Real estate investment trusts, or REITs, are popular investment choices among dividend investors, and it's easy to see why -- they generally have above-average dividend yields and many have distributed consistently growing income for decades. In fact, there are some rock-solid REITs in the market that have dividend yields greater than 5%.
However, not all REITs with high dividend yields make great investments. Here's a quick guide to why REIT dividends tend to be so high, how to tell a solid high-dividend REIT from one that should be avoided, and three REITs with 5% or higher dividend yields you might want to take a closer look at.
Why are REIT dividend yields so high?
The short answer is that REITs pass most of their income through to investors, instead of reinvesting profits in the business or using them to buy back shares like many companies do.
The longer version is that a REIT is a special type of corporation that enjoys a valuable tax benefit -- specifically, REITs don't pay any corporate income tax on their profits. However, in order to avoid corporate income tax, REITs are required to distribute a minimum of 90% of their taxable income to investors.
In practice, "taxable income" doesn't tell the full story of how much profit a REIT earns (a metric called funds from operations, or FFO, is far better for that), so most REITs pay out significantly more than 100% of their taxable income. In simple terms, REITs typically pass most of their profits through to investors, which is why they tend to have such high dividend yields.
How to make sure a high yield isn't too good to be true
Before you start buying high-dividend REITs, it's important to point out that while REITs are designed to be generally stable ways to generate income, that isn't true in all cases. As a dividend stock investor of any kind, you should know how to distinguish between a safe dividend paid by a solid company and a dividend yield trap, which is a common nickname for stocks that pay dividends that are too good to be true.
There's no magic formula that allows you to find a yield trap with 100% accuracy, but there are some telltale signs to watch out for. The presence of any one or two of these doesn't necessarily mean you're looking at a yield trap, but they are definitely a good reason to take a closer look.
Dividend yield trap red flags, and what you should look for instead
With that in mind, here's a handy list of what you don't want to see when researching high-paying REITs to buy, as well as some of the things you should look for:
- Avoid high payout ratios: As mentioned earlier, funds from operations (FFO) is the best metric to gauge a REIT's profitability. While REITs generally pay out the bulk of their profits to shareholders, you certainly don't want to see that a REIT is paying more than it's bringing in. By dividing a REIT's current annual dividend by its last 12 months of FFO, you can calculate the FFO payout ratio. I like to look for FFO payout ratios less than 80%, but as long as it's comfortably under 100%, there's not necessarily a reason for alarm.
- Too much debt is a sign of trouble: If a company has a high debt burden (or specifically a high interest expense), it can make it tougher to maintain its dividend in tough economic times. There's no set rule in regards to how much debt is too much -- my particular preference is a debt-to-EBITDA below 6.0 -- but by comparing a REIT's debt-to-EBITDA ratio or its interest coverage (the ratio of its FFO to its interest expense) with some of its peers, you can get a sense of whether a company's debt is appropriate or excessive.
- Declining revenue can be a bad sign: You want to invest in REITs that not only can maintain their dividends but can afford to increase their payouts over time. Therefore, you should look for a REIT whose revenue has steadily increased over the past several years. On the other hand, declining revenue could be a sign of a troubled business or a declining industry, neither of which are good for dividend sustainability.
Just to reiterate, just because you notice one of these characteristics doesn't necessarily mean that you have a yield trap. For example, maybe a REIT recently sold some of its assets and its revenue temporarily declined. Or, maybe a REIT's payout ratio is a little on the high end because of a slight (but manageable) dip in rent collections during the COVID-19 shutdowns. But in most cases -- especially if two or more of these are clearly present -- these indicate that a REIT's dividend yield might not be sustainable.
3 top real estate stocks with dividends above 5%
With interest rates at such a persistently low level, finding yield is extremely difficult. Investors looking for income should take a look at the REIT market for stocks that pay above-average dividends. REITs are required by law to pay out 90% of their earnings as dividends, which pretty much means big yields. Here are three REITs with yields over 5% that an income investor should consider.
New Residential has numerous business lines that will perform in all environments
New Residential (NYSE: NRZ) is a mortgage REIT that invests primarily in mortgage-backed securities, which are guaranteed by the U.S. government. The company also owns mortgage servicing rights and is a top-tier nonbank mortgage originator. This gives New Rez a diversified portfolio of operations that should perform well in all interest rate environments.
New Residential’s core portfolio consists of agency mortgage-backed securities, which are guaranteed by the U.S. government. The company also owns mortgage servicing rights, which are an unusual financial asset. The mortgage servicer collects mortgage payments, sends them to the ultimate investor, ensures property taxes and escrows are paid, and handles delinquencies. The servicer gets a fee of 0.25% per year as compensation for performing these services. Mortgage servicing is one of the few assets that increases in value as interest rates rise, which makes it an attractive asset in this environment.
Finally, New Rez has been building its mortgage origination arm and recently completed its acquisition of Caliber, which puts New Rez in the top tier of mortgage originators. At current levels, New Residential is trading with a dividend yield of 9.2%.
Employees will be heading back to the office
SL Green (NYSE: SLG) is a REIT in an out-of-favor sector: office space. SL Green is the largest office landlord in Manhattan. The COVID-19 pandemic has caused investors to question the office REIT business model, given that work-from-home has proven effective. New York City office space is extremely expensive, and the fear is that firms will relocate for cheaper, lower-taxed areas.
SL Green’s tenant base is 33% tech, media, and advertising, 30% financial services, and 11% legal services. On its earnings conference call, the company stated that the majority of its tenants were expected to return this fall and new leasing activity has been continuing. While the delta variant of COVID-19 may have pushed some returns back, the overall trend is to head back to the office.
SL Green’s Manhattan-based portfolio has an additional benefit: While it's easy for commuters to get from the suburbs to Manhattan, it is not so easy to go from one suburb to the other. Any move to cheaper suburban real estate will alienate a good percentage of a company’s employees.
The company has been through the worst of the COVID-19 pandemic, and the company is seeing year-over-year decreases in funds from operations as the company had less bargaining power during the pandemic. These effects should largely be over. SL Green pays a monthly dividend of $0.303, which works out to be a 5% dividend yield.
Redwood Trust doesn’t need to fear the Fed
Redwood Trust (NYSE: RWT) is another mortgage REIT; however, it doesn’t have the same exposure as most agency REITs. Redwood Trust invests primarily in mortgage-backed securities, which are not guaranteed by the U.S. Government. Redwood’s portfolio is made up of mortgages that are too large to qualify for a government guarantee (jumbo mortgages). It also invests in business-purpose real estate loans for professional developers.
These loans have one big advantage over government-guaranteed loans: They are less interest-rate sensitive. This means that as the Fed raises rates and pulls back on its purchases of mortgage-backed securities, these loans will suffer much less. Since Redwood is taking credit risk, it benefits from home price appreciation, which has been growing at a 19% clip, according to the FHFA House Price Index.
This means that even if the borrower defaults on the loan, Redwood will get its money back after foreclosure because the property will be worth much more than the loan. Redwood just bumped up its quarterly dividend to $0.21, which gives the company a dividend yield of 6.4%.