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).

How to Know When a Dividend Will Grow

It's important not to use price to earnings for REITs, or to compare P/E for REITs with P/E for non-REIT stocks. Funds from Operations (or FFO) is a standardized metric, though not GAAP; AFFO is not standardized, and equity analysts have different ways of constructing it. Both of them are better than earnings for valuing REITs.

By utilizing price to FFO valuation, analysts and investors can determine the trading history of each REIT by itself and relative to the entire REIT sector. Accordingly, payout ratios are based on AFFO (adjusted funds from operations) because it more accurately measures cash flow when compared to net income (due to depreciation), and given the contractual nature of lease payments today, earnings growth rates are higher than the S&P.

One criterion for separating good REITs from great REITs is by exploring the dividend policy and specifically a REIT's payout ratio. A modest payout ratio is also good insurance against unexpected events that might cause a temporary downturn in free cash flow. By looking at current and historical trends for dividends over AFFO, an investor could possibly determine when to know a dividend will grow.

A Few REITs on the Street

This week I want to tell you about a few REITs on the Street. Many REITS are announcing second-quarter earnings this week and there could be an opportunity to capitalize on some good (or bad) results.

Last week, Digital Realty ( DLR) announced earnings. As suspected, shares fell with some "wild card" comments (on the call) that were brought on when the company announced new accounting changes. It seems that Digital has a track record for upsetting Mr. Market and although the fundamentals remain sound; I believe the market overreacted to the negative comments on Friday. Digital closed at $58.28 (paying a 5.35% dividend) and I have a buy rating on the shares (shares closed down around 8% on Friday).

Chambers Street Group ( CSG), Healthcare Trust of America ( HTA) and American Realty Capital Properties ( ARCP) are all set to report earnings in a week or so. Chambers with a market cap of $1.97 billion has traded down by around 17% since the company listed its shares on May 22. The current price of the shares is $8.33 and the dividend yield hit 6% on Friday. I have a buy in Chambers.

Healthcare Trust of America, a "pure play" medical office building REIT is set to report earnings on Thursday. I see plenty of value and upside in the shares (trading at $11.05) and the dividend yield (of 5.2%) is safe and reliable. I have a buy rating on HTA.

Finally, American Realty Capital Properties is set to announce earnings on August 6. The New York-based Triple Net REIT has been extremely busy with its announcements to acquire CapLease ( LSE) and American Realty Capital Trust IV ( ARCT4). Once the announced deals close, ARCP will be the second largest Triple Net REIT (with a current market cap of around $2.7 billion). ARCP closed at $14.65 and the current dividend yield is 6.21%. I have a buy rating on ARCP.

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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