Low rates have made investors hungry for yield. As a result, traditional higher yielding investments such as utilities and real estate investment trusts are getting bid up by investors. If this madness continues, the possibility that many investors will get burned down the road increases exponentially.
Real estate investment trusts (REIT) are required by law to distribute at least 90% of their taxable income to shareholders. The REITs I own typically distribute somewhere close to 80 to 90% of their Funds From Operations (FFO) to shareholders. FFO is a commonly accepted tool to measure profitability for REITs, and is a more accurate indicator than earnings per share.
FFO adds back for certain non-cash items such as depreciation, in order to determine the amount of profits that are available. Most REITs that I follow tend to have a FFO payout ratio between 80% to 90%. I own shares of Realty Income (O), Omega Healthcare Investors (OHI), Digital Realty Trust (DLR) and American Realty Capital Properties (ARCP).
As a result, I find it safe to assume that for REITs a low yield usually shows a stock that is overvalued, whereas a higher yield usually shows an attractively valued stock. I define a low yielding REIT in the current environment as a REITs that yields somewhere close to 4% or lower. A higher yielding REIT is one that yields at least 5%. This generalization only includes REITs whose primary business is to own physical real estate.
Some investors believe that current lower than historical yields on REITs are justified by record low interest rates. For example, yields on U.S. 30-year Treasuries are close to 3%. These investors believe that today is the new normal, as low interest rates justify REIT valuations. The mentality that the this time it’s different might be costly to your portfolio.
Investors who purchase a REIT yielding 3% are generally receiving 80 to 90% of cashflows. In contrast, an investor in a typical dividend champion such as Procter & Gamble (PG) or Johnson & Johnson (JNJ) who gets a 3% yield today also gets a 5% to 6% earnings yield.
Even in the current environment however, there are reasonably priced opportunities for investors who are on the lookout for bargains. I have been able to use the weakness in Digital Realty Trust to acquire a decent position in the stock. In addition, the following low yielding REITs seem to have very low FFO payout ratios:
Low yields could be justified by the expectation for higher distribution growth down the road. If your REIT slashed distributions to the bone during the 2007 – 2009 recession, they could not yield much today, but could have the potential to yield twice as much in a few years. In addition, REITs in different sectors have different yields. A healthcare REIT that might be overvalued at a yield of 4%, even though a 4% yield would be considered fair for other types of REITs.
Many REITs are able to sell ten year bonds at yields as low as 3-4%. They have particularly benefited from falling interest rates in the past five years. If you re-finance debt that used to cost 6%-7% with debt that costs half of that, the FFO bottom line will be instantly improved. However, the problem that REITs might get to in a decade is if interest rates are substantially higher than interest rates today. Many investors believe that rates will go up, which could be costly to real estate trusts that want to refinance debt a decade from now.
Another risk that we might see is if REITs bid up assets they purchase to yield below 6-7 percent. If the low cost of capital drives REITs to compete aggressively for new assets to purchase, without any regards to quality or future possibilities, this could spell disaster for REIT investors. If rates increase over next decade, this could result in reductions in FFO. This could mean trouble for REIT investors one decade down the road – low property returns relative to high interest rates in 10 years. The mitigating factor here is that interest rates might increase gradually, once they start increasing in 2- 3 years. As a result, REITs will have plenty of time to adjust their debt costs. In addition, many REITs would be able to raise rents if inflation increases alongside with interest rates.
In my personal portfolio, I have replaced National Retail Properties (NNN) with American Realty Capital Properties. Check my analysis of National Retail Properties. I used the fact that investors pushed yields on National Retail Properties below 4% to exit my position. I did not like the slow growth in FFO/share, as well as the slow growth in distributions. The slow growth over the past decade did not justify current valuations. Buying National Retail Properties was justified up until 2010, after which I simply held on and cashed the dividends along the way. In all reality, this REIT could probably go as high as yielding 3%, which translates to $52 per share.
Based on FFO per share of $1.77 and annualized dividend of $1.58 per share, the forward FFO payout for National Retail Properties comes out to roughly 89%, which is rather high. For American Realty Capital Properties, FFO is expected to be in the range of 91 to 95 cents per share in 2013, and $1.06 – $1.10 per share by 2014. The annual dividend is 91 cents per share, which could make up for a forward FFO Payout of 95.80 to 100% in 2013. It looks high, but in reality the company just recently completed the acquisition of American Realty Capital Trust III, which will probably distort how financials look like this year.