In a yield-starved investment world, should investors be buying Real Estate Investment Trusts (REIT)? Can they bring solid, safe returns? Many investors love them, while some shy away. How volatile are they? How do you evaluate them?

A subscriber recently asked a good question. He purchased a subscription from one of our trusted affiliates, The Dividend Hunter. He looked at a recent recommendation and was “stunned” to find a price/earnings ratio (P/E) over 25 and a payout ratio well in excess of 100%. What gives?

I asked our expert, friend, and colleague, Tim Plaehn for further clarification. I’m glad I did. It was an excellent learning experience and one our readers should appreciate.

DENNIS: Tim, thanks for taking the time for our education. Let’s get right to it. REITs are different from an investing standpoint. The Dividend Hunter seeks out companies in many different businesses that have good and sustainable dividends.

How can a company pay out dividends in excess of profits and still be highly recommended?

TIM: Dennis, thanks for the opportunity to educate, I appreciate it

The particular investment I recommended is currently paying a 6% dividend. The high P/E ratio is not a useful metric to evaluate the safety of the dividend payments.

To answer your question. Most accounting systems are designed for tax purposes. To truly understand the REITs, you must dig further. Here is the prime reason.

As an example, suppose a business buys a $2,000,000 building and rents it out. While they spent $2,000,000 in cash, the IRS does not allow them to charge their profits for the entire amount in the first year. Each year they are allowed a depreciation expense against profit. If they depreciate the building over 20 years each year they are allowed to depreciate $100,000. Depreciation is called a “non-cash” expense.

Let’s assume the tenant pays all the taxes, maintenance, etc., and their net rental income was $120,000. For tax purposes, they would expense the $100,000 in depreciation, reporting a net profit of $20,000.

Although their reported profit is $20,000, they generated $120,000 in positive cash flow which is available for dividends. They could payout 200% of reported earnings ($40,000) and still have plenty of funds available to pay mortgages and grow.

The standard accounting measures investors would use to evaluate a business, like Coca-Cola or GM, will not truly measure the performance of a REIT. We must look at the type of leases, current, and future cash flow projections.

DENNIS: That leads to my next question. What other measures do you use to evaluate a REIT, particularly in relation to its peers?

TIM: The first order of business is to find the free cash flow produced by the REIT and compare that number to the current dividend rate. In REIT jargon, that cash flow is called FFO – funds from operations.

When I find a REIT with an attractive yield and good FFO coverage of the dividend, I dig deeper looking for historical FFO per share stability and growth, the company’s policy on dividend increases, and the prospects for sustained future cash flow.

Each company is different. I balance the factors of current yield, dividend growth potential, and cash flow coverage of the dividend compared to other stocks recommended in my Dividend Hunter service. A new recommendation has to bring added value to the recommendations list.

DENNIS: Several years ago, I interviewed a college professor who had a sizable investment in student housing apartments. He emphasized student housing was a good market to be in as opposed to others like strip shopping malls etc.

He NEVER rents to law students. Apparently, his fellow professors in law school taught students exactly when to stop paying rent, and how to play the game so they would not be evicted until the semester is over. Those insights have to come from expensive, bad learning experiences.

Tim, what type of REITs should our readers look for, and what should they avoid?

You certainly would not want management on their learner’s permit. How do you evaluate management’s capabilities?

TIM: The REIT sector is divided into a dozen subsectors. One great feature of REITs is that the subsectors cover most of the U.S. economy. Sectors include retail, residential, infrastructure, healthcare, office, industrial, data centers, self-storage, cell towers, self-storage, lodging, and timberlands.

In each sector, there are high-quality companies with good management teams and great track records – and also those which are struggling. For an investor new to REITs, I suggest starting with the blue-chip REITs and don’t chase yield with more speculative bets.

A couple of sectors I suggest avoiding are the residential finance REITs that invest in residential mortgage-backed securities. These REITs use huge leverage to generate enough cash flow to pay decent yields.

Another sector I am avoiding is healthcare, especially REITs that own a lot of nursing home and senior housing properties. There are a lot of operators in the space that struggle to make their lease payments to the REITs.

DENNIS: Are there any special tax considerations readers should understand about REITs?

TIM: A REIT operates as a pass-through entity for tax purposes. As long as the company pays out at least 90% of net income as dividends, it is exempt from paying corporate income taxes. Not paying taxes leaves more cash to pay dividends.

This means that REIT dividends will not be qualified dividends taxed at a lower rate. Your REIT income will be taxed at your marginal tax rate. Owning REIT shares in a tax-qualified account such as an IRA can be a good move to keep your taxes down.

DENNIS: How important are interest rates or the direction of interest rates in evaluating a potential REIT investment?

TIM: In the short term, stock market traders care about interest rates. Rising rates are viewed as a negative for REITs. Unfortunately, recent history shows that the “experts” are usually wrong when they predict what will happen with interest rates.

I tell my subscribers to build a portfolio that pays an attractive current yield and a growing income stream.

One difference with REIT’s vs. fixed income investment is that many REIT’s will grow their dividends. 

Investing in a selection of quality REITs will provide peace of mind that the income stream will keep growing. Less focus needs to be placed on share prices, except to be ready to buy more when the market gets dumb about the value of dividend-paying stocks.

DENNIS: I know you are a big believer in diversification. The Dividend Hunter has a wide range of dividend payers including stocks, funds, bonds, and REITs.

If one was starting from scratch looking to build a solid, long term dividend paying portfolio, how much would you recommend they allocate toward REITs?

TIM: I’ll answer that this way. There are 35 investments recommended across my two income stock focused services – The Dividend Hunter and Automatic Income Machine. Out of that number, there are three finance REITs and seven equity REITs. Equity REITs are the ones that own properties. Finance REITs make loans or own mortgage-backed securities.

DENNIS: One final question. I titled this interview, “Are REITs safe investments?” How would you answer that?

TIM: As a REIT investor, you are an owner of rental properties. I think you would agree that owning quality properties with good tenants sounds like a safe way to invest for capital appreciation and earn some income. Of course, I have to state that there are no guarantees of safety in the stock market, but REITs tend to be stable investments.

There are great, high-quality REITs. Some have paid growing dividends for over 30 years straight. REITs are also a safer, more conservative way to invest in the technology and e-commerce trends.

REITs are passive investments for our readers. You must look for management with a proven track record, just like you would when you hire a property manager for an investment property you own individually.

The important factor for investors is to understand what a REIT owns, how it is managed and how it takes care of investors. This is information you will not find on a stock screen or with metrics like P/E ratio or current yield. Well managed REITs, with good properties, are safe investments, and we stake our reputation on the good ones in our publications.

DENNIS: Once again, thank you for your time.

TIM: My pleasure Dennis

Dennis here again. In today’s yield-starved world, it is easy to get fooled by REITs offering unsustainable returns. Owning good, safe, well-managed REITS with solid dividends is part of a well-diversified retirement portfolio. As Tim explained, the criteria for evaluation is different than those for other types of stocks.