Stock Quotes in this Article: ACC, NLY, RYN, SNH, SSS

MILLBURN, N.J. (Stockpickr) -- With bond interest rates at all-time-low yields to maturity, concerns about a double-dip recession and the beginning of baby boomer retirements, the need to generate income from one’s investment portfolio has become increasingly important and difficult to attain. I have written in the past about low volatility stocks that yield above market dividend rates. Now I want to turn to an entire asset class, Real Estate Investment Trusts.

REITs are companies that invest in real estate and receive special tax treatment. Provided that a REIT distributes 90% of its taxable income to investors, then the REIT can avoid taxes at the corporate level, hence removing the double tax quandary that many investors face.

The REIT business has grown tremendously over the last decade. According to the industry group National Association of Real Estate Investment Trusts, the market capitalization of REITs representing 153 companies at the end of 2010 was $389.3 billion. Be forewarned that REITs do carry many risks that other stocks face such as the vagaries of the economy, interest rates and financing availability.
It is necessary to introduce a unique metric for REITs. This metric: Funds From Operations, measures cash generation by the REIT. FFO equals net income plus depreciation plus amortization and less gains on property sales. FFO can then be equalized on a per-share basis. In order to compare REITs, one can use the ratio of price-per-share to FFO-per-share, sort of a proxy for price-to-earnings ratio for the industry.

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    REITs can be divided into many different subsectors. It is the purpose of this article to put together a portfolio of REITs across several of those sectors.

    American Campus (ACC)

    REIT Subsector: Apartments
    Market Cap $2.7 billion
    Dividend Yield 3.51%
    P/FFO 21.6

    My wife and I have three children in college or graduate school, with more yet to enroll in the future. One of the most challenging aspects of going to college is finding housing. Most students live in campus housing their freshman and/or sophomore year. However the dormitory experience gets real tired quickly and students seek off-campus housing. I also know several people who own off-campus residences which they rent out to students. This is a good business, a very good business which also tends to somewhat immune to declining economic conditions. The same cannot be said for general housing REITs which tend to focus on apartment buildings and cater to families. The best pick in this subsector is American Campus Communities, owns and operates off-campus housing in and around colleges and universities. American Campus’ P/FFO is less than that of the two largest residential REITs, Equity Residential (EQR) (25.0) and Avalon Bay (AVB) (28.8). Furthermore, American Campus’ dividend yield is greater than that of Equity Residential (2.23%) and Avalon Bay (2.65%). Taken together, American Campus is my top choice in this subsector.

    Rayonier (RYN)

    REIT Subsector: Diversified
    Market Cap $5.0 billion
    Dividend Yield 3.92%
    P/E 20.7

    The diversified subsector is kind of a catch all for everything does not fit elsewhere in the REIT kingdom. However, a large part of this subsector is the forestry and timber companies. Unlike most other REITs, the concept of FFO is less important (but not irrelevant) for forestry and timber companies and we can rely at least in part on the more conventional concept of PE ratios for analytic comparisons.

    There are three major forestry and timber REITs to choose from: Plum Creek Timber (PCL), Rayonier and Weyerhaeuser (WY). Immediately I would knock Weyerhaeuser out of contention in this category. The stock has acted poorly over many years and the dividend is less than its peers. That leaves us with Plum Creek Timber and Rayonier. I have followed these two companies for a while and can say that Rayonier has generated superior earnings growth to that of Plum Creek. While, Rayonier’s dividend of 3.92% is less than that of Plum Creek’s 4.55%, I am happy to pick up superior earnings and FFO growth with Rayonier, hence making Rayonier my choice in the sector.

    Senior Housing Property Trust (SNH)

    REIT Subsector: Healthcare
    Market Cap $3.6 billion
    Dividend Yield 6.37%
    P/FFO 13.1

    I thought long and hard about opportunities in the healthcare REIT subsector. On the one hand I could have easily selected HCP (HCP) which is one of the largest companies in this sector with extensive holding in senior housing, nursing homes, medical offices, life sciences and hospitals in the nation. With an estimated P/FFO of 14.23, HCP is rather cheap. That company’s FFO is expected to grow nearly 35% this year. A dividend yield of 5.28% is certainly welcoming. However, as our population is ever aging and the baby boomers set to retire, I chose to get more thematic in this sector and focus in on a pure play in Senior Housing Property Trust, which concentrates its investments on retirement communities and nursing homes. Senior Housing Properties Trust pays a more robust dividend of 6.37% and sells for a lower P/FFO of 13.1 than HCP. However, FFO growth has been erratic the last few year but I am confident that growth rate will increase in a positive fashion as our population continues to age.

    Annaly Capital Management (NLY)

    REIT Subsector: Mortgage
    Market Cap $16.9 billion
    Dividend Yield 14.9%
    P/E 6.7

    Annaly Capital Management was one of my featured low volatility stocks for a volatile market. As it also turns out, Annaly is a REIT. I would add that Annaly is the best in its class, led by a world-class mortgage specialist, Michael Farrell. If Annaly Capital Management is good enough for my low-volatility portfolio, it should no doubt be included in my diversified REIT portfolio.

    Sovran Self Storage (SSS)

    REIT Subsector: Storage
    Market Cap $1.1 billion
    Dividend Yield 4.53%
    P/FFO 15.5

    If you are a fan of Storage Wars as we are in the Rothbort household then you would know that the self-storage business is big. People will pay to keep valuable items as well as junk in storage lockers. The storage business is growing as more and more people are losing their homes due to the mortgage crisis. The REIT storage subsector offers interesting opportunities that are worth taking advantage of. The largest player in this subsector is Public Storage (PSA) with a $22 billion market capitalization that dominates the industry. But the stock has a lower yield (3.13%), higher P/FFO (20.8) and declining FFO (-15.9%) relative to my pick in this sector, Sovran Self Storage.

    However, I would note that Public Storage has several preferred stock issues which offer superior yield to its common stock that I would suggest taking a look at for income-oriented investors. I currently own the Public Storage 6.5% Series Q Preferred shares, which currently yield 6.07%. For my REIT portfolio, I prefer to go with the higher yielding Sovran Self Storage which also has the potential for greater future growth and as a future takeover.

    There are some other REIT sectors that I have decided not to consider at this juncture due to the economic uncertainty which is being faced by the consumer and a paucity of new business creation due to the lack of pro-business policies by the Obama administration in Washington. These subsectors are: Office Properties; Regional Malls; Shopping Centers; and Warehouses.

    -- Written by Scott Rothbort in Millburn, N.J.

    At the time of publication, author was long NLY ad PSA 6.5% Ser Q Preferred.

    Scott Rothbort has over 25 years of experience in the financial services industry. He is the founder and president of LakeView Asset Management, a registered investment advisor specializing in customized separate account management for high net worth individuals. In addition, he is the founder of TheFinanceProfessor.com, an educational social networking site, and publisher of The LakeView Restaurant & Food Chain Report. Rothbort is also a professor of finance at Seton Hall University's Stillman School of Business.

    RELATED LINKS:

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