Practical Investing: Why You Need REITs

Kathleen is an investment newbie who has started digging into financial statements to do a better job of analyzing stocks. But she was flummoxed when trying to assess a company that was similar to one I had written about in the May issue. When she sent me the symbol, I understood why. She wasn’t looking at an ordinary stock; she was looking at a real estate investment trust.

REITs are something of a hybrid. They trade like stocks, but their dividend yields can approach those of junk bonds. I bought a couple of them in late March—Starwood Property Trust (symbol STWD) and Apollo Commercial Real Estate Finance (ARI)—because I think REITs belong in every diversified portfolio. REITs provide stock market–like returns, but they usually don’t move in sync with the market. Thus, holding REITs can add stability to your portfolio without reducing returns. Better yet, REITs are a good hedge against inflation because rents and real estate values tend to climb with rising prices.

But REITs are different from regular com­panies, and that makes them trickier to analyze. REITs invest in real estate or loans on real estate. Some 90% of REITs own properties, generating most of their income from rents. Moreover, all REITs are required by law to distribute 90% of their earnings to shareholders.

To be sure you’re buying a REIT at a good price, compare its share price to its funds from operations, or FFO. FFO is calculated by adding back depreciation deductions to earnings. Tax law allows a company to write off the value of long-term assets to recognize their diminishing value over time. That’s a nice tax break, but it doesn’t cost a REIT any cash, nor does it affect the value of a com­pany’s assets. And unlike, say, computers, real estate tends to gain, rather than lose, value over time.

You can also compare a REIT’s share price to its net asset value (NAV)—that is, the value of all of the properties it owns. Assuming that the assets are valued accurately, buying at a discount to NAV means you’re getting a bargain.

But what Kathleen was asking about, and what I hold, are mortgage REITs. Instead of owning properties, these REITs invest in the mortgages on those properties. Lending on commercial property is risky, especially in a dicey economy. But I think it’s worth taking a chance on mortgage REITs because I believe the economy is improving and because I am more worried about inflation than a new recession. Mortgage REITs benefit in two ways from an improving economy: Their clients, commercial landlords, collect more rent, improving their creditworthiness. And a rising economy can boost the value of the real estate that serves as collateral.

But even when I gamble, I gamble carefully. So I consider a mortgage REIT’s cash flow and asset value, just as I would with a traditional REIT. I also scour recent financial reports for other investment clues.

With Starwood, two things give me comfort. The company projects that earnings will grow 3% to 12% in 2012 based on its existing mortgage portfolio; but it says the projection doesn’t account for deals in the works, which could increase revenues by nearly 25%. The company also brags that its borrowers have a lot of equity in the deals, providing a measure of safety.

As for Apollo, the price I paid for the shares ($16.02) represented a slight discount to its NAV, which makes me think I got a relative bargain. Apollo also restructured its debt. That should lower its costs and improve profitability.

I rushed to buy both REITs so that I’d be able to collect the rich dividends. Sure, I knew the price would drop to reflect the payout, but I think investors have a visceral, positive reaction to dividends that tends to buoy the stock. It doesn’t make great logical sense. But we are the market and we are not infinitely logical.

Kathy Kristof is a contributing editor to Kiplinger’s Personal Finance and author of the book Investing 101. Follow her on Twitter. Or email her at practicalinvesting@kiplinger.com.

Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. Download the premier issue for free.