices) and income (through above-average and rising payouts).

Most REITs get virtually all their revenue from rents, and they pass 90 percent of this revenue to shareholders to avoid taxes. The typical REIT, for example, was recently yielding close to 4 percent. Another benefit of real estate is that it is a hedge against inflation, should that become a problem down the road.

Below are three REIT plays with smart acquisition plans, good yields and strong portfolios.

The Big O

Realty Income (NYSE: O) controls 34 million square feet of space rented through long-term leases to major retailers such as AMC Theatres, LA Fitness, BJ’s Wholesale, and a wide variety of fast food and sit-down restaurants. This REIT’s share price has nearly tripled in value since the market bottomed in March 2009. But we see lots more potential here.

The payout, recently at $1.81 per share annually, should continue to rise from current levels for the following reasons:

Triple-net, long-term leases with stable clients. Throughout the Great Recession, Realty Income’s occupancy rate remained around 97 percent, where it was recently. The REIT signs mostly “triple-net” leases, meaning that in addition to the rent, the tenants pay for property tax, insurance and maintenance. Lease duration averaged 11 years recently.

Low cost of capital is fueling acquisitions. Compared to its competitors, Realty Income is able to borrow at very favorable rates—averaging 2.5 percent—and has used this advantage to buy additional properties and to bid for American Reality Capital Trust (ARCT), whose purchase was announced in September. This purchase would increase Realty Income’s properties by close to 20 percent, making it the 18^th largest REIT in the US and twice as large as the next largest net-lease REIT.

The merger could be delayed since certain disgruntled ARCT shareholders have filed lawsuits in various states to oppose the transaction. But we think the purchase was for a fair price—$2 a share more than ARCT price at the time—and will be completed in 2013.

Diversification away from retail. Realty Income is already well diversified. About 144 different tenants, none accounting for more than 5 percent of revenue, lease its 2,828 properties located across 49 states. But the REIT is likely to become even more secure as it diversifies away from retail.

Retail tenants were recently 86 percent of revenue (down from 98 percent three years ago), and this would fall further to 77 percent after the ARCT deal. In the meantime, industrial clients have risen to 13 percent of revenue, up from less than 2 percent four years ago. Also, four years ago, Realty Income had no investment-grade tenants. But this was recently up to 20 percent and will rise to 35 percent with the purchase of ARCT.

Realty Income has posted an enviable 60 straight quarters of dividend growth. Currently, the annual yield is 4.6 percent and distributions are monthly. Management is targeting a pay out ratio of around 85 percent of funds from operations (basically earnings plus depreciation).

Doctor in the House

Medical Properties Trust (NYSE: MPW) buys health care facilities and leases them back to the former owners. This is an increasingly popular way for medical providers to fund investments such as new technology and staff upgrades, while lowering their overall operating costs. MPW currently owns 79 facilities worth $2.1 billion and leased to 21 different hospital-operating companies in 24 states.

MPW’s dividend yield was recently close to 7 percent, vs. close to 6 percent for the typical health care REIT. We do not see the payout as risky. In fact, it should rise from here due to continued acquisitions.

For the first nine months of 2012, MPW invested some $780 million in purchases. Many of the REIT leaseback deals have returns of around 10 percent, are “triple-net” leases and allow for annual inflation increases, typically of 2 percent to 5 percent.

For the first nine months of 2012, MPW’s funds from operations came in at $85.5 million, up 48 percent from the year-earlier period, on revenue of $145 million, up 42 percent. Yet MPW’s share price, recently at around $11, has remained at very reasonable levels, sporting a price-earnings ratio of 20.5 on trailing earnings and 11.3 times on 2013 earnings estimates.

So why isn’t MPW’s share price higher? In general, healthcare REITs have lower valuations because of their lack of diversification and an outlook tied to the financial health of the medical providers.

However, any changes that affect the profitability of the providers are not likely to have a material affect on health care REITS, unless the problems are so severe that they cause a default. MPW’s clients are well-established hospital operators, many of them with award-winning facilities.

One-Stop Shopping

For instant, diversified exposure to REITs, an exchange-traded fund (ETF) is worth considering. One such play is iShares FTSE NAREIT Residential Capped Index (NYSE: REZ). The fund contains 34 REITs, about half of them apartments, a third health care facilities, and 15 percent self-storage sites. The 10 largest REITs comprise 65 percent of the assets.

REZ is up close to 12 percent so far in 2012, and has been good to investors over the last three years, with a three-year total return of 24.5 percent. REZ currently yields 3.1 percent.

What do you think of this article? Please post your feedback in the “comments” section below!

Bruce Vanderveen is a Florida-based financial writer and investor.

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