By Philip van Doorn
Real estate investment trusts are typically considered by investors who are looking for dividend income.
In the COVID-19 pandemic environment, some REITs have been forced to cut their dividend payouts considerably, because their investments are concentrated in affected industries, especially hotels, multifamily properties, nursing homes and health-related facilities.
To follow up our recent screens of dividend stocks , below is a screening and scoring methodology for REITs. It incorporates a potential scoring framework used as an example by Frank Haggerty, a senior portfolio manager at Duff & Phelps Investment Management in Chicago. Haggerty didn’t make any recommendations for specific REITs for investment.
Haggerty co-manages the Virtus Duff & Phelps Real Estate Securities Fund /zigman2/quotes/202863038/realtime PHRIX -0.41% , which is rated three stars (out of five) by Morningstar, the Virtus Duff & Phelps Global Real Estate Securities Fund /zigman2/quotes/200381804/realtime VGISX -0.93% (five stars) and the Virtus Duff & Phelps International Real Estate Securities Fund /zigman2/quotes/205218223/realtime PXRIX -1.69% (four stars).
During an interview, Haggerty stressed the importance of doing your own research if you are going to invest in individual REIT stocks. He suggested several items that can be of use in an initial screen of the group, but stressed that this is only a starting point.
After narrowing down the REITs, you need to learn about each company’s investment concentration and how it has been faring in the pandemic environment. The real-estate sector of the S&P 500 Index /zigman2/quotes/210599714/realtime SPX -0.88% is down 8.5% this year, excluding dividends, according to FactSet. That may be surprisingly good performance — after all, entire industries of rent-paying businesses have been on the ropes, and millions of people are having difficulty paying their rents.
Even with so many people now working from home as offices stand empty, “collection rates remain very high” for office leaseholders, according to Haggerty — even into the high 90s percentage range this year.
Michael Cuggino, president of the Permanent Portfolio Family of Funds in San Francisco, agrees that collection rates for high-quality office rents have been “a pleasant surprise” since REIT stocks took a beating in March, before the stock market staged a broad recovery rally.
In an interview, Cuggino said the REIT sector as a whole has held up “pretty well,” but that there are “real risks” for the long term, including “right-sizing behavior,” which is likely to continue after the pandemic.
“San Francisco is starting to see a decline — office more than retail,” he said. “You are starting to see vacancies go up and sublet space available, because tech companies are telling people they do not have to come back until 2021, or they may even move elsewhere and never come back” to the office, he said.
Cuggino said investors need to look very closely at REITs’ property locations and try to answer a number of questions: How will companies operate after the pandemic? He doesn’t expect “the death of the downtown office.”
Haggerty said something similar: “We are not in the camp predicting the office is dead. We would not put it in the category that retail has been in, the past five years.”
For residential properties, Cuggino recommends investors consider: How difficult are rent vs. buying decisions in that area? How high is the cost of living? Might that be more of a factor, outweighing the desirability of living there, than it was before the pandemic?
“Anything challenged because of COVID-19’s impact on the economy has been thrown into the value camp or value-trap territory,” Haggerty said.
In our previous stock screens, which didn’t include REITs, we compared current dividend yields to expected free cash flow or earnings (for financial companies) to see if there was “headroom” for additional dividend increases or other uses of excess cash flow that might benefit shareholders.
For REITs, Haggerty suggested using consensus estimates for adjusted funds from operations (FFO). In the REIT industry, FFO adds depreciation and amortization back to earnings, while subtracting gains on the sale of property. Adjusted FFO (AFFO) nets out expected capital expenditures to maintain the quality of property investments. REITs can be ranked by the ratio of estimated AFFO to estimated dividend payouts.
Haggerty suggested looking at REITs’ dividend growth, saying: “If a company has increased its dividend in 2020, it would potentially be a positive signal for the health of the business.” In the scoring below, we actually used consensus estimates for 2020 and 2021 dividends per share to rank companies by expected dividend growth in 2021. But the top ranked companies listed below all are expected by analysts to pay higher dividends in 2020 than they did in 2019.
The third factor Haggerty suggested measuring is leverage. By their nature, REITs tend to have higher leverage than companies in many other industries. The REITs were ranked by their ratios of current debt, as of the most recently reported quarter ends (through Nov. 2), by 2021 consensus estimates for earnings before interest, depreciation, taxes and amortization (EBITDA).
Our screen began with the 112 REITs that are included in the S&P 1500 Composite Index. The composite index itself is made up of the S&P 500, the S&P Mid Cap 400 Index /zigman2/quotes/219506813/composite MID -0.74% and the S&P Small Cap 600 Index /zigman2/quotes/210599868/delayed SML -0.39% . Then we made the following cuts:
For all three rankings, lower scores were better. We then summed the three scores for each REIT. Combined scores ranged from 16 to 201.
Here are the 15 REITs with the best (lowest) scores. There are two tables of data for the same group of companies. You will need to scroll the tables to see all the data. (Dividend yields and 2020 stock performance are in the second table.)
Here’s the second table with current yields, 2020 stock returns and summaries of sell-side analysts’ opinions:
Some of the best-performing REITs among our high scorers have rather low yields. These include names in growth industries, such as Equinix /zigman2/quotes/208927761/composite EQIX +1.16% , which is focused on datacenters and digital infrastructure; Prologis /zigman2/quotes/200785374/composite PLD -0.56% , which owns and operates logistics and distribution centers; and SBA Communications /zigman2/quotes/208397406/composite SBAC +0.89% , which owns cellular towers.
Then again, the best performer this year among the listed REITs has been Innovative Industrial Properties /zigman2/quotes/208038978/composite IIPR -0.70% , which owns regulated medical-use cannabis facilities. It has a dividend yield of 3.45%. That’s attractive when considering the company’s growth potential and the low yield of about 0.78% for 10-year U.S. Treasury notes /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +0.89% .