Carla's Call: The Right REITs

07/23/2004 12:00 am EST

Focus:

Carla Pasternak

Editor, The Income Investor

High Yield Investing, as its name implies, is devoted to income investments. In a special report, editor Carla Pasternak, looks at some favorite income opportunities in real estate, providing an in-depth analysis of two individual REITs, and two real estate ETFs.

"Real estate investment trusts (REITs), offer some of the richest dividends on the market today. These unique stocks make their money by investing in real estate. Most REITs offer yields of 6% to 7%. That's three times more than the average 2% yield sported by the 374 dividend-paying stocks in the S&P 500. What's behind the big payouts? Simply, REITs are legally required to pay out 90% of their taxable income as dividends. One hitch is that since REITs don't pay income tax, their dividends are mostly taxed as ordinary income, up to 38.6%. Unlike other stocks, REITs don't qualify for the new 15% dividend tax rate. Even after the higher tax rate, though, REIT dividends will put more cash in your pocket than most other stocks. In addition, you can defer taxes by stashing your REITs in a tax-advantaged IRA or avoid taxes altogether by placing them in a Roth IRA.

"In the bear market of the last three years, the benchmark Morgan Stanley REIT Index gained 103% compared to the S&P 500, which lost 24%. REITs continued their run-up in the first quarter of 2004, rallying 12% and easily topping the market's paltry 1% gains. However, fears of rising interest rates have weighed heavily on this sector ever since. In fact, the average REIT has lost over 10% of its value since April. The problem is that when interest rates rise, real estate investors often head for the hills. Expecting REITs to decline as rates rise, investors have dumped these stocks ahead of the anticipated round of continued Fed rate hikes in the coming months.

"Our belief is that savvy investors should view the recent pullback as a selective buying opportunity. Yet with nearly 200 publicly traded REITs on the US market, it's often hard to separate the wheat from the chaff. With that in mind, we have set out to help you identify a number of REITs that now look attractive. After carefully sifting through hundreds of companies, we recently uncovered a handful of REIT investment ideas that we believe are well positioned to thrive in a rising interest rate environment. All are relatively insulated from higher interest rates and all should benefit from an improving economy going forward. Thanks to their solid performance and stellar long-term prospects, each of the companies we identify below offers a safe dividend and a good deal of capital appreciation potential.

"The world's largest neighborhood shopping center REIT, Kimco Realty (KIM $46.25) owns over 600 shopping centers that together contain more than 100 million square feet of leasable space throughout the US, Canada, and Mexico. Its centers attract local customers and are generally anchored by large-scale discount stores or supermarkets that sell day-to-day necessities. With their focus on consumer staples that people buy in both good times and bad, Kimco's retail centers remain largely insulated from cycles in consumer spending. In addition to its core portfolio of community shopping centers, Kimco invests in other higher risk/higher reward opportunities. These include joint venture interests in upscale shopping centers, property development, and mortgage financing. These businesses account for nearly half of Kimco's profits and are important sources of growth for the company. Kimco pays an annual dividend of about $2.30 per share, which equates to a yield of about 5% based on current prices. While the yield is on par for its industry, the firm's five-year dividend growth record of over 10% stands head and shoulders above the industry and the market in general. Funds from operations (FFO), a key industry measure, have seen a dramatic 16% advance in the past five years. Company sales are expected to climb another +18% this year. Meanwhile, the improved economic outlook has led management to up its guidance and analyst estimates now call for a 9% rise in 2004 FFO to $3.53. Next year should see a further 6% gain. At a P/E multiple of about 12 times next year's earnings, the company is trading at a discount to its industry peers. Kimco's A- credit rating from Standard & Poor's is the highest in the industry. Given its strong track record, solid dividend yield, and bright growth prospects, this stock appears to be a bargain at current levels.

