REITs have been hot for a while. But there's still a corner of the market that has room for growth.
This is the third in a series of five articles looking at the most popular bond alternatives and the safest ways to use them to improve your income prospects when rates are low. Adapted from “Reaching for Yield” in the January/February issue of MONEY magazine.
High demand over the past year for the traditionally lofty yields on real estate investment trusts—the trusts are required to pay out 90% of their profits—has led to spectacular returns. Among the most popular REIT funds, for example, iShares Real Estate Fifty ETF and longtime MONEY 50 member Cohen & Steers Realty both gained more than 27% in 2014.
The rally has resulted in skimpy payouts for new investors: REIT index funds were yielding about 3% by year-end, far below their 7.5% historical average.
That’s led many analysts, such as Brad Thomas, editor of The Intelligent REIT Investor newsletter, to urge investors to be very picky about where they put new money. One pocket of opportunity now, he says, can be found in health care REITs, which specialize in leasing space to nursing homes, hospitals, and other medical facilities and will profit from the aging of the population. While their high P/Es may be off-putting—some are selling at more than 40 times earnings—a better way to assess REITs is to look at their funds from operations, or FFO. Whereas reported earnings treat depreciation on real estate holdings as an expense that lowers results, FFO adds depreciation back, which more accurately reflects the value of a trust’s property. Using that metric, health care REITs look relatively inexpensive, trading at 14.5 times FFO, compared with the industry’s average of 15.5.
Your best strategy: While you’re usually better off investing via mutual funds and ETFs, there are none now that substantially overweight health care trusts. That’s why Thomas and Morningstar senior REIT analyst Todd Lukasik instead favor individual health care REITs.
Both, for example, are fans of Ventas VENTAS VTR -0.6838% , which owns about 1,500 senior housing communities, skilled nursing facilities, and similar properties in the U.S. and Britain and was recently selling for 15 times FFO. Ventas raised its dividend 9% in December, giving it a yield around 4%. They also like HCP Inc. HCP, INC. HCP -0.5815% , which owns $22 billion worth of medical-related property. It is selling for 12 times FFO and yields 4.5%.