Mr. Market Likes These 10 Good-Yielding Reasonable-Risk REITS. Should You?

Real Estate Investment Trusts (REITs) are great for income and asset-class diversification. Starting with the latter, this is a great way for investors to get exposure to real estate without having to jump through the operating hoops best left to those who pursue the field as a profession, and without having to treat their homes as if they were pork-belly futures. (Click here for an example of a well-reasoned discussion of the merits of REITs relative to investment via private equity funds.)

As to income, REIT yields tend to be well above those of corporate shares of comparable risk. But REITs can scare many investors, even well-read investors who find themselves confronted with unfamiliar terminology (FFO, AFFO, NAV, cap rate, etc.), suggestions that familiar basics such as sales, earnings and payout ratios, are irrelevant, and discussions that can leave you to wonder if you have to feel guilty about not being a developer.

Good news: Teaming up with Mr. Market (yes, that Mr Market, the mythological manic depressive trader invented by Ben Graham and later popularized by Warren Buffett), we can smash through such obstacles and take sensible steps toward earning unexpectedly high yields.

© Can Stock Photo, 8vfanC

The General Dividend-Safety Protocol

On 5/28/19, I described an approach to income investing that largely eschews conventional dividend-safety tests such as payout ratio and leans instead on three elements of market-based risk assessments:

  1. The yield itself: Look for high yields, but not too high since very high yields are caused by share prices that have been pushed down by investment-community fears that the dividend will soon be reduced or eliminated, We can debate forever about whether the market usually knows, but whatever we think about the big picture (in my view, it’s right more often than my ego used to allow me to believe), my experience and research over the years convinces me that Mr. Market is especially skilled at assessing dividend safety.
  2. Behavior of significant investment-community participants: The idea here is to look at what analysts, short sellers, insiders are saying and doing with respect to these stocks. I capture this through the “Expert Opinions” component of Marc Chaikin's Chaikin Power Gauge ranking system.
  3. Behavior of the investment-community crowd: This involves technical analysis, which uses price and volume trends to discern the sentiment of the not-nearly-as-ignorant-as-cynics-enjoy-assuming herd. I capture if through the “Technicals” component of the Power Gauge model.

If we assume Mr. Market knows what he’s doing, an assumption I’ve leaned (sometimes the hard way) to accept (absent stock-specific indications to the contrary), we’ll indirectly be taking into account textbook standard payout ratios, etc. and also qualitative judgments regarding company-specific oddities that make basic datas-points less useful than naive observers might realize (this actually happens a lot) as well as assessment for future dividend-paying capacity (historical data can take you just so far in a world in which past performance cannot be assumed to determine future outcomes). 

The World of REITS

The accounting conventions that produce the data with which we’re all so familiar presume we’re looking at simple manufacturing companies (in business schools, the product is said to be “widgets” (If you’re wondering what widgets are, I think they are used to hunt snipe — if you’re confused, check Google). Any time we encounter a non-manufacturing entity, we’ll probably be looking at one that doesn’t mesh well with accounting for widgets, which means we need to invent different metrics and/or to interpret standard metrics in non-standard ways. REITs fall into this challenging category.

REITs own and/or manage real estate; land and buildings. The depreciation rules that apply to manufacturers don’t apply to REITs the same way. Slumlords aside, depreciation is relevant because property does age and need to be kept up to date (in manufacturing, depreciation is a ballpark estimate for annual capital spending). But the numerical profile is quite different from other kinds of physical assets. So REITs can typically devote a lot more of the cash associated with the non-cash depreciation expense to payment of dividends — which is why a payout ratio that looks shockingly high for most companies could be quite reasonable, even low for a REIT (REITs actually compute payouts relative to Funds from Operations, an unofficial but widely used industry measure of financial performance).

Another major issue is the balance sheet. Did you pay 100% cash for your house? Unless you’re a 1%-er type buyer typically depicted on the reality TV Million Dollar Listing franchise (“all cash, 30-day close” the buyer’s agent typically brags), you probably borrowed a lot of the funds and took a mortgage. Professional real estate works the same way. It’ expected that you will work largely with other peoples money (debt). This is acceptable because, pre-2008 idiocy aside, real estate loans can usually be comfortably covered by security in assets worth at least as much as and usually more than the amount of the loan. From the operator’s point of view, if you’re putting up all or most of the money, most will find it hard to work to enough scale to actually make for a real business. So with REITs, excess borrowing is as dangerous as it is for any other, but the thresholds that define excessive are much higher than they are for the typical manufacturer.

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Disclosure: None.

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