High-Yield REITs Show Strength As U.S. 10-Yr Treasury Falls Below 2%

A recent Wall Street Journal article highlighted how deflation fears fueled by the recent downward spike in the price of oil has spurred investors to look for "safe havens."However, in contrast to the weaker global economic forecasts for 2015, the U.S. economy remains relatively strong. One way for investors to profit from the strength in the U.S. economy has been to invest in the commercial real estate sector.

A High Yield Alternative

During the trading day Tuesday, January 6, the U.S. 10-Yr Treasury note interest rate fell to 1.964 percent.Income investors looking for higher yields often consider the U.S. REIT sector, because REITs are required by law to pay out at least 90 percent of taxable income as dividends to shareholders.

A Quick Screen -- Relative Strength

The equity REIT sector had an incredible run during 2014, with many REITs having reached new highs during the past year.During trading on January 6, there were a total of 27 equity REITs that gained 1.25 percent or more in share price -- with a market capitalization of $1 billion or more -- that traded or closed at new 52-week or all-time highs. As these REIT shares continue to climb in value, (effectively lowering the dividend yield in sympathy with the 10-Yr Treasury note), it indicates that some investors view these REITs as a "safe haven."

Market Cap Range

The largest REIT in this group, by market cap, was $60 billion Simon Property Group Inc (NYSE: SPG). This well-known mall landlord traded up $5.18 to a new high of $191.28 for a dividend yield of only 2.72 percent.Data center REIT QTS Realty Trust Inc (NYSE: QTS) was the smallest of the 27, sporting a market cap of just over $1 billion. QTS shares hit an intra-day, all-time high of $35.98, closing up 1.34 percent for the day, with a dividend yielding 3.25 percent.

Kicking It Up A Notch

There were 18 REIT stocks that fit all the criteria while yielding over 3 percent.However, investors looking to make at least 2 percent risk premium over the 10-Yr note would typically only consider REITs that meet the relative strength screen while yielding over 4 percent. This narrows the field considerably, with only 8 equity REITs meeting all the criteria:Single-Tenant Triple-Net Sector

• $5.48 billion National Retail Properties, Inc. (NYSE: NNN), yielding 4.05 percent.
• $11.2 billion Realty Income Corp (NYSE: O), yielding 4.38 percent.
• $4.91 billion Spirit Realty Capital, Inc (New) (NYSE: SRC), yielding 5.43 percent.

Healthcare Sector

• $25.9 billion Health Care REIT, Inc. (NYSE: HCN), yielding 4.02 percent.
• $21.2 billion HCP, Inc. (NYSE: HCP), yielding 4.72 percent.
• $5.36 billion Omega Healthcare Investors Inc (NYSE: OHI), yielding 4.95 percent.
• $2.3 billion American Realty Capital Healthcare Trust Inc (NASAQ: HCT), yielding 5.41 percent. (Note: HCT is to be acquired by Ventas, Inc. during 2015).

Specialty Office/R&D

• $4.44 billion Biomed Realty Trust Inc (NYSE: BMR), yielding 4.45 percent

A Dual-Edged Sword

While these high yields may look attractive, it is also crucial for investors to weigh the current high valuations of many REITs. The two most common ways to value REITs are by looking at the underlying net asset value (NAV) of the real estate and by comparing FFO multiples (similar to P/E ratios for C-Corps).

Investor Takeaway

Inevitably, interest rates will rise, and the value of rate sensitive REIT shares will fall -- unless management is able to grow cash available for distribution (CAD), which is often referred to as AFFO or adjusted funds from operations.This can be accomplished by increasing cash flow from the underlying leases through contract rent escalations, market rent increases and reducing vacancy. Alternatively, management can work to lower costs by spreading G&A over more properties, or by the ability of the REIT to managing its balance sheet to lower the overall cost of capital.Many REITs have already taken advantage of the recent low interest rate environment to replace variable rate and higher cost fixed debt with lower cost debt, effectively increasing their CAD.