REITs can provide reliable income
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What’s on tap for the stock market in 2023? Even halfway through the first quarter, there isn’t a strong indication which direction markets will go. The best we can say is that uncertainty will be the theme.
That uncertainty may play well for real estate investment trusts (REITs), which own and finance real estate. They make money through rents, property sales, interest income. Most also pay their shareholders generous cash investment income.
Read on to find out why 2023 may be a good year for REIT, which REITs are paying big dividends and how to choose reliable REITs for your own portfolio.
Outlook For REITs
The last year has not been good to REITs. As of February src5, 2023, the S&P U.S. REIT index was down more than srcsrc% over the prior src2 months. By comparison, the S&P 500 dipped only 7.2% in the same time frame. There is some positive news: year to date the S&P U.S. REIT index is outperforming the S&P 500.
Strong Balance Sheets, Low Stock Prices
While interest rates may rise in 2023, the pace is likely to be slower than what we saw in 2022.
And, as advocacy group Nareit reports, REITs have historically low leverage in terms of debt-to-market-assets. They also hold a good measure of fixed-rate debt, which is unaffcted by interest rate hikes—at least until that debt must be refinanced. Fortunately, as of the third quarter of 2022, REITs collectively had a weighted average term to maturity of more than seven years.
Investment manager Hazelview Investments sees upside for REITs this year. Not only because their balance sheets are strong, but also because their valuations are low. Investor sentiment drove the 2022 decline for REITs, more so than business results. That positions high quality REITs for a comeback this year.
Potential For Recession
Fitch’s REIT outlook, however, is more tempered. The credit ratings agency predicts that recessionary conditions, higher capital costs, and waning demand in some sectors will keep REITs from outperforming in 2023.
With inflation at a 40-year high running at more than 6.4%, dividend stocks offer one of the best ways to beat inflation and generate a dependable income stream. Download “Five Dividend Stocks To Beat Inflation,” a special report from Forbes’ dividend expert, John Dobosz.
src0 Best REIT Investments
REITs return value to shareholders in two ways—share price appreciation and dividend yield.
As a reminder, dividend yield is the cumulative annual dividend payment dividend by the share price. So, a REIT that pays dividends of $src0 per year and trades for $src00, yields src0%. For context, the dividend yield on the benchmark FTSE Nareit All REIT Index in 2022 ranged from 3.src% to 4.3%.
The REITs shown in the table below outperform that index, with yields ranging from 4.48% to src0.8%.
REIT Yields Vs. Stock Yields: Remember The Taxes
Looking at the list above, you might conclude that REIT yields seem higher than traditional stock yields. You’d be correct, in a sense.
REITs have a special tax status that requires them to pay out at least 90% of their taxable income to shareholders. For the REITs that are profitable, that requirement can lead to a higher-yielding investment than, say, blue-chip stocks or investment-grade debt.
Still, the practical difference between REITs and dividend stock yields will be less than you’d think.
Most REIT dividends are taxed as ordinary income. Dividends from U.S. companies and eligible foreign companies are usually taxed at the lower capital gains rates. So while you can earn higher yields with REITs, taxes will consume some of the difference. You can avoid that problem temporarily by holding REITs in tax-advantaged accounts such as traditional IRA, Roth IRA, 40src (k) and more.
For context, the highest income tax rate is 37%, while the highest long-term capital gains rate is 20%.
src0 Highest Dividend REITs
REITs can also produce dividend yields much higher than src0%. The table below introduces src0 REIT stocks that yield between src2% and 2src%. Just know that these high-yielding options are likely to come with more volatility in share price and dividend payout.
In the next section below, you’ll learn more about that trade-off and how to evaluate it.
Yield Vs. Reliability
As an investor, you routinely make trade-offs between risk and reward. If you want stability, you invest in slow-growing, mature companies. If you want fast growth, you accept the potential for higher volatility.
