My Favorite REITs: Dividend Darlings

REITs: Real Estate Investment Trusts. You will often hear that there is real money to be made in real estate. You're likely to know someone who wants to flip houses or become a landlord, or you may be tempted to become a landlord (or slumlord) yourself. It is a wise way to build dependable income. However, few of us have the time, capital, or risk tolerance to actually get our hands directly on rental properties. Those that do stand to gain a lot, but it requires time and energy with a hefty dose of risk. 

Fortunately, those of us who want the benefits of being a landlord without actually owning property can take advantage of Real Estate Investment Trusts, or REITs, where professionals manage properties and pay us a cut of the profits in the form of dividend.

tl;dr REITs are a means of investing in rental property if you cannot or do not want to own rental property yourself. They are required to pay dividends and make great long-term holds. My favorites are O, NLY, and PEAK.

What is an REIT?

As stated above, REIT stands for Real Estate Investment Trust. A REIT is a company that sells shares to investors to raise money, invests the money into real estate, and then pays the investors a cut of the income.

Therefore, you can look at a REIT as a group of investors who come together to buy real estate, elect leaders, and share the profits. REITs are managed by professionals, so they're better than you and a couple of buddies going in on a house to rent out and pretend to be slumlords. You get professional real estate managers running the show, and all you need to do is buy some shares to be entitled to a cut of the profits.

The cut is hefty. REITs are required to pay out 90% of their taxable income to investors in the form of dividend. You don't need to participate in an IPO to get your hands on REIT shares, either. Most REITs are publicly traded, so you can buy them on the open market like any other stock.

REITs come in two flavors

Equity REIT: A company that buys real estate properties and rents them out to tenants to earn money. They may also flip properties. This is what most people think of when they think about REITs or being a landlord in general. Some equity REITs focus on one industry (like owning hospitals), while others own diverse properties.

Mortgage REIT (mREIT): A company that buys mortgages from other lenders (usually banks) and benefits from the interest rate spread. mREITs can raise money from investors or borrow money at a rate close to the federal interest rate. For example, an mREIT will raise or borrow $500,000 and connect with a bank that recently gave a loan to someone to buy a house. The mREIT will buy that mortgage from the bank and replace the bank as the creditor in that loan. The mREIT will then benefit from the interest on that mortgage instead of the bank. mREITs might also lend money to developers and collect interest from that loan.

Equity REITs are easier to conceptualize and thus easier for most investors to evaluate. mREITs are complicated and can raise more of their money from swaptions, interest rate swaps, and shorting treasuries. As such, they can be harder for most people to evaluate. Fortunately, professionals evaluate these companies for us, so we can take our pick from their recommendations.

Benefits of owning REITs

1) Be a landlord with no land: REITs offer you an opportunity to receive rental income without having to take the risk of owning and managing property.

2) Reliable income: REITs are required to pay 90% of their income to investors in the form of dividend. Because of this, dividends are often high, occasionally approaching 10% or even higher on dips. Top REITs tend to also increase their dividends regularly.

3) Access to restricted real estate: Even the most successful landlords typically deal with single-family homes or, at the most, apartment buildings. Most people cannot buy Class-A skyscrapers in NYC as investment properties. Investing in an REIT allows the little guy to get into this expensive segment of real estate.

Drawbacks of owning REITs

1) Non-qualified dividends: Most REITs don't meet the definition of qualified dividends, so you will always pay taxes on dividends as though they are ordinary income, rather than the lower qualified dividend rate.

2) Interest Rate Sensitivity: Rising interest rates are bad for REITs because it makes it more expensive for them to borrow money to invest in properties. However, rising interest rates usually indicate a strong economy, in which property owners like REITs do well. Therefore, REITs will usually react negatively to rising rates in the short term but do well in sustained high-interest environments. Be prepared for share price swings when interest rates change.

My Favorite REITs

I want to own rental property one day. But for now, I am happy with my REIT holdings and plan on keeping them for the long term. Here, I will show my favorite REITs.

