Why REITs may be right
The carnage in the property sector is creating enticing dividend yields in real estate investment trusts - for investors who can avoid the pitfalls.
NEW YORK (Fortune) -- The notion that real estate could be a safe haven may seem like investing lunacy right now. After all, the words "real estate" conjure nightmares of the nation's decimated housing industry and the downward spiral of commercial real estate. And yet, as often happens, the wreckage of the sector is creating opportunities: a group of dependable real estate investment trusts (REITs) whose prices have been pummeled so badly that their yields are nearing double digits.
Typically investors seek out REITs for their stable, predictable cash flows and strong dividend yields. By law REITs can avoid most corporate taxes as long as they distribute at least 90% of their taxable income as dividends.
REITs currently offer dividend yields averaging 7%, according to the National Association of Real Estate Investment Trusts, compared with 2.6% for the stocks of the S&P 500 (all yields as of May 4). Certain segments of the REIT universe offer even gaudier payouts, such as industrial warehouse REITs, where yields average 8.7%, and commercial mortgage REITs, with 54.4%.
Of course, the frothiest yields can mean danger. "A dividend that high indicates the market doesn't believe that dividend is sustainable," says Steven Marks, a managing director at Fitch Ratings. In the past six months about half of the country's publicly traded REITs have cut their dividends, suspended them, or opted to pay a portion in stock, notes Richard Anderson, a senior analyst at BMO Capital Markets. The reason, in most cases: debt calls. (A few REITs have trimmed their payouts to hoard cash so that they can take advantage of buying opportunities later this year.)
Analysts say debt is the biggest threat facing REITs. Consider General Growth Properties. The mall REIT was yielding 37% before slicing its dividend and then sliding into Chapter 11 bankruptcy in April. A key cause of its woes was heavy debt. That's a crucial warning sign for investors, analysts caution. Be wary of REITs with debt levels exceeding 70% of their market capitalization and significant debt due in the next two years. "When you get to those levels, you have to question the company's ability to continue to fund that [dividend]," says Tom Bohjalian, portfolio manager at Cohen & Steers.
Between the real estate sector's turmoil and meltdowns such as General Growth's bankruptcy, REITs have been punished: Total returns for the group, including dividends, sank 37% in 2008 and have fallen another 6.2% so far in 2009, according to Nareit.
But among the wreckage are REITs whose prices have been unfairly hammered. In general, Anderson argues, those that specialize in health-care facilities and apartments offer the safest bets, with average dividend yields of 7.8% and 8.5%, respectively. Healthcare REITs have endured as demand for medical care continues even in bad times.
Anderson recommends HCP (HCP), Health Care REIT (HCN), and LTC Properties (LTC), with yields of 8.8%, 8.2%, and 8.6%, respectively. HCP and Health Care REIT are diversified; they own nursing homes, medical office buildings, senior housing, assisted-living facilities, and hospitals. That means the companies won't collapse if one segment turns sour.
LTC is less diversified, with about 50% of its business coming from nursing homes. Still, demand for senior housing, assisted living, and nursing homes is expected to surge as baby boomers cross into their golden years. Also, the company's balance sheet is sound. Bohjalian is bullish on LTC as well as on Omega Healthcare Investors (OHI), which has a 7.9% yield. Omega focuses on nursing homes and assisted-living facilities.
Apartment REITs are reaping the benefits of the battered housing market as foreclosed homeowners turn to rental units while fewer renters venture into home ownership until they're certain the market has bottomed. Apartment REITs (and certain health-care REITs) can also tap cheap debt from mortgage giants Fannie Mae and Freddie Mac. "If you've got access to Fannie and Freddie and you're an apartment company or a health-care company, you're in pretty solid shape," says Bohjalian.
Anderson is bullish on Equity Residential (EQR), which generates a 9% yield. The company is considered a bellwether in the REIT world because of its size and national platform, and is chaired by real estate titan Sam Zell. Although rising unemployment has caused rents to fall during the past year, the company indicated in a recent conference call that they've held steady so far in 2009 and that occupancy is at 94%. Equity Residential has never trimmed or suspended its dividend since going public in 1993, Anderson notes, and CEO David Neithercut reiterated that commitment on the call.
Bohjalian is bullish on Home Properties (HME) and AvalonBay Communities (AVB), which offer more conservative yields of 7.7% and 6.6%, respectively. Home Properties focuses on class B quality properties in high-growth markets in the Mid- Atlantic corridor, where demand for moderately priced apartments has increased. In the downturn of 2001--04, the company boasted the highest revenue growth among its peers. AvalonBay owns class A apartment properties in major high-growth cities, especially in coastal markets. Although it's been hurt in the downturn, it has a strong balance sheet and a highly regarded management team, making now the REIT time to consider buying. 
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