How to Find the Best REITs.

How to Find the Best REITs

Real estate investment trusts (REITs) are popular with dividend investors. While REITs have historically outperformed the overall market, the credit market freeze up triggered by the subprime mortgage fiasco has knocked REIT prices down. Most lost value in 2007 and dropped further so far in 2008.

However, since few have cut their dividends, yields are up and this might be a good time to consider REITs. I’ll describe how to find REIT candidates in a minute, but first some background.

REITs are publicly traded corporations that invest solely in real estate. REITs come in two flavors. Equity REITs own commercial real estate while mortgage REITs invest in real estate mortgages and don’t own property.

Most equity REITs specialize in a particular type of property such as shopping centers, office buildings or hotels. However, a few, termed “diversified REITs,” own properties in multiple categories.

Mortgage REITs borrow at short-term rates to invest in long-term real estate loans. Short-term loans are scarce in this market, so it’s best to stick with equity REITs for now.

REITs don’t pay income taxes as long as they pay out at least 90% of their taxable income to shareholders. Because they don’t pay taxes, REIT dividends are taxed as regular income instead of the lower 15% capital gains rate. So, it’s best to keep your REITs in a tax-sheltered account.

Screen For REIT Candidates
I’ll fill in more details as I describe how to screen for promising REIT candidates. If you're not familiar with the term, screeners are programs available on certain financial websites that allow you to search through all listed stocks to find those that meet your selection requirements.

MSN Money's Deluxe Screener is the only screening program I know of that can do this particular search. MSN's screener only works with Internet Explorer. Find the screener from MSN Money’s homepage (moneycentral.msn.com) by selecting Investing and then Stock Screener (left menu). Once there, scroll down to the Deluxe Stock Screener link near the bottom. Clicking on that link takes you to a page for downloading the free software needed to run the screener. Once you’ve downloaded the software, the Deluxe Screener will appear automatically when you click on Stock Screener in the left menu.

MSN's screener looks intimidating at first, but if you read the instructions in the Help section, you will get the hang of it after a while.

About Dividends
Dividend yield is the expected next 12-months’ dividends divided by the recent share price. For example, the yield would be 10% for a REIT trading at $10 per share that is expected to pay dividends totaling $1 per share over the next year ($1 divided by $10).

Specify Yield
Since you’re buying REITs for the dividends, you should insist on a sizable yield. Equity REITs are currently paying dividends equating to 4% to 7% yields. I prefer yields of at least 5%. Since my choice of 5% is arbitrary, adjust your minimum up or down to suit your needs.

Dividend Growth Drives Share Prices Up
Once you’ve established a satisfactory yield, dividend growth is the next most important consideration. You win two ways if the dividends grow while you own a REIT. The higher payouts increase your yield and the dividend increase usually drives the share price higher.

Funds From Operations
For REITs, most investors and analysts pay more attention to funds from operations (FFO), which is a cash flow measure, than to earnings. Thus, although labeled earnings, the analyst forecasts you see on MSN and other financial sites for equity REITs are actually FFO forecasts.

FFO Growth Drives Dividend Growth
REITs with the strongest expected FFO growth should also be the fastest dividend growers. REITs are slower growers than regular growth stocks. Typically, about 5% to 10% annual FFO growth is about all that you can expect. Searching for 6% minimum expected annual FFO growth (labeled EPS growth).

Avoid Risky Bets
Minimizing risk is an important part of dividend investing. A high dividend yield doesn’t mean much if the stock price drops in half.

MSN tabulates analyst buy/sell ratings into the following categories: strong buy, moderate buy, hold, moderate sell, and strong sell. Since analysts are usually overoptimistic about a stock's outlook, any version 'sell' rating signals high risk. Avoid any such stocks by requiring analyst buy/sell ratings of 'hold' or better.

Real Stocks Only
Sometimes MSN erroneously lists stocks that are no longer traded. To avoid that problem, require a minimum 10,000 share average daily trading volume over the last quarter.

Research, Research, Research
You can see a rundown on each REIT's business by clicking on a REIT’s ticker symbol on the screener results list and then selecting Company Report. The report also lists each REIT's current annual dividend rate based on its last declared dividend.

While still on MSN, select Earnings Estimates, which, as mentioned earlier, actually lists FFO forecasts for equity REITs. Compare a REITs' current annual dividend rate to its current year's forecast FFO.

The annual dividend vs. FFO ratio approximates the percentage of cash flow used to pay dividends. Research has found that REITs with ratios below 80% outperform REITs with ratios above 90%. Given the current market, to be on the safe side, stick with ratios of 70% or less

Spend some time understanding a REIT's business by reading its quarterly earnings press release as well as the management discussion portion of its quarterly and annual SEC reports which can be found on MSN Money, Yahoo, and other sites. The more you know about your stocks, the better your results.