1) Realty Income (O)

Type: Equity
Price: $61.10
Dividend: $2.80 // 4.59%
Frequency: Monthly

Realty is one of my favorite stocks overall and easily my favorite REIT. It invests in defensive retail properties such as convenience stores, grocery stores, and drug stores that do well during recessions. Its 4.59% dividend is attractive at this share price because the company has increased its dividend almost every quarter since its 1994 IPO. Buying in today is virtually a guarantee that you will never see lower than a 4.59% annual dividend on your investment. Further, the company pays dividend on a quarterly basis and so it can be reinvested quickly, giving you a higher dividend every month. 

I own 232 shares of O and collect about $54/month in dividend that gets immediately reinvested into new shares from a DRIP. I'll continue buying shares in my Roth account and expect that $54 to keep growing into something worthwhile.

2) Annaly Capital Management (NLY)

Type: Mortgage
Price: $6.30
Dividend: $0.88 // 13.75%
Frequency: Quarterly 

Annaly took a beating during the COVID-19 crisis and is trading at its lowest level ever. This likely stems from concern that the mortgage industry will get slammed during this recession. However, the 13.75% dividend is eye-popping, and management states that it believes its dividend is fully sustainable. Although yields tend to only get this high when the dividend is at risk, Wall Street may have gotten it wrong this time.

Annaly has 93% of its mortgage holdings in Agency Mortgage-Backed Securities. In other words, Freddie Mac, Fannie Mae, and Ginnie Mae (basically the US government) guarantee 93% of these loans. Therefore, concerns that a housing market collapse could hurt this mREIT are likely overblown since only 7% of its holdings are not guaranteed.

Granted, if half of those non-guaranteed holdings were to fall apart, a 3.5% dent in the company's revenue would hurt. But I believe this is hardly enough to justify the price cut it's suffered this year, and there are analysts pushing this view too. Click here for deeper assessment if you are interested (Seeking Alpha).

I hold 1,083 shares of NLY that pay about $270/quarterly, or $90 monthly. I plan to keep wheeling 1,000 shares and reinvest the dividends until I am up to 2,000 shares, then I will sell off the original 1,000 and hold the shares I bought with premiums. I will hold them long-term and keep the dividends reinvested.

3) Healthpeak Properties

Type: Equity  
Price: $28.47
Dividend: $1.48 // 5.2%  
Frequency: Quarterly  

Normally, you want diversification when you buy an REIT. Healthpeak breaks this rule by investing specifically in healthcare spaces. Although there is a move toward telehealth, there is a 0% chance that the various hospitals, senior living centers, and medical research facilities PEAK owns are going away any time soon. I am therefore confident that lack of diversity is not a problem for PEAK.

This company slashed its dividend in 2016, but has since held a steady $0.37/quarter dividend. The 5.2% dividend is already great, but the company stands to benefit tremendously from appreciation of its holdings, which are likely to push the stock higher. Hospitals, medical labs, and senior living communities will likely continue appreciating in value as Baby Boomers retire and downsize, and our health in the US is not improving, which will keep hospitals in high demand. Investors who hold for the long terms will likely watch PEAK's balance sheet improve while collecting a solid dividend.

I do not hold any PEAK shares now, but I will start picking some up once I round out my positions on some other stocks on my hit list.

Tips

- Do not pay attention to EPS (earnings per share) when it comes to REITs. EPS ignores depreciation, which is a major part or REIT's valuation. Use FFO (funds from operations) to evaluate how much REITs are earning.

- If you don't want to pick individual REITs and want to hold a basket of them instead, you can buy a REIT ETF like VNQ. Click here for a good list of ETFs.

- Be prepared to hold REITs into the long term. REITs can be fickle with wide price swings. Their real value comes from dividends, so consider investing only in REITs that you are prepared to hold. There are better investment instruments you can use if you are looking for a quick flip.

- Don't chase yield. You'll occasionally come across a REIT with a 20+% dividend. Carefully consider if you believe that dividend is sustainable before investing in it, as I did with NLY. Don't chase dividend or you're liable to accidentally buy into a stock with bad news pending that crushes the stock price and makes the dividend moot.

Disclaimer

I am not an investment advisor and so cannot give financial advice, which includes recommending specific securities. The stocks above are my favorite REITs, but I strongly recommend you research your own investment choices before making any investments yourself. If you need assistance in managing finances, do not be ashamed to approach a financial advisor.