Rules of the Game: Flavorful REITs

 | May 09, 2013 | 9:00 AM EDT
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One of the nice things about real estate investment trusts (REITs) is that they are required by law to pass along at least 90% of taxable income to shareholders. For investors, that's money in your pocket. Because the dividends are taxable, it's advantageous to hold REITs in a tax-deferred account whenever possible.

REITs come in a number of flavors and colors. At their most basic, they are companies that own and manage real estate properties. They also own mortgages. They give equity investors, small and large, exposure to real estate without having to answer the phone at 3 a.m. when a pipe has burst or the burglar alarm is going off.

There was some chatter in the financial media Wednesday about Digital Realty Trust (DLR), after hedge fund manager Jonathon Jacobson said the REIT's spending rate was too high to sustain dividend rates. Its yield is currently 4.5%. Jacobson is short DLR.

I prefer to look at more "plain vanilla" opportunities when seeking to help clients offset future liabilities (and, eventually, to keep pace with inflation). We have held the Vanguard REIT ETF (VNQ) for quite some time. This offers exposure to commercial real estate, which is on the mend. Its low fees and liquidity are also attractive.

There are substantial mall-operator holdings in VNQ. The top -position is Simon Property Group (SPG), which owns and operates regional malls throughout the country. Simon constituted 9.8% of the ETF, at the end of the first quarter. Another sizeable holding within VNQ is General Growth Properties (GGP), another regional mall developer with operations around the U.S.

VNQ is pegged to the MSCI U.S. REIT Index, which comprises approximately two-thirds of the market value of domestic REITs.

We also hold some REITs in our equity overlay portfolio. Health Care REIT (HCN) invests not only in the health-care facilities you would expect, but also in senior housing. HCN said Wednesday it would invest $1 billion to take a 75% stake in 47 senior housing facilities throughout Canada. Most of the properties are in Vancouver and Toronto.

Other elements in the portfolio include medical office buildings throughout the U.S. Here, too, is one of those attention-grabbing dividend yields that are characteristic of REITs. In this case, the yield is 4.1%, even as the investment itself is trading in new high ground. Revenue growth has been in the double- and triple-digit range for the past eight quarters.

Another REIT holding in our equity portfolio is Rayonier (RYN), which has a specific concentration in timberlands. (Not work boots, but the actual acreage where forests are grown.)

An improvement in U.S. housing starts should boost performance of this REIT's underlying timber properties. Revenue growth accelerated in the past three quarters, coinciding with the housing revival. Its dividend yield is 2.9%. The company also has a performance fibers unit, whose output is found in products including TV and computer screens, tires, paint, and even food and pharmaceuticals.

With a market cap of $7.5 billion, Rayonier is much smaller than HCN or VNQ. Along with that, we have a smaller holding in this REIT than in most of our other holdings.

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