Will the Fed Taper Doom These REITs?

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Talks of the Fed taper, in which our central bank winds down its long-held practice of monthly bond purchases designed to stimulate the economy, have caused the markets to whipsaw over the past couple of months.

The stocks receiving the brunt of the carnage have widely come from the market’s higher-yielding sectors. One such sector getting hit hard is real estate investment trusts, or REITs.

However, the industry fundamentals remain strong. Should investors succumb to the fear of Fed tapering and rush for the exits? Or are fears overblown?

Taper talk delivers a body blow
Due to fears of the Fed tapering off its bond-buying, high-yielding instruments like REITs have trended down sharply over the past few months, since their yields would need to rise in conjunction with higher rates.

In addition, companies reliant on debt financing, such as REITs, would see increases in their interest expenses going forward.

That's spelled trouble for REIT investors. For example, Realty Income (NYSE: O) has seen its shares drop from $55 per share in May to its current level of $42 per share. That means Realty Income has lost nearly a quarter of its value in the last three months.

This is especially confusing, considering Realty is usually bought for its dependable dividends, which certainly haven’t turned against investors. Consider that Realty Income has paid 517 consecutive monthly dividends. That’s a span of more than 43 years.

A similar story has played out for Digital Realty Trust (NYSE: DLR), a REIT that invests in data centers and other properties catering to the technology industry.

Digital Realty has sunk from nearly $80 per share exactly one year ago to $53 per share today, despite maintaining a strong track record of rewarding shareholders.

Earlier this year, Digital Realty increased its dividend by 6.8%, marking the eleventh increase since the company first went public in 2004. Impressively, the company has increased its payout by 15.3% compounded annually since its first full quarter of operations following the IPO.

Another interesting REIT development is the dramatic drop seen in shares of healthcare property operator HCP (NYSE: HCP), which manages senior housing properties, hospitals, and skilled nursing facilities.

An aging population in the U.S. and the healthcare industry as a whole on the precipice of greater demand should buoy the outlook for a company like HCP.

That hasn’t stopped HCP shares from collapsing 27% in just three months, despite the fact that HCP has increased its dividend per share for 28 consecutive years and is the only REIT included in the S&P 500 Dividend Aristocrats index.

Get to know FFO
Since REITs have a different tax status than traditional corporations, non-GAAP measures are better indicators of a REIT’s true performance. One of these is funds from operations (FFO), which is the non-GAAP equivalent of earnings per share.

It’s plain to see that fundamentally, these REITs have performed quite well in recent periods.

Realty Income recently posted record quarterly and first-half operating results. The company posted 22% and 21% FFO growth over the second quarter and first six months of 2013, respectively.

Now, Realty Income trades for 20 times its 2012 adjusted funds from operation and 17 times its expected 2013 FFO.

Realty Income isn’t a screaming bargain, but at the same time, investors likely own the stock for its dividend, which is now a healthy 5.2% annualized, in addition to its great track record of dividend growth.

Meanwhile, Digital Realty’s funds from operations grew 12% in the second quarter of 2013 and 10% in the first six months, year over year. Moreover, the company recently raised its full-year FFO guidance. Digital Realty now expects 6.5% growth in 2013 FFO.

At a recent price of $54 per share, Digital Realty trades for 12 times 2012 FFO and just 11 times its full-year 2013 FFO expectations.

And HCP continues to fall even though it posted 9% growth in FFO over the first six months of the year.

Even better, HCP upped its full-year 2013 FFO expectations to a minimum of $2.96 per share, which would represent 9% growth year over year.

At its current level, HCP exchanges hands for 15 times 2012 FFO and 13 times full-year 2013 FFO projections, certainly a reasonable valuation profile for a well-run 5% yielder.

Stick with these high-quality REITs
Investors likely bought REITs like these for their steady income. These stocks pay yields which handily beat the approximately 2% yield on the S&P 500 Index.

Higher interest rates do present a measurable headwind for a high-yielding sector such as REITs.

That being said, yields on traditional savings products like certificates of deposits and money market funds are still paltry at best. These solid REITs already pay handsome yields, and will even increase their dividends every year.

While further share price depreciation is an entirely plausible scenario, these REITs are growing FFO, and consequently, their dividends.

Although valuation multiples may compress further, there's no reason to fear the real underlying health of these REITs. As a result, these three REITs remain strong and should be held with confidence.

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Robert Ciura owns shares of Digital Realty Trust. The Motley Fool has no position in any of the stocks mentioned. 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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