Mortgage REITs and Interest Rates

5 Best REITs to Buy in 2020 [Real Estate Investment Trust]

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Learn how to pick the best REIT stocks for the highest dividend returns

There are over 640 REITs available on the U.S. exchanges but how do you find the best for your portfolio.

In this video, I’ll show you how to pick REIT stocks, why I won’t invest in some with the highest dividend yields and why an entire category of REITs could be dead money. Then I’ll reveal the five best REITs for your 2020 portfolio.

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Why Every Investor Needs Real Estate Stocks

Nation we are to the last video in our stock sectors series and this one is going to be my favorite. We’ve covered the best stocks for 2020 in 10 stock sectors but today we’re talking one of the best builders of wealth in all of investing.

Those of you in the nation know I’m a big believer in real estate. I started my professional career as a commercial property analyst in college before managing my own portfolio of rental properties. The cash flow from property is unbeatable and there’s just something about owning a real asset.

Not only is real estate investing going to produce cash flows of five to eight percent a year plus price gains, it’s one of the best ways to diversify your wealth and protect you from a stock market crash.

This is going to be a longer video because we’ve got a lot to cover. I’ll show you the different types of real estate investment trusts, those REITs that trade just like stocks and give every investor the chance to be in this property wealth-builder. I’ll reveal why you need to be careful with mortgage REITs that pay dividends of 10% and higher and why I’m not investing in an entire property type in REITs.

We’ll look at how REIT returns have compared to other stocks and what real estate looks like in 2020. Then I’m going to share my five favorite REIT stocks for your portfolio for that diversification and returns.

It’s part of our 11-video series, uncovering the best companies in each stock sector. Over these 11 episodes, one for each stock sector, I’ll show you how to pick the best of breed in each. We’ll look at some of the big trends and how to pick stocks to buy.

Watch the entire stock sectors series from the beginning

Types of Real Estate Investment Trusts

Now I love talking about real estate investment trusts, REITs, because it is such a great way for main street investors to get some real estate in their portfolio. A REIT is a special type of company that owns real estate and gets a tax break for passing the majority of profits on to investors.

So REITs are not only a super-efficient way of managing property because you don’t get that corporate tax drag but it’s also an easy way for regular investors to diversify their portfolio. Whether you’ve got residential rental properties or are saving up for that first investment, REITs give you the opportunity to invest in different property types and in every region of the U.S.

While equity REITs, so that’s a real estate investment trust that invests directly in real estate and owns property, while those are about 80% of the market, there’s also something called a mortgage REIT or mREIT.

I get a question about one of the mREIT stocks at least twice a day so I want to highlight these and tell you why you might want to be careful here. mREITs are companies that invest in real estate mortgages instead of in the actual property. They borrow on short-term rates and invest in those long-term commercial mortgages.

Now this is important and where a lot of investors get trapped. The mREITs use a huge amount of leverage, like ten-times their equity or more to buy those investments and produce dividends above a 10% yield.

For example this iShares Mortgage Real Estate Fund, ticker REM, holds shares of 36 mREITs and pays an 8.5% dividend yield. So these mREITs are really attractive and investors are pulled into those huge dividends but a lot of times, that’s the only return you’re going to see.

Because these mortgage REITs use such high leverage and are so tied to interest rates, they are really volatile around changes in rates. Whenever rates decrease, people start prepaying their mortgages and suddenly the mREITs are stuck with this increased cash flow they now have to reinvest at lower rates.

Another problem lately is the flattened yield curve, so the fact that long-term interest rates aren’t that much higher than short-term. That means these mREITs aren’t making as much money, the spread between borrowing short-term and investing long-term.

Mortgage REITs and Interest Rates
Mortgage REITs and Interest Rates

The result is just that these types of REITs aren’t the spectacular investments they might appear just by looking at the dividend yield. Now I do think you can make some money here and I’m going to highlight a mortgage REIT in our five 2020 picks but I would focus most of my money in those equity REIT stocks.

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REITs vs Stocks

And if you want to talk returns, even through the worst real estate crash in U.S. history, REITs have way outperformed stocks. Here I took data from the National Association of REITs equity REIT index, the blue line, versus the S&P 500 index in red. The total return on REITs is 10% a year versus a return just over 7% annualized for stocks.

reit investing diversification
REITs vs Stock Returns

Now most REITs just had a stellar year because of falling interest rates. For equity REITs because they’re so highly leveraged, lower interest rates actually help because they can borrow at lower rates. The high dividend yields also help to attract investors looking for cash flow so REITs are up about 25% this year.

