A yield hunter walks into a bar, sees a bunch of nice-looking men and women, but then gasps in delight. Not at the men and women, but at the other side of the room. Could they be casting agents working for HGTV or “Million Dollar Listing?” Not quite, but almost as good. Its a crowd of beautiful-yielding REITS looking for love. How can our intrepid yield hunter choose? Here’s an idea: Get to know them not as equity vehicles but based on inner beauty . . . as sincere, genuine portfolios of real estate; dirt, bricks, mortar, tenants, rent checks, etc.

Land, land, land. Now all we need is a beautiful dividend. Cue the REITs (and the violins). Photographer: James MacDonald/Bloomberg

The inner soul versus the outer surface of a business

Suppose you buy shares of Apple (AAPL). Legally speaking, you are indeed, a part owner of the business and accordingly, have a stake in whether Tim Cook continues as CEO, how the newest generation of phones should be priced and what their specs will be, etc. Yeah, right.

The technical fact of legal ownership is just that . . . a hyper-technical fact and your percentage stake is likely to round to 0% unless you extend the computation to a lot of decimal places. And the legalities of the corporate structure makes it highly unlikely you were consulted by anybody else connected with Apple about much of anything, other than which credit card you want to use when you buy one of the company’s products at an Apple Store. And, by the way, don’t even think of asking detailed questions of the sort any diligent business owner should be expected to routinely ask, lest you and whoever gave you the answers, wind up indicted or worse for insider trading.

So assuming I can avoid sleeping and snoring too loudly as gurus yammer about how shareholders should think of themselves a business owners, I go right back to doing what shareholders in the public market must do simply by virtue of the legal characteristics and scale of the public market—choosing and analyzing pieces of paper (or nowadays, bits of digital storage we use in lieu of paper stock certificates).

Publicly traded REITs, although trusts rather than corporations, share much the same characteristics when it comes to information and operational control. So the natural inclination is to similarly treat REITs as pieces of paper and work with the information we find in public filings. Details of the items we look at may differ (funds from operations, for example, instead of net income) and we may evaluate conventional things differently (debt leverage is more routine for this kind of business) but at the end of the day, all that changes are the details: The process, working with 10Qs and 10Ks, is the same.

So far, it looks like it’s Outer Surface: 1, Inner Soul: 0.

A case for thinking differently 

Suppose we really could evaluate Apple as if it were, in substance and not just in legal form, an ongoing real-world business in which we had a stake. Would you do it? I sure as heck would. Having really good information and bona fide control is preferable if you can get it. That’s why takeovers are typically priced at premiums to public market valuations. It’s why the legal consequences of sticking your nose into places where it shouldn’t be can be severe. The Feds understand the temptation and really need to deter.

Interestingly, though, with REITS, while we can’t get the true insider’s view nor can we exercise insiders’ control, the nature of the available data and the characteristics of the business allow us to move a step closer to the ideal than we can with many other kinds of businesses. 

I’m an investment professional, rather than a real estate pro. But my wife is involved in real estate as are many others we know and as a lawyer in New York, I availed myself of the opportunity to quickly get a Real Estate Broker’s license. And to keep my marriage intact, I became a full-fledged realtor and power-user of the local MLS (multiple listing service) platform. (New York City is infamous for not having an MLS, but that’s just Manhattan; I’m in Queens which, having joined forces with Long Island, is part of the third-largest realtor board and MLS in the U.S.) 

What a life: Not only am I a numbers guy from 9 to 5, I’m also a numbers guy from 5 to 9. 

The point is, I understand how real estate folks think (and I use the word “think” very loosely considering many of the valuations prevalent in the New York City area). I can’t replicate it all for REITs using publicly available information. But I believe I can get usable versions of two important metrics,“cash on cash return” and “capitalization rate,” when I access and use the data on Portfolio123.com. 

The numbers I get aren’t the the same as the ones management has; they are precise and have it property by property. Mine are approximations, and are aggregates for the entire REIT which, for all practical purposes, is the entire real estate portfolio. But that’s OK. I’ve long believed in and preached the doctrine that it’s better to be vaguely right than precisely wrong.

My Approach

The ideal for any income seeker is to simply invest in the securities offering the highest yields one can find. The reality is that the higher the yield, the more likely it is that this is being caused by declines in prices due to selling pressure from investors who anticipate a divided cut or elimination. Therefore, the income-seeker’s task is to identify the highest yields available for a subset of the dividend group that is likely to be able to at least maintain the level of the dividend (the ability to grow the dividend would also be nice).

Based on that logic, I rank “eligible” REITs by yield and choose the top five issues. Whether the model I use succeeds or fails will depend on how successful I am in prequalifying the group to eliminate actual or potential dogs before I sort for yield.

Here’s how I do it:

*I start by eliminating a group known as mortgage REITs. I want genuine real estate operations, not wannabe-but-less-regulated banks. The data I use doesn’t work for them and I’m not confident in my ability to evaluate the kinds of risks they present.

*Next, I try to weed out dividend problems that have already surfaced. I ban REITs that have eliminated the dividendin any of the last four quarters. In a perfect world where we could always count on dividend achievers, dividend aristocrats, etc., I’d also expel REITs that have reduced, but not completely eliminated, the dividend in any of the past four quarters. But if we’re going to focus on business rather than investment-guru factors, we have to cope with the reality that sometimes, life stinks. As pass-through entities required to pay pretty much all their earnings to shareholders (which means they don’t have the luxury of being able to pay out much smaller portions of earnings so they can smooth things when they hit some turbulence), even good, worthwhile, REITS are going to reduce payouts every now and then. We’re trying to reduce the likelihood this will happen in the future while we hold the shares, but if we wag our fingers every time it happened in the past, we’ll eliminate far too many meritorious operations. So I’ll tolerate reductions in dividend over the past four quarters, so long as the drop wasn’t so severe as to be the functional equivalent to an elimination.

