If you plan on raising your cash investment income in 2023, a position in REITs (real estate investment trusts) may help you do it.
REITs are dividend-paying entities that own or finance real estate. They can make their money through rents, property sales, interest income or all of the above.
REITs have a special tax status that requires them to pay out at least 90% of their taxable income to shareholders. For the REITs that are profitable, that requirement can lead to a higher-yielding investment than, say, blue-chip stocks or investment-grade debt.
As a reminder, dividend yield is the cumulative annual dividend payment dividend by the share price. So, a REIT that pays dividends of $10 per year and trades for $100, yields 10%.
Intrigued? Read on for a crash course in REIT investing. You’ll learn about the trade-off between yield and reliability, common risks among highest yielding REITs, the best REIT investments and how to pick reliable REITs for your own portfolio.
Yield Vs. Reliability
As an investor, you routinely make trade-offs between risk and reward. If you want stability, you invest in slow-growing, mature companies. If you want fast growth, you must accept the potential for higher volatility.
With REITs, the relationship between yield and reliability works the same way. REITs that produce very high yields can be less reliable. REITs that produce income like clockwork pay more moderate yields.
The good news is, you get to pick your sweet spot on that yield-reliability spectrum. There are enough REITs out there so you can tailor your portfolio to your comfort zone.
You’ll learn more about picking the best REITs below, but you can choose from two general approaches. You might define a narrow range of screening criteria for every REIT you buy. Or, you could cast a wider net and find your balance in the aggregate. You might invest in a couple aggressive REITs and hold them alongside more conservative positions, for example.
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Highest Dividend REITs
For context, in 2022, the dividend yield on the benchmark FTSE Nareit All REIT Index ranged from 3.1% to 4.3%.
If you’re targeting higher-than-average yields without excessive risk, you can find good options yielding 4% to 8%. You’ll see some of these below. Yields above 10% are achievable, but they’re likely to involve more volatility in share price and dividend amount.
Invesco Mortgage Capital: A High-Yield REIT Example
A case in point is mortgage REIT Invesco Mortgage Capital (IVR). IVR’s dividend yield is among the highest out there, about 20%. But the REIT has struggled in 2022 under the pressures of rising interest rates, falling property values and cautious financial markets.
In the second and third quarters of 2022, IVR recorded net losses per common share of $3.52 and $2.78, respectively. The company also cut its third quarter dividend from $0.90 per share to $0.65.
Notably, IVR completed a 10-for-1 reverse stock split earlier this year. Reverse stock splits don’t change a company’s capitalization–they only reallocate the market value into a smaller number of shares. Because each share represents a larger slice of the company after the split, the stock price rises. The increase usually corresponds to the split ratio.
Pre-split, IVR was trading for less than $2 per share. Post-split, the share price rose more than 900% to about $17.50. Now, six months later, IVR has slipped below $13.
So, yes, IVR has an impressive yield. But it comes with the risk of ongoing share price declines and additional dividend cuts. For many investors that trade-off isn’t worth it, particularly when the economic outlook remains uncertain.
What To Watch For
Some investors will take the opposite perspective on IVR and other mortgage REITs–that the underlying issues are temporary. In that case, these downtrodden REITs may have lots of long-term upside.
If that’s where your mind is going, plan on thorough analysis before you buy. Pay special attention to the nature of the share price declines, the viability of the business model and the REIT’s debt level.
1. Duration and range of share price declines.
Share price declines mathematically push dividend yield higher. So, your highest-yield REIT options often show a downward price trend.
Dive into that trend. How long has the share price been declining, what does leadership have to say about it and what are the root causes? If the underlying issues are external, is the REIT managing better or worse than its peers?
2. Obsolete or overly complex business models.
REITs can run into trouble when they’re too concentrated in the wrong types of tenants or properties. Specializing in indoor malls, where foot traffic has been declining for years, is an example.
Another yellow flag is a complex business model. Complexity adds risk. Mortgage REITs, for example, buy and sell mortgages and mortgage-backed securities so they are more sensitive to interest rate changes than equity REITs. Depending on the type of mortgages they finance, default risk may also be a factor.
3. Too much debt.
REITs pay out 90% of their taxable income to their shareholders. That doesn’t leave much funding for business expansion.
They commonly use debt to solve that problem. New borrowings can fund property acquisitions, which increases profits, cash flow and dividends.
It’s not unusual for REITs to be highly leveraged. But debt can become unmanageable very quickly—particularly under changing economic conditions. A REIT shouldn’t be so leveraged that it can’t absorb temporary periods of lower occupancy, higher interest rates or lower property values.
