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REITs on the Street

NEW YORK ( TheStreet) -- Real estate investment trusts have been around since 1960 and the dividend-centric asset class has outperformed stocks and bonds in both the U.S. and global markets during the modern REIT era (beginning in 1991).

Even over the past decade -- a difficult period marked by two recessions, two asset bubbles, a financial crisis, and three periods of rising inflation -- REITs have enhanced the return of a stock and bond portfolio, while reducing overall risk.

When it comes to REIT investing, I consider dividends to be "the most important thing" since, by law; REITs are "forced" to payout at least 90% of taxable income (in the form of dividends). According to Michael C. Jensen, Professor Emeritus at Harvard Business School, when a company generates an excessive surplus of free cash flow and it doesn't find profitable investment opportunities, management tends to abuse the cash flow resulting in an increase in costs.

As Jensen wrote (source: Google Scholar has been cited 13,513 times in other academic articles):

Managers with substantial free cash flow can increase dividends or repurchase stock and thereby pay out current cash that would otherwise be invested in low-return projects or wasted. This leaves managers with control over the use of future free cash flows, but they can promise to pay out future cash flows by announcing a "permanent" increase in the dividend. Such promises are weak because dividends can be reduced in the future. The fact that capital markets punish dividend cuts with large stock price reductions is consistent with the agency of free cash flow.

Ben Graham, another highly regarded value investor, summed up the efficiency of dividends in his 1949 classic, "The Intelligent Investor": Paying out a dividend does not guarantee great results, but it does improve the return of the typical stock by yanking at least some cash out of the manager's hands before they squander it or squirrel it away.

In Jensen's prolific research article, he explained his free cash flow hypothesis whereby he argued that a company with too much free cash flow would result in internal insufficiency and waste of corporate resources, thus leading to agency costs as a burden of stockholder wealth. Now, keep in mind, REITs don't have that problem since they are forced to pay out 90% of cash flow in the form of dividends. (That's why I call them "sleep well at night" stocks).

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