High yield REITs come with a warning

That soaring dividend yield might look good now, but remember: The higher they are, the harder they can fall.

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By Janet Morrissey, contributing writer

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NEW YORK (Fortune) -- Many investors looking for safe havens in a rough market are latching onto double-digit dividend yields offered by real estate investment trusts.

"Equity REITs absolutely are a place for an investor to get a very meaningful spread versus treasurys," says Ritson Ferguson, chief investment officer at ING Clarion Real Estate Securities, an investment management firm.

Typically, investors seek out REITS for their stable, predictable cash flows and above-average dividend yields. Under REIT rules, companies avoid paying most corporate taxes as long as they distribute at least 90% of their taxable income to shareholders as dividends. And with the past year's market selloff, those dividends, which are typically paid quarterly, have become even more attractive.

Equity REITs (which own brick-and-mortar properties) currently offer average dividend yields of 7.7%, while mortgage REITs (which hold mortgage securities on properties) yield an average of 15.5%, according to the National Association of Real Estate Investment Trusts. That far outpaces the S&P 500 index (SPX), where stocks currently average a dividend yield of about 3%.

Some individual REITs offer far loftier yields: Sunstone Hotel Investors Inc., CBL & Associates Properties Inc., Macerich Co., Hersha Hospitality Trust, and Apartment Investment & Management Co., all exceed 30%, while the yields at several mortgage REITs - Newscastle Investment Corp, Arbor Realty Trust, and RAIT Financial Trust - top the 100% mark.

But industry experts caution investors to beware of REITs offering the frothiest yields. "A dividend that high indicates ... the market doesn't believe that dividend is sustainable," says Steven Marks, a managing director at Fitch Ratings.

"Yields in the 20s and 30s (and higher) often reflect a view by the market that this dividend is likely to be cut," Ferguson concurs. When investors get jittery about a REIT's ability to cover its dividend, they tend to sell shares, which causes the yields to jump.

About 40 REITs have already cut their dividends in the past six months, notes Tom Bohjalian, senior vice president and portfolio manager at Cohen & Steers Inc. Some have suspended their dividends, while others have either trimmed them or opted to pay a portion of them in stock. He says investors looking at REITs with yields north of 15% need to "do a deep dive into the balance sheet" to assess if a company will need to trim or scrap its dividend to meet debt obligations.

Indeed, industry analysts say debt is the biggest threat facing REITs and their dividends in today's seized-up credit markets, and it must be carefully considered before buying a stock.

Two blue chip names show what can happen when debt problems can lead to dividend cuts and then panic. Last year, mall-owner General Growth Properties Inc. (GGP) and industrial warehouse giant ProLogis (PLD, Fortune 500) were trying to dig themselves out from under a mountain of debt accumulated during the real estate boom of the past five years. Like just about every other business, REITs have had a tough time finding lenders who are willing to refinance their debt in today's frozen credit markets.

Stunned investors watched General Growth suspend its dividend, replace its management team, and sell off some of its crown jewel properties to meet debt calls and stave off bankruptcy. Its stock lost more than 98% of its value in the last year, leading to its ouster from the S&P 500 index.

Similarly, ProLogis slashed its dividend by 52% to shore up cash to cover debt maturities, and 85% of its share value disappeared. General Growth's dividend yield was 37%, and Prologis' yield was 46% when they changed their dividend policies.

Spooked investors responded by dumping REITs in droves: The group's total returns, which include dividends, fell 37% in 2008 and are off another 20% so far in 2009, according to NAREIT. But as share prices have fallen, dividend yields have risen - even for companies that face little debt risk, and this is where cherry-picking becomes key.

Industry analysts caution investors to be wary of equity REITs with debt levels that exceed 70% of total market cap and - more importantly - those with a significant amount of debt rolling over in the next two years.

"A company needs to have dealt with or presented a credible plan for dealing with maturities in 2009 and 2010 to get out of the penalty box," says Ferguson.

Among the equity REITs with leverage exceeding 70% and who have at least 39% of their debt expiring in 2009 and 2010 are General Growth, CBL & Associates Properties Inc., Ramco-Gershenson Properties Trust, Developers Diversified Realty Corp., U-Store-It Trust, and Strategic Hotels & Resorts Inc., according to SNL Financial LC.

"When you get to those levels, you have to question the company's ability to continue to fund that (dividend)," says Bohjalian, although he does emphasize that dividend yield isn't the only factor to consider when looking at a company's overall story and growth outlook.

Healthcare and apartment REITS offer the safest bets, with average dividend yields of 8.6% and 9.8% respectively, says Richard Anderson, a senior analyst at BMO Capital Markets.

Healthcare REITs have been largely unscathed in the economic downturn as demand for nursing homes and doctors continues in good economic times and bad, Anderson notes. As a result, most have the cash flow to cover their debt maturities and pay their dividends.

In the apartment sector, REITs are reaping the benefits of the battered housing market as foreclosed homeowners turn to rental units to live while fewer renters are venturing into homeownership until they're certain the market has bottomed. Apartment REITs and certain healthcare REITs also have access to cheap debt from mortgage giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), says Anderson.

"If you've got access to Fannie and Freddie, and you're an apartment company or a healthcare company, you're in pretty solid shape," says Bohjalian. To top of page

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