A Guide to Investing in Real Estate Investment Trusts (REITs)

How to Analyze a REIT

Let’s go over an example of how to analyze a REIT, using Realty Income, “the monthly dividend company,” as an example. This is one of the oldest and most popular REITs thanks to its exceptional track record of slow but steady dividend growth though all types of economic and interest rate environments. Realty Income has been the definition of a blue-chip dividend stock.

Source: Realty Income Investor Presentation

First, looking at the dividend profile we can see that Realty Income’s yield is far more generous than what the S&P 500 is offering. However, note that, while the payout ratio appears very high, for a REIT, especially one with as vast, diversified, and long-term contracted rental income stream as Realty Income, this is actually a safe level.

Sources: Yahoo Finance, earnings release, Fastgraphs, Factset Research, Mutlipl.com, Money Chimp.com

Remember that a REIT must pay out 90% of taxable income as dividends, meaning that its AFFO payout ratio will naturally be high; usually between 70% and 90%. So as long as a REIT is in the 80’s or below, and more importantly, has a long track record of stable payout ratios in this range, investors can remain confident of the safety of the payout under normal economic conditions.

Now, in terms of future dividend growth analysts aren’t expecting much, thanks to Realty Income’s already large size, which makes growing the portfolio, and thus AFFO, harder than in the past. That being said, keep in mind that analysts have a tendency to fall victim to “recency bias,” meaning they project the most recent results far into the future.

In this case, Realty Income’s most recent AFFO per share growth has been 4.4% in the first half of 2016. However, this has also been a time when Realty Income’s shares have soared to all-time highs, so management has wisely been using its expensive shares as currency to fund property growth, while also strengthening the balance sheet by bringing down its leverage ratio.

In other words, management has been purposely holding back on borrowing, which would create leverage that allows for less investor dilution to take advantage of the high share price. Even if a big acquisition isn’t in the cards, by raising high amounts of cheap equity capital when the shares are arguably overvalued, Realty Income’s management team will have greater flexibility to continue growing even if the economy takes a downwards turn and a falling market sends the share price crashing.

That’s a very wise move, because recessions are the best time for long-term focused REITs to acquire quality properties on the cheap. So deleveraging now, by choosing cheap equity funding over debt leaves Realty better poised to take advantage of future growth opportunities.

Why this matters is because the recent rise in share count, which results in slower AFFO per share growth, may turn around in the future, when management takes on more debt to take advantage of undervalued properties, and thus grows its AFFO stream while keeping share count constant. In other words, the recent slow growth in AFFO per share is something that is likely temporary and a choice that management is making to take advantage of current market conditions.

Speaking of balance sheets, here is Realty Income’s. As you can see the retail triple net lease REIT space is one where high leverage ratios (Debt/EBITDA) are the order of the day. So it’s important to note, that while Realty Income’s leverage ratio may initially appear very high, in fact it’s better than most of its rivals. In addition, the high interest coverage ratio means that the company should have little problem servicing its debt; the reason that its credit rating is among the highest in its industry.

Source: Morningstar, Fastgraphs

This combination of strong dividend coverage, and a solid balance sheet is partially why Realty Income will likely be able to maintain long-term dividend growth closer to 5% to 6% per year, similar to this year’s 6.1% payout increase. That would make for a projected total return of 8.6% to 9.6%, which is in line with the market’s historical 9.1% CAGR since 1871.

However, keep in mind that basically matching the market in terms of total returns isn’t necessarily a bad thing, especially considering the yield is nearly double that of the market’s and Realty Income is a much less volatile stock than most. Specifically its beta is one of the lowest you can find, at 0.39. This means that Realty Income is 61% less volatile than the S&P 500, making it an ideal, core holding for high-yield portfolios.

For more fundamental analysis of Realty Income’s business, please see my whole investment thesis (link at end of article).

Closing Thoughts on Investing in REITs

Despite their unqualified dividend status and interest rate sensitivity, REITs have proven to be an amazing long-term wealth building tool over long periods of time, especially for high-yield investors.

As long as you embrace effective investing habits, remember to be selective in which REITs you invest in, focus on the most important industry specific metrics, such as AFFO, and remain properly diversified, this sector can make a great core holding for many dividend portfolios.

Many REITs currently look expensive relative to their historical valuation multiples. Record low interest rates around the world have made REITs an especially appealing asset class in recent years.

Price volatility seems likely should the Fed actually begin raising interest rates, but this event is more likely an appealing buying opportunity for patient long-term investors. I know I will certainly be watching the sector closely for opportunities for our Conservative Retirees dividend portfolio (link below).

Additional Links

Dividend Safety Scores: http://www.simplysafedividends.com/dividend-safety-scores/

Realty Income Investment Thesis: http://www.simplysafedividends.com/realty-income-monthly-dividend-stock-analysis/

Conservative Retirees Dividend Portfolio: http://www.simplysafedividends.com/portfolios/conservative-retirees/