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Nov 04, 2008

Winning With Real Estate Investment Trusts

By Andrew Mickey, Q1 Publishing

According to Forbes magazine 46 out of the worldís 691 billionaires made their fortunes in real estate.

Buying land and buildings has always been a profitable bet over the long term. Tens of millions of U.S. families have accumulated wealth by purchasing homes in growing communities and hanging onto them. Despite the recent housing market downturn, real estate is a great place to grow and store your wealth.

Of course, the illiquidity of real estate, large amount of capital required, and time required turned a lot of investors off of real estate investments. However, that all changed with Real Estate Investment Trusts (REIT).

REITs are holding companies which own and operate real estate properties. There are many types of REITs. Some hold commercial properties like malls and office space. Others hold residential properties like apartment buildings. Still others hold industrial facilities like warehouses and factories.

In a way, owning a REIT is like owning a share in an apartment building, mall, or industrial park...without having all the headaches of managing the property. Thatís just part of the attraction of REITs. High cash dividend yields are much more important to investors. REITs are required by law to pay out 90% of income to shareholders. That has pushed the yields on many of them up to 5%, 10% or more.

Itís no wonder REITs have become one of the most popular investment vehicles in the past few years. REITs offer high dividends, tax advantages, superior annual returns, and liquidity.

All good things (and bull markets), however, come to an end sooner or later. In the case of REITs, the end has been dramatic. Most REITs have shed between 40% and 90% of their value over the past year as the global real estate market has collapsed.

But when prices have plummeted and real estate values are at record lows, it is the best time to buy. This is the time the real money is made in real estate. Despite all the bad news hitting real estate investors these days, Iíve identified three REITs worth buying in this market.

Frankly, REITs are now a contrarianís dream. They are on sale across the board and you can buy them at fire-sale prices. You can get your pick of the litter and not have to worry about overpaying. After all, the majority of real estate billionaires laid the seeds of their fortunes buying real estate at rock bottom prices. They bought when few others were willing to buy.

But they didnít buy just any real estate on the market. They bought wisely. And by knowing the ins and outs of REITs, you too can invest in them profitably...even in a bear market for real estate. These include:

- a REIT yielding 7.7% and has increased its dividend 51 times in the past 14 years
- one company that only gets more profitable as the population gets older
- a beaten down REIT which never stops growing...even during a depression

Of course, I know what youíre probably thinking...

ďReal estate...right now. Weíre in a bear market for housing that will last for years. Too much capacity, not enough demand, nothing is going right in real estate.Ē

REIT: ďNow? Youíre Crazy...Ē

Frankly...youíre right. But, let me introduce you to Donald Bren.

Bren led a team of investors to purchase the Irvine Company in 1977. At the time, the U.S. economy was in a stagflationary spiral and the go-go Reagan days were years away. Real estate was performing well, but it certainly wasnít anywhere near picking.

Over the next three decades, Irvineís commercial properties and real estate developments would soar 3,800% in value. Thatís an annualized return of 12.9% for 30 years (Not bad, but when you add leverage to the mix, itís huge).

Bren is the wealthiest man in American real estate. Among other assets, he owns the 93,000 acre Irvine Ranch in Orange County which has 400 office buildings, 35 shopping centers, 80 apartment complexes and two luxury hotels.

Bren made an absolute fortune buying real estate when it wasnít a hot investment and holding onto it for a long time. Like most investments, buying low and selling high is the key to making big profits. Bren did it in the 1970s. And again in the 1990s. Now you have a rare opportunity to do the same thing because almost no one wants to buy real estate.

Home prices are plummeting. Millions of Americans have lost their homes. Itís hard to find investors who want to hear about real estate. Eventually that will change. Buildings are not going to be worthless in the long term.

At Q1 Publishing we try to take a contrarian perspective where we recommend buying things cheaply that people donít want and selling it later at higher prices. Thatís one of the few ways to make big money investing without taking on too much risk.

And right now, the combination of a bear market in real estate and recessionary fears have created a few (very, very few!) opportunities in REITs. And if you invest in the right ones now using a few ultra-conservative strategies which limit downside risk and allow you to stay positioned for the eventual rebound, the investment potential is enticing.

EIT: 31 Years of Superior Returns

In 1960, the U.S. Congress created REITs to allow regular investors to purchase real estate with ease. REITs also provided real estate industry with a source of equity funding in addition to traditional loans and other credit-based financing.

It was a win/win situation...that got even better.

