You’ve seen headline after headline that owning real estate is a key piece to building wealth. Well, what if you move around a lot, aren’t interested in dealing with tenants, or don’t have enough money for a down payment? You can still diversify your portfolio and build wealth by investing in one of these best REITs.
Some investors focus on price appreciation, leading them to invest in growth stocks like Tesla (TSLA). Some investors focus on dividend growth stocks like Johnson & Johnson (JNJ), and others focus on high-yield stocks like AT&T (T). But when you’ve gotten all of those, it’s time to diversify so you don’t have all your eggs in one or two baskets.
Yet another asset class can be a good investment, real estate investment trusts (REITs). REITs are publicly traded likes common stocks but are organized as trusts, and importantly owning a REIT has tax implications.
Hence, quality matters when selecting REITs to buy. In this article, after covering the basics, I will cover the best REITs to buy today.
Basics of a REIT?
Before we discuss the best REITs to buy today, we should first talk about the basics of a REIT?
According to Investopedia, a REIT is a corporation that owns, operates, or finances income-generating real estate. A publicly traded REIT’s stock is traded on stock exchanges. Therefore, investors can invest in the commercial real estate market, which is not something that most retail investors can do on their own.
To qualify as a REIT, it must own real estate that generates income to distribute to shareholders. Specifically, a REIT must
- Invest at least 75% of total assets in real estate, cash, or US Treasuries
- Derive at least 75% of gross income from rents, interest on mortgages that finance a real property, or real estate sales
- Pay a minimum of 90% of taxable income in the form of shareholder dividends each year
- Be an entity that’s taxable as a corporation
- Be managed by a board of directors or trustees
- Have at least 100 shareholders after its first year of existence
- Have no more than 50% of its shares held by five or fewer individuals
Investors in REITs are technically unitholders and not shareholders. REITs have generated good total returns for investors in the past but at the same time have had relatively high rates of dividend cuts and suspensions during recent recessions.
Tax Rate for REITs
Investors should be aware that there are tax implications for owning REITs. The dividend tax rates for REITs are the same as the regular income tax rate.
This taxing is because REITs are pass-through entities and do not pay federal income tax. Hence, these companies pay 90% of their income to shareholders. It is essential to know that REITs technically pay distributions and not dividends to their unitholders. Distributions are divided into a regular income, return of capital, and capital gains.
For this reason, distributions paid by REITs are not qualified and thus do not receive advantaged tax treatment like qualified dividends. The difference in tax rates between qualified and non-qualified dividends can be considerable. For example, suppose your household income for jointly filing an income tax return is $100,000, the regular income tax rate is 22%, and the qualified dividend tax rate is 15%. This difference increases as your tax bracket increases.
Criteria for the Best REITs
It should be clear the REITs are traded like stocks but are different due to their structure and tax implications. As a result, REITs are even valued differently than common stocks.
For instance, a stock may be valued using earnings per share and the historical price-to-earnings (P/E) ratio. On the other hand, REITs are valued using an alternative metric, funds from operations (FFO) per share, and a historical P/FFO ratio.
FFO measures cash flow from normal business activities for a REIT. Thus, FFO is a way to measure a REIT’s operating performance. However, many of the criteria used to determine the best stocks to buy are qualitatively similar to selecting the best REITs to buy today.
- One of the main reasons to buy a REIT is the dividend yield. It is a significant contributor to total return. We require a yield of more than 4%.
- The dividend payout ratio must be relatively low for a REIT to make the list of best REITs to buy. For A REIT, we define payout ratio as dividend-to-FFO. The dividend payout ratio should be sufficiently low to reduce the risk of a dividend cut or suspension. Too high a payout ratio suggests that the REIT may use too much debt to fund growth plans. A conservative payout ratio for REITs is 80% meaning the dividend is no more than 80% of FFO.
- A third criterion for making the best REIT list is an investment-grade balance sheet with relatively low debt. We require a debt-to-equity ratio of less than 100% and interest coverage greater than 2X. Too high debt places the dividend at risk as more cash flow is required to pay interest expenses.
Realty Income’s current dividend yield is 4.03%, with an annual dividend rate of $2.83. In addition, the trust is estimated to generate FFO per share of $3.56 in 2021, giving a payout ratio of ~80%, which is just at my target cutoff value for payout ratio. Hence, it pays to keep an eye on this safety metric.
