Two REITs to Rise Above the Rate Spike

 | Jun 05, 2013 | 12:00 PM EDT  | Comments
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Stock quotes in this article:

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psa

Dividend stocks have had a hard time lately. Utilities, MLPs, REITs -- you name it, it's down.

All have been collateral damage as bond yields jumped higher on fears of the Fed tapering purchases. REITs fared the worst, with many big names down 17-19%. With carnage of this magnitude, it's time to sift through the REIT rubble and pick up the treasure.

It's understandable to be reluctant. If the recent jump in yields marks the end of a 30-year bull market in bonds, dividend-paying stocks will come under more pressure. But in their panic, many are forgetting that bonds can't offer the payout growth that many dividend stocks can. In the long run, that will matter.

I am going to highlight two REITs with steady growth and plentiful cash flow that can be bought here at a bargain price.

Home Properties (HME) is an apartment REIT operating mostly in East Coast metropolitan areas. It owns, acquires and rehabilitates apartment communities. Think of them as turnaround artists. Home's model is to purchase "Class C" or older "B" apartment communities and revitalize them into a high-end "B" community, reaping the benefit of higher rent prices. After seven to 10 years, it  often sells and redeploys capital into other communities needing work with the potential for high returns.

Data Source: Morningstar

The previous quarter's results are part of a long-term trend towards renting on the East Coast, where unemployment is relatively low and home prices high. Operating income was up 5.4% and revenue 3.7%. Home has gotten behind a powerful trend by positioning itself in high-quality locations within these metropolitan areas, building a high barrier to entry that will continue driving steady growth in both income and dividends.

Source: FAST Graphs

At the same time, debt levels are stable and declining relative to earnings. In 2011 through 2012, Home has acquired many new properties, and capital spending on these properties depleted free cash flow (FCF) to below zero. Home financed this with equity offerings, but acquisitions have since stopped due to a less favorable buyer's environment. As current construction projects are finished, FCF will swing up and the company will be in a very strong position. At 11.4x FFO and yielding 4.6%, Home is a bargain ready to be picked up.

Public Storage (PSA) is an operator of self-storage units for monthly lease for individuals and businesses in the U.S. and Europe. It is a growth and free cash flow machine. At this stage in its business, little capital is needed for Public Storage to grow FFO. And grown it has. Consider also its low debt levels and we have a perfect stock for this volatile rate environment.

Data Source: Morningstar

In 2012, Public Storage grew revenue by 6% and FCF by 14%. Its 2012 annual report clearly spells out rowth and dividend prospects. While dividend growth has been in the double-digits lately, management sees this as a "catching up" period that will not be sustainable. Going forward, it predicts the dividend rising along with FCF. Fortunately, Public Storage has averaged FCF growth of 8% in the last five years. That's enough to keep the bond rot away.

Source: FAST Graphs

Although Price/FFO is still at a lofty 20x, consider the above chart. The dividend yield is at a three-year high. Now is a good time to get a piece of Public Storage.

Fed tapering fears have sent dividend stocks reeling, but do not panic. Sift through the rubble. Companies that have healthy balance sheets and can grow earnings in the long run will transcend this rate scare.

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