With REITs, the relationship between yield and reliability works the same way
Pay attention to the balance between reliability and high yield
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REITs that produce very high yields can be less reliable. REITs that produce income like clockwork pay more moderate yields.
The good news is, you get to pick your sweet spot on that yield-reliability spectrum. There are enough REITs out there so you can tailor your portfolio to your comfort zone.
You’ll learn more about picking the best REITs below, but you can choose from two general approaches. You might define a narrow range of screening criteria for every REIT you buy. Or, you could cast a wider net and find your balance in the aggregate. You might invest in a couple aggressive REITs and hold them alongside more conservative positions, for example.
Even at low levels, inflation destroys wealth, but at current rates it’s downright deadly. Defend yourself with dividend stocks that raise their payouts faster than inflation. Download “Five Dividend Stocks To Beat Inflation,” a special report from Forbes’ dividend expert, John Dobosz.
Invesco Mortgage Capital: A High-Yield REIT Example
Mortgage REIT Invesco Mortgage Capital (IVR) is an interesting case study on the yield-reliability trade-off. IVR’s dividend yield is among the highest out there, about src9%. But the REIT has struggled recently under the pressures of rising interest rates, falling property values and cautious financial markets.
In the second and third quarters of 2022, IVR recorded net losses per common share of $3.52 and $2.78, respectively. The company also cut its third quarter dividend from $0.90 per share to $0.65.
Notably, IVR completed a src0-for-src reverse stock split in 2022. Reverse stock splits don’t change a company’s capitalization–they only reallocate the market value into a smaller number of shares. Because each share represents a larger slice of the company after the split, the stock price rises. The increase usually corresponds to the split ratio.
Pre-split, IVR was trading for less than $2 per share. Post-split, the share price rose more than 900% to about $src7.50. In February, 2023, eight months later, IVR has traded between $src3.70 and $src5.39.
So, yes, IVR has an impressive yield. But it comes with the risk of ongoing share price declines and additional dividend cuts. For many investors that trade-off isn’t worth it, particularly when the economic outlook remains uncertain.
Evaluating High-Yield REITs
Some investors will take the opposite perspective on IVR and other mortgage REITs–that the underlying issues are temporary. In that case, these downtrodden REITs may have lots of long-term upside.
If that’s your thought process, plan on thorough analysis before you buy. Pay special attention to the nature of the share price declines, the viability of the business model and the REIT’s debt level.
src. Duration And Range of Share Price Declines
Share price declines mathematically push dividend yield higher. That’s why the highest-yield REITs often show a downward price trend.
Dive into that trend. How long has the share price been declining, what does leadership have to say about it and what are the root causes? If the underlying issues are external, is the REIT managing better or worse than its peers?
2. Obsolete Or Overly Complex Business Models
REITs can run into trouble when they’re too concentrated in the wrong types of tenants or properties. Specializing in indoor malls, where foot traffic has been declining for years, is an example.
Another yellow flag is a complex business model. Complexity adds risk. Mortgage REITs, for example, buy and sell mortgages and mortgage-backed securities. This makes them more sensitive to interest rate changes than equity REITs. Depending on the type of mortgages they finance, default risk may also be a factor.
3. Too Much Debt
REITs pay out 90% of their taxable income to their shareholders. That doesn’t leave much funding for business expansion.
They commonly use debt to solve that problem. New borrowings can fund property acquisitions, which increases profits, cash flow and dividends.
It’s not unusual for REITs to be highly leveraged. But debt can become unmanageable very quickly—particularly under changing economic conditions. A REIT shouldn’t be so leveraged that it can’t absorb temporary periods of lower occupancy, higher interest rates or lower property values.
Even at low levels, inflation destroys wealth, but at current rates it’s downright deadly. Defend yourself with dividend stocks that raise their payouts faster than inflation. Download “Five Dividend Stocks To Beat Inflation,” a special report from Forbes’ dividend expert, John Dobosz.
