Don’t neglect MLPs and REITs as some of the best dividend stocks this year
I’ve found the five best dividend stocks for 2019 and they’re not technically dividend stocks.
That doesn’t make them any less powerful for growing your portfolio and putting cash in your pocket though. I’m going to reveal these five stock picks along with two types of investments everyone needs in their portfolio.
In fact, I have a retirement fund that’s exclusively invested in one of these and earn double-digit returns every year.
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The Best Dividend Investments that aren’t Stocks
I love dividend stocks and we’ve had a few really popular dividend investing videos on the channel but there are two huge cash flow investments that people sometimes overlook.
These two investments trade like dividend stocks but are a special type of company.
We’re talking about master limited partnerships (MLPs) and real estate investment trusts or REITs. Not only are these two of the best cash flow investments you can make but it’s a great way to protect your money from ordinary stocks.
In this video, I’ll explain why these two types of stocks aren’t dividend stocks. I’ll reveal the danger in treating them like other stocks and why they should be part of everyone’s portfolio.
I’ll then share the five best investments in MLPs and REITs you can make this year.
How are MLPs and REITs Different from Stocks?
First, there are two very important differences between these two types of stocks and other dividend stocks that you must know about. First is that they are pass-through companies which means they pass profits through to investors and taxes are treated differently.
These companies and their investors get special tax breaks because of the way they handle cash flow and profits.
Second, and this is the one that most investors miss, is that these companies can’t be valued like other dividend stocks. These companies own assets like real estate and pipelines that mean a huge amount of depreciation on the income statement.
They take that depreciation off their earnings to lower taxes but it also means that earnings are a terrible view of profitability for the business.
So if you ever hear anyone talking about the price-to-earnings ratio of an MLP or a REIT, they don’t know what they’re talking about. You can’t use the P/E ratio with these stocks. There is a special way to value each of these types of stocks and I’ll show you how to do that for each.
What is MLP Investing?
On to these special types of dividend investments though. First, let’s look at the master limited partnership. MLPs are a company set up to own energy assets, usually oil or natural gas pipelines and storage facilities. MLPs get a fee from energy companies for letting them use those pipelines and storage.
This is one of the benefits to MLP investing is that profits don’t necessarily depend on the price of oil. The stock price is going to bounce around a little if the price of oil jumps or crashes but the company is still collecting those fees on the volume of oil pumped through the pipelines.
Compared to an oil company where sales are directly affected by the price of oil, MLPs are a little safer here because of those fees.
Since MLPs pass their income and expenses on to investors through special reporting, the company doesn’t pay taxes. That’s a very efficient way to hold the assets and it’s why many oil companies have sold off their pipelines into an MLP company.
With MLPs you don’t get that double taxes problem you get with regular companies where the company pays taxes on profits first then investors pay taxes again on any returns.
Another benefit to MLPs is that the cash return you receive isn’t all taxed in the same year either. Some of those dividends count to lower your cost in the shares so you don’t pay taxes on them until you sell the stock. And if you pass these through to your heirs in an estate, taxes are never paid on that portion of the return.
Because they pass almost all the income on to investors, MLPs have some of the highest cash return of any types of stocks. The dividend on the Alerian MLP ETF, a fund that holds shares of MLPs, pays an 8.4% annual dividend yield.
There is one downside to MLPs I want to point out before getting to how to value these stocks and my two favorite MLP picks. MLP investors get a K-1 form, a special tax form each year, from the company that details the return. This means a little more work at tax time to report the investment but any online tax software makes it easy to file taxes on these.
Now on to how to value an MLP. Remember, you can’t use the price-to-earnings ratio here. These companies have a huge amount of depreciation that makes earnings misleading but it doesn’t affect actual cash flow.
So what we’re going to do is use what’s called price-to-distributable cash flow or price-to-DCF. Finding this value for distributable cash flow, the amount of money the company has available to return to investors, is important also because it gives us an idea of sustainability.
A company can’t pay out more than is available forever so it’s a good metric to make sure that dividend isn’t going to be cut any time soon.
I’ll show you how to calculate DCF yourself but all MLPs will calculate it on their reporting. I do it myself only because I like to double-check the numbers coming out of the company and make sure I’m comparing stocks with the same calculation.
Here’s the table, and again don’t get freaked out because this is always provided to you in reporting. To find how much money the company has available to distribute, you take the cash flow from operations, this is all going to be found on the Statement of Cash Flows, and you remove any spending on capital and income from non-controlling interests.
That gives you sustainable DCF which is what the company can return to investors and still keep operations running smoothly.
While sustainable DCF is a better measure, most people use the DCF as reported because it’s sometimes the only number reported. To get to DCF, you also add back that income from non-controlling interests as well as working capital reported.
The big one here is adding back this proceeds from asset sales. This is technically proceeds the company can return to investors, a company can’t forever be selling its assets and still keep business running so that’s why we use that sustainable DCF if it’s available.
With this number, you can find that valuation with the price-to-DCF or you can find how much the company is returning to investors for what’s called the distribution coverage ratio. This is how much DCF the company earns versus how much it pays out.
This last measure is important because an MLP that pays out more than it’s Distributable Cash Flow can’t do so forever. You see here the coverage ratio for a group of MLPs and that the average is around a DCF that’s 1.2 times the distribution. This means the company has cash flow about 20% higher than what it’s returning but you also see some companies here that save back more or much less.
Best MLP Investments for 2019
Now on to my two favorite MLP picks for 2019.
DCP Midstream, ticker DCP, is an integrated MLP which means it owns energy assets throughout the supply chain from pipelines to processing plants and storage.
This gives it better pricing power and more control negotiating with energy companies. DCP hedges most of it’s exposure to natural gas prices and 80% of its revenue is that fee-based so it’s not going to be as volatile as even other MLPs.
