Berko: REITs are a smart investment

Dear Mr. Berko: Please tell me what a real estate investment trust is. And what can you tell me about Realty Income Corp., which sells for $48 and pays 4.8 percent? Would you recommend a 200-share investment?

— TW, Bethlehem, Pa.

Dear TW: Real estate investment trusts, or REITs, are companies that own several, possibly 1,000, commercial buildings — e.g., medical-related properties, office buildings, shopping malls and rental apartment complexes. They trade on major exchanges and distribute 90 percent of their income in the form of dividends. And in most instances, those dividends aren’t taxable, because the properties’ depreciation is passed on to the REIT holder, and each dividend reduces his cost basis. So when you sell a REIT, you will pay long-term capital gains taxes. What a swell way to convert ordinary income to the lower long-term tax rates.

This market has been hot as Hades. It’s been bid up by yield-starved investors treating REITs as an alternative to low-yielding bonds, though REITs don’t provide the same protection. Last year, the Dow Jones Equity All REIT Total Return Index (REIT-1,455.89) was up 23.2 percent. However, in 2015, the possibility of rising interest rates has caused REIT to fall about 10 percent so far. If investors believe that Federal Reserve Chair Janet Yellen will raise rates, they may flee this sector as the prospect of owning bonds becomes more appealing. However, because the very important Chinese market and economy are tanking, there are a growing number of market-watchers who will pooh-pooh a raising of rates in 2015. Still, there’s about a 25 to 30 percent chance that Yellen will raise rates this year.

But it’s a smart move to include REITs in your portfolio because over 13 percent of our 2014 gross domestic product was attributed to real estate, rentals and leasing. (Housing falls into another category.) My rule of thumb suggests that REITs could comfortably constitute between 5 and 8 percent of a long-term growth and income portfolio. According to Goldman Sachs, a portfolio with $100 invested in the Dow Jones U.S. Completion Total Stock Market Index (DWCPF-1,094.99) in 1987 would have appreciated to $5,376 by the end of June. However, if one invested $90 in the DWCPF and just $10 in the REIT, it would have turned into $6,097 in that same time frame. And that’s gospel!

Realty Income (O-$48) is an attractive real estate investment trust that I am comfortable recommending. O owns 4,338 commercial properties, with 66.38 million leasable square feet in 49 states and a 98.73 percent occupancy rate, and the tenants are primarily under long-term triple-net leases. Walgreens, FedEx, CVS, Sam’s Club, Dollar General, the U.S. government, Wal-Mart, AMC Theatres, LA Fitness, Rite Aid, Circle K and Regal Entertainment Group are a dozen of O’s biggest customers. Lesser lessees that are also recognized national names — such as Taco Bell, Panera Bread, CarMax, 3M and Firestone — garnish O’s blue chip clients. O won’t lease to pikers.

As most readers know, during the past 35 years, I’ve consistently preached dividend stocks, primarily those that have a long history of yearly dividend increases. And O’s $2.28 dividend, which yields 4.8 percent, has increased every year since O came public in 1994. The latest dividend will be O’s 81st consecutive quarterly dividend increase, and since 1994, the dividend has enjoyed an annual 5 percent compounded growth. Since 2004, the dividend has nearly doubled. And slow construction since the end of the Great Recession has constrained the supply of leasable spaces, which augurs well for commercial property owners. So prospects for O’s commercial property business remain strong (79 percent of revenues) and robust. Top- and bottom-line growth should continue improving revenues, earnings and dividends.

Although the shares are still a bit high, I’d be a buyer at $48. A 5 percent compounded dividend will grow to $4.56 in 10 years, and that ain’t chopped liver.