In 1986, the Tax Reform Act permitted REITs to own and manage their properties. They werenít just asset-backed commercial mortgages anymore. They were vertically integrated companies spinning off mountains of free cash flow back to their shareholders.

This law made REITs even more attractive.

Today, about 170 REITs trade on major stock exchanges. These REITs have a combined equity market capitalization of nearly $350 billion.

Despite their growing size, REITs are required to comply with a unique set of operational and distribution rules. All of which are aimed at benefitting shareholders.

By law a REIT must be governed by directors or trustees and its shares must be transferable. It must have at least 100 different shareholders and five people cannot own more than 50% of total REIT stock. This ensures that one large shareholder canít ďrun the showĒ at the expense of others.

To qualify as a REIT, a company must have the majority of its assets and income in land and buildings and must distribute at least 90% of its taxable income to its shareholders. REITs are allowed to deduct dividends from its corporate taxable income. As a result, REITs are exempt from the ďdouble taxationĒ which reduces the value of dividends from other corporations.

REIT: Double Payday

Because of the taxation structure of REITs they typically yield high dividends. An index of residential house prices nationwide gained 6% compounded on average from 1978 to 2006. Equity REITs, meanwhile, produced a 7 % percent compound annual return just on the REIT share price. But once you add reinvested dividends, the REITs compounded annual total return for the same period was 15 %.

One of the risks with conventional dividend yielding stocks is that the executive board can vote to change the dividend structure. This isnít an option for REITs. The dividend income is relatively secure. REITs are forced to issue dividends to the investors to maintain their tax exemption status.

REITs have considerable flexibility in how they derive income and create shareholder value. Revenue growth comes from raising rents, increasing occupancy, cutting costs and buying more real estate.

Like everything else, itís all supply and demand. Commercial leases rise as the economy expands and there is increased demand for space. Low occupancy rates in neglected buildings can be addressed by renovating the facilities, or offer better building services, or by marketing the properties to deeper pocketed tenants.

REITs share prices have shown competitive growth over the last 30 years. The annualised average returns have beaten the Dow, the NASDAQ and the S&P 500.

REIT: Liquidity is Your Best Friend

One of the biggest appeals of REITs is that they are bought and sold just like stocks. They can be quickly converted into cash and you can protect yourself against losses by using trailing stops.

A trailing stop is a useful tool that allows you to let profits build up, while at the same time cutting potential losses. Trailing stops are typically set at 15% to 25% below market price. You buy the stock (or in this case the REIT) hoping that it will go up. But you are building in an insurance policy by saying, ďIf this stock ever loses more than 15% or 25% of its value Ė sell itĒ.

If the REIT doubles in value (goes up 100%) and then falls back 15%, you will automatically exit from your position with a 70% gain.

When you are talking about owning assets, like high rises, that are subject to all sorts of external forces, itís very handy to be able to enter and exit your position with a few keystrokes or a quick phone call. Thatís certainly not an option when buying and selling real estate itself.

REIT: The Good, The Bad, and The Ugly 

There are three main types of REITs.

Equity REITs (The Good) own and operate income-producing real estate. They engage in a variety of different real estate activities, including renting, leasing and maintenance of properties. In fact, REITs must acquire and develop its properties for the main purpose operating them, rather than developing and resale.

Hybrid REITs (The Bad) have the properties of equity and mortgage REITS. The own properties and make loans to real estate owners and operators.

Mortgage REITs (The Ugly) lend money directly to real estate owners and operators or extend credit indirectly through the acquisition of loans or mortgage-backed securities. Todayís mortgage REITs extend mortgage credit only on existing properties. Many mortgage REITs also use securitized mortgage investments, dynamic hedging techniques and other derivative strategies. As a result, they have been dragged downward by the fallout from the ďsubprime loanĒ fiasco.

REIT: Thrivers and Survivors

Most REITs are trading at or near record lows. A prolonged recession will keep real estate values on the downtrend. However, the REITs with substantial and sustainable dividend yields are some of the best values in this beaten down market. And with the markets still at very low valuations, you can pick up cream of the crop REITs at very low prices.

In fact, there are three REITs Iíve been eyeing for a long time and just waiting for a sell-off like this. These three REITs all have unique qualities which make them the safest of the breed, but without sacrificing the upside potential for long-term REIT investors.

Itís the best of both worlds. And they all pay some pretty nice dividends too. They will be the survivors during this market downturn and will thrive when the real estate markets do turn around.

The ďMonthly Dividend CompanyĒ

Realty Income (NYSE:O) has become one of the most popular income investments in the world. If youíre an investor looking for reliable and regular income, look no further.