How To Pick The Best REIT StocksGetty
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You’re smart to develop your own process for picking REITs that suit your goals and risk tolerance. Many REIT investors screen their options by REIT type, business model, dividend track record, revenue and cash flow production, and leverage. Below are some pointers on each of these that will help you set your own parameters.
You can get up to speed quickly by applying these guidelines to the 20 REITs introduced in the two tables above.
src. Understand your options
REITs come in many varieties. The primary REIT types are:
Equity REITs own property
Mortgage REITs finance property
Hybrid REITs own and finance property
Equity, mortgage and hybrid REITs can be further categorized by the property types they specialize in, such as:
Office buildings
Retail storefronts and shopping centers
Industrial properties, including warehouses and manufacturing facilities
Residential, such as apartment buildings
Healthcare facilities and hospitals
Self-storage properties
Timberland
Farmland
Infrastructure, such as cell towers and data centers
In investing, the simplest option is often the best choice, especially for novices. You might start with an equity REIT specializing in residential or retail space, for example. That’s likely to be more relatable to you than a mortgage REIT or an infrastructure REIT.
2. Get comfortable with the business model
You should understand how the REIT makes money today and how revenue growth will continue going forward. Review the REIT’s tenant profile, average lease length and occupancy trends. Also read through annual reports and other documentation to understand the REIT’s growth and acquisition strategy.
3. Review the dividend history
The best REITs have a solid history of dividend payments and dividend increases. Dividend increases benefit your net worth and improve the efficiency of your portfolio. More than that, dividend increases show the REIT isn’t stagnant. Long term, sustainable dividend growth requires business growth to support it.
4. Check revenue and cash flow trends
If you see a track record of dividend growth, you should also see rising revenue and cash flow. Analyze those trends. How much has the revenue grown, and for how long? How does the growth compare to the REIT’s closest competitors? Is long-term debt rising at the same rate?
For cash flow, a popular metric to watch is FFO or funds from operations. FFO is earnings from business activities plus the noncash expenses of depreciation and amortization.
FFO does not include interest income or gains or losses from property sales, so it’s a good measure of operating performance. This is why REITs and their analysts often refer to FFO per share instead of the more general metric, earnings per share.
You can find a REIT’s FFO, current and historic, on its public financial statements.
5. Analyze the balance sheet
As noted above, REITs can be heavily leveraged, so a balance sheet review is necessary. To compare a REIT’s leverage to its peers, focus on the debt-to-equity ratio and the debt ratio.
Debt-to-equity ratio: This ratio tells you how much debt the REIT uses relative to equity in funding the business. You calculate debt-to-equity as total liabilities divided by total equity. A 3:src ratio means the business is financed with 75% debt and 25% equity. REITs can support high debt-to-equity ratios in the range of 2.5:src to 3.5:src.
Debt ratio: The debt ratio measures solvency by dividing total assets into total liabilities. High debt ratios, above 60%, can limit the REIT’s ability to borrow money in the future. Nareit reports that the debt ratio across publicly traded equity REITs was 34.5%.
It’s also useful to understand how the REIT uses fixed-rate vs. variable-rate debt as well as the average maturity on its fixed-rate borrowings.
If you’re ready to invest in REITs for income in 2023, start by defining your sweet spot on the yield-reliability spectrum. Err on the conservative side if you’re not sure. Choose REITs with simple, understandable business models that have a long track record of paying and increasing their dividend.
As is best practice with any investment, don’t go all in. Hold your high-yield REITs alongside traditional stocks and fixed-income positions. That’s how you achieve a good, sustainable balance of growth potential and stability—which is the key to building wealth in the stock market.
Five Top Dividend Stocks to Beat Inflation
Many investors may not realize that since src930, dividends have provided 40% of the stock markets total returns. And what is even lesser known is its outsized impact is even greater during inflationary years, an impressive 54% of shareholder gains. If you’re looking to add high quality dividend stocks to hedge against inflation, Forbes’ investment team has found 5 companies with strong fundamentals to keep growing when prices are surging. Download the report here.