"If you're looking for a solid stock with an above-average yield, then hotel owner Hospitality Properties Trust (HPT NYSE) is the REIT to own. The company's stable earnings growth and steady dividend increases bode well for investors. With nearly 300 moderately priced hotels located across the United States, Hospitality is one of the nation's most diversified hotel REITs. Hospitality has been paying dividends for 34 consecutive quarters and has raised its payout 14 times since its 1995 IPO (initial public offering). The stock pays a dividend of $2.88, which equates to a yield of nearly 7%. What's more, given its payout ratio of only 80%, the company's dividend appears secure and has room to move higher. The firm's FFO has also risen steadily over the past five years and earnings have gained a solid 11% a year during the same period. Last year, company profits jumped an impressive 66% thanks to higher revenues and strong profit margins. For the past few years the company has acquired new hotel rooms at an average annual 10% clip. Management has turned its attention recently to reducing the firm's heavy debt load, which nearly doubled last year to fund acquisitions. Total debt now represents only about 20% of the firm's total capitalization. The company's stellar financial performance has resulted from the rapid pace of recent acquisitions. Although growth is expected to slow going forward, analysts are still projecting a 5% earnings hike over the next year and a half. Trading at just a touch over 10 times earnings, the company is now valued at a discount to its own historical multiple and remains undervalued relative to both its industry average and the market as a whole. That suggests the stock still has room to move despite an expected revenue slowdown. Given its above-average dividend, shareholders should be well rewarded for holding this stock.

"In addition to owning individual stocks, one way to profit from the industry's high returns is to buy an entire index of REITs. With REIT exchange-traded funds (ETFs), you can hold a cross-section of property types in one simple security. As managed funds, ETFs do charge a management fee. However, since they are not actively managed, these fees tend to be fairly minimal. Since they trade in the open market just like stocks, you'll need to pay a transaction fee to purchase an ETF. But again, these small fees tend to be fairly insignificant for the long-term investor. Together with the capital gains potential, REIT ETFs pay attractive quarterly dividends just like the REITs they track. These payments are derived from dividends received from the REITs they hold, as well as capital gains earned from these holdings. The capital gains portion is taxed at the reduced long-term capital gains rate of 15% (if held for more than a year). Although only a handful of REIT ETFs are available, two particular funds provide superior long-term growth and income potential: iShares Cohen & Steers Realty Majors Index Fund (ICF ASE) and streetTRACKS Wilshire REIT Index Fund (RWR ASE).

"The iShares Cohen & Steers Realty is an excellent proxy for the 30 largest and most actively traded names in the REIT industry. Weighing in with a 28% one-year return, iShares Cohen & Steers Realty as the top-performing REIT ETF. The fund pays a generous $5.64 annual dividend, which equates to a 5.2% yield. Since the portfolio tracks only a few select names in the REIT space, each holding is heavily weighted. ICF distributes a quarterly dividend of $1.40, which equates to a yield of +3.8% based on recent prices. Since its inception in 2001, the fund has outpaced the market, delivering total returns of over +16% a year after an expense ratio of 0.35%. With a P/E of under 12, the fund is reasonably priced compared to its peers.

"The streetTRACKS fund tracks a well-diversified portfolio of 90 REITs that invest in a variety of different property types, ranging from offices to malls to apartments. The fund delivered a market-beating 26% return in 2003. RWR now pays a hefty $5.35 per share annual dividend, which equates to a yield of +3.5% based on recent prices. No individual stock accounts for more than 6% of the fund's total holdings. The fund's stellar +26% returns in the past 12 months rank a close second to top-performing ICF. The fund pays an attractive $1.34 quarterly dividend (+3.5% yield) and actively trades more than 28,600 shares a day. Its 0.28% expense ratio is the lowest in its sector, and its 11.5 P/E is also the lowest among REIT ETFs.

"Overall, REITs offer some of the highest dividend yields on the market today. And after a recent pullback, a number of companies and funds in this industry now offer an excellent short-term buying opportunity for the discriminating investor. The attractively valued REITs we profiled above are reasonably interest rate-proof and should benefit from a burgeoning economy going forward. Thanks to their fat dividend payouts, REITs tend to be high-reward and relatively low-risk investments. Long-term investors have much to gain and little to lose by diversifying their portfolio into some carefully selected real estate investments."

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