*The next test may come as a surprise considering how I waxed poetic about the virtues of the high-to-low yield sort. No REIT makes it into my sorting if its yield is in the top 10% relative to the REIT group. In my experience, I’ve seen many times that the best way to handle a sort is to quickly wipe out the very top (the candidates assumed by naive observers to be the cream of the crop). I don’t want to get into debates on market efficiency or mean-reversion here, but I have found, by observation and by research, that Mr. Market is remarkably good at recognizing the most dangerous income plays and signaling the world by pricing the securities such as to push yields up to the stratosphere. It’s as if you're looking to buy a house and comparable properties in the area have been going for about $650,000 and your agent proudly suggests one that photographs beautifully and is listed at $280,000. If the agent doesn’t the have an immediate and credible answer when you ask “What’s wrong with it?” (as I hope you would), decline the showing and find a new agent.

* Next I look at cash-on-cash return and limit consideration to REITs that rank in the top 50% of the group when the numbers are calculated for the trailing 12 months and also over the past five years. This does not have a direct and immediate impact on capacity to pay dividends, but bad numbers here do suggest possibilities with which I’d rather not associate: Relative to other REITs, those with bad cash-on-cash returns are overpaying for properties and/or aren’t great when it comes to extracting cash flow from them. (A private investor with suitable liquiditymight tolerate low or even negative cash-on-cash returns in anticipation of changes that will produce strong priceappreciation. But that doesn’t work for REITs that are seen as income vehicles.)

* Finally, I address (debt) leverage. REITS, whose debt is typically secured by mortgages on income-producing properties can and usually do carry heavier borrowings than do many other kinds of businesses. But even here, there comes a point where enough is enough. Banks understand this and those that choose not to act like reckless jerks have standards regarding how much debt a property can safely carry. This is important: Real estate operators are remarkably adept at seeing to it that when projects fail, it’s somebody else’s money, not theirs, that vaporizes. So I won’t invest in a REIT with a debt-to-equity ratio above 2. 

Those are my gatekeepers. (I tried working with capitalization rate too; think of it as a cousin to operating margin) but haven’t yet found a strategy in which it's productive for my purposes.) Among the limited number of REITs that make it into my personal promised land, I’m comfortable picking the five with the highest yields. 

The Catch—Sort of

This strategy requires a genuinely low-cost brokerage account. The model and the stock list is refreshed every four weeks and you can expect to trade at least one and usually more stocks on each occasion. In a way, though, this evens the scales for public shareholders versus hands-on operators. They have the advantages of control and more precise information. So we owe it to ourselves to take advantage of the built-in edge we have; we can get in and out a heck of a lot more easily than they can. Simulations I’ve done suggest you should expect to turn the portfolio over 5-6 times per year. So think of yourself as a dividend trader rather than a long-term investor.

Performance Testing

I know past performance assures us of nothing regarding the future and relative to quants in the investment field, I’m probably more open and loud about this. But I also understand that if a strategy is based on ideas that make sense, rather than a statistical treasure hunt to see what just so happens to have worked in one or more past periods, you can learn a lot from backtesting. So in that spirit, I offer some tests of this strategy in comparison to a simple one-stop buy-and-hold REIT strategy: the Vanguard REIT ETF (VNQ).

Before getting to the nitty gritty, let’s start with dessert: the yields.

Table 1

That’s a good start. Now, though, the question becomes whether the high yield comes at a cost; lesser share gains and/or greater losses.

Basic backtest results are shown in Table 1. These are “total return” figures that reflect the impact of dividends and share price change.

Table 2

* In all cases, Alpha is computed relative to the a generic fixed-income ETF, the Vanguard Total Bond Market RTF (BND).

Table 2 shows a “rolling” backtest. It addresses for the possibility that what we see in Table 2 reflects the luck of the draw when it comes to the starting date; in other words, whether things might look different if we started the test on a different day and, hence, had a different set of once-every-four-week re-runs of the model. In the rolling test, we look at a lot of self-contained four-week portfolios that start every week. Here, we examine the results of all these one-shot portfolios (519 of them in the 10-year test) and compare the average returns achieved over the course of the four week intervals to the average return for the benchmark (the VNQ ETF) during those same four-week periods.

Table 3

Current Portfolio Holdings

Here are the five REITs currently in the portfolio:

CoreCivic (CXW): A private prison operator with a yield of 6.48% previously discussed by me.

LaSalle Hotel Properties (LHO): A portfolio of upscale full-service hotels in major urban, resort or convention locales whose REIT shares yield 6.19%

Outfront Media (OUT): A provider of out-of-home advertising structures and sites mainly highway billboards; the yield is 6.75%

RLJ Lodging Trust (RLJ): A portfolio of premium-branded compact full-service hotels with a REIT yield of 6.08%

Sabra Health Care (SBRA): Invests in skilled nursing and assisted living-type facilities; the shares yield 6.18%

This is not a SWAN (sleep well at night) portfolio. For that I suggest a good Pinot Noir or something that yields, say, 2% or less. So don’t expect to look into any of these REITs and marvel about how all is great and wonderful. But that’s life nowadays. If you want big yields, you need to be able to live with baggage, or sleep well at night after a strong Espresso. This strategy takes on the baggage only because of the screening tests I use that seek a high probability of hanging in there until the next monthly re-run of the model. (I tested with longer holding periods: Not great.)

Finally, I do need to mention that this list is the result of the model having been updated on September 4. So we’re pretty close to the next update, at which all or some may get the boot. So if you’re interested in this strategy, rather than buying right away, you may want to familiarize yourself with these REITs to get a sense of the kind of baggage you have to carry in order to earn your yield.