EC Screening To Shield REIT Yield Hogs From The Butcher’s Knife

Income investors know all too well, especially in today’s still-stingy environment, that high yields typically come with high, often too-high as it turns out, risks. But there are “inefficiencies” to be found, especially with Real Estate Investment Trusts (REITs), where Mr. Market often waffles between seeing stock-like securities or ownership interests in real estate. This opens up opportunities for venturesome income-seekers to find unexpectedly high yields on unexpectedly good-quality REITs.

They Look Like Stocks

REIT units are often confused for common stock. That’s not surprising since they trade in the same marketplace the same way using the same brokers using a familiar ticker protocol, order entry protocols, conformations, etc. The  entities also report financials the same way. 

But They Aren’t Stocks

The T in REIT strands for Trust. For most purposes, the difference between a publicly-traded investment trust and corporation is confined to obtuse legalese about which we needn’t worry, except that there is one thing we can’t ignore: Trusts are not taxed the way corporations are. Unlike a corporation, a bona fide REIT (i.e. one that is operating as a REIT should) pays no taxes and distributes substantially all of its profits to the unit holders (shareholders) as dividends. 

This, of course, has no impact on yield; that’s determined by how Mr. Market chooses to price the units. But typically, they are priced such as to make for higher yields than is typically seen on corporate stocks of comparable business risk. There are several reasons for this.

• Because REITs are, in effect, paying dividends from the equivalent of pretax earnings (as opposed to corporations, which can only distribute after-tax earnings), REIT dividends are more generous (a target 100% payout ratio will do that)  and are taxed as ordinary income, rather than at lower rates accorded to what the I.R.S. deems “qualified” dividends.
• Because REITs have to pay out all of their income as dividends, the notion of internal growth (growing by reinvesting profits) does not exist, as it does for corporations. To grow, a REIT must obtain new debt and/or equity capital. The only thing it can do without external financing is trade its portfolio of properties with the idea of selling slow growers and replacing them with more promising properties.
• Because internal growth is not part of the picture here, an important motivation that causes investors to tolerate low or non-existent yields is absent. Low growth is the other reason (besides high risk) why a yield might be higher.
• Because REITs can’t retain earnings, there is no rainy-day stockpile that can be tapped in down years, meaning that dividend fluctuations are more likely than with corporate dividends. Lower dividend security, even for good quality REITs, also tends to push yields higher. (In other words if REIT A and Corporation B have identical levels of business risk, A’s dividend will be less secure simply because it has no surplus that can be used to fund the dividend in down years; on the other hand, shareholders get 100% of what A has but a small percentage of what B has because the IRS and the Board’s desire to retrain earnings come ahead of shareholders).

So REITs are of interest for income seekers who aren’t bothered by the ordinary income tax status of the dividends, either because the units are held in non-currently-taxable accounts or because the owner’s tax bracket is such as to allow for better after-tax returns even after factoring in the non-qualification.

Hence REITs Should Be Evaluated Differently 

The absence of internally-funded growth and the mandatory pass-through of profits to shareholders strengthens the relationship between the shareholder (for convenience, I’ll use the language of stocks) and the business itself. It’s said by some in the guru-sphere that investors should think of themselves as owning stakes in real businesses rather than pieces of paper (or nowadays, digital memos). For the typical corporation, however, that’s often impractical given the way the wide discretion enjoyed by corporate managers can and typically does keep large walls between shareholders and the business.

The link is, on the other hand, clearer with REITs. If you own a REIT that has an office-building portfolio, your fortunes, or lack thereof, will be tied to the ebb and flow of the office markets just as if you actually had your name on the deeds as a part owner and signed onto the contract that hires a property management company. If you own units of a healthcare REIT, you’re tied to the healthcare markets in the locales touched by the property portfolio. Etc.

Because of this, I chose to assess and screen for REITs using the sort of metrics I’d be looking at if I were investing directly in the real estate. In that case, I’d be most wired in to “cash-on-cash (COC) return” which, essentially, is pretax cash flow divided by total investment (equity — typically down payment — plus closing-related costs and if relevant, renovation costs). I’d need a satisfactory COC return right now unless I had serious and credible expectations of capital gains down the road (if I were buying property in an area I expect to gentrify, I’d even take a negative COC return right now expecting to take a big profit by selling down the road, or maybe by getting high rents later; in the latter case, I’d have to add rehab costs to the denominator (the investment amount) part of the equation. But absent something like that, I’d really need to see a good COC return right now.