The company pays an 8.6% dividend and a 1.35-times distribution coverage which means that dividend is relatively safe. Pipeline volume increased 35% in the third quarter versus last year so cash flow is on a good trend and shares trade for about 8-times DCF.
Our next MLP pick here is Energy Transfer or ticker ET. ET is a little more diverse than DCP both geographically and by assets. The company owns natural gas pipelines through several regions as well as some oil pipeline and export facilities.
Energy Transfer has one of the best project backlog profiles I’ve seen in MLPs meaning it has a lot of projects lined up for growth. Cash flow jumped 40% year-over-year in the second quarter so this is a company growing fast.
The 8.2% dividend yield is covered by about 1.2-times DCF and shares trade for about 8.8-times DCF.
One last note about MLPs here is that you shouldn’t own them in a retirement or tax-advantaged account. The profits here are already taxed-advantaged so you lose that benefit if you hold them in an IRA or Roth IRA.
What are REIT Stocks?
Our next dividend stock investment here is real estate investment trusts or REITs and these are my favorite of the two.
Those of you in the community know I’m a big believer in real estate and I love REITs because they give everyone the opportunity to get into property investing but without that big down payment needed.
We’ve got another video on the channel detailing the seven property strategies I used after getting out of the Marine Corps to get started with no money.
So REITs are special companies set up to manage commercial real estate and pay out the cash flow to investors. REITs can specialize in a property type so apartments, office, retail, warehouse and self-storage or they can hold a mix of properties.
Most REITs hold properties across the country so it’s a great way to diversify your portfolio of individual properties, getting exposure to other regions and property types.
REITs pay no corporate taxes as long as they pay out at least 90% of income to investors so like MLPs this makes for a great way to manage property, avoid that double taxation and means huge cash dividends for investors.
In contrast to MLPs, REITs can be held in a retirement account and that’s how I invest. The dividends from a REIT are either taxed as income or at the capital gains tax rate so you would owe taxes on these if you hold them in a regular account.
Holding them in a retirement account means I don’t pay any taxes for decades on all that cash flow.
This is a great strategy for any high-yield investment like dividend stocks, REITs or bonds. Hold these in a retirement account so you pay no taxes. Your other stocks where most of the return is through those capital gains when you sell it, those you can hold in a regular investing account.
There are primarily two types of REITs, an equity REIT which actually owns the properties and a mortgage REIT which invests in real estate loans. Now these mortgage REITs pay higher dividends but they tend to be more volatile, especially when interest rates are rising. I’ve invested in mortgage REITs but prefer equity REITs as a better long-term investment.
Just like with MLPs, you can’t rely on reported earnings for a REIT because of that high amount of depreciation they get from real estate. Instead, we use a measure called Funds from Operations or FFO.
FFO is very similar to that DCF we saw with MLPs. You take the reported net income of the REIT and add back depreciation but minus out any gains they made on property sales. Those property sales are a source of income but not something the REIT can do forever and expect to stay in business.
Investors also look at the adjusted funds from operations this AFFO, which takes out capital expenditures. Capex here is money the company spends to keep its properties in good shape so maintenance spending.
Remember, the idea is to find how much cash the company has available to distribute without cutting into money it needs to run the business.
Again, like the DCF calculation for MLPs, you don’t necessarily have to do this yourself because it’s always reported by the company. It’s just a good idea to understand the concept and be able to double-check the company’s reporting.
You use FFO just like our other metric so you can take the price of the REIT over FFO to compare the valuation to other REITs. You can also get a coverage ratio of FFO over the dividend to see how safe the yield is for the stock.
Best REITs for 2019
Now I’m going to share three REITs that I own and love for strong dividend yields and price appreciation.
Dividend yields are a little lower for REITs compared to MLPs but you tend to have higher price appreciation in the shares. This is because those real estate properties appreciate and REITs tend to hold a little more back for growth than MLPs.
First here is Extra Space Storage, ticker EXR, which owns over 1,600 storage facilities across the country. This is a great property type because it’s very easy to manage so costs are extremely low and that means lots of cash flow.
Let’s face it, we Americans love to buy lots of stuff we don’t have room for and that means rented storage space. Occupancy at EXR is at 93%, almost completely full, and the percent of the population using self-storage has risen to 8%, doubling over the last 20 years.
Shares have produced a 715% total return over the last decade, the highest among storage REITs and second-highest against all REITs. The dividend has grown 115% over the last five years and pays a 3.6% yield.
Our next REIT is Ventas or ticker VTR, a leader in medical and senior living properties. The company is well-diversified with about 55% of net operating income from senior living facilities, nearly a fifth from medical office space, another 7% from university-based research centers and the rest from a mix of health centers and loans.
I love the healthcare REIT space because of that broad demographic trend and the stability in healthcare spending. The senior living space has been weak lately on over-supply but is turning around and the boomer generation is just now aging into the segment.
Shares pay a 5.2% dividend yield and have produced an annualized 13.5% return over the last two decades. The shares trade for about 15-times FFO on a really strong outlook for growth.
Our last REIT pick isn’t a REIT itself but a fund that holds REITs, the Vanguard Real Estate ETF, ticker VNQ. The fund holds shares of 184 REITs across all property types.
The VNQ is the best way to get that instant diversification for your real estate portfolio because it holds pretty much everything and the expense fee on the fund is one of the lowest you’ll find. Shares pay a 4.4% dividend yield and have produced a total return of 11.3% annually over the last decade.
Do not neglect these two types of dividend stocks for your portfolio. Not only do they pay dividend yields of three- and four-times the rest of the market but they’re going to give you exposure to assets that will smooth out risk of a crash in other stocks. Remember to value these stocks differently with that DCF or FFO calculation and check out some of those five great dividend picks I highlighted.