Three Rs for Risk Control: Retirement, Recession and REITs

NEW YORK (TheStreet) -- Remember in school when we learned about the "3 Rs" that referred to the basic skills of reading, writing, and arithmetic?

These days, investors are more concerned about the future: retiring and, more important, when the next recession may start. Of course, nobody can forecast the future but we intelligent investors can manage to acquire that necessary "trace of wisdom" that Benjamin Graham calls for.

It is critical to recognize that risk control is invisible in good times, but essential.

That is why controlling risk in your real estate investment trust portfolio is important and worthwhile and the outstanding investors are distinguished as much for their ability to control risk as for generating returns.

First off, I don't think that mortgage REITs (mREITs) belong in a retirement portfolio. I issue this as a warning (with a fair conscious) knowing that many investors like Annaly Capital Management ( NLY) and American Agency ( AGNC) in particular.

The main concern I have is the continued squeeze in the spreads that have resulted in refinancing trends. As we have already seen, the implied consequences of that trend has been imminent cuts in the dividend distribution of these mREITs. As fellow Seeking Alpha writer, Regarded Solutions explains:
With the Federal Reserve basically calling the shots in these areas, the potential for profits are greatly diminished for NLY and other companies in the agency backed mortgage-backed securities sector. Diminished profitability will mean more dividend cuts in the near to medium term from what I can tell. If dividends are cut then total returns on an already risk-oriented sector to begin with, could mean that the share price will continue the downward trend we have seen since the Fed announced the latest actions.

As Howard Marks wrote (in "The Most Important Thing"):
Risk control lies at the core of defensive investing. Rather than just trying to do the right thing, the defensive investor places a heavy emphasis on not doing the wrong thing. Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in good times, investors must decide what balance to strike between the two. The defensive investor chooses to emphasize the former.

Recognizing interest rate risk is essential to intelligent REIT investing and especially when one is considering an alternative that has considerable debt and use of leverage. Before you go out and buy mortgage REITs for their high yields, keep in mind that these investments are very risky.

Unlike other types of dividend-paying companies that pay the same dividend each quarter, the dividends paid by mortgage REITs are very unstable and are cut often -- sometimes drastically -- when interest rates and/or mortgage defaults rise or the yield curve flattens.

Let's Focus on the Right REITs

Now, I'm not forecasting the next recession. But what I can forecast are the best REITs for a recession-proof dividend portfolio. Namely, I like the health-care REITs, the triple-net REITs, the self-storage REITs and select shopping center REITs. Let me tell you why.

Due to the fact that health care is a needs-based industry, economic cycles have little effect on demand. As the U.S. population ages and life expectancy increases, demand for assisted living and skilled nursing facilities is expected to grow.

Some of my favorite health care REITs include Medical Office Properties Trust ( MPW), Omega Healthcare Investors ( OHI), Healthcare Trust of America ( HTA) and Ventas ( VTR).

Another choice sector is the triple-net sector. Although the stand-alone class does not have the growth of the apartment and hospitality sectors, the contractually long-term leases make the triple-net sector more durable and dependable. In fact, during the Great Recession, three triple-net REITs not only paid dividends but all three of them actually increased.

Realty Income ( O), National Retail Properties ( NNN) and W.P. Carey ( WPC) were all stalwart dividend champions as they continued their amazing track record of dividend performance.

Another sector I really like is self-storage. This is not a sexy sector and in fact it's downright boring. But remember, we Americans store stuff. Lots of it. The average house size today is getting smaller and there isn't enough room to store grannies armoire or Uncle Bob's treasure trunk.

One of my favorite picks is Extra Space Storage ( EXR). This Salt Lake City REIT has around 720 storage properties and it due to the highly fragmented component of the storage industry, Extra Space has plenty of room to grow its brand.

Finally, not all retail is gonna die. If you don't believe me, ask my five kids. The big malls are unique because you just can't go throw up a $100 million mall anymore. That makes REITs like Taubman Centers ( TCO) and Simon Property Group ( SPG) irreplaceable.

I also like certain necessity-based REITs like Regency Centers ( REG), Weingarten Realty Investors ( WRI), Excel Trust ( EXR) and Retail Opportunity Investment Corp ( ROIC).

Last but not least, who can't like Tanger Factory Outlets ( SKT)-- the only "pure play" outlet center REIT with an incredible track record for paying and increased dividends for 20 years in a row. That is what I call a "crown jewel."

Remember what Ben Graham said: "It is the consistency in the products that creates consistency in a company's profits. Consistency and durability are attributes for competitive advantage."

Make sure you consider the REITs with the more lasting differentiation and you are certain to avoid costly mistakes and help you sleep well at night!

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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