Searching for Attractively Valued Real Estate Investment Trusts

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

It’s a frustrating time to be an income investor. The combination of historically low interest rates and rising equity markets has brought yields down significantly in recent months.

One asset class that has received extra attention over the past couple years, because of their tendency to provide solid income above and beyond the yield available on the S&P 500, is real estate investment trusts (REITs). These companies invest in real estate properties, and can offer such attractive yields because they are required to distribute 90% of their income to shareholders as part of their favorable tax structures.

Securing market-beating dividend yields from REITs is easy. However, finding REITs that not only provide compelling income, but also trade at attractive valuations, is much harder nowadays. Are there any cheap REITs left out there?

Many REITs seem fully valued

At first glance, a REIT that pays a dividend on a monthly basis would seem like an income investor’s dream. In fact, this company calls itself "The Monthly Dividend Company" to emphasize its shareholder-friendliness. I’m referring to Realty Income (NYSE: O), one of the most well-known publicly traded REITs. Realty Income generates profits through its ownership of more than 2,800 properties that it leases to commercial entities, mostly retail chain store operators.

Another REIT investors are likely familiar with is Health Care REIT (NYSE: HCN), which, as you can probably infer, manages health-care related properties including hospitals, senior living communities, life science facilities, and medical office buildings.

Let funds from operations (FFO) be your guide

Earlier this year Health Care REIT reported full-year funds from operations (FFO) -- a metric similar to net income that is used to analyze the true operating performance of real estate investment trusts -- of $3.52 per diluted share. This represents an increase of only 3% versus the prior year.

In addition, the company’s 2013 forecast calls for funds from operations of between $3.70 per share and $3.80 per share, meaning Health Care REIT now trades for trailing and forward price-to-FFO ratios of 22 and 21 times, respectively.

Meanwhile, Realty Income performed less impressively in 2012, with normalized FFO per share increasing just 2% year over year to $2.02 per share, and looking forward, the company expects 2013 normalized FFO per share to fall between $2.32 per share and $2.38 per share. In total, Realty Income trades for a whopping 27 times its 2012 FFO and 23 times its forward FFO.

One cheaper REIT for your watch list

Thankfully, not all REITs trade as expensively as Realty Income and Health Care REIT. Digital Realty Trust (NYSE: DLR) is an $8 billion REIT that operates technology-related real estate properties.

Digital Realty recorded $4.44 in funds from operations in 2012, a 9.4% increase from the year prior. That means that new investors are paying roughly 14 times last year’s FFO, a much more reasonable price to pay for a REIT that actually has better growth than many other REITs.

The bottom line

If you’re absolutely starved for current income, you could certainly do worse than Health Care REIT, or Realty Income. If, on the other hand, you take the pursuit of value stocks seriously, you might find a little to be desired with regard to these REITs.

It’s worth noting that Realty Income recently provided investors a nearly 20% increase. That being said, Realty Income’s share price has increased so much that the stock’s current yield is now under 4% annualized—not exactly compelling enough for a REIT. Ditto for Health Care REIT—it yields less than 4% at recent prices.

Digital Realty, on the other hand, still provides a hefty dividend yield thanks to a stock price that hasn’t skyrocketed like many of its peers. The company recently raised its dividend and yields nearly 5% at recent prices.

While all three stocks will provide dependable income for years to come, I prefer to invest with a more meaningful margin of safety. As a result, I would wait for a pullback before jumping in to Realty Income or Health Care REIT. Digital Realty Trust, on the other hand, looks much more attractively priced and offers a significantly higher yield.

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Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends Health Care REIT. 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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