3 Best REITs to Buy
1. Realty Income Corporation
The first best REIT on our list is Realty Income Corporation (O). The trust owns more than 6,500 properties with commercial tenants. In addition, Realty Income owns retail properties that are not part of a mall but are standalone properties.
Thus, the properties are viable for many different tenants, including government services, healthcare services, and entertainment. Realty Income was founded in 1969.
Realty Income is well-known for its successful dividend growth history and monthly dividend payments. The trust has paid a dividend since its founding in 1969.
The REIT has paid 615 consecutive monthly dividends. The dividend has been raised 112 times and for 96 straight quarters. The company is a Dividend Aristocrat with 27 years in a row of dividend increases.
In addition, the trust has an investment-grade balance sheet. Realty Income has an A3 credit rating from Moody’s and an A- credit rating from Standard & Poor’s.
Both ratings are upper-medium grades and indicate that the company has a solid capacity to meet its financial obligations. Total debt was $9.2 billion at the end of Q2 2021, giving a debt-to-capitalization ratio of 36%, which is conservative. In addition, interest coverage is approximately 3.9X based on FFO meeting our third criteria.
2. SL Green Realty Corp
The second REIT on our best REIT list is SL Green Realty Corp (SLG). It is unlikely that most readers will know of the REIT, but it is New York City’s largest landlord.
At the end of Q2 2021, the trust had an ownership interest in more than 77 buildings and 35.3 million square feet of commercial properties. In Manhattan, SL Green has ownership interest in 27.1 million square feet of commercial properties. The REIT was founded in 1980.
SL Green Realty faces unprecedented challenges during the COVID-19 pandemic as many of its tenants have to work from home or hybrid work models. This new reality has resulted in NYC having the highest office vacancy rates in the US.
However, NYC schools restarted in mid-September, and the mayor has directed all city workers to return to the office. Still, SL Green Realty did not cut or suspend the dividend since its occupancy rates have been stable at 93% – 94% for the past year due to long-term contracts.
The REIT pays a $0.3033 dividend each month, giving an annual dividend rate of ~$3.64. The company switched from a quarterly to a monthly dividend payment in 2020. The current dividend yield is approximately 4.9%.
The trust is estimated to generate FFO per share of $6.56 in 2021, giving a payout ratio of ~55%. This ratio is a conservative value and should let the trust continue to pay the dividend even in the face of the pandemic.
SL Green Realty has an investment-grade balance sheet. The REIT has a BBB credit rating, which is the lowest medium investment grade.
3. Industrial Logistics Properties Trust
The third REIT on our best REIT list is Industrial Logistics Properties Trust (ILPT). This REIT is probably another company that is little known.
Total debt was $4,699 million at the end of the second quarter in 2021. The debt-to-capitalization ratio was about 50%, which is reasonably conservative. Interest coverage is approximately 4X based on FFO meeting our criteria.
However, the trust owned 291 industrial and logistics properties with 35.2 million square feet of rentable space at the end of Q2 2021. In addition, ILPT owns 226 properties and 16.7 million square feet in Oahu, Hawaii.
These properties generate about 50% of annual revenue. The remainder of the revenue comes from 65 properties with 18.5 million square feet in the US mainland.
ILPT is a relatively young company and has only been publicly traded since 2018. Therefore, this young REIT has not been around as long as the other two best REITs on this list. However, ILPT has a 99% occupancy rate and stable and growing rents in Hawaii. The REITs two largest customers are Amazon and FedEx, contributing more than 14% of rental revenue.
ILPT pays an annual dividend rate of $1.32 per share. The forward dividend yield is 4.72%. The trust is estimated to generate FFO per share of $1.89 in 2021, giving a payout ratio of roughly 70%, which is acceptable and below my target value.
ILPT’s balance sheet is conservative. It has only $889 million in total debt. The debt-to-capitalization ratio is about 47%. Interest coverage is good at about 3.8X based on FFO meeting our criteria.
Final Thoughts on Best REITs to Buy
REITs can be an asset that many investors can add to their portfolios. They tend to have higher dividend yields than common stocks and generate decent total returns. However, REITs have a different tax treatment than common stocks that investors should understand. We can add other REITs to this list of best REITs, but the three discussed above are a starting point.
Disclaimer: The author is not a licensed or registered investment adviser or broker/dealer. He is not providing you with individual investment advice. Please consult with a licensed investment professional before you invest your money.