I’m not going to tell you 2020 will be anywhere as good as that but fundamentals are looking solid. Interest rates are still low and real estate companies can get all the funding they need to buy properties. There hasn’t been a bubble in any property types and the economy looks to grow at least marginally so that should support commercial property.

There is one property type I’m avoiding though and those of you in the nation have heard me talk about this. Retail property; so we’re talking shopping malls, department stores and other types has been a value trap for years. The shopping mall REITs are trading well below the price of other REITs and showing much higher dividend yields and that’s dangerous.

Online sales are growing at a 13% annual pace and still only account for 10% of total retail sales. Consumer spending is the only bright spot in the economy right now and STILL traditional retailers like Toys R Us and Sears are in bankruptcy. Mall operators are going bust right and left and if these retailers can’t survive when the economy is growing, what happens in a recession?

Best Real Estate Funds to Buy

We’re going to look at how to analyze these REIT stocks, how to pick the best stocks, in a bit but if you’re looking at any REIT that holds retail property, I want you to look deeper than just the share price and the dividend yield.

Just like the other videos in our series, I’ve got two real estate funds I want to highlight and then we’ll look at how to pick REITs and those five favorite REIT stocks.

The first here is my favorite and for everyone here in the nation an, “OH MY GOD, I can’t believe he’s talking about the Vanguard REIT ETF AGAIN!”

Sorry not sorry because I love this fund for that all-in-one real estate play and the 3% yield against a super-low 0.12% expense ratio. Ticker VNQ holds shares in 184 REITs diversified across all property types and has produced a nearly 13% annual return over the last decade.

Now it does hold some REITs in the retail space but they’re a small part of the fund and this is a strong overall play.

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Income Investing on Fundrise

How to Pick REIT Stocks

Before we look at those five best REITs for 2020, I want to show you what to look for in these investments because these are going to be different than what we’ve seen in the other videos.

The biggest difference in real estate investment trusts and other stocks is that you can’t use that price-to-earnings ratio. I see investors trying to say a REIT is cheap because of its PE ratio or the payout ratio and I just die a little inside.

The problem is that earnings or net income is a bad measure for REITs. These companies report so much depreciation expense, that’s the amount they write-off on the value of properties against their taxes, this number skews that earnings reported. Since depreciation isn’t something the companies have to pay but they can take it off taxable income, earnings look way lower than they actually are.

I know it’s more accounting than you probably want to hear but let me just say one more time, you CANNOT use the price-to-earnings ratio or payout ratio when looking at REITs.

Instead you have to use what’s called Funds from Operations or FFO. This is a measure of the actual cash flow available that a real estate company can pay out to shareholders. Now I don’t want to get into the math here because all REITs are going to show you this number in their reporting. Basically you’re taking that skewed net income number then adding back the depreciation and a couple other one-time items.

Funds from Operations for REIT Stocks
Funds from Operations for REIT Stocks

You’ll also usually see this Adjusted Funds from Operations or AFFO which is an even better measure of the company’s available cash flow.

So instead of using that PE ratio, when you look at REITs, you want to find this FFO number and then measure things like the price-to-FFO to see if the shares are cheap or expensive compared to peers. You can also look to see how much the company is paying out in dividends from those funds available to give you an idea of dividend sustainability.

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Best REIT Stocks for 2020

Next here before we look at those five REITs is you want to be investing in a mix of property types and locations.

There are six major property types; office, residential, storage, industrial, retail and leisure and you should try to own REITs in at least three or four of these. Each property type reacts differently to the economy so by diversifying across a few, you’re going to get a smoother ride and protect that cash flow.

Most REITs invest in properties across the U.S. or North America so location isn’t usually a problem but I’ve tried to pull from multiple property types in our REIT list here.

First on my list of Best REITs is Crown Castle International, ticker CCI, and it’s 3.6% dividend yield.

CCI is a leader in the connectivity space with 40,000 cell towers, 70,000 small cell nodes and 75,000 miles of fiber cable. These assets are going to be vital as internet and smartphone bandwith demand booms over the next few years. Between the adoption of 5G, the Internet of Things where everything you own is connected to the net and the push to smart cities, this company owns the assets that will make it all happen.

The company has been growing its small cell nodes over the past few years to be in front of that demand. They doubled their 2018 growth with another 12,000 installed this year and should be positioned when demand is there.

The company is guiding to 5% revenue growth next year and a 7% growth in that adjusted FFO to $2.7 billion.

On a per share basis, that means the shares are priced at about 21-times AFFO which is a little pricey compared to the average of 17.5-times for all REITs but the company is only paying out 74% of its adjusted funds to cover the dividend. That means a lot of room for growth and dividend increase.

