Finding the Sweet Spots in the REIT Sector
Market commentators tend to talk in broad terms when describing the up-and-down performances of certain sectors.
For some sectors, there is a fairly close correlation of stocks that fall into the categories of utilities, telecoms, big pharma, banks, industrials, materials and aerospace defense issues. Other sectors like technology trade more in alignment with the sub-sectors like enterprise software, semiconductors, cyber security software, cloud-based software, networking, fiber optic, etc.
They can trade in tandem on any good day for the Nasdaq. But they also have a history of trading independently of each other.
The same can be said for the real estate investment trust (REIT) sector. REITs come in many different classes and, in general, are fantastic income vehicles for just about any kind of economic cycle if the right REITs are owned.
The Internal Revenue Service shows that there are about 1,100 U.S. REITs that have filed tax returns. As of the start of 2016, there were more than 200 REITs in the United States registered with the Securities and Exchange Commission (SEC) that trade on one of the major stock exchanges, with the majority traded on the NYSE. Here are some of the classes of REITs:
Mortgage REITs (residential and commercial)
Office REITs
Industrial REITs
Infrastructure REITs (data centers and telecommunications towers)
Retail REITs (neighborhood strip malls, mega malls, outlet malls)
Residential REITs
Lodging REITs
Casino REITs
Self-Storage REITs
Health Care REITs (hospitals, assisted living, nursing homes, medical offices)
Timberland REITs
Specialty REITs (movie theatres, amusement parks, outdoor advertising)
After a long period of exceptionally accommodative monetary policy, the Federal Reserve recently restarted the process of raising short-term interest rates to a more neutral range. Expectations of this rate increase and of future changes in monetary policy have at times affected the valuations of many investments, including the share prices of stock exchange-listed equity REITs.
Asset prices often decline as the immediate response to a rise in interest rates because higher interest rates reduce the present value of future cash flows, including bond coupons and stock dividends. If future cash flows are not expected to rise, then increasing interest rates would have a clear negative impact on asset values, including the prices of listed REIT stocks.
Changes in the level of interest rates, however, often reflect changes in the level of economic activity. Today’s economic environment, for example, includes several factors that reasonably could be expected to boost future REIT earnings and dividends, even in the context of higher interest rates to help support or even increase stock valuations. It is in the context of this shift in monetary policy that investors have to be very selective in which kinds of REITs to invest in that will be viewed as benefiting. The perception here is one where revenue growth is well outpacing rising interest rates and the cost of money.
In my flagship high-yield income advisory service, Cash Machine, I’ve taken a sharp focus on a few REITs that, in my view, fit to a T the kind of businesses that thrive in the current economic cycle. The REITs include hotel and casino REITs because they can raise the overnight room rates as needed to offset rising costs or have the luxury of doing so because demand is strong.
I also like industrial REITs that are leveraged to a stronger economy where businesses are expanding and requiring more space and willing to pay for it. I’m also a fan of Logistics REITs that are prospering from the expansion of ecommerce distribution. The transformational shift to cloud computing is a boon to operators of data center REITs. Likewise, the explosive use of smart phones, streaming content and mobile office applications that dominate the wireless world is driving the fortunes of the cell tower REITs.
I tend to only recommend REITs that can pay out a yield as close to 5% or more as possible. Considering the income from REITs is taxed as ordinary income, investors in the highest tax bracket can be subject to a 39.6% tax rate. For most REIT investors, something along the lines of 20-25% is a more likely tax rate. That being the case, taking home 4% after taxes is a nice yield and almost twice that of what the 10-year Treasury Note pays.
Of the six REIT positions that we’ve exited during the trailing 12 months, our average gain has been 20.2% with an average holding period of 14.2 months. For income investors, these are home run returns. Not only are the yields at or better than 5%, we’re getting long-term capital gains treatment of 15% on the sale of the stocks by holding them over 12 months. This is money management at work that outperforms with lower volatility while also being tax efficient. Click here now to learn how Cash Machine has served the needs of income investors for over 10 years and, like fine wine, is only getting better with time.
In case you missed it, I encourage you to read my e-letter from last week about how big software and semiconductor are driving the markets with with excellent earnings reports.
