Why You Should Retire on REIT's

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

Perhaps one of the most discouraging maxims, which stock market investors ever hear, goes like this, “The price of a stock reflects all of the information available to market participants.”  The implication is that you cannot outsmart the market.  Whether or not we actually subscribe to this defeatist philosophy, let us entertain it.  We will explore how we can still beat the market when we apply fundamental valuation principles to one of the market’s most fascinating stock types, real-estate investment trusts (REIT’s).

Some of the traits unique to both traditional REIT’s and mortgage-REIT’s are their immunity to taxation at the corporate level and the massive dividends that they yield.  Tax law stipulates that so long as these companies pay investors a whopping 90% of their GAAP net income to investors, these companies need not pay any corporate income tax to the federal government. 

The idea behind this 90% rule is to ensure that Uncle Sam can extract at least some tax revenue out of investors’ dividend income.

So what does this mean to you?

Let’s go back to our stuffy philosophers, who would maintain that the stock-prices reflect all information available and that the stock market is void of opportunity for the average investor.  These same individuals would likely agree that the fundamental value of any asset would be equal to the sum of the present values of all future free cash flows that the asset is expected to generate.

Since REIT’s pay out such hefty dividends (90% of their earnings) we can conceptualize REIT stocks as instruments which yield a stream of cash dividend payments over time.  Ordinary dividends are taxed similarly to income.  In the highest bracket, dividends are currently taxed at 35%.  This tax rate will likely jump to 39.6% in 2013.

In valuing these stocks, since dividend payments make up such a large portion of each REIT’s free cash flow, investors must take into account the rate at which their dividends will be taxed.  Take as a conceptual example, Pennsylvania R.E.I.T. (NYSE: PEI) At a 35% tax rate, assume for a moment, that it will be able to yield its current $0.64 annual dividend indefinitely into the future.  If we assume a 2.5% cost of capital, the after tax present value of all future $0.64 dividend payments would be $16.64 (pretty close to the PEI ticker price today)  However, if none of these payments were to be taxed at a 35% rate, their present value would total $25.60.

Simply put, when held by a long term investor, dividend payments are worth 54% more in tax exempt accounts than they are worth in other accounts.  For stocks, such as REIT’s, where dividend payments make up the lion’s share of free cash flows, this represents a lot of value.  Please note that this 54% increase for tax exempt accounts is independent of assumptions made for the dollar amount of future dividend payments and the cost of capital assumption.  It is universal.

So the investor who believes that there is no beating the intelligence of the market, can indeed beat the market.  Stocks, which are likely valued by the crowd, assuming taxation, need not be taxed at all. 

Now the typical disclaimer must follow:  “I am not a tax advisor, please consult your accountant or tax professional before making any investment decisions, et cetera, et cetera.”  However, the conclusion to be drawn here is straightforward.  Investment in REIT stocks, which are taxed not at the corporate level, but at the individual investor level, is more lucrative in environments which are tax exempt.  REIT’s should be worth more to the Roth IRA investor and the 529 college savings plan investor than they should be worth to other investors whose dividends will be exposed to taxation.

Note also that this advantage is barely noticeable in the stocks of companies from other industries.  It is most pronounced in REIT’s and mortgage-REIT’s, which are compelled by the tax code to distribute large dividends. 

So, while scouring for stocks entertaining the dual suppositions that an asset’s price reflects all available information and that there are real benefits to holding high dividend dolling REIT’s in tax exempt accounts, where do we turn? 

Look through this lens, on the Motley Fool Stock Screener.  There you will find the clear winners.  There we find a company that is a CAPS favorite and yields a tidy 16.0% dividend.

Apollo Residential Mortgage (NYSE: AMTG)  So how does one sustain a 16% dividend payment by investing in mortgages?  Aren’t mortgage rates pretty low?  It is important that we understand the business model. 

At a high level, Apollo carries a blended portfolio of $2.64 billion in Agency (think Fannie Mae) Residential Mortgage Backed Securities (RMBS) and $368 million in non-Agency RMBS. 

As with many other firms in the industry, AMTG uses significant leverage to squeeze returns out of conforming mortgage products.  In its 2Q 2012 investor report, Apollo indicated that the assets in its Agency portfolio produced a very typical but meager 2.2% spread.  However, Apollo employed a 6.3x debt-to-equity ratio in order to boost returns.

Apollo exercises less leverage (2.7x debt-to-equity ratio) in its non-Agency assets.  Non-Agency mortgages are simply loans, which do not conform to the requirements of Freddie Mac, Ginnie or Fannie Mae.  These are the “creative” mortgages and are usually the subprime mortgages.  In its 2Q 2012 investor report, Apollo attributed a 641 average FICO score to its non-Agency assets. 

It has been said that subprime borrowers “are always in a recession” and so these assets must naturally be priced attractively for investors.  While Apollo uses less leverage on this portfolio, these assets carry with them a healthy 6.4% interest rate spread.

Being leveraged, Apollo aims to maintain a ~10% cash position in order to protect against potential margin calls by its debt financiers.

Enjoy searching through the stock screener and please leave a comment if you are able to find any other stocks or asset classes, which are able to benefit from this long term approach. 

Fool contributor, John Monaghan, does not own shares in any of the companies mentioned in this entry. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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