As investors continue to gravitate to real assets and income opportunities, commercial real estate continues to show its mettle. Over the last few years, the asset class has benefited from the trio of bargain hunting, low interest rates and retirees seeking income.
Both individual and institutional investors have plowed some big bucks into commercial real estate … and that’s helped real estate investment trusts (REITs) post some of the best returns of any sector since bottoming out during the Great Recession.
One subset of the REIT market outside the world of office towers, shopping malls, industrial properties and apartment buildings has been exceptionally strong, though: “specialty” REITs. These invest in real estate other than the four major groups and have managed to outperform their more “traditional” brethren. More importantly, recent IRS private-letter rulings have allowed more non-traditional real estate assets to be placed into the tax structure.
While cold storage warehouses, cell phone towers and salt caverns aren’t exactly what most investors have in mind when they look to real estate, the esoteric property types could be the best bang for your REIT bucks. These weird real estate assets have managed to turn in some hefty gains for their owners.
The Dow Jones Specialty REIT Index — which tracks 15 of the largest publicly traded alternative real estate plays — produced a 23.95% total return in 2012, which is more than 6 percentage points higher than the Dow Jones U.S. Diversified REITs Total Stock Market Index.
While some may be quick to peg the outperformance on these trust’s riskier nature, the truth is they actually could be more stable than the core four … and perhaps compared to overall equities as well. Unlike office buildings and shopping malls, these specialty and niche properties feature markets that are not generally dictated by larger macroeconomic trends, meaning the recent economic malaise hasn’t really affected underlying performance.
For example, timber REITs can continue to grow trees when log prices are low, while storage centers have benefited from the housing crisis and the shift toward increased renting. Another sector is data storage centers and it has continued to grow because of increased internet usage. Wireless data transmission and smartphone and tablet adoption seem to be pretty recession-proof.
However, the specialty REITs aren’t done yet. As investor interest in income-producing securities has risen, more and more firms have petitioned the IRS to gain REIT tax status — much like what we have seen in the master limited partnership (MLP) space. REITs are required to distribute more than 90% of their income to shareholders, so making the switch can boost a company’s stock performance into the stratosphere.
When wireless and cellular tower owner American Tower (NYSE:AMT) announced that its board of directors had approved the company’s conversion back in May of 2011, the stock soared. Since then, AMT has returned a cumulative 46%, compared with a gain around 10% for the S&P 500. CBS (NYSE:CBS) and Lamar (NASDAQ:LAMR) are both planning on “unlocking the value” of their outdoor real estate — i.e. billboards — by turning their portfolios into REITs, as is data-center firm Equinix (NASDAQ:EQIX).
Due to the sector’s “non-traditional” nomenclature, though, the specialty REITs are often ignored by mainstream and institutional investors. The National Association of Real Estate Investment Trusts (NAREIT) — an industry group — doesn’t even track a specific specialty REIT category anymore.
On the upside, this can provide deep discounts to book value, along with outsized dividend opportunities. Plus, the sector can add valuable diversification to a real estate portfolio by providing investors with alternatives they may not have considered. With that in mind, let’s take a look at three non-core picks for your portfolio.
Entertainment Properties Trust: Even with the American consumer straining, cheap forms of entertainment continue to thrive. That has benefited movie theater owner Entertainment Properties Trust (NYSE:EPR). In addition to its multiplex operations, though, the REIT owns a variety of retail, restaurant and other entertainment venues — including ski resorts — across 33 states. Over the last 10 years, EPR has constantly outperformed both the Russell 2000 and the broad REIT indexes. Shares of the firm yield a delicious 6.4%.
Iron Mountain: Owning vast salt-caverns for document storage may seem boring … unless you’re a shareholder at Iron Mountain (NYSE:IRM). Back in June, the firm announced that it would be making the switch over to a REIT by the start of 2014. Since then it has climbed 27%. Longer-term investors may still want to nibble at the future specialty REIT as well, as it sports a dividend yield over 3%, which will only get higher after the conversion takes place. Plus, the company continues to churn steady cash flows from its both physical and digital-secured storage operations.
Digital Realty Trust: The explosion of cloud computing and internet-enabled devices has meant a boom for data center REITs. Building and maintaining data centers can be expensive, as they eat up large amounts of CAPEX and operating budgets. As a result, many companies are expected to embrace the concept of leasing of data centers and data center space. That bodes well for Digital Realty Trust (NYSE:DLR), one of the largest wholesale data center providers which operates over 100 data centers across North America, Europe and Asia. Shares of the firm currently yield 4.5%, while DLR has managed to consistently grow its funds from operations and that payout … and both should only expand further. Analysts anticipate continued data center growth as more businesses move to the cloud.
The bottom line? There certainly is something special about the specialty REITs. Don’t be turned off by what you don’t know.
As of this writing, Aaron Levitt did not own a position in any of the aforementioned securities.