Too many investors these days own mega-cap tech stocks like Apple (AAPL) or Amazon (AMZN). These stocks are excellent investments, but you may not be adequately diversified if you own too much. As the old saying goes, don't put all your eggs in one basket.
Hence, it would help to look at other investment classes like bonds, cash, and real estate investment trusts (REITs). REITs are different than stocks, more on that below. However, they are slightly correlated with stocks. Keeping that in mind, let’s examine some of the best REITs to diversify your investment portfolio.
Basics About REITs?
The first step in investing is to learn about it. REITs are popular with some investors, but many investors may not know about them.
Shares of REITs are publicly traded on stock exchanges, like common stocks. However, they are not C-Corporations; instead, REITs are organized as trusts. Hence, investors in REITs own units as opposed to shares. Besides structure, there are other differences between REITs and stocks, including dividends and taxation.
For a corporation to qualify as a REIT, it must own real estate or finance real estate that produces income. In addition, corporations choosing to organize as a REIT must meet specific requirements. Chief among these requirements is that 90% of taxable income must be paid to unitholders as dividends. Hence, there are tax implications for investors owning REITs.
Specifically, according to Investopedia, a REIT is required to
- Invest more than 75% of total assets in real estate, cash, or US Treasuries
- Derive more than 75% of gross income from rents, interest on mortgages that finance real property, or real estate sales
- Pay a minimum of 90% of taxable income to shareholders as dividends each year
- Be an organization that is 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
Who Should Invest in REITs?
REITs permit retail investors to own a piece of commercial real estate, which most cannot do on their own. Hence, they are suitable for investors seeking to own commercial real estate but do not have the capital to own it directly. In addition, REITs are ideal for investors seeking higher dividend yields.
Pros and Cons of REITs
Many, but not all, REITs have a higher dividend yield than common stocks. For example, the average dividend yield of the S&P 500 Index is about 1.4% now, near its all-time low. On the other hand, the FTSE Nareit All REITs Index has more than double the dividend yield of the S&P 500 Index at ~3.13%.
Many popular REITs have even higher dividend yields. For instance, Realty Income Corporation (O) has a forward dividend yield of 4.11%. Some mortgage REITs have even higher dividend yields but with somewhat higher risks.
Diversification is another advantage of REITs. According to Morningstar, REITs are mildly correlated with US stocks looking at data between 2000 and 2018. However, they tend to move upward like US stocks. Moreover, REITs have a long track record for decades, with total returns outperforming stocks over specific periods.
REITs pay distributions to their unitholders divided into a regular income, return of capital, and capital gains. REITs are pass-through entities and do not pay federal incomes taxes. Hence, the income REITs pay as distributions (dividends) to investors is taxed at the higher regular income tax rate as opposed to the qualified dividend tax rate.
Depending on your tax bracket, the difference between qualified and regular income dividend tax rates can be significant. The difference between the two rates becomes more significant as your income rises. For example, for a married couple filing jointly with an income of $80,000, the standard income tax rate is 12%, and the qualified dividend tax rate is 0%.
Like commons stocks, REITs face market risks and regular business risks. Because they must pass through 90% of their income to investors, REITs usually use debit and equity raises to fund capital investments. This point causes REITs to be sensitive to income fluctuations and recessions, for example, during the sub-prime mortgage crisis and the COVID-19 pandemic downturn, a meaningful percentage of REITS cut or omitted their dividends, although many were eventually reinstated.
Best REITs to Diversify Your Investment Portfolio
Realty Income Corporation
The first REIT on our list is Realty Income Corporation (O), which was founded in 1969. The trust is known for its monthly dividend payments and increases. In addition, the stock is a Dividend Aristocrat, meaning it has raised the dividend for at least 25+ years in a row. Total revenue was ~$2,065 million in 2021.
Realty Income owns more than 11,000 commercial retail properties after acquiring Vereit. These are primarily standalone properties in all 50 states, Puerto Rico, the United Kingdom, and Spain. There are 1,030+ clients in 60 industries. Clients include governments, healthcare, movie theaters, restaurants, fitness centers, and retailers. The top three clients are Walgreens Boots Alliance (WBA), Dollar General (DG), and 7-11, with 13.1% of space.
