September 10, 2011

Using REITs for Current Yields: Portfolio Fix

REITs offer a compelling blend of decent current yield and future price appreciation

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If there is one defining characteristic of the financial markets over the past two decades, it would have to be the ultra-low interest rate environment. For the benchmark U.S.10-year Treasury note, you have to go back to April 1995 to find a time when it consistently paid more than 7%.

This month, the yield on the 10-year dropped below 2% for the first time ever, which delivered both a welcome rise in price for those fortunate enough to own it already as well as an unwelcome dose of frustration for those looking to buy something that offers a reasonable yield.

With ultra-safe assets like Treasury bonds paying next to nothing, stock market volatility nearing historic highs, and gold trading at previously undreamed of prices, there is no obvious choice for investors seeking to put money to work, especially those who want current yield.

One asset class, though, offers a compelling blend of decent current yield and future price appreciation that merits the attention of exasperated, yield-hungry investors: real estate investment trusts (REITs).

 

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To be sure, REITs suffered during the economic downturn of 2008 and 2009 as rents on properties they owned plunged. As a plodding but nevertheless real recovery develops, their fortunes have improved, says S&P Equity Analyst Royal Shepard.

“The gradual economic recovery is helping to stabilize cash flows in most commercial real estate sectors,” he says. “Moreover, a depressed level of commercial-construction activity has constrained new supply while generally serving to increase occupancy levels in existing facilities. We think many REITs, also bolstered by newly raised capital, are taking advantage of the better operating environment.”

There are more than 100 REITs listed on U.S. exchanges, and they own a wide variety of real estate-related assets. In general, there are two types or REITs: those that own actual real estate and those that own mortgages.

As of March, 2010, the largest real estate category owned by REITs was regional shopping malls, which comprised about 14% of REIT assets, according to the industry’s trade group NAREIT. Apartments, health care facilities, and office buildings also each accounted for more than 10% of REIT assets. Mortgage REITs accounted for 8.4% of the total.

Similarly, there is a great deal of variation in the level of risk individual REITs carry. While many are managed fairly conservatively, others are highly leveraged, and some have recently been paying out more than they take in.

REIT Strategies

Among individual REITs, the highest yielding issue for which S&P Equity Research has a “buy” rank is Medical Property Trust (MPW), an Alabama-based owner of health care-facilities focused on acute care and inpatient rehabilitation hospitals. It currently yields 7.9%. The company is less leveraged than many of its peers, with a long-term debt to capitalization ratio of about 29%.

For those willing to live with leverage in order to obtain yields reminiscent of the glory days of junk bonds, mortgage REITs may be attractive. These REITs offer investors the tantalizing opportunity to turn the low-interest rate environment to their advantage, as they borrow at miniscule short-term rates to fund a portfolio of high-yielding mortgages.

Annaly Capital Management, the only mortgage REIT covered by S&P Equity Research and one of the oldest and largest mortgage REITs, currently yields a breathtaking 14.9%. It accomplishes this seemingly impossible feat by financing almost 90% of its portfolio with debt, a typical strategy employed by mortgage REITs.

Those seeking a more diversified exposure to mortgage REITs may want to look at Van Eck’s Market Vector Mortgage Income REIT ETF (MORT), which launched in August 2011 and has about $3.5 million in assets.

Annaly is the fund’s largest holding, accounting for about 21.5% of assets. It has an indicated yield of about 14% as well.

Mortgage REITs have come under regulatory scrutiny recently due to their use of leverage, which could be restricted in the future.

There are dozens of real-estate focused mutual funds, though most have delivered only tepid performance over the past five years. One option is Fidelity Real Estate Income Fund (FRIFX), with an annualized five-year total return of 3.5%, though it does not invest exclusively in REITs. It currently yields 3.6%, and it has more than half its $1.5 billion in assets invested in fixed income securities.

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S&P Senior Editorial Manager Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for ETF or mutual fund stories.

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