Realty Income has grown into one of the most consistent dividend payers in the world. It has increased its dividend 51 times since 1994 and now yields a healthy dividend of 7.3%.

Of course, as Realty Income so proudly points out, it pays that dividend monthly. Realty Income has proclaimed itself the ďMonthly Dividend Company.Ē And for good reason. This REIT has paid a monthly dividend for 459 straight months.

 This is one of those companies in which is always a great buy. Itís one of the least volatile stocks on the New York Stock Exchange. Of course, with the recent across the board sell-off in stocks, this is a buying opportunity which only comes along once in a decade.

Profits Get Bigger as Population Gets Older

Senior Housing Property Trust (NYSE:SNH) is a REIT focused on properties which cater directly to the elderly Americans. It operates independent and assisted living communities.

Of course, SNH is very similar to about a dozen other REITS. There are a lot of companies in this growing sector. However, SNH is set apart from its competitors by its tenants. You see, SNH has successfully attracted residents with a higher net worth than many of its competitors. SNH gets about 70% of its revenues from private sources. It is not reliant on Medicare payments or other government entitlement programs to pay the rent.

On top of that, SNH has an enviable debt to equity ratio. Remember, we always have to be concerned about how much debt a REIT has on its books. Itís not an issue during good times, but when times get tough a bloated debt load can send a leveraged REIT into bankruptcy very quickly.

So we look at the debt/equity ratio. SNH has a debt/equity ratio of 0.23. Basically, that means SNH has a 77% equity stake in its properties. Itís like a homeowner that still has to pay the remaining 23% of their mortgage off.

SNH is a high quality REIT that will only see demand grow over the next decade. It also doesnít rely on government handouts for revenues (a source that will eventually decline), hasnít taken on too much debt, and yields more than 7%. It has all the makings of a quality REIT you can hold onto for 10 or 20 years.

A REIT Only a True Contrarian Could Love

Some of the worldís most steadily appreciating real estate isnít on the Miami coastline or in celebrity-attracting Los Angeles suburbs. In fact, itís nowhere near as enticing and most of the population doesnít even want to live in it. In fact, it will continue to grow regardless of how weak the economy gets.

Itís timberland. Trees!

Thatís right. Timberland is one of the best investments you could have made in the past two decades. National Council of Real Estate Investment Fiduciaries (NCREIF) states timberland has beaten the S&P 500 since 1990. The NCREIF Timberland Index returned an annualized 12.88% compared to 10.54% for the S&P from 1990 to 2007.

Timberland is also a great hedge against inflation. Jeremy Grantham, who manages about $120 billion in assets for Grantham, Mayo, Van Otterloo, says timberland has on average outpaced inflation by 3% a year for the past 100 years.

Itís truly a great investment. Of course, now with the U.S. housing market in a state of oversupply and construction demand grinding to a halt, the lumber market is suffering. As a result, shareholders have dumped shares of companies which have anything to do with the lumber industry. That includes timber.

However, the timber market will come back. Itís going to take a few years, but it will. It always does. It survived recessions, depressions, wars...for the long term, timberland is one of the best investments you can make. After all, trees continue to grow during even the worst economic time periods.

Thatís why a REIT like Plum Creek Timber (NYSE:PCL) which holds timberland is a great way to invest directly into a diversified portfolio of timberland. The company hasnít taken on too much leverage either. It has a debt/equity ratio of 1.45 and allows you to buy a stake in timberland across North America while timberland is on sale. It also pays a dividend of a little over 4%.

REIT: What to do Now

REITs are one of the many investments selling at rock bottom prices these days. Fears of a global recession have taken hold.

As a rule, catching a bottom just right is almost impossible, but for some high-quality REITs a bottom is near. Yields are high, share prices have already been slashed, and the market will begin anticipating an economic recovery over the next year.

Of course, a market meltdown is never out of the question (as many investors have re-learned the hard way) so some risk-limiting strategies are in order.

First, a dollar cost averaging approach is recommended to enter any position during a choppy market. This allows you to take advantage of any further downturns by buying more shares while  staying positioned for any recovery.

Secondly, a 25% trailing stop is always advisable. This way, if the markets are in for another round of craziness, your losses are limited to 25%.

Good investing,

 

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

 

Additional Sources for Information on REITs:

REITs will Cash Continue to Expand

REIT Directory from Dividend Investor

How REITs Work

Investment Ideas
Receive the Prosperity Dispatch



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