Most investors view a real estate investment trust, or REIT, as a safe investment. These companies typically generate stable rental income, enabling them to pay out attractive dividends.
However, not all REIT stocks are safe investments. Many have had to reduce or suspend their dividend payments during market downturns because they didn't have enough financial flexibility to maintain them. Some have put themselves in such poor financial positions that they've struggled to survive.
Because of that, an investor needs to carefully consider the safety of a REIT before buying shares. Here's a look at the hallmarks of the safest REITs as well as three top ones to buy right now.
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What makes a REIT safe?
The safest REITs share many common characteristics. Three factors stand out as being important to dividend safety:
- An investment-grade credit rating backed by low leverage metrics. Debt financing is crucial in real estate. It's much easier to access funding with lower interest rates if a REIT has an investment-grade credit rating backed by low leverage, such as a debt-to-EBITDA ratio of less than 6.0 times. The higher the credit rating, and lower the leverage ratio, the safer the REIT.
- A conservative dividend payout ratio. REITs must distribute at least 90% of their net income to remain compliant with IRS regulations. However, many pay more than 100% of their taxable income because they generate more cash flow -- measured by metrics like funds from operations, or FFO -- than net income because of depreciation. REITs still need to keep their FFO payout ratio to a conservative level, ideally less than 80%.
- A high-quality commercial real estate portfolio leased to credit-worthy tenants. Rental payments are the lifeblood of REIT dividends. Because of that, REITs need to own properties with high rental demand and lease their space to tenants that can afford to pay their rents.
REITs that boast having all three of these characteristics will be much safer than rivals lacking one or more of these traits. Because of that, they should pay a secure dividend yield while also offering consistent dividend growth.
The average REIT, using Vanguard Real Estate Index ETF (VNQ 1.04%), was up 30% not too long ago. Now, though, that figure has dropped to just 20% or so. However, that still beats the S&P 500 Index, which is up roughly 15% and hasn't suffered through the same degree of pullback.
These are uncertain times, and REITs, as a group, are obviously in a state of flux. This is not the moment to take risky positions; it is a time to focus on the biggest and the best names you can find. Here are three that you should probably be considering as October gets underway.
The net lease giant
It is hard not to like Realty Income (O -0.04%). It is the largest net lease REIT around with a portfolio that post its planned acquisition of peer VEREIT will contain over 10,000 properties.
The company has an investment-grade-rated balance sheet and a market cap of $25 billion (a figure that will likely rise after the VEREIT deal closes). It has also increased its dividend -- with its disbursem*nt paid monthly -- for more than 25 consecutive years, making it a Dividend Aristocrat.
The one main reason to dislike Realty Income is valuation. Using dividend yield as a rough guide, at roughly 4.3%, the REIT's yield is near historically low levels, though it's been about middle of the road over the past decade.
Basically, at best, it is fully priced and, perhaps, even a bit expensive. The thing is, this conservatively managed industry bellwether is a reliable giant. So, it is probably worth a premium price for more conservative types. And, oddly enough, selling stock is a key source of capital for Realty Income, so a premium price is, counterintuitively, conducive to growth. If you want to sleep well at night when times get tough, this is a great name to own.
The big-city comeback kid
The next name in our lineup is AvalonBay Communities (AVB 0.92%), one of the largest apartment landlords you can buy. The dividend yield here is 2.8%, again near the low end of the REIT's historical yield range.
The landlord owns or has an interest in 288 communities with more than 85,000 individual apartments. Included in that number are 16 apartments that are currently under development and two that are being redeveloped. And in September, the REIT bought three apartment communities.
There's actually a lot to unpack here. AvalonBay is a giant in the industry ($30 million market cap), with a big city, coastal focus. These historically strong markets have started to bounce back from the pandemic's hit, even though investors were worried about a population shift to less dense areas.
Further, the REIT has an investment-grade balance sheet and a long history of recycling capital to build and/or buy assets, depending on the market opportunity. All in, it is a well-run REIT with well-located properties, and it has a history of trading at a premium price. However, that gives it easy access to capital (along with its strong credit rating) to spend on the growth initiatives that help keep it at the top of the apartment heap.
Meanwhile, that history of ground-up construction means there are often internal growth opportunities even during tougher times. Unlike Realty Income, AvalonBay's dividend hasn't gone up every single year, but it has been on a steady upward march since 1995. This is another name worth paying up for if you value dividend consistency over a high yield.
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The perfectly positioned intermediary
Rounding out this trio is Prologis (PLD 2.35%), the largest name in the warehouse space. Like the other two, this REIT historically trades at a premium price. Notably, this $90 billion market cap company's yield is a tiny 2% or so. That's historically low, but like Realty Income and AvalonBay, that means access to cheap growth capital for this investment-grade-rated REIT.
Meanwhile, its globally diversified portfolio of warehouses totaling roughly 1,000 properties is located in key transportation hubs. Basically, it is positioned extremely well for the growth in demand for warehouses, thanks to the increased use of online shopping.
But here's the thing: Prologis has a long history of successfully building new warehouses. It's put $36.5 billion to work over the past two decades, achieving a 21% internal rate of return (IRR) on that investment. Meanwhile, it has a roughly $18 billion development pipeline ahead of it, so there's a huge amount of internal growth opportunity here. Couple that with cheap capital, and there's no reason to think that Prologis will be slowing down anytime soon.
To be fair, the dividend was cut during the deep 2007 to 2009 recession, but it has been growing since 2013. Given the industry tailwinds and the company's strengths during the pandemic, it's not shocking that the dividend was increased in 2020 and again in 2021. And there's no reason to think that trend is going to change.
The bottom line: Paying up
For anyone with a value bias, these three REITs probably won't sound too appealing. However, when times are uncertain, it often pays to stick with the biggest and strongest names. Realty Income, AvalonBay, and Prologis all fall more broadly into that category within the REIT sector, as well as within their respective property niches.
Through good times and bad, these REITs are likely to have the capital access needed to outperform at the business level. That ability should, over time, continue to widen their leadership positions and back reliable dividends. That's the type of investment that will let you sleep well at night, which for conservative types is probably a cost worth paying.
Reuben Gregg Brewer has positions in Realty Income. The Motley Fool has positions in and recommends Prologis, Realty Income, and Vanguard Specialized Funds - Vanguard Real Estate ETF. The Motley Fool recommends AvalonBay Communities. The Motley Fool has a disclosure policy.
