REITs Still Looking Good

By Aaron Levitt | March 29, 2012 AAA

With traditional income sources drying and paying nothing, investors have been continuing to pile into real estate investment trusts (REITs). As one of the hardest hit sectors in the Great Recession, the sector has rebounded sharply over the last few years, driven by the Federal Reserve's low interest rate policies. However, this sharp rise and continued investor attraction has some analysts questioning whether the sector has now become overvalued. Despite these concerns, there is still much to like about the commercial real estate sector. For investors looking for income potential, the REITs still are top notch.

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Rising Cash Flows and Dividends
At their core, REITs are a type of company that hold physical properties or property mortgages and then generate revenue from rent payments. In order to qualify for federal tax breaks, REITs are required to pay out a large percentage (90%) of their net income to shareholders through dividends. The factors that support these high payments continue to improve and remain stable.

According to the National Association of Real Estate Investment Trusts (NAREIT), real estate investment trusts are currently yielding roughly 3.5%, and are paying out around 70% of their funds from operation (FFO). Analysts at Morningstar (Nasdaq:MORN) estimate that REITs should have no trouble maintaining and supporting these high yields as the economy improves. Real estate firms that saw strength during the downturn will thrive in a recovered market, while those that suffered will see an easing to their troubles. With both the capital markets and tenant fiscal health returning to stability, payments to shareholders will be more than covered.

Driving much of that recovery has been rising rent rates in shorter-termed lease properties. The demand for apartments, lodging and self-storage units remains bullish as supply/demand continues to be out of whack. While the housing boom saw single family construction skyrocket, multi-family apartment construction remained low. As the housing crisis took hold, many former homeowners have been forced to downsize to apartment living. At the same time, those already renting are finding it difficult to gain access to a mortgage. The lack of apartment supply has pushed rent rates upwards. According to real estate data provider Zillow (Nasdaq:Z), median rents rose 3% from January 2011 to January 2012 nationally, while home prices declined 4.6% over that time period. These higher rents ultimately support higher margins for REITs.

While the situation for longer term lease properties, such as retail space and office buildings, is not as bullish, it is improving. Consumer spending was robust in 2011, and the improving economy continues to see an uptick in positive employment numbers. These trends bode well for the operators of such real estate.

SEE: How To Analyze Real Estate Investment Trusts

Still Time to Add Some REIT Muscle
Given the positives still facing the commercial real estate, investors may want to add the sector to a portfolio. The Vanguard REIT Index ETF (ARCA:VNQ) remains one of the largest and cheapest options for investors. Charging a rock-bottom 0.12% in expenses, the fund spreads its approximate $22 billion dollars across 113 different REITs. Top holdings include mall-superstar Simon Property Group (NYSE:SPG) and apartment owner Avalonbay Communities (NYSE:AVB). The Vanguard ETF yields around 3.36%. Also providing access to a wide swath of real estate investment trusts is the iShares Dow Jones US Real Estate (ARCA:IYR).

Improving consumer spending trends are helping to improve retail REITs bottom lines. Triple-net king and monthly dividend payer, Realty Income (NYSE:O) recently used its fortunes to raise its dividend for a 58th consecutive quarter. The company owns almost 2600 different retail properties across the U.S. In addition, shares of Realty Income yield a healthy 4.5%. Fellow triple net retail REIT, National Retail Properties (NYSE:NNN) has also had a lustrous history of increasing its dividend - for 22 straight years. NNN currently yields around 5.6%.

SEE: The REIT Way

The Bottom Line
While the commercial real estate sector has seen a huge increase in investor attention due to its dividend yields, it still offers opportunity. Improving economic conditions and rising rent rates are bullish factors that will support the group's high dividends. For investors, adding a swath of REITs still makes sense. The previous examples, along with the SPDR Dow Jones REIT (ARCA:RWR), make great ways to add that dividend income.

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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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