Why REITs Are One of the Top Sectors for Income Investors Right Now
by David Fessler, Investment U's Advisory Panelist
Friday, January 21, 2011: Issue #1433
If you're among the many millions of baby-boomers approaching retirement, there's an excellent chance that you've focused your investment portfolio heavily towards one main investing theme: Income.
But the ballgame has changed significantly.
Not so long ago, traditional income-based investments like high-yield savings accounts, bank CDs and U.S. Treasuries were the most popular choices.
But these days, those choices are akin to dumping your money in the living room and staring at it, in hope that it will somehow multiply.
Income from them won't even feed your pets, let alone allow for a comfortable retirement.
But here's an investment that will - my big income idea for 2011...
REITs... Wall Street's New Investment Gem
It's no surprise that Real Estate Investment Trusts - better known as REITs - are quickly becoming Wall Street gems among in-the-know investors. After all, REITs boast some of the highest yields on the market and were one of the best-performing areas in the financial sector last year.
For example, the Vanguard REIT ETF (NYSE: VNQ) - which holds nearly 100 different REITs - closed out 2010 with a respectable 24% gain. That's in stark contrast to the broader financial sector, which pretty much flat-lined during 2010.
For 2011, I expect REITs to perform in a similar fashion as last year, while churning out large dividends. Why? Cheap money...
What Makes REITs Such Great Investments?
When interest rates are low - as they were last year - REITs can make a killing. In fact, some are paying over 19% interest to shareholders.
So how do REITs offer the kind of killer returns we're talking about?
Their business model is quite simple:
- They borrow money using low-interest, short-term securities.
- Then they use those funds to purchase high-interest, long-term assets.
- Investors pocket the difference, known as the "spread," which can be substantial.
As long as interest rates remain low, they can continually refinance their short-term borrowings, thus boosting their profits and dividend payouts for shareholders. And the consensus is that interest rates will remain low. Here are a few key reasons why:
- Unemployment continues to hover just below 10% and will likely remain there for the foreseeable future.
- Inflation is nowhere to be seen.
- We may see more "quantitative easing" from the Federal Reserve.
In addition, REITs are required by law to distribute 90% of their taxable income to shareholders. This keeps dividend payments stable, further increasing their attractiveness to income-seeking investors.
The Top Two REITs on the Block
Having scoured the market, there are two REITs that stand out from the pack...
The first is Annaly Capital Management, Inc. (NYSE: NLY). Annaly owns, manages and finances real estate investments. Its massive portfolio mostly includes assets that it's purchased from Fed-backed Fannie Mae (NYSE: FNM) and Freddie Mac.
And for income hunters, the company throws back an annual $2.56 per share to investors - a 14.5% dividend yield.
Even in the rough real estate climate, Annaly is faring extremely well. It's strung together several quarters of strong results, which should keep those high dividends flowing to shareholders throughout 2011.
In addition, consider American Capital Agency Corporation (Nasdaq: AGNC). Similar in structure to Annaly, American Capital's earnings come from investing in residential pass-through securities and collateralized mortgage obligations (CMOs).
And like Annaly, it's safe in the knowledge that, Fannie and Freddie guarantee these securities, while some others are backed by the Government National Mortgage Association (Ginnie Mae).
You should steer clear of REITs that don't invest in government-backed securities. They carry significantly higher implied risk, with little difference, if any, in yield.
American Capital sports a whopping 19.5% yield a $5.60 per share payout each year.
REITs: Giving Your Portfolio a One-Two Punch
It's also worth keeping in mind that while most investors are drawn to REITs for their high-income producing ability, some REITs generate healthy capital appreciation, too. That one-two punch, coupled with virtually no default risk, is compelling, to say the least.
As long as interest rates and inflation remain close to zero, REITs will continue to generate significant earnings... and monster dividends for shareholders who decide to invest in them.
If you're looking for high income with relatively low risk, REITs could be for you.