Investing: In the quest for income, REITs look promising

 

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If the quest for investment income were a journey, right about now we'd see lots of cacti, a few cattle skulls in the shimmering heat and vultures with napkins around their necks.

You're not going to reach an income oasis anytime soon. But you can look at some alternatives that can give you enough income until the income drought ends. One reasonable alternative is real estate investment trusts, especially if the economy continues to improve. They're not exactly undiscovered, nor are they terribly cheap — but they can deliver yields of 4% or more.

First of all: We're not talking about single-family housing here. REITs are companies that own and manage commercial real estate: Office buildings, shopping malls, hotels and even storage units. By law, they have to pass at least 90% of their taxable income to investors in dividends.

And REITs pay good dividends. The FTSE NAREIT U.S. Real Estate index had a dividend yield of 4.16% at the end of July, vs. 1.49% for the 10-year Treasury note.

One drawback: REIT dividends are taxed at your ordinary income rate, vs. the maximum 15% rate on qualified stock dividends.

REITs have done well on a total return basis — price action plus dividends — this year. The REIT index is up about 17% this year, vs. 11.5% for the S&P 500.

REIT performance hasn't gone unnoticed, which means you can't buy them on the cheap — as you could in 2009, when the average REIT yielded 11.13%. (Yield is dividend payout divided by price. It can rise because the REIT is paying more, or — in this case — because the price has been demolished.)

One measure of a REIT's price is comparing its funds from operations to its price. By that measure — similar to a price-to-earnings ratio — prices are a bit higher than average, says Steve Buller, manager of Fidelity Real Estate Investment fund.

But the spread between REIT yields and the 10-year Treasury note's yield is higher than usual, making them attractive. And REITs, unlike bonds, have the ability to increase their income payouts.

Probably the best argument for a continued rally in REITs is the economy. The unemployment rate was 8.3% in July, which is awful. Should the economy improve, and the jobless rate fall, demand for office space should increase.

And, at least at the moment, you're probably not seeing many new office buildings going up, says David Lee, manager of T. Rowe Price Real Estate fund. "It takes awhile to get these projects restarted, even when they are justified and financing is available," he says.

Low interest rates will give REITs a boost as well: They can refinance their debt at lower rates, a savings that flows quickly to their bottom line. Three REIT sub-sectors to consider:

•Storage space REITs. "No matter what the environment, death, divorce, students and life changes are constant," says Buller. There's little new supply in the area, which is dominated by four publicly traded companies: CubeSmart, Extra Space Storage, Public Storage and Sovran Self Storage.

•Industrial/logistics. All that stuff you order online has to pass through large distribution facilities. REITs that invest in distribution facilities could benefit from the trend to online shopping.

•Malls. You may hear about online companies clobbering retailers, but Apple and Microsoft both have retail outlets, and Amazon has been rumored to be opening a retail store in Seattle.