Best REIT Investments
For most investors, the best REITs to own have sustainable business models, reliable cash flows and manageable debt. These won’t deliver eye-popping, double-digit yields—but they do earn higher marks for consistency and reliability. See the table below for ten examples.
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REIT Yields Vs. Stock Yields: Remember The Taxes
Looking at the list above, you might conclude that REIT yields seem higher than traditional stock yields. You’d be correct, in a sense. But the practical difference between REITs and dividend stock yields will be less than you’d think.
Most REIT dividends are taxed as ordinary income. Dividends from U.S. companies and eligible foreign companies are usually taxed at the lower capital gains rates. So while you can earn higher yields with REITs, taxes will consume some of the difference. You can avoid that problem temporarily by holding REITs in tax-advantaged accounts such as traditional IRA, Roth IRA, 401 (k) and more.
For context, the highest income tax rate is 37%, while the highest long-term capital gains rate is 20%.
How To Pick The Best REIT Stocks
You’re smart to develop your own process for picking REITs that suit your goals and risk tolerance. Many REIT investors screen their options by REIT type, business model, dividend track record, revenue and cash flow production, and leverage. Below are some pointers on each of these that will help you set your own parameters.
If you’re up for a fun exercise, try applying these guidelines to the ten REITs introduced in the table above.
1. Understand your options
REITs come in many varieties. The primary REIT types are:
- Equity REITs, which own property
- Mortgage REITs, which finance property
- Hybrid REITs, which own and finance property
Equity, mortgage and hybrid REITs can be further categorized by the property types they specialize in, such as:
- Office buildings
- Retail storefronts and shopping centers
- Industrial properties, including warehouses and manufacturing facilities
- Residential, such as apartment buildings
- Healthcare facilities and hospitals
- Self-storage properties
- Timberland
- Farmland
- Infrastructure, such as cell towers and data centers
In investing, the simplest option is often the best choice, especially for novices. You might start with an equity REIT specializing in residential or retail space, for example. That’s likely to be more relatable to you than a mortgage REIT or an infrastructure REIT.
2. Get comfortable with the business model
You should understand how the REIT makes money today and how revenue growth will continue going forward. Review the REIT’s tenant profile, average lease length and occupancy trends. Also read through annual reports and other documentation to understand the REIT’s growth and acquisition strategy.
3. Review the dividend history
The best REITs have a solid history of dividend payments and dividend increases. Dividend increases obviously benefit your net worth and improve the efficiency of your portfolio. More than that, dividend increases show the REIT isn’t stagnant. Long term, sustainable dividend growth requires business growth to support it.
4. Check revenue and cash flow trends
If you see a track record of dividend growth, you should also see rising revenue and cash flow. Analyze those trends. How much has the revenue grown, and for how long? How does the growth compare to the REIT’s closest competitors? Is long-term debt rising at the same rate?
For cash flow, a popular metric to watch is FFO or funds from operations. FFO is earnings from business activities plus the noncash expenses of depreciation and amortization.
FFO does not include interest income or gains or losses from property sales, so it’s a good measure of operating performance. This is why REITs and their analysts often refer to FFO per share instead of the more general metric, earnings per share.
You can find a REIT’s FFO, current and historic, on its public financial statements.
5. Analyze the balance sheet
Debt can be a risk for REITs, so a balance sheet review is necessary. To compare a REIT’s leverage to its peers, focus on the debt-to-equity ratio and the debt ratio.
- Debt-to-equity ratio: This ratio tells you how much debt the REIT uses relative to equity in funding the business. You calculate debt-to-equity as total liabilities divided by total equity. A 3:1 ratio means the business is financed with 75% debt and 25% equity. REITs can support high debt-to-equity ratios in the range of 2.5:1 to 3.5:1.
- Debt ratio: The debt ratio measures solvency by dividing total assets into total liabilities. High debt ratios, above 60%, can limit the REIT’s ability to borrow money in the future. Nareit reports that the debt ratio across publicly traded equity REITs was 34.5%.
REITs For Income In 2023
If you’re ready to invest in REITs for income in 2023, start by defining your sweet spot on the yield-reliability spectrum. Err on the conservative side if you’re not sure. Choose REITs with simple, understandable business models that have a long track record of paying and increasing their dividend.
As is best practice with any investment, don’t go all in. Hold your high-yield REITs alongside traditional stocks and fixed-income positions. That’s how you achieve a good, sustainable balance of growth potential and stability—which is the key to building wealth in the stock market.
Five Top Dividend Stocks to Beat Inflation
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