Published on September 23rd, 2020 by Nate Parsh
Investors in search of higher yields often turn to Real Estate Investment Trusts, or REITs, in order to secure a higher level of income. These stocks tend to offer generous dividend yields which make them appealing to income investors.
There are more than 160 publicly-traded REITs and you can download your free REIT list (along with metrics like security price, dividend yield and market capitalization) by clicking on the link below:
This article will explore why REITs are a viable strategy for growing dividend income.
What are Real Estate Investment Trusts?
Real Estate Investment Trusts, or REITs as they are commonly known, are corporations that own real estate properties. These types of investments came into existence 60 years ago when President Eisenhower signed the Cigar Excise Tax Extension of 1960. This gave ordinary investors the ability to make investments in income-producing real estate.
These properties include office space, retail outlets, medical office buildings, apartments, hotels, storage facilities and buildings used for technological purposes. Properties are then leased to customers in a variety of areas including the retail, health care, leisure and technology sectors.
There are two types of REITs: equity REITs, those corporations that invest in land, buildings and equipment, and mortgage REITs, which invest in mortgages. Equity REITs are the more common type and likely the less risky of the two investment options.
Mortgage REITs make income from the interest on the mortgages that they own. When those loans begin to default, like they did in the 2007-2009 recession, mortgage REITs tend to perform poorly. They often have to cut their dividends due to the lack of income from the mortgages that they own. We believe the average investor should avoid the potential pitfalls of mortgage REITs and stick with equity REITs.
REITs Are Better to Own Than Physical Estate And Are Designed to Deliver Income
Fortunately, there are many equity (or eREITs) to choose from and they all pay dividends. Some even have a dividend growth streak of more than 50 years that enables them to qualify as a Dividend King. or at least 25 years to qualify as a Dividend Aristocrat. Some REITs also pay a monthly dividend.
Owning shares of an equity REIT allows the average investor some distinct advantages compared to owning real estate itself. The average investor can gain access to the real estate asset class through REITs without having to acquire the knowledge of how to be a landlord and all that it entails. They also don’t have to find the necessary funding to purchase real estate properties.
Instead, equity REIT investors can let people who know the sector purchase, develop and lease real estate properties. They can capitalize on this expertise simply by buying shares of the REIT. And with most brokers now offering commission free trades, investors can buy as little or as much of a REIT as they wish.
Owning a REIT also lowers the risk in owning the actual real estate property. While the underlying corporation could always cut its dividend or go bankrupt, the investors would only be placing investment dollars on the line. Owning an actual piece of real estate carries much more risk when the market deteriorates, or the investor is unable to pay its lease or for the maintenance of the property.
In addition, REITs offer the diversification of owning multiple properties in different parts of the country or, in some cases, the world. On the other hand, the typical individual landlord owns just a few properties that are likely in the same area.
Finally, and most important to income seeking investors, U.S. law dictates that REITs must distribute at least 90% of taxable income back to shareholders in the form of dividends. This means that 90 cents on every dollar of income for the REIT must be paid out to shareholders.
This is different from a regular corporation, such as Johnson & Johnson (JNJ) or Microsoft Corporation (MSFT). These types of companies could likely never afford to pay out 90%+ of their profit in the form of dividends long-term. Shareholders of these companies would likely be concerned that the dividend could be due to a cut if profitability suddenly became endangered.
REITs, however, can survive with a payout ratio of this magnitude because they are required to by law. This can lead to high dividend yields for equity REITs. It’s not uncommon for REITs to offer a dividend yield of at least 5% to 6%. Some yields even reach double-digits, though we would stress that extremely high yields might be foreshadowing an impending dividend cut.
These higher yields can then compound faster, allowing the investor to either reinvest into the security, which will provide new shares that are also producing a high level of income. Or, the investor can simply take the hefty payout in cash and use for their own purposes. Either way, investors benefit from having a position in a REIT.
The Risk of Owning REITs
There are items investors should be aware of prior to investing in a REIT. Since the vast majority of profits are paid out in the form of dividends, REITs often have to find additional avenues for growth beyond using earnings. Since profits are mostly distributed, REITs tend to grow by either issuing stock or taking on additional debt.
Issuing stock to fund acquisitions is common among REITs since nearly all profits are returned to shareholders. This does dilute the share count, but enables the REIT to add properties to its portfolio in hopes that the acquisition will provide growth for the future.
This is a pretty effective way to grow revenues and profits if it is done correctly. Adding additional properties often allows well-managed REITs to continue paying dividends even though the share count is higher.
Consider this scenario: REIT called ABC currently has 100 million shares and pays an annual dividend of $1. The REIT would need $100 million to cover the dividend. Suppose ABC dilutes the share count to the tune of 20 million shares in order to make an acquisition, but plans to maintain its current dividend. Now, ABC needs $120 million in order to keep its dividend at the same rate.
Let’s assume further that ABC is also offering a dividend increase of 5%. The REIT would now need $126 million in order to pay for this increase. While the total amount of capital needed to pay and raise the dividend following the acquisition is 26% higher than before, ABC now has added another property or group of properties to its portfolio, which will help to grow its business.
Investors should note that the best managed REITs often issue new shares at what they feel is an attractive price. If the security has increased significantly in value, the management team might feel that issuing shares is a good way to harvest additional funds for future use.
Another way REITs grow is through the issuing of debt. While too much debt is usually a risk, using debt just like issuing shares can allow the REIT to pay for an acquisition or to payoff higher-cost debt. Fueling growth or lowering the cost of debt can be an effective management tool, one that the best REITs often employ.
Investor sentiment on REITs often turns negative when interest rates are on the rise, as higher interest rates will negatively impact REITs. This is especially troublesome for REITs carrying significant amounts of debt with floating interest rates. These loans move up or down depending on the market and rising interest rates require more capital to finance.
Rising interest rates also tend to drive up the yield on Treasury bonds. These bonds don’t always offer the same level of income that REITs can, but they do offer an alternative investment for investors seeking more safety than stocks usually provide. This can be appealing to those more risk adverse.
While investors might feel that rising interest rates are an overall negative for the REIT industry, they tend to impact those REITs that are poorly run. The conservatively managed REIT will not be bothered too much by higher interest rates.
Consider the following chart:
Source: Cohen & Steers
The Federal Reserve raised interest many times in the years leading up to the Great Recession, but REITs as an asset actually outperformed both traditional stocks and bonds even as the yield on the 10-year Treasury moved higher.
Let’s consider an individual example. Realty Income (O) is one of the most well-known REITs. The chart above shows that the company grew its bottom-line at a high single-digit rate during the rate increase cycle prior to the Great Recession.
In fact, the Realty Income even outperformed its own sector growing funds from operation by almost double during this period. This example shows that rate tightening did impact some REITs, but not the best ones.
That being said, interest rates are at or near zero at the moment and the Federal Reserve has stated that they likely will be for some time so higher costs to service debt likely isn’t an issue today. We continue to advocate that investors look for more high-quality REITs, but higher interest rates and higher expense from debt likely won’t be a severe headwind for most REITs.
Real estate investment trusts are a popular pick for investors looking for a high level of income. However, extremely high yields, especially those in the double-digit range, can come with higher risk. There are many REITs available for purchase that are well-run, high-quality names that we recommend to investors. These investments can deliver generous yields because they are growing their business and distributing almost every penny as a dividend.
REITs that can strategically issue shares or debt in order to grow often are able to reward shareholders with a growing dividend. As with any asset class, there individual investments that will underperform or that should be avoided entirely. That said, we continue to believe that investing in REITs is an excellent strategy for those looking for higher levels of dividend income.