How to screen for top REITs

By Harry Domash

If you think that Real Estate Investment Trusts (REITs) are boring because they're dividend stocks, think again.

Talk about the tortoise and the hare. For the five years ending Dec. 31, 2004, REITs as a group (using the NAREIT Composite Index) returned 22% compounded compared with the Nasdaq's 6.7% loss and a 0.7% loss for the S&P 500.

Maybe you think I stacked the deck, picking a timeframe that includes the infamous bubble burst? Over 10 years, the NAREIT index returned 14.8%, nearing the Nasdaq's ($COMPX) 17.6% and edging out the S&P's ($INX) 14% returns. (Note: Those returns include capital appreciation and dividends.)

Alas, the good news is also the bad news. REITs as a group did so well last year (up 32%), that many of them may have already seen their best days.

Consequently, picking REITs requires some care. Before I get into the details, let me explain some of the basics.

A REIT primer

REITs are a special form of corporation that invests only in real estate. REITs do not pay corporate income tax as long as they pay out at least 90% of their earnings as dividends to share owners. Because they don't pay income taxes, REIT dividends are fully taxable. That is, they do not qualify for the 15% capital gains tax rate.

REITs fall into two major categories, those that own real estate (equity REITs) and those that invest in mortgages (mortgage REITs). Equity REITs are further categorized according to their area of specialization, such as shopping malls, office buildings, etc. 'Diversified' REITs invest in a variety of property types. For instance, Duke Realty (DRE, news, msgs) owns retail, industrial and office properties. Mortgage REITs buy real-estate-backed mortgages from mortgage originators or from quasi-government firms such as Ginnie Mae.

REIT performance varies by category and how current economic conditions affect each category. For instance, despite the recent soft economy, consumers continued to shop, and shopping-center REITs were the best performers. By contrast, apartment and office REITs, which do best during periods of high employment, lagged.

Divining the dividends

In a minute, I'll show you a series of screens for finding the best candidates in each REIT category. But first, I'll describe the overall screen philosophy.

Dividends, dividends, dividends: You buy REITs because they pay high dividends, so I start the process by specifying a minimum dividend yield. In case you're not up on the terminology, yield is the next 12 months' expected dividends divided by the price you pay for the shares.

What's a reasonable minimum yield? Since REIT dividends don't qualify for the capital gains rate, you need a higher yield to compensate for the extra taxes you'll pay if you're holding your REITs in a taxable account.

Many variables affect the calculation, but using a rough approximation, I set the minimum required REIT dividend yield at 3.7%, which, when taxed as ordinary income equates to a 2.25% or so yield taxed at capital-gains rates. Consider lowering the yield requirement if you intend to hold your REITs in a tax-sheltered account.

• Screening Parameter: Current Dividend Yield >= 3.7%

Dividends should grow: You'll improve your returns by picking REITs that increase their dividends while you own them. You win two ways if that happens. The higher payouts increase your yield, plus the dividend gain usually drives the stock price higher. This is an instance where history is the best teacher. There are no guarantees, but stocks with a record of strong historical dividend growth are your best bets to increase future payouts. I set the minimum at 4%, which doesn't sound like much, but it eliminates all those naughty REITs that never increase their dividends much. Increase the minimum if you get too many hits.

• Screening Parameter: 5-Year Dividend Growth >= 4%

Make the analysts do the heavy lifting: Most REITs are sensitive to the economy and its cycles. So even if it's paying a high dividend, there's no point buying a REIT that's heading for rough times. How do you know? You could try to figure out where the overall economy is heading and how that will affect each REIT's outlook, but why bother? That's what REIT analysts do all day long.

As you probably know, analysts often rate stocks from "strong buy" to "hold" to "strong sell," but "hold" is often a codeword meaning "sell." But I've found that isn't usually the case for REITs. In my experience, "hold" rated REITs perform equally to "buy" rated REITs.

However, since analysts, if anything, are too optimistic, I pay attention to "sell" ratings, which often portend that, at least in the analysts' view, the REIT is likely to suffer negative earnings growth and a possible dividend reduction.

That's the reason I require analyst ratings of "hold" or better for qualifying REITs.

• Screening Parameter: Mean Recommendation >= Hold

Look for FFO growth on steroids: Just like other stocks, strong earnings growth moves REIT share prices higher. But earnings growth is even more significant for REITs. Because REITs must pay out 90% of their net income to shareholders, earnings growth also fuels dividend increases. So, you'll get the best overall returns with REITs churning out above-average earnings growth.

How do you know how much earnings growth to expect from a REIT? This is another instance where I let the analysts do the work by relying on their long-term FFO growth forecasts.

How high is high? REITs are relatively slow growers. It's rare to see expected growth forecasts much above 10%, and many report less than 5% average annual growth. I set the minimum long-term FFO growth requirement at 5%, but, of course, higher is better. Increase the minimum to 7% or 8% if you get too many hits.

• Screening Parameter: EPS Growth Next 5-Yr >= 5%

8 category-specific screens

That's the concept for screening for superior REITs. Here are the screens for each REIT category that can be searched separately using the Deluxe Screener.

Diversified REITs: The category title is misleading because it includes pure-play mortgage REITs in addition to diversified REITs. See the screen here.

Office REITs: These generally specialize in a specific office building class such as Class A buildings, which are the best in terms of amenities and location, or Class C buildings, which are usually in low-rent areas. Try this screen.

Health-care facilities REITs: These usually invest in various types of health-care facilities, such as nursing homes, that are operated by lessees. When I ran the screen, no health-care REITs passed the tests, for the most part, because their historical dividend growth and expected FFO growth didn't pass muster. So I reduced the minimum forecast FFO growth to 4% so that the screen would turn up at least one candidate. See the screen here.

Hotel/motel REITs: This group was hard-hit by the consequences of Sept. 11, and most show negative 5-year dividend growth. Delete the 5-Year dividend growth requirement if you want to see any hotel REITs. Here is the screen.

Industrial REITs: This category includes REITs owning self-storage facilities as well as industrial properties. See them here.

Residential REITs: This group includes mostly multifamily residential property owners. Screen for them here.

Retail REITs : These own regional shopping centers, outlet centers and small neighborhood centers. Find them here.

Property management REITs: This includes property managers plus diversified REITs and others, such as restaurant and service station owners, that don't fit into the other groups. Try this screen.

As is the case with any screen, the stocks turned up are candidates for further research, not a buy list.

REIT earnings explained

Generally accepted accounting practices (GAAP) require that commercial property owners depreciate the cost of their properties down to zero over a specified time, say 20 years. Obviously, that's not realistic since most real estate goes up, not down in value, over time. Since GAAP requires deducting deprecation when computing net income, the result doesn't tell you much about a property REIT's performance.

So the National Association of Real Estate Investment Trusts (NAREIT) came up with funds from operations (FFO) as another performance gauge. Basically, FFO adds back depreciation and amortization charges to net income and excludes gains or losses from property sales.

At the time of publication, Harry Domash didn't own any stocks mentioned in this article. He does own or control the following REITs that were turned up by the screens on Feb. 17, 2004: Redwood Trust (Diversified) and Chelsea Property Group (Retail).

Editor's Note:Most analysts forecast FFO (funds from operations) instead of earnings for property REITs. So even though labeled EPS in the earnings forecast summaries listed on practically all financial sites, including MSN Money, the figures really show the analysts' FFO per-share forecasts. Consequently, when you use MSN's Deluxe Screener to screen for forecast earnings growth, the figures used are actually the FFO growth forecasts.