Of the four analysts with price targets, the low estimate is for $130 per share and a high at $152 each over the next year.

Duke Realty, ticker DRE, doesn’t offer the highest dividend with just a 2.7% yield but this is a solid pick for growth. Duke is a leader in the industrial warehouse and logistics space with 513 properties in 20 major U.S. markets.

What I love about Duke is that business is 75% correlated to growth in e-commerce sales while only 40% correlated to overall retail sales.

Now if you don’t speak nerd like me, that means the business moves much closer to online shopping sales and doesn’t depend on traditional retail.

Basically the company rents its industrial properties to companies like Amazon and other online stores to hold inventory for e-commerce sales. Occupancy averages 98% across its four property sizes and rent growth was 21% over the last year.

Management is expecting 8.7% growth in adjusted FFO this year to $478 million. On a per share basis, that puts the shares at 27-times AFFO and a 72% FFO payout to cover the dividend.

Seven analysts have price targets on the shares with a target of $33.50 at the low end to $39 per share at the high end.

Realty Income, ticker O, is easily the most popular REIT and maybe one of the most popular of all stocks with its 3.6% dividend paid on a monthly basis.

Realty Income has 50 years of operating history and owns nearly 6,000 properties in 49 states, Puerto Rico and the United Kingdom.

Even though 83% of rental revenue is from retail, I’m OK with this one because its diversified across some of the safer types of retail property like convenience, dollar stores, drug and grocery. Lease terms average nine years and occupancy has never been below 96% for the properties. Rent growth isn’t terrifically strong at around 1% annualized but it’s consistent and supports the dividend.

That dividend isn’t the highest among REITs but investors love the monthly payouts and the company has reported 88 consecutive quarterly increases. The 4.5% annualized dividend growth has beaten the 2.9% average for REITs so expect this one to keep paying.

Adjusted Funds from Operations is expected to $3.32 per share this year for a price of 22.5-times and 82% of those funds are going to pay the dividend so while I still like the company, I think you need to spread your investment in other REITs as well. It’s a good monthly payer but a little expensive and doesn’t quite have that cash cushion we see with others on the list.

AGNC Investment Corporation, ticker AGNC, is our mortgage REIT pick with an 11% dividend yield and a good bet in the mREIT theme.

AGNC holds a $103 billion investment portfolio with $99 billion of that in Agency mortgage backed securities.

Understand that mREITs are more like financial companies so instead of the FFO measure we’ve been using, you can use the price-to-book value to value shares. This is similar to the banks we saw in our previous video on bank stocks.

Now book value has been ugly for all the mortgage REITs because of the interest rate picture and it’s fallen to $17.52 for AGNC. That means the shares are trading just under their book value which is a pretty good place in terms of value.

One bright spot is that the net interest spread, that’s the difference between the interest rates on investments minus those short-term rates on which the company borrows, that spread jumped in the third quarter so could be signaling better profitability ahead.

Analysts have a low target at $16 per share and a high around $18 each so like most mREITs, that dividend is going to be most of the return. Still there is some room for price gain on this one if that net interest spread stays higher.

Ventas, ticker VTR, is a leader in the healthcare REIT theme and pays an attractive 5.6% dividend yield.

Ventas owns 1,200 properties in North America and the U.K. with about 54% of income from senior housing and 27% from medical office space. I like this 21% of the portfolio in triple-net lease senior housing which means the company is leasing space out to other senior care companies as well as operating its own properties.

Now the senior housing market has been tough for a few years. There’s no doubt that an aging population is driving demand but companies have built way too many properties. You see that in this chart of property construction, that’s the light blue line, against demand or property absorption in dark blue. You see how the construction starts has been way above the demand really since 2012 but the bright spot is that it looks like this might be turning around.

Senior housing starts were at their lowest level in nine years in the third quarter and demand is at its highest level on record.

Even as the company waits for senior housing to improve, the medical office environment is very strong and has a 92% occupancy rate across the portfolio.

Management expects to report $3.83 per share in funds from operations this year which means the stock is trading for just 14.7-times FFO. The company pays out 82% of FFO to cover the dividend so a little on the high side but this one could be a good turnaround play.

The company has produced a 9% annual growth in FFO since 2001 and nine consecutive years of dividend growth even in that weak senior housing environment. Ventas is widely covered with 10 analysts providing price targets from $56 a share on the low end to a high of $72 per share.

Investing in real estate investment trusts is an easy and fast way for regular investors to diversify their portfolio. Not only do you get different property types but also a simple real estate investment strategy that anyone can use. Understand how to value these real estate stocks to find the best ones with the highest dividend returns.

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