REIT Investment Opportunities Continue to Become More Diverse

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Traditionally, companies that own office buildings, shopping malls, and apartment complexes have been the most likely to be structured as real estate investment trusts (or “REITs”). However, there has been a trend in recent years for a much broader range of companies to make the conversion to a REIT structure. This conversion process has been so widespread that the IRS has begun to ramp up scrutiny of the application of the definition of “real estate” as applied to the rules for REITs.

REITs have huge benefits for shareholders

REITs offer a compelling investment option for several reasons. The REIT structure exempts qualifying companies from income tax. This lack of taxation leaves more money to be returned to shareholders. To this end, REITs are also required to distribute at least 90% of their taxable income to shareholders; as a result of this requirement, REITs are often among the highest yielding stocks available.

REITs can beat the market whether they are growing trees or operating high technology businesses

Even during the recent bull market, REITs have demonstrated an ability to translate the tax advantages noted above into market-beating returns as noted in the following chart.

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Vanguard's REIT Index ETF (NYSEMKT: VNQ) has almost doubled the performance of the S&P 500 over the past five years. Interestingly, this outperformance is attributable to a wide range of REITs. 

Timber REITs such as Weyerhaeuser (NYSE: WY) and Plumb Creek Timber (NYSE: PCL) have surged thanks in large part to growing demand generated by the early stages of a recovery in housing. On the opposite end of the spectrum, data center operator Digital Realty Trust (NYSE: DLR) and wireless tower operator American Tower (NYSE: AMT) have participated in industry trends towards wireless data and cloud computing with great success.

It should be noted that Digital Realty Trust's data center operations are comparable to those of Equinix, a company that recently received IRS scrutiny in its attempt to gain REIT status; as a result, it will be important to monitor any developments regarding whether data center operators like Digital Realty Trust will have any risk of losing REIT status based on the IRS review of Equinix.

Even after a strong run, yields remain higher than most of the market

While the relentless search for yield has driven REIT share prices upward in the recent low interest rate environment, REITs still provide above-average yields as noted in the chart below:

<table> <thead> <tr><th> </th><th>VNQ</th><th>WY</th><th>PCL</th><th>DLR</th><th>AMT</th></tr> </thead> <tbody> <tr> <td>CAPS rating (out of 5 stars)</td> <td>3 stars</td> <td>4 stars</td> <td>3 stars</td> <td>2 stars</td> <td>4 stars</td> </tr> <tr> <td>Share price</td> <td>$68.57</td> <td>$28.10</td> <td>$46.12</td> <td>$60.00</td> <td>$72.01</td> </tr> <tr> <td>Market capitalization (in billions)</td> <td>$17.7</td> <td>$15.4</td> <td>$7.5</td> <td>$7.7</td> <td>$28.5</td> </tr> <tr> <td>Dividend yield</td> <td>3.6%</td> <td>2.8%</td> <td>3.8%</td> <td>5.1%</td> <td>1.5%</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td colspan="6">Source: Motley Fool CAPS - July 1, 2013     </td> </tr> </tbody> </table>

Despite the yields on REITs remaining higher than the average for the S&P 500 (currently 2.1%), shares of each of these stocks (and the Index ETF) have experienced a pullback as interest rates have started to climb. There will likely be further pressure on REITs and other higher yield investments as yield-hungry investors begin to have more options for investment at comparable yields.

Like any other stock, buy a REIT based on the strength of the business

Given the potential sensitivity of REIT prices to interest rate fluctuations, it is important to follow the same discipline in picking a REIT as would be applied to any other stock. This involves a thorough understanding of the business and development and refinement of a long-term investment thesis. If these criteria are satisfied AND the company benefits from the favorable taxation of a REIT structure, that's even better!

With that in mind, one of the companies in the list above stands out from the competition: American Tower. The company operates over 55,000 towers, more than half of which are international. Despite this huge number, American Tower only operates in 10 countries outside of the United States. Room for international expansion combined with the explosion in demand for wireless services thanks to the smartphone revolution has management expecting approximately 2,500 new communication sites to be constructed in 2013

With such a solid growth story still ahead, analysts expect 27% annual growth from American Tower over the next five years. This growth, combined with the recent 15% pullback thanks to the broader retreat of REITs in the face of rising interest rates, has presented an excellent opportunity to invest in this long term winner. There is little reason to doubt that American Tower will continue to build its competitive advantage thanks to scale and prudent management.

Despite this opportunity, the stock may not be done being dragged down by the broad interest rate pressure, so it is advisable to accumulate shares over time as good value points present themselves. Regardless of short-term volatility, American Tower has a tremendous business that is made even more attractive to investors because of its REIT status. To back this bullish conclusion, I will open a CAPScall that American Tower will outperform the market.

Not sure which REIT to pick? An ETF is not a bad option

I personally prefer choosing individual stocks as opposed to ETFs whenever possible. However, the Vanguard Index ETF is a solid choice for investors looking for a combination of high yield and exposure to real estate. Aside from a broad mix of over 100 REITs in various sectors that provides instant diversification, the ETF boasts a solid performance history and a minuscule 0.1% expense ratio. 

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Brian Shaw has no position in any stocks mentioned. The Motley Fool recommends American Tower and Equinix. The Motley Fool owns shares of American Tower . Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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