Real estate investments aren’t for everyone. For one thing, many of us have a high percentage of our net worth tied up in our homes.
Still, real estate offers a better yield than high-grade corporate bonds or blue-chip stocks, so a modest real estate holding offers both diversification and extra income.
But beware: Real estate is especially vulnerable to business downturns, so we should only be investing for the long term.
REIT = Real Estate Investment Trouble?
Another problem is that a few seemingly attractive investments – such as real estate investment trusts (REITs) – are actually quite dangerous right now.
Eight years of cheap money has made developers overconfident, leading to a glut of space. This is especially true in the hotel industry, where too many “great years” are producing the inevitable overhang.
Meanwhile, in retail real estate, the demand for retail space is in a secular decline. Large chains like Sears Holdings Corp. (SHLD) are perpetually making losses, waiting only for the next downturn to throw in the towel.
Then there’s the problem with REITs themselves.
That is, REITs present an inherent conflict of interest, with groups selling participation in real estate vehicles to outside investors without having truly independent managers themselves.
There will inevitably be a tendency to pass the doubtful projects onto the REIT while keeping the good ones in the parent company.
Finally, the fancy returns in home mortgage REITs such as Annaly Capital Management Inc. (NLY) have been generated by borrowing in short-term markets and investing in fixed rate mortgages on a levered basis.
That’s been a great game since 2009, but it’s less attractive now that the gap between short-term and long-term rates is narrowing, and it will become highly dangerous once short-term interest rates start rising.
One mortgage REIT that suffers less from this extreme interest rate risk is Resource Capital Corp. (RSO). RSO invests in commercial, industrial, and multifamily residential loans, mostly carrying a floating interest rate with term funding for much of its portfolio.
It therefore doesn’t have the interest rate mismatch problems of home mortgage REITs. Of course, it doesn’t have the benefit of its loans being government-guaranteed, either.
RSO has a spectacular dividend yield of 16.4% currently, based on a $0.42 quarterly dividend that management projects will be covered by earnings in 2016. Its next dividend should go ex-dividend in late March.
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Finally, RSO is trading at 36% of book value after a 1-for-4 reverse stock split knocked its stock price.
From a yield and potential capital gain perspective, therefore, RSO looks very attractive – just remember that it’s also high-risk, with the biggest potential problem coming from a major real estate downturn.
Now, most REITs invest in equity interests in real estate rather than mortgages. Consequently, they tend to pay out lower dividends than mortgage REITs.
They also often pay out more in dividends than they earn, which is justifiable since real estate depreciates in the books while its actual value often rises. However, like many such practices, this can go wrong in a downturn.
One conservatively run REIT for which this isn’t true is Cousins Properties Inc. (CUZ), which owns office, multifamily, retail, and industrial properties, as well as development land.
CUZ recently reported net income of $0.58 per share for 2015, comfortably covering its $0.32 per share dividend. At present its shares yield 3.9%. Thus, its dividend is well-covered and should have scope to increase in the near future.
Additionally, CUZ is selling only just above book value, so shareholders should get the benefit of increases in the portfolio’s value. Its next dividend should go ex-dividend in early May.
Finally, a REIT with a better yield but less opportunity for growth is Lexington Realty Trust (LXP).
Based in New York City, it invests in single-tenant properties on which it signs long-term leases, with a portfolio including office, industrial, and retail properties. It provides investors a very nice yield of 9.5%, based on four quarterly dividends of $0.17.
However, its earnings for the four quarters to September 30 were just $0.46 per share, so it’s paying part of its dividend out of cash flow. Its next dividend should go ex-dividend in late March.
Here’s the bottom line when it comes to investing in real estate for income: Even though the yields can look attractive, income investors should avoid putting too much of their money into REITs.
The chances of something going wrong are too great, as in energy MLPs.
Nevertheless, the three REITs discussed above, at varying levels of risk and reward, provide investors with some real estate exposure and an attractive yield for a modest part of their portfolios.