Realty Incomes pays an annual dividend rate of $2.96 per share, giving a forward dividend yield of 4.13%. Consensus estimates from analysts are $3.96 FFO per share in 2022. Hence, the payout ratio is about 75%, a decent value for REITs.
Realty Income has an A-/A3 upper-medium investment-grade credit rating from S&P Global and Moody's, adding to the dividend safety. In addition, the trust has an investment-grade balance sheet. In addition, Realty Income did not cut its dividend during the last two recessions.
Medical Properties Trust
The next REIT on our list of best REITs is Medical Properties Trust (MPW), a healthcare REIT. The trust was founded in 2003 to purchase and own hospitals. Few other REITs offer this type of exposure to investors, so it provides diversification. Total revenue was about $1,573 million in 2021.
Today, MPW is one of the largest owners of hospitals globally. It has acquired more than $12 billion worth of properties in the US and nine other countries. MPW owns a total of 438 properties and ~46,000 licensed beds. Clients include general acute care hospitals, behavioral health facilities, inpatient rehabilitation hospitals, long-term acute care hospitals, free-standing ERs, and urgent care facilities. Most of the leases tend to be long-term averaging 17.7 years.
The trust pays a forward dividend of $1.16 per share, giving a dividend yield of 5.71%. Analysts estimate MPW will have an FFO of $1.87 per share in 2022, providing a payout ratio of approximately 62%. This value is conservative.
MPW has a BBB- lower-medium investment-grade credit rating from S&P Global, but only a Ba1 rating from Moody’s, meaning the financial position is riskier. However, the dividend has been raised for nine years even during the challenges of the pandemic, suggesting the trust has the financial strength to pay the dividend during difficult times.
Adding further diversification to our REIT portfolio takes us to Public Storage (PSA). The REIT was founded in 1972 to acquire, develop, own, and operate self-storage facilities. Today, the trust is the market leader in the US and has the No. 1 position in 14 out of the 15 top markets where it operates. Los Angeles, San Francisco, and New York are the top three markets. Total revenue was around $3,204 million in 2021.
PSA has a tremendous scale. It owns or operates more than 2,600 facilities in 39 states with 182 million of rentable square feet and 1.6 million customers. The brand has excellent customer awareness too. Yet, despite the already enormous scale, only about 9% of the US population uses a self-storage facility indicating many more years of growth ahead.
The dividend rate is $8.00 per share, giving a forward dividend yield of 1.97%. This value is on the lower end for REITs, mainly due to the run-up in stock price during the pandemic. Analysts expect an FFO of $15.37 per share in 2022. These numbers give a payout ratio of approximately 52%, a conservative value.
PSA has one of the most robust balance sheets of any REIT. It has an A/A2 upper-medium investment-grade credit rating from S&P Global and Moody's. This solid credit rating provides confidence in dividend safety.
Final Thoughts on Best REITs to Diversify Your Investment Portfolio
REITs are an asset class most investors should consider. They constitute a significant part of the stock market. REITs have a total market capitalization of more than $1.6 trillion. Collectively, publicly-traded REITs own 500,000+ properties worth more than $2.5 trillion. This size means REITs should be on every retail investor's radar, especially those seeking income.
Many investors may own REITs through their retirement plans since companies like PSA are in the S&P 500 Index and are likely owned by index funds. However, fewer investors own REITs directly. We have discussed several pros and cons of owning REITs, but generally, the pros outweigh the cons. For example, REITs can provide higher dividend yields than common stocks, excellent total returns, and diversification.
REITs are only slightly correlated to stocks; however, they are still subject to market fluctuations and risks. This point means investors should seek quality. We listed three quality REITs to consider above.
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This article was produced by Wealth of Geeks.
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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.
Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor and blogger on dividend growth stocks and financial independence. Some of his writings can be found on Seeking Alpha, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, Entrepreneur, FXMag, and leading financial blogs. He also works as a part-time freelance equity analyst with a leading newsletter on dividend stocks. He was recently in the top 1.5% (126 out of over 8,212) of financial bloggers as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.