Why Retail and Data REITs Are a Buy

Larry is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Editor's Note: The initial post incorrectly stated that DLR had not raised their dividend payout in several years. This is incorrect, this version has been corrected.

Now is the time to buy real estate investment trusts, especially in growing sectors like Internet data centers and recovering ones like retail.

The income-starved investor needs help amid low rates and cannot take a lot of risk. With U.S. Treasury bonds returning record lows, REITs have done pretty well this year.

Total returns, according to the FTSE NAREIT All-Equity REIT index, are up 17.3% this year for the trusts, which mainly own property and pass 90% of earnings to dividends to investors. The average equity REIT dividend yield is 3.4%, a third higher than that of the Standard & Poor’s 500 stock index.

But since September, REITs retracted slightly in price as Washington wrangles over the fiscal cliff, threatening to increase taxes on dividends. The fear that taxes will return to 20% or higher has put REITs prices under pressure, and this feels like an opportunity for the yield-hungry investor.  

There are many REITs to choose from that slice different pieces of the real estate market pie. However, there are three that that I like that not only pay very nice dividend yields but have sustainability and a promise of future growth.

Two of them are in the shopping mall area. This sector suffered during and after the recession, but vacancies are falling and rents rising again. In the third quarter, research firm Reis found that fell to 8.7% from 8.9% in the previous period. It helps that not a lot of new malls are opening. Rents rose 0.3%, marking the fifth consecutive quarter of growth. Mall REITs have done very well in the stock market this year, as a result.

Simon Properties (NYSE: SPG) owns and operates regional malls, outlets and shopping centers in 41 states. It is one of the largest REITs with a market capitalization of $47 billion. Though the 2.9% dividend yield is not nearly as high as the REIT average, the company is growing its sales in the low teens and has excellent profitability metrics.

The cash flow from operations – rising 17.3% to $2.3 billion over the trailing 12 months, which equates to $7.81 per share – is very high so it can increase dividends and have done so seven times since 2010. It also bodes well that management owns over 10% of the stock outstanding. They have skin in the game since a chunk of their net worth is tied to the success of the firm.  

Realty Income (NYSE: O) buys retail properties leased to regional and national retail chain operators in 49 states. This company is much smaller than Simon Properties at $5.3 billion in market cap. One attractive feature of this REIT is that it pays a much bigger dividend at 4.5%.

Like Simon, it is growing at double-digit rates and doing it with less debt. But their financial health, especially cash flow, is not as strong, $309 million over the trailing 12 months, which translates to $2.32 per share. Still, they have been around for many years and survived the recent financial crisis without a dip in earnings. In fact, earnings have steadily increased consistently over the years.

Digital Realty (NYSE: DLR) is more focused, in that they own and manage technology-related real estate in the U.S., Europe and Asia. This company specializes in Internet data centers that hold the servers that store websites and user data such as email and photos. Research firm International Data Group says the amount of digital information more than doubles every two years. That means ever more data centers are needed all the time, and more demand for data centers.

This REIT carries a market cap of $8 billion. Their dividend yield is 4.5%, with strong cash flow ($477 million, or $4.30 per share) and better consistency of earnings over the years than either Simon Properties or Realty Income.

The company pays a nice dividend rate of 4.4%, and raised it each year recently. They have used their growth in profits to buy properties.

REITS have to pay out 90% of their income in dividends, so as profits rise, dividends generally will, too. However, with property values depressed in recent years, many property REITs have been buying assets. This may suppress payouts in the short term but make for excellent long-term investments. Retirees desperately looking for income should carefully consider the risks as REITs can be volatile in price. But for the patient investor their earnings and dividends, especially for these three have been consistent even in poor economic times.  

Steve Peasley is president of KPP Financial, Inc. in Dana Point, Calif. KPP Financial, Inc. owns DLR and SPG in many of their managed accounts.

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