Focus on REIT Fundamentals

NEW YORK (TheStreet) -- Losses occur when risk meets adversity, and based upon the last few weeks, it's clear that real estate investment trust investors are beginning to fear the worst.

The latest Federal Reserve announcement that it might scale back quantitative easing has prompted many REIT investors to take a profit and sit on the sidelines until the overhyped markets settle down.

The REIT selloff is an indicator that record low rates won't last forever. Nonetheless, the current earnings multiples for U.S. REITs reflect strong growth, and so their seemingly higher valuations remain reasonable.

Contrary to common misconception, rising interest rates don't necessarily lead to poor REIT performance. REITs have generated an annual return of 12.6% over the six monetary tightening cycles that have occurred since 1979. Over an equal number of periods when Treasury yields were rising, REITs generated an annual return of 10.8% (source: Cohen & Steers).

It's no time to depart from the course, especially when it comes to minimizing risk or avoiding losses, even though rising interest rates can affect real estate values and the performance of REITs.

Through diversification, investors seek to minimize volatility, and the high and steady dividends distributed by REITs can play a large role in asset allocation. Accordingly, investors should stay the course with diversified investments in stocks, bonds and real estate.

The Most Important Thing

REIT dividends are arguably the most important attribute for investors because REITs generally have more stable dividend streams than other asset sectors. REITs offer above-average dividend yields due in large part to the minimum distribution requirement for companies structured as REITs as REITs must pay out at least 90% of net income in the form of dividends. They also have a history of consistently raising their dividends, resulting from cash-flow growth that comes from rising rents and occupancies, or from development and acquisitions, or both.

Historically, REITs have offered higher dividend yields than other equities with similar risk profiles -- REIT dividends have been a large factor in the outperformance of real estate securities relative to the broad equity market. On average, REIT dividends make up 60% of the returns for U.S. REITs, much more than those of the broad equity markets.

By owning a diversified portfolio that includes REITs, investors benefit from the REIT yield premium that provides a potentially attractive alternative for income-seeking investors. Intelligent REIT investors should pay attention to operating fundamentals and examine which REITs will continue to prosper even if (or when) interest rates rise.

In my sleep-well-at-night (or SWAN) portfolio, I examine the fundamentals of the high-quality REITs in an effort to make sure they can withstand the added stress of rising interest rates.

Some of the REITs in my SWAN portfolio are Realty Income ( O), WP Carey ( WPC), Ventas ( VTR), Healthcare Trust of America ( HTA) and Digital Realty ( DLR).

As legendary author and investor Ben Graham taught, it's impossible to eliminate all investment risk. But by using certain valuation methods, investors can greatly minimize risk in REITs by filtering out risky REITs with poor fundamentals from the outset.

An asset-allocation strategy with REITs can enhance total return, while not adding meaningfully to risk. 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 boosted the return of a stock and bond portfolio, while reducing overall risk.

Stay focused on the most important thing -- protecting your principal at all costs -- and you should be able to withstand market-driven adversity and sleep well at night.

Source: Bloomberg and Cohen & Steers

At the time of publication, the author owned shares of Realty Income.

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

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