Down But Not Out
Real estate investment trusts, better known as REITs, have long been a common choice for investors who prioritize dividend income.
REITs were formed by legislation in 1960 to give regular joes the opportunity to invest in real estate. In purchasing a REIT on the stock exchange, you effectively own units in the REIT, which give you a small proportionate ownership of physical properties held by the trust.
Don’t Be Fooled By Paper Losses
In order to qualify as a REIT, a company must distribute at least 90% of taxable income to unitholders. Literally, they are legally required to distribute most of their taxable earnings.
However, this is somewhat misleading because if you look at REITs’ balance sheets, it’s not uncommon to see unprofitable REITs. Put another way, officially they have no taxable income, so technically they don’t have to pay any dividends. Yet we know REITs continue to do so. What gives?
Because REITs typically own many properties, they recognize a lot of depreciation expenses, which eat into earnings. However, these expenses are non-cash charges. Even though they reduce profits on paper, the REITs do not actually need to pay out cash, so they do not reduce the cash on hand.
This is why it makes sense to look at REITs’ funds from operations (FFO) or even more specific, adjusted FFO, to evaluate a REIT’s ability to pay and increase its dividend. The more FFO or AFFO REITs generate, the more flexibility they have to pay unitholders.
A Diverse Group
REITs operate in all kinds of industries. There are industrial REITs, retail REITs, digital REITs, storage REITs, cell tower REITs, commercial REITs, apartment REITs, hotel REITs, healthcare REITs, farmland REITs, and more.
Usually a REIT will focus on a specific industry because it takes a lot of skill and knowledge to build and operate a successful real estate portfolio. It is more efficient—and easier—to have expertise in one specific industry than to be involved in multiple industries.
All businesses are sensitive to interest rate changes but REITs are more sensitive than most since they need a lot of financing to purchase new properties to grow or refinance existing debt obligations.
Higher borrowing costs reduce their available cash for dividend distribution. Furthermore, when rates rise, property values tend to fall, which reduces the value of REITs’ portfolios. Also, their relatively high dividend yield looks less attractive when Treasury yields rise since Treasuries are regarded as “riskless.”
Hence, as a group, REIT units (shares) have dropped significantly in the last year or two and their valuation metrics (e.g., price-to-FFO ratio) have shrunk the lowest level in years, making them cheap on a historical basis.
Still Rewarding Unitholders With Reliable Dividend
Just because REITs have been money losers recently doesn’t mean they should be permanently shunned. REIT investors are still receiving regular quarterly (and in some cases, monthly) dividends in their brokerage accounts. The quality REITs still maintain solid balance sheets and their ability to pay and increase dividend isn’t in question and should remain safe unless things get radically worse.
Moreover, REITs can offer a degree of defense during economic downturns. For example, when the market crashed when the economy entered mandated Covid lockdown in early 2020, some REITs actually stayed in the green while the overall market was still regaining lost ground and sat in the red.
To evaluate REITs you will need to consider the type of industry they focus on and other factors such as the geographical concentration of their properties. For example, if you are considering an apartment REIT, you will want to see who has the most properties in high-demand regions. If you wanted a REIT least impacted by Covid lockdown and social distancing, you would have picked something like a cell-tower REIT. A cell tower does not require any social gathering to generate revenue. It just lets telecom carriers rent space in the tower for equipment. You will also want to find REITs that are staying in sound financial shape despite the difficult interest environment.
If chosen wisely, the REIT space has some gems for long-term investors seeking a steady and growing dividend.
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