We are moving deeper into January, and it is the time of year when I start testing and tweaking all my various screens and models. One of my more interesting discoveries last year was that most investors should own a lot more REITs than has historically been the case. REITs have outperformed just about every other asset class out there, with the exception of small capitalization stocks. On a risk-adjusted basis, REITs are the clear long-term winner. Most of the asset allocation models I see suggest a 3-5% REIT allocation, and it should be a lot higher than that for most of us.
When I took a deeper look at REIT investing, I found that if you limited your investment operation to owning REITs that had an F-score of 7 or higher, then excess returns were even higher. This approach used a quarterly rebalancing. If REITs fundamentals had slipped and they no longer earned a high grade for fundamental conditions and prospects, they were sold. Turnover was still pretty low, but this method allowed us to avoid any fundamental blow ups or management errors that destroyed shareholder value.
Last night I dug still deeper into REIT data and found that if you ran a more focused high F-score portfolio, results improved even further. Once we developed our universe of high F-score REITs and limited our purchases to just the highest yielding two stocks, returns accelerated even further. Volatility increased somewhat, but returns have been nearly double the REIT indexes and overall stock market. I stayed with the three-month rebalancing and turnover was still low, so transaction costs would not damage long-term returns by a significant amount.
The list going into 2017 has some kind of interesting REITs on it. CYS Investments (CYS) is the highest yielding REIT on the list, with a current yield of 12.70%. While many are concerned about the impact of higher interest rates on the mortgage REITs, the company earns an F-score of 7, so it is in sound shape financially. The second highest yielding REOT is also a mortgage REIT. Ellington Residential Mortgage REIT (EARN) has a yield of 12.40% and also earns an F-score of 7 right now. I am confident that if the mortgage REITs have a problem with rising rates, fundamentals will deteriorate and the model will sell them long before we develop a serious issue.
Government Properties Income Trust (GOV) makes our list as well. I love the idea of this REIT. It owns properties around the United Sates that are leased to the U.S. government. There is no better tenant than the government and its various agencies and the buildings tend to be located in attractive locations. Government Properties also owns 28% of Select Income Real Estate Investment Trust (SIR) , which owns and invests in single-tenant and net-leased properties around the United Sates. The knock on this REIT has been the fact that it is managed by the RMR Group (RMR) , which is controlled by the somewhat controversial Portnoy family. This approach is quantitative, so we will overlook that, and since the REIT currently yields 8.6% and has an F-score of 7 it goes into the portfolio.
Since I am a big fan of buying REITS at low multiples to book value, I ranked the equity REITs in the portfolio by price to book and found that one of the cheapest stocks in the mix is Medical Properties Trust (MPW) . This REIT owns medical properties around the United States, Germany, Italy and Spain. It also makes mortgage loans to healthcare operators. Medical Properties currently has 249 properties representing more than 27,000 licensed beds around the world. Wall Street didn't like the last earnings report, and the stock has sold off to the point the REIT sells for just 1.2x book value. It earns an F-score of 7 and the shares yield 7.31% at the current price.
This is a much more concentrated approach to REIT investing than just buying all the high F-score REITs, but it is an approach that has rewarded investors willing to be a little more aggressive in their approach to REIT investing. The quarterly rebalance using F-scores should allow us to sidestep much of the company risk of individual REITs, and focusing on dividends should provide steady cash flows to help balance the increased price volatility. There is some turnover, and the dividends are taxed at ordinary income rates, so it is a strategy that is probably best used